Edgar Filing: APRIA HEALTHCARE GROUP INC

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Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2010

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

For the transition period from to .

Commission file number 333-168159

APRIA HEALTHCARE GROUP INC.

(Exact name of Registrant as specified in its charter)


Delaware		33-0488566
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

26220 Enterprise Court Lake Forest, California		92630
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (949) 639-2000

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 ¨ No x

(Note: the registrant became subject to the filing requirements of the Securities Exchange Act of 1934, as amended, on August 13, 2010)

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

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

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

As of November 1, 2010, there were 100 shares of the issuer’s common stock, par value $0.01 per share, issued and outstanding.

APRIA HEALTHCARE GROUP INC.

FORM 10-Q

TABLE OF CONTENTS


		Page No.
	PART I—Financial Information
Item 1.	Condensed Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and December 31, 2009		4
	Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and September 30, 2009		5
	Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and September 30, 2009		6
	Notes to Unaudited Condensed Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		55
Item 4.	Controls and Procedures		55

	PART II—Other Information
Item 1.	Legal Proceedings		57
Item 1A.	Risk Factors		57
Item 2.	Unregistered Sale of Equity Securities and Use of Proceeds		70
Item 3.	Defaults Upon Senior Securities		70
Item 4.	[Removed and Reserved]		70
Item 5.	Other Information		70
Item 6.	Exhibits		71
SIGNATURES			72

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q includes forward-looking statements regarding, among other things, our plans, strategies and prospects, both business and financial. These statements are based on the beliefs and assumptions of our management. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Generally, statements that are not historical facts, including statements concerning our possible or assumed future actions, business strategies, events or results of operations, are forward-looking statements. These statements may be preceded by, followed by or include the words “believes”, “expects”, “anticipates”, “intends”, “plans”, “estimates” or similar expressions.

Forward-looking statements are not guarantees of performance. You should not put undue reliance on these statements. You should understand that various important factors, in addition to those discussed elsewhere in this quarterly report on Form 10-Q, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in our forward-looking statements:

•

trends and developments affecting the collectibility of accounts receivable;

•

government legislative and budget developments that could continue to affect reimbursement levels;

•

potential reductions in reimbursement rates by government and third-party payors;

•

the effectiveness of our operating systems and controls;

•

healthcare reform and the effect of federal and state healthcare regulations;

•

economic and political events, international conflicts and natural disasters;

•

acquisition-related risks; and

•

the items discussed under “Risk Factors” in this quarterly report on Form 10-Q.

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing cautionary statements. We undertake no obligations to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

PART I. FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)


	September 30, 2010			December 31, 2009
	(in thousands, except share data)
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	151,798		$	158,163
Short-term investments		253			23,673
Accounts receivable, less allowance for doubtful accounts of $47,859 and $39,927 at September 30, 2010 and December 31, 2009, respectively		308,392			252,133
Inventories		69,490			68,267
Deferred income taxes		88,010			87,016
Deferred expenses		3,219			3,049
Prepaid expenses and other current assets		25,112			24,362

TOTAL CURRENT ASSETS		646,274			616,663
PATIENT SERVICE EQUIPMENT, less accumulated depreciation of $134,054 and $97,874 at September 30, 2010 and December 31, 2009, respectively		175,342			198,808
PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET		79,221			80,227
GOODWILL		760,247			759,197
INTANGIBLE ASSETS, NET		579,992			582,259
DEFERRED DEBT ISSUANCE COSTS, NET		56,510			63,110
OTHER ASSETS		7,384			8,783

TOTAL ASSETS	$	2,304,970		$	2,309,047

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	88,835		$	123,856
Accrued payroll and related taxes and benefits		62,690			66,842
Other accrued liabilities		126,531			100,768
Deferred revenue		27,176			27,253
Current portion of long-term debt		1,575			1,690

TOTAL CURRENT LIABILITIES		306,807			320,409
LONG-TERM DEBT, net of current portion		1,018,257			1,019,456
DEFERRED INCOME TAXES		264,709			259,030
INCOME TAXES PAYABLE AND OTHER NON-CURRENT LIABILITIES		30,892			31,421

TOTAL LIABILITIES		1,620,665			1,630,316
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Common stock, $0.01 par value: 1,000 shares authorized; 100 shares issued at September 30, 2010 and December 31, 2009		—			—
Additional paid-in capital		687,561			684,445
Accumulated deficit		(3,256	)		(5,714	)

TOTAL STOCKHOLDERS’ EQUITY		684,305			678,731

	$	2,304,970		$	2,309,047

See notes to unaudited condensed consolidated financial statements.

APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	(in thousands)
Net revenues:
Fee for service/product arrangements	$	486,027		$	479,193		$	1,433,562		$	1,434,063
Capitation arrangements		39,987			40,322			119,506			124,411

TOTAL NET REVENUES		526,014			519,515			1,553,068			1,558,474

Costs and expenses:
Cost of net revenues:
Product and supply costs		167,198			156,479			488,265			474,244
Patient service equipment depreciation		23,094			25,490			71,843			77,659
Amortization of intangible assets		—			42,200			—			42,200
Home respiratory therapy services		5,456			8,887			21,671			26,239
Nursing services		9,258			9,338			27,258			27,105
Other		2,978			3,261			9,871			8,718

TOTAL COST OF NET REVENUES		207,984			245,655			618,908			656,165
Provision for doubtful accounts		10,981			13,256			39,801			38,760
Selling, distribution and administrative		271,157			264,567			787,738			790,959
Amortization of intangible assets		1,035			(215	)		3,777			2,740

TOTAL COSTS AND EXPENSES		491,157			523,263			1,450,224			1,488,624

OPERATING INCOME (LOSS)		34,857			(3,748	)		102,844			69,850
Interest expense		32,736			32,055			97,971			96,624
Interest income and other		(250	)		(530	)		(555	)		(1,021	)

INCOME (LOSS) BEFORE TAXES		2,371			(35,273	)		5,428			(25,753	)
Income tax expense (benefit)		2,476			(12,292	)		2,970			(6,310	)

NET (LOSS) INCOME	$	(105	)	$	(22,981	)	$	2,458		$	(19,443	)

See notes to unaudited condensed consolidated financial statements.

APRIA HEALTHCARE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Nine Months Ended September 30,
	2010			2009
	(in thousands)
OPERATING ACTIVITIES
Net income (loss)	$	2,458		$	(19,443	)
Items included in net income (loss) not requiring cash:
Provision for doubtful accounts		39,801			38,760
Depreciation		93,722			95,164
Amortization of intangible assets		3,777			44,940
Amortization of deferred debt issuance costs		7,919			5,503
Deferred income taxes		4,686			(11,443	)
Profit interest compensation		3,194			6,165
Loss on disposition of assets and other		12,472			9,486
Other		—			(4,945	)
Changes in operating assets and liabilities:
Accounts receivable		(96,060	)		(23,756	)
Inventories		(1,223	)		1,852
Prepaid expenses and other assets		(270	)		(5,647	)
Accounts payable, exclusive of book-cash overdraft		2,730			(15,168	)
Accrued payroll and related taxes and benefits		(4,152	)		256
Income taxes payable		(2,126	)		3,434
Deferred revenue, net of related expenses		(247	)		(1,907	)
Accrued expenses		27,357			16,843

NET CASH PROVIDED BY OPERATING ACTIVITIES		94,038			140,094

INVESTING ACTIVITIES
Purchases of patient service equipment and property, equipment and improvements		(84,682	)		(101,926	)
Purchases of short-term investments		(8,087	)		(27,875	)
Maturities of short-term investments		31,507			1,746
Proceeds from disposition of assets		634			6,828
Cash paid for acquisition		(2,260	)		(1,161	)

NET CASH USED IN INVESTING ACTIVITIES		(62,888	)		(122,388	)

FINANCING ACTIVITIES
Proceeds from ABL Facility		—			630
Payments on ABL Facility		—			(6,630	)
Payments on Senior Secured Bridge Credit Agreement		—			(1,010,000	)
Proceeds from issuance of Series A-1 Notes		—			700,000
Proceeds from issuance of Series A-2 Notes		—			317,500
Payments on other long-term debt		(1,314	)		(2,170	)
Change in book-cash overdraft included in accounts payable		(32,533	)		(4,644	)
Debt issuance costs		(3,590	)		(18,495	)
Equity contributions		—			2,075
Cash paid on profit interest units		(78	)		—

NET CASH USED IN FINANCING ACTIVITIES		(37,515	)		(21,734	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(6,365	)		(4,028	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		158,163			168,018

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	151,798		$	163,990

SUPPLEMENTAL DISCLOSURES — See Note 6 and Note 9 for a discussion of cash paid for interest and income taxes, respectively.

Purchases of patient service equipment and property, equipment and improvements exclude purchases that remain unpaid at the end of the respective quarter. Such amounts are then included in the following period’s purchases when paid. Unpaid purchases were $5.8 million and $11.0 million at September 30, 2010 and December 31, 2009, respectively.

See notes to unaudited condensed consolidated financial statements.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation: The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These statements include the accounts of Apria Healthcare Group Inc. (“Apria” or “the Company”) and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation.

In the opinion of management, all adjustments, consisting of normal recurring accruals necessary for a fair presentation of the results of operations for the interim periods presented, have been reflected herein. The unaudited results of operations for interim periods are not necessarily indicative of the results to be expected for the entire year. For further information, refer to the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2009.

On October 28, 2008, the Company completed its merger (the “Merger”) with Sky Merger Sub Corporation (“Merger Sub”), a Delaware corporation and wholly-owned subsidiary of Sky Acquisition LLC, a Delaware limited liability company (“Buyer” or “Sky LLC”). Buyer is controlled by a private investment fund affiliated with The Blackstone Group (the “Sponsor”).

In March 2010, we effected a reorganization transaction pursuant to which we added two new holding companies, Apria Holdings LLC and Apria Finance Holdings Inc., to our corporate structure. Apria Holdings LLC is now a company beneficially owned by the Sponsor and certain members of our management and all of the equity securities of Sky Acquisition LLC held by such holders prior to the reorganization were converted or exchanged into equivalent securities of Apria Holdings LLC.

Company Background: Apria operates in the home healthcare segment of the healthcare industry, providing a variety of high-quality clinical patient care management programs, related products and supplies as prescribed by a physician and/or authorized by a case manager as part of a care plan. Essentially all products and services offered by the Company are provided through the Company’s network of approximately 500 locations, which are located throughout the United States. The Company provides services and products in two reportable operating segments: (1) home respiratory therapy and home medical equipment and (2) home infusion therapy. Within these two operating segments there are three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. Both segments provide products and services in the home setting to patients and are primarily paid for by a third-party payor, such as Medicare, Medicaid, managed care or other third-party insurer. Sales for both segments are primarily derived from referral sources such as hospital discharge planners, medical groups or independent physicians.

Use of Accounting Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Among the significant estimates affecting the consolidated financial statements are those related to revenue recognition and the resulting accounts receivable, share-based compensation, income taxes, goodwill and long-lived assets.

Revenue Recognition and Concentration of Credit Risk: Revenues are recognized under fee-for-service/product arrangements for equipment the Company rents to patients, sales of equipment, supplies, pharmaceuticals and other items the Company sells to patients and for capitation payments received from third party payors for services and equipment the Company provides to the patients of these payors. Revenue generated from equipment that the Company rents to patients is recognized over the rental period, typically one month, and commences on delivery of the equipment to the patients. Revenue related to sales of equipment, supplies and pharmaceuticals is recognized on the date of delivery to the patients. Revenues derived from capitation arrangements were approximately 8% of total net revenues for each of the three and nine months ended September 30, 2010 and the three and nine months ended September 30, 2009. Capitation revenue is earned as a result of entering into a contract with a third party to provide its members certain services without regard to the actual services provided, therefore revenue is recognized in the period that the beneficiaries are entitled to health care services. All revenues are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors, including private insurers, prepaid health plans, Medicare and Medicaid. For the nine months ended September 30, 2010 and 2009, revenues reimbursed under arrangements with Medicare and Medicaid were approximately 30% and 28%, respectively, of total revenues. In the nine months ended September 30, 2010 and 2009, no other third-party payor group represented more than 8% of the Company’s revenues. Rental and sale revenues in the fee for service/product arrangement revenue line item were:


	Three Months Ended September 30,								Nine Months Ended September 30,
*(dollars in millions)*	2010				2009				2010				2009
Rental	$	154.3	31.8	%	$	160.2	33.4	%	$	466.7	32.6	%	$	491.3	34.3	%
Sale		331.7	68.2			319.0	66.6			966.9	67.4			942.8	65.7

Total fee for service	$	486.0	100.0	%	$	479.2	100.0	%	$	1,433.6	100.0	%	$	1,434.1	100.0	%

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

In the Company’s business, there are multiple products that are delivered to patients. These arrangements involve equipment that is rented and related supplies that may be sold that cannot be returned. In arrangements with multiple deliverables, revenue is recognized when each deliverable is provided to the patient. For example, revenues from equipment rental supplies sales are recognized upon delivery of the products, as the supplies sold are considered a separate unit of accounting.

Cash and Cash Equivalents: Cash is maintained with several financial institutions. These financial institutions are located throughout the United States and the Company’s cash management practices limit exposure to any one institution. Book cash overdrafts, which are reported as a component of accounts payable, were $0 and $32.5 million at September 30, 2010 and December 31, 2009, respectively. Management considers all highly liquid instruments purchased with a maturity of less than three months to be cash equivalents.

Short-Term Investments: Certificates of deposit with maturities greater than three months from our purchase date are classified as short-term investments. In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments. As of September 30, 2010, the carrying value of the Company’s short-term investments approximates fair value and such investments do not individually exceed FDIC insurance limits.

Accounts Receivable: Included in accounts receivable are earned but unbilled receivables of $62.0 million and $44.6 million at September 30, 2010 and December 31, 2009, respectively. Delays ranging from a day up to several weeks between the date of service and billing can occur due to delays in obtaining certain required payor-specific documentation from internal and external sources. Earned but unbilled receivables are aged from date of service and are considered in the analysis of historical performance and collectibility.

Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record total net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review.

Management performs periodic analyses to evaluate accounts receivable balances to ensure that recorded amounts reflect estimated net realizable value. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and the extent of contracted business. Also considered are relevant business conditions such as governmental and managed care payor claims processing procedures and system changes. Additionally, focused reviews of certain large or problematic payors are performed. Due to continuing changes in the healthcare industry and third-party reimbursement, it is possible that management’s estimates could change in the near term, which could have an adverse impact on operations and cash flows.

Accounts receivable are reduced by an allowance for doubtful accounts which provides for those accounts from which payment is not expected to be received, although services were provided and revenue was earned. Upon determination that an account is uncollectible, it is written-off and charged to the allowance.

Deferred Revenue and Deferred Expense: A lessor is required to recognize rental income over the lease term. Rental of patient equipment is billed on a monthly basis beginning on the date the equipment is delivered. Since deliveries can occur on any day during a month, the amount of billings that apply to the next month are deferred. Only the direct costs associated with the initial rental period are deferred.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market and consist primarily of pharmaceuticals and items used in conjunction with patient service equipment. Inventories are written down to net realizable value for slow moving or obsolete inventory.

Patient Service Equipment: Patient service equipment is stated at cost and consists of medical equipment rented to patients on a month-to-month basis. Depreciation is provided using the straight-line method over the estimated useful lives of the equipment, which range from one to ten years.

Property, Equipment and Improvements: Property, equipment and improvements are stated at cost. Included in property and equipment are assets under capitalized leases which consist of information systems hardware and software. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets.

Capitalized Software: Included in property, equipment and improvements are costs related to internally developed and purchased software that are capitalized and amortized over periods that the assets are expected to provide benefit. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and benefit costs for employees directly involved in the development of internal-use software. Additions to capitalized internally developed software totaled $2.6 million and $8.7 million for the three and nine months ended September 30, 2010, respectively.

Goodwill and long-lived assets: Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization.

Goodwill and indefinite-lived intangible assets are not amortized but instead tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that the assets might be impaired. Goodwill is tested for impairment by comparing the carrying value to the fair value of the reporting unit to which the goodwill is assigned. A two-step test is used to identify the potential impairment and to measure the amount of impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, goodwill is impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit with the carrying amount of goodwill. Management has determined that our two operating segments, home respiratory therapy/home medical equipment and home infusion therapy, are reporting units. The Company performs the annual test for impairment as of the first day of its fourth quarter and determines fair value based on a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining value. This determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. Changes in these assumptions can materially affect the estimate of fair value. During the annual goodwill impairment test in 2009, the Company completed step one and determined that there was no impairment of goodwill since the fair value of the reporting units exceeded the carrying value. Our annual indefinite-lived intangible assets impairment test in 2009 also resulted in no impairment as the fair value of the assets exceeded the carrying value.

Long-lived assets, including property and equipment and purchased intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment tests. Recoverability of assets to be held and used is measured by the comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such an asset is considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Purchased intangible assets consist primarily of trade names, patient backlog, capitated relationships and payor relationships resulting from the Merger. Purchased intangible assets that have definite lives are amortized over the estimated useful lives of the related assets, generally ranging from one to twenty years.

Deferred Debt Issuance Costs: Capitalized debt issuance costs include those associated with the issuance and registration of $700.0 million of the Company’s 11.25% Senior Secured Notes due 2014 (Series A-1) (the “Series A-1 Notes”), $317.5 million of the Company’s 12.375% Senior Secured Notes due 2014 (Series A-2) (the “Series A-2 Notes”) and the Company’s senior secured asset-based revolving credit facility (“ABL Facility”). Such costs are classified as non-current assets. Costs relating to the ABL Facility are amortized through the maturity date in October 2013. Costs relating to the Series A-1 Notes and Series A-2 Notes are amortized from the issuance date through October 2014. See Note 6—Long-term Debt.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Fair Value of Financial Instruments: The carrying value of Apria’s Series A-1 Notes and Series A-2 Notes approximates fair value because the underlying instruments are variable notes that reprice frequently. The fair value of the Series A-1 Notes and Series A-2 Notes, as determined by reference to quoted prices for private transactions in these securities, are $775.2 million and $353.2 million at September 30, 2010, respectively. The carrying amounts of cash and cash equivalents, short-term investments, accounts receivable, trade payables and accrued expenses approximate fair value due to their short maturity.

Product and Supply Costs: Product and supply costs presented within cost of net revenues are comprised primarily of the cost of supplies and equipment provided to patients, infusion drug costs and enteral product costs.

Home Respiratory Therapy Expenses: Home respiratory therapy expenses presented within cost of net revenues are comprised primarily of employee salary and benefit costs or contract fees paid to respiratory therapists and other related professionals who are deployed to service a patient. Home respiratory therapy personnel are also engaged in a number of administrative and marketing tasks, and, accordingly, these costs are included within selling, distribution and administrative expenses and amounted to $9.5 million and $5.8 million for the three month periods ended September 30, 2010 and 2009, respectively, and $22.6 million and $17.6 million for the nine month periods ended September 30, 2010 and 2009, respectively.

Distribution Expenses: Distribution expenses are included in selling, distribution and administrative expenses and totaled $41.1 million and $39.2 million for the three months ended September 30, 2010 and 2009, respectively, and $120.0 million and $120.5 million for the nine month periods ended September 30, 2010 and 2009, respectively. Such expenses represent the cost incurred to coordinate and deliver products and services to patients. Included in distribution expenses are leasing, maintenance, licensing and fuel costs for the vehicle fleet; salaries and other costs related to drivers and dispatch personnel; and amounts paid to courier and other outside shipping vendors. Such expenses fall within the definition of “shipping and handling” costs and are classified within selling and administrative expenses and, as a result, cost of net revenues may not be comparable to other companies.

Self-Insurance: Coverage for certain employee medical claims and benefits, as well as workers’ compensation, vehicle liability, professional and general liability is self-insured. Accruals for medical claims at September 30, 2010 and December 31, 2009 were $6.1 million and $7.0 million, respectively. Amounts accrued for costs of the other liability coverages totaled $30.2 million and $27.8 million at September 30, 2010 and December 31, 2009, respectively. All such amounts are classified in other accrued liabilities.

Advertising: Advertising costs are expensed as incurred. Such expenses are included in selling, distribution and administrative expenses and amounted to $2.2 million and $0.5 million for the three month periods ended September 30, 2010 and 2009, respectively, and $4.5 million and $1.8 million for the nine month periods ended September 30, 2010 and 2009, respectively.

Income Taxes: Deferred income tax assets and liabilities are computed for differences between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining the necessity and amount of a valuation allowance, management considers our current and past performance, the market environment in which the Company operates, tax planning strategies and the length of tax benefit carryforward periods.

Profit Interest Units: Compensation expense for all profit interest unit awards made to employees is measured and recognized based on estimated fair values on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in our consolidated financial statements. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Profit interest units expense is recognized on a straight-line basis over the requisite service period. The estimate of fair value of profit interest unit awards on the date of grant is determined through the allocation of all outstanding securities to a business enterprise valuation. The enterprise valuation is based upon a combination of the income approach and the market approach. The income approach is based on discounted cash flows. The market approach uses a selection of comparable companies in determining value. This determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. Changes in these assumptions can materially affect the estimate of the fair value.

Reclassification: Certain amounts from the prior year have been reclassified on the statements of cash flows to conform with the current year presentation. For the nine months ended September 30, 2009, $8.0 million was reclassified from accrued expenses to accrued payroll and related taxes and benefits.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

NOTE 2 — RECENT DEVELOPMENTS

Exchange offer for Series A-1 Notes and Series A-2 Notes: In August 2010, the Company completed its registered exchange offer with respect to the Series A-1 Notes and Series A-2 Notes.

Outsourcing Initiatives Review: In August 2010, based on a review of key outsourcing initiatives, the Company refined its initial decisions concerning certain billing, collections and other administrative functions that were outsourced or designated to be outsourced to third parties. Based on this review, it was determined that certain of such functions should instead be performed by the Company. Accordingly, the Company is in the process of transitioning certain services presently outsourced to third parties back to the Company and expects to be substantially completed with that transition by June 30, 2011. In connection with that transition, the Company expects to incur associated one-time costs presently estimated to be $10 million. Further consolidation and outsourcing of billing, collections and other administrative functions are being evaluated on an ongoing basis.

Announcement of Single Payment Amounts (“SPAs”) and Contract Offer Process Related to Round 1 Rebid of the Medicare Durable Medical Equipment, Prosthetics, Orthotics and Supplies (“DMEPOS”) Competitive Bidding Program: In early July 2010, the Centers for Medicare and Medicaid Services (“CMS”) announced the new SPAs for each of the product categories included in the Round 1 Rebid. CMS then began the contracting process with suppliers by issuing contract offer letters to qualified providers. The Company received and accepted contract offers for a substantial majority of the bids it submitted as announced by CMS on November 3, 2010. For example, for the oxygen product category, the Company won eight of its nine submitted bids; for the continuous positive airway pressure (“CPAP”)/bilevel category, the Company won seven of its nine bids and for enteral nutrition, the Company won all nine of its nine bids. A complete list of contract winners is available on the CMS website at www.cms.gov/DMEPOSCompetitiveBid. The new rates are still expected to take effect in January 2011. Approximately $21 million of net revenues for the fiscal year ended December 31, 2009 was generated by the products and competitive bidding areas (“CBAs”) included in the Round 1 Rebid. The Company estimates that the initial results of the Round 1 Rebid would reduce net revenues in the fiscal year ending December 31, 2011 by approximately $8 million, assuming the current contracts and no changes in volume. Assuming that Round 2 would include the same product categories and bidding rules and the markets currently being proposed by CMS, the Company estimates that approximately $110 million of net revenues for the fiscal year ending December 31, 2011 would be subject to competitive bidding. Although the bidding process for Round 2 is currently scheduled to commence in 2011, the new Round 2 rates and guidelines are not scheduled to take effect until January 2013. Therefore, the Company cannot estimate the impact of potential Round 2 rate reductions on its business until more specific information is published by CMS and its contractors.

NOTE 3 — RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue Arrangements” which amends ASC Topic 605, Revenue Recognition (“ASU 2009-13”) Under this standard, management is no longer required to obtain vendor-specific objective evidence or third party evidence of fair value for each deliverable in an arrangement with multiple elements, and where evidence is not available we may now estimate the proportion of the selling price attributable to each deliverable. ASU 2009-13 will be effective prospectively for revenue arrangements entered into or materially modified in the fiscal years beginning on or after June 15, 2010. The Company is currently evaluating the impact of ASU 2009-13 on its financial position, results of operations, cash flows and disclosures.

In January 2010, the FASB issued ASU 2010-6, “Improving Disclosures About Fair Value Measurements” (“ASU 2010-6”) which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair- value measurements. ASU 2010-6 is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010. The Company does not expect the adoption of ASU 2010-6 to have a material impact on its consolidated financial statements.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

NOTE 4 — BUSINESS COMBINATIONS

The Company periodically acquires complementary businesses in specific geographic markets. The results of operations of the acquired companies are included in the accompanying condensed consolidated statements of operations from the dates of acquisition. During the nine months ended September 30, 2010 and 2009, the Company purchased certain assets and businesses for total consideration of $2.6 million and $1.2 million, respectively.

NOTE 5 — GOODWILL AND INTANGIBLE ASSETS

Goodwill activity during the nine months ended September 30, 2010 was as follows:


*(in thousands )*	Home Infusion Therapy		Home Respiratory Therapy and Home Medical Equipment		Total
Balance, December 31, 2009	$	257,823	$	501,374	$	759,197
Acquisition		—		1,050		1,050

Balance, September 30, 2010	$	257,823	$	502,424	$	760,247

Intangible assets consist of the following:


*(dollars in thousands)*	September 30, 2010									December 31, 2009
*(dollars in thousands)*	Average Life in Years		Gross Carrying Amount		Accumulated Amortization			Net Book Value		Gross Carrying Amount		Accumulated Amortization			Net Book Value
Intangible assets subject to amortization:
Patient backlog			$	—	$	—		$	—	$	44,000	$	(44,000	)	$	—
Capitated relationships		20.0		40,000		(3,833	)		36,167		40,000		(2,333	)		37,667
Payor relationships		20.0		11,000		(1,054	)		9,946		11,000		(642	)		10,358
Net favorable leasehold interest		3.6		3,553		(2,079	)		1,474		3,553		(1,319	)		2,234
Customer list		1.2		710		(305	)		405		—		—			—

Subtotal				55,263		(7,271	)		47,992		98,553		(48,294	)		50,259
Intangible assets not subject to amortization:
Trade names				525,000		—			525,000		525,000		—			525,000
Accreditations with commissions				7,000		—			7,000		7,000		—			7,000

Subtotal				532,000		—			532,000		532,000		—			532,000

Total			$	587,263	$	(7,271	)	$	579,992	$	630,553	$	(48,294	)	$	582,259

Amortization expense amounted to $3.8 million and $44.9 million for the nine months ended September 30, 2010 and 2009, respectively. Estimated amortization expense for each of the fiscal years ending December 31 is presented below:


Year Ending December 31,	(in thousands)
2010	$	4,812
2011		3,827
2012		2,854
2013		2,550
2014		2,550

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

NOTE 6 — LONG-TERM DEBT

Series A-1 Notes and Series A-2 Notes. Series A-1 Notes and Series A-2 Notes were issued by the Company in May 2009 and August 2009, respectively. The Series A-1 Notes and the Series A-2 Notes bear interest at a rate equal to 11.25% per annum and 12.375% per annum, respectively. The indenture governing the Series A-1 Notes and the Series A-2 Notes, among other restrictions, limits the Company’s ability and the ability of its restricted subsidiaries to:

•

incur additional debt;

•

pay dividends and make other distributions;

•

make certain investments;

•

repurchase our stock;

•

incur certain liens;

•

enter into transactions with affiliates;

•

merge or consolidate;

•

enter into agreements that restrict the ability of our subsidiaries to make dividends or other payments to us; and

•

transfer or sell assets.

Subject to certain exceptions, the indenture governing the Series A-1 Notes and the Series A-2 Notes permits Apria and its restricted subsidiaries to incur additional indebtedness, including senior indebtedness and secured indebtedness. The Series A-1 Notes are entitled to a priority of payment over the Series A-2 notes in certain circumstances, including upon any acceleration of the obligations under the Series A-1 Notes, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Series A-1 Notes and the Series A-2 Notes.

Senior Secured Bridge Credit Agreement: In connection with the Merger on October 28, 2008, the Company entered into a $1,010.0 million senior secured bridge credit agreement (the “senior secured bridge credit agreement”) with Banc of America Securities LLC and Wachovia Capital Markets, LLC, as joint lead arrangers, Banc of America Securities LLC, Wachovia Capital Markets, LLC and Barclays Capital, the investment banking division of Barclays Bank PLC, as joint bookrunners and Banc of America Bridge LLC, as administrative agent and Bank of America, N.A., as collateral agent, and a syndicate of financial institutions and institutional lenders. Proceeds from the issuance of the Series A-1 and Series A-2 Notes, together with cash on hand, were used to repay all borrowings under the senior secured bridge credit agreement and the senior secured bridge credit agreement was terminated.

ABL Facility: In connection with the Merger on October 28, 2008, the Company entered into the ABL Facility with Banc of America Securities LLC and Wachovia Capital Markets, LLC, as joint lead arrangers, Banc of America Securities LLC, Wachovia Capital Markets, LLC and Barclays Capital, the investment banking division of Barclays Bank PLC, as joint bookrunners and Bank of America, N.A., as administrative agent and collateral agent, and a syndicate of financial institutions and institutional lenders.

The ABL Facility provides for revolving credit financing of up to $150.0 million, subject to borrowing base availability, with a maturity of five years, including both a letter of credit and swingline loan sub-facility. The borrowing base at any time is equal to the sum (subject to certain reserves and other adjustments) of 85% of eligible receivables and the lesser of (a) 85% of the net orderly liquidation value of eligible inventory and (b) $20.0 million.

As of September 30, 2010, there were no outstanding borrowings under the ABL Facility, outstanding letters of credit totaled $16.1 million and additional availability under the ABL Facility, subject to the borrowing base, was $133.9 million. As of September 30, 2010, the available borrowing base did not constrain ability to borrow the entire $133.9 million of available borrowings under the ABL Facility. At September 30, 2010, the Company was in compliance with all of the financial covenants required by the credit agreement governing the ABL Facility.

Interest paid on debt totaled $0.2 million and $17.5 million for the three months ended September 30, 2010 and 2009, respectively, and $60.3 million and $80.2 million for the nine months ended September 30, 2010 and 2009, respectively. Interest expense for the three months ended September 30, 2010 and 2009 was $32.7 million and $32.1 million, respectively, and $98.0 million and $96.6 million for the nine months ended September 30, 2010 and 2009, respectively.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

NOTE 7 — STOCKHOLDERS’ EQUITY

For the nine months ended September 30, 2010, changes to stockholders’ equity were comprised of the following amounts (in thousands):


Net income	$	2,458
Cash paid on profit interest units		(78	)
Profit interest compensation		3,194

	$	5,574

NOTE 8 — EQUITY-BASED COMPENSATION

Profit Interest Units: In November and December of 2008, BP Healthcare Holdings LLC (“BP Holdings”) and Sky LLC, parent entities of the Company affiliated with the Sponsor, granted equity units to the Company’s Chief Executive Officer and the Company’s Chief Financial Officer for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. In addition, in 2009 and during 2010, Sky LLC (and following our reorganization in March 2010, Apria Holdings LLC) granted equity units to certain management employees for purposes of retaining them and enabling such individuals to participate in the long-term growth and financial success of the Company. Profit interest units are measured at the grant date, based on the calculated fair value of the award, and are recognized as an expense over the employee’s requisite service period. These equity awards were issued in exchange for services to be performed.

BP Holdings granted the Company’s Chief Executive Officer 38,697,318 Class B units, all of which are subject to vesting terms based on either (i) continued service to BP Holdings or its subsidiaries and/or (ii) performance/market conditions.

•

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 80% of the total Class B units. These units vest ratably over 48 months starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis either (x) upon a change in control while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries or (y) if affiliates of the Sponsor receive cash proceeds in respect to 50% of their units in BP Holdings equal to at least 200% of their aggregate capital contributions in respect of such units while the Company’s Chief Executive Officer continues to provide services to BP Holdings or its subsidiaries. In addition, if the Company’s Chief Executive Officer’s services are terminated (a) by the Company without “cause” or (b) by the Chief Executive Officer as a result of “constructive termination,” an additional number of these time-vesting Class B units will vest equal to the number that would have vested over the 24-month period following the applicable termination date. Any of these time-vested Class B units that are unvested on termination of the executive’s services will be forfeited.

•

Performance-Vesting Units. The remaining portion of the Class B units that vest based on performance/market conditions represent 20% of the total Class B units. One-half of these units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of all of their units in BP Holdings, with the other half eligible to vest if they receive cash proceeds equal to at least 300% of their aggregate capital contributions in respect of all of their units in BP Holdings. Any of these performance-vesting units that are unvested upon a termination of the Company’s Chief Executive Officer’s services (x) by the Company without “cause,” (y) by the executive as a result of “constructive termination” or (z) by the executive for any reason on or following October 28, 2012, will remain outstanding until the second anniversary of the applicable termination date (unless they vest prior to that date). If the units do not vest by such anniversary, then any unvested performance-vesting units shall be immediately forfeited.

Assumptions used were as follows:


Expected Asset Volatility (1)	23.0	%
Risk Free Interest Rate (2)	2.24	%
Expected Life (3)	5.0 years

(1)	The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(2)	The risk free interest rate is interpolated from the constant maturity treasury rate (“CMT Rate”) as of the valuation date with the maturity matching the contractual life.

(3)	The expected life is based on management’s estimate.

The following table summarizes activity for profit interest units for the period December 31, 2009 to September 30, 2010:


	Class B Units		Weighted Average Grant Date Fair Value		Weighted Average Remaining Contractual Life
Balance at December 31, 2009		38,697,318	$	0.36
Granted		—
Exercised		—
Forfeited		—

Balance at September 30, 2010		38,697,318				2.1

Vested units at September 30, 2010		13,544,061				2.1

The grant date fair value of the B units was $13.9 million.

Sky LLC granted the Company’s Chief Financial Officer 500,000 Class A-2 units, 6,675,287 Class B units and 2,225,096 Class C units, all of which are subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

•

Class A-2 Units. The Class A-2 units vest if an initial public offering (“IPO”) or change of control occurs and the valuation of Class A-1 units of Sky LLC implied by the transaction exceeds 110% of the aggregate capital contributions of affiliates of the Sponsor for the Class A-1 units. The Company’s Chief Financial Officer does not need to be employed at the time of the IPO or change in control to vest. The Class A-2 Units will be forfeited if an IPO or change of control occurs at a valuation that does not result in vesting.

•

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest ratably over 57 months starting on October 28, 2008 based on continued service, but will become fully vested on an accelerated basis upon a change in control while the Company’s Chief Financial Officer continues to provide services to Sky LLC or its subsidiaries. Any of these time-vested Class B units that are unvested on termination of the executive’s services will be forfeited.

•

Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while the Company’s Chief Financial Officer continues to provide services to Sky LLC or its subsidiaries.

Assumptions used were as follows:


Expected Asset Volatility (1)	23.0	%
Risk Free Interest Rate (2)	1.35	%
Estimated Life (3)	5.0 years

(1)	The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.

(2)	The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the contractual life.

(3)	The estimated life is based on management’s estimates.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The following table summarizes activity for profit interest units for the period December 31, 2009 to September 30, 2010:


	Class A-2 Units		Weighted Average Grant Date Fair Value		Class B Units		Weighted Average Grant Date Fair Value		Class C Units		Weighted Average Grant Date Fair Value
Balance at December 31, 2009		500,000	$	0.75		6,675,287	$	0.35		2,225,096	$	0.15
Exercised		—		—		—		—		—		—
Forfeited		—		—		—		—		—		—

Balance at September 30, 2010		500,000				6,675,287				2,225,096

Vested units at September 30, 2010						1,779,899

The grant date fair value of the 500,000 A-2 units is $0.4 million, the grant date fair value of the B units is $2.3 million and the grant date fair value of the C units is $0.3 million.

Sky LLC (and following our reorganization in March 2010, Apria Holdings LLC) granted certain management employees 41,938,220 Class B units and 14,463,122 Class C units, all of which are subject to vesting terms based on either (i) continued service to Sky LLC or its subsidiaries or (ii) performance/market conditions.

•

Time-Vesting Units. The portion of the Class B units that vest based on continued service represent 66 2/3% of the total Class B units. These units vest ratably over 60 months starting on the later of (x) October 28, 2008 and (y) the date the employee commenced employment based on continued service, but will become fully vested on an accelerated basis upon a change in control while the employee continues to provide services to Sky LLC or its subsidiaries. Any of these time-vested Class B units that are unvested on termination of the employee’s services will be forfeited.

•

Performance-Vesting Units. The remaining portion of the Class B units and all of the Class C units vest based on performance/market conditions. These units will vest if affiliates of the Sponsor receive cash proceeds equal to at least 200% of their aggregate capital contributions in respect of 25% of their units in Sky LLC while the employee continues to provide services to Sky LLC or its subsidiaries.

Notwithstanding the vesting terms described above, if the employee voluntarily resigns (in the absence of “constructive termination”) then Sky LLC may require the forfeiture of any vested Class B or C units.

Assumptions used were as follows:


Expected Asset Volatility (1)	25.0	%
Risk Free Interest Rate (2)	1.96	%
Estimated Life (3)	5.0 years

(1)	The expected asset volatility is derived from the asset volatilities of comparable publicly traded companies.

(2)	The risk free interest rate is interpolated from the CMT Rate as of the valuation date with the maturity matching the contractual life.

(3)	The estimated life is based on management’s estimate.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The following table summarizes activity for profit interest units for the period December 31, 2009 to September 30, 2010:


	Class A-2 Units		Weighted Average Grant Date Fair Value		Class B Units		Weighted Average Grant Date Fair Value		Class C Units		Weighted Average Grant Date Fair Value
Balance at December 31, 2009		2,075,000	$	0.59		37,280,029	$	0.28		12,426,676	$	0.13
Granted		—		—		—		—		—		—
Exercised		—		—		—		—		—		—
Forfeited		—		—		4,643,678		—		1,547,893		—

Balance at March 31, 2010		2,075,000		—		32,636,351		—		10,878,783		—
Granted		—		—		1,393,104	$	0.44		464,367	$	0.33
Forfeited		—		—		174,138		—		58,046		—

Balance at June 30, 2010		2,075,000				33,855,317				11,285,104
Granted		—		—		2,002,587	$	0.44		1,151,246	$	0.33
Forfeited		—		—		1,388,265		—		91,906		—

Balance at September 30, 2010		2,075,000				34,469,639				12,344,444

Vested units at September 30, 2010						6,683,004

The grant date fair value of the A-2 units is $1.2 million, the grant date fair value of the outstanding B units is $9.9 million and the grant date fair value of the outstanding C units is $1.9 million.

Pursuant to a reorganization we conducted in March 2010, units of Sky LLC were converted or exchanged into units of Apria Holdings LLC, its parent entity.

Expense recorded related to profit interest units was $1.0 million and $1.8 million in the three months ended September 30, 2010 and 2009, respectively, and $3.2 million and $6.2 million in the nine months ended September 30, 2010 and 2009, respectively. As of September 30, 2010, total unrecognized profit interest compensation cost related to unvested profit interest units was $5.3 million, which is expected to be expensed over a weighted average period of 3.2 years.

NOTE 9 — INCOME TAXES

The Company’s effective tax rate was 104.4% for the three months ended September 30, 2010 compared with 34.9% for the three months ended September 30, 2009. The Company’s effective tax rate was 54.7% for the nine months ended September 30, 2010 compared with 24.5% for the nine months ended September 30, 2009.

The Company accounts for its tax uncertainties under generally accepted accounting principles. Accordingly, the Company is required to disclose, within its interim financial statements, material changes to the following five disclosure categories: (1) gross unrecognized tax benefits recorded on the balance sheet; (2) total unrecognized tax benefits that, if recognized, would affect the effective tax rate; (3) interest and penalties related to tax uncertainties; (4) amounts and relevant information concerning unrecognized tax benefits for which it is reasonably possible that an increase or decrease would occur during the 12-month rolling period ending September 30, 2011 and (5) disclosure of tax years and major tax jurisdictions which remain subject to examination by taxing authorities.

As of September 30, 2010, the Company does not expect any material increases to its unrecognized tax benefits for the 12-month rolling period ending September 30, 2011.

As of September 30, 2010, it is reasonably possible that unrecognized tax benefits could be decreased by $9.8 million within the 12-month rolling period ending September 30, 2011. This decrease relates to the timing uncertainty for when certain deductions should be recognized for tax return purposes, allocation of expenses between affiliates, and state tax uncertainties. Ultimate realization of this decrease is dependent upon the occurrence of certain events (including the completion of audits by tax agencies and expiration of statutes of limitations).

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

For the nine months ended September 30, 2010, no other material changes occurred with respect to the Company’s tax uncertainties and the other four disclosure categories discussed above.

As of September 30, 2010, federal net operating loss (“NOLs”) carryforwards of approximately $96.8 million were available to offset future federal taxable income. Such NOLs will expire at various times and in varying amounts during the Company’s calendar 2015 through 2029 tax years. A significant portion of these NOLS are subject to an annual utilization limitation as required by Section 382 of the Internal Revenue Code of 1986, as amended.

Net income taxes paid for the nine-month period ended September 30, 2010 and 2009 amounted to $0.1 million and $0.7 million, respectively.

NOTE 10 — COMMITMENTS AND CONTINGENCIES

Litigation: The Company is engaged in the defense of certain claims and lawsuits arising out of the ordinary course and conduct of its business, the outcomes of which are not determinable at this time. Insurance policies covering such potential losses, where such coverage is cost effective, are maintained. In the opinion of management, any liability that might be incurred upon the resolution of these claims and lawsuits will not, in the aggregate, have a material adverse effect on the Company’s financial condition or results of operations.

Medicare and Medicaid Reimbursement: There are a number of provisions contained within recent legislation or proposed legislation that affect or may affect Medicare and Medicaid reimbursement polices for items and services provided. The Company cannot be certain of the ultimate impact of all legislated and contemplated changes, and therefore cannot provide assurance that these changes will not have a material adverse effect on the Company’s financial condition or results of operations.

Supplier Concentration: Currently, approximately 58.9% of purchases for patient service equipment and supplies are from five vendors. Although there are a limited number of suppliers, management believes that other vendors could provide similar products on comparable terms. However, a change in suppliers could cause delays in service delivery and possible losses in revenue, which could adversely affect the Company’s financial condition or operating results.

Guarantees and Indemnities: From time to time, certain types of contracts are entered into that contingently require indemnification of parties against third party claims. These contracts primarily relate to (i) certain asset purchase agreements, under which indemnification may be provided to the seller of the business being acquired; (ii) certain real estate leases, which may require indemnification to property owners for environmental or other liabilities and other claims arising from use of the applicable premises; and (iii) certain agreements with officers, directors and employees, which may require indemnification of such persons for liabilities arising out of their relationship with the Company.

The terms of such obligations vary by contract and in most instances a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, no liabilities have been recorded for these obligations on the balance sheets for any of the periods presented.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

NOTE 11 — SEGMENTS

The Company has two reportable operating segments (1) home respiratory therapy and home medical equipment and (2) home infusion therapy. Within these two operating segments there are three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. The home respiratory therapy and home medical equipment segment provides services and equipment to assist patients with oxygen systems, sleep apnea, ambulation and general care around the home, as well as to provide respiratory medications and related services. The home infusion therapy segment primarily provides patients with pharmaceuticals and services prescribed in conjunction with the administration of nutrients or medication intravenously or through a gastrointestinal tube.


	Net Revenues
	Three Months Ended September 30,					Nine Months Ended September 30,
*(in thousands)*	2010		2009			2010		2009
Operating Segment
Home Respiratory Therapy and Home Medical Equipment	$	270,223	$	284,592		$	821,666	$	871,767
Home Infusion Therapy		255,791		234,923			731,402		686,707

Total	$	526,014	$	519,515		$	1,553,068	$	1,558,474


	EBIT
	Three Months Ended September 30,					Nine Months Ended September 30,
*(in thousands)*	2010		2009			2010		2009
Operating Segment
Home Respiratory Therapy and Home Medical Equipment	$	3,129	$	(20,418	)	$	21,687	$	28,209
Home Infusion Therapy		31,611		16,767			81,118		41,840

Total	$	34,740	$	(3,651	)	$	102,805	$	70,049


	Depreciation and Amortization
	Three Months Ended September 30,					Nine Months Ended September 30,
*(in thousands)*	2010		2009			2010		2009
Operating Segment
Home Respiratory Therapy and Home Medical Equipment	$	28,420	$	61,812		$	86,375	$	121,746
Home Infusion Therapy		3,899		11,523			11,124		18,358

Total	$	32,319	$	73,335		$	97,499	$	140,104

Our Chief Operating Decision Maker (“CODM”) does not review assets assigned to segments. Therefore, such items are not reflected in the table above.

Earnings before interest and taxes (“EBIT”). EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles (“GAAP”) and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.

The following table provides a reconciliation from net income to EBIT:


*(in thousands)*	Three Months Ended September 30, 2010							Three Months Ended September 30, 2009
*(in thousands)*	Home Respiratory Therapy and Home Medical Equipment		Home Infusion Therapy		Total			Home Respiratory Therapy and Home Medical Equipment			Home Infusion Therapy		Total
Net loss					$	(105	)						$	(22,981	)
Interest expense, net (a)						32,369								31,622
Income tax expense						2,476								(12,292	)

EBIT	$	3,129	$	31,611	$	34,740		$	(20,418	)	$	16,767	$	(3,651	)

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)


*(in thousands)*	Nine Months Ended September 30, 2010						Nine Months Ended September 30, 2009
*(in thousands)*	Home Respiratory Therapy and Home Medical Equipment		Home Infusion Therapy		Total		Home Respiratory Therapy and Home Medical Equipment		Home Infusion Therapy		Total
Net income (loss)					$	2,458					$	(19,443	)
Interest expense, net (a)						97,377						95,802
Income tax expense						2,970						(6,310	)

EBIT	$	21,687	$	81,118	$	102,805	$	28,209	$	41,840	$	70,049

(a)	Reflects $32.7 million of interest expense, net of $0.3 million of interest income for the three months ended September 30, 2010. Reflects $32.1 million of interest expense, net of $0.5 million of interest income for the three months ended September 30, 2009.

Reflects $98.0 million of interest expense, net of $0.6 million of interest income for the nine months ended September 30, 2010. Reflects $96.6 million of interest expense, net of $0.8 million of interest income for the nine months ended September 30, 2009.

The Company allocates certain expenses that are not directly attributable to a product line based upon segment headcount.

NOTE 12 — CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Transaction and Management Fee Agreement: In connection with the Merger, Merger Sub entered into a transaction and management fee agreement with Blackstone Management Partners V L.L.C. (“BMP”). The Company succeeded to and assumed the rights and obligations of Merger Sub pursuant to the transaction and management fee agreement upon the closing of the Merger. Under the transaction and management fee agreement, Merger Sub agreed to pay BMP, at the closing of the Merger, an $18.7 million transaction fee in consideration for BMP undertaking financial and structural analysis, due diligence and other assistance in connection with the Merger. In addition the Company agreed to reimburse BMP for any out-of-pocket expenses incurred by BMP and its affiliates in connection with the Merger and the provision of services under the transaction and management fee agreement.

In addition, under this agreement, BMP (including through its affiliates) agreed to provide services, including without limitation, (a) advice regarding the structure, distribution and timing of debt and equity offerings and advice regarding relationships with the Company’s lenders and bankers, (b) advice regarding the business and strategy of the Company, including compensation arrangements, (c) advice regarding dispositions and/or acquisitions and (d) such advice directly related or ancillary to the above financial advisory services as may be reasonably requested by the Company. In consideration for the services, the Company pays BMP at the beginning of each fiscal year a management fee equal to the greater of $7.0 million or 2.0% of the Company’s consolidated EBITDA, as defined in the agreement, for the immediately preceding fiscal year. BMP shall have no obligation to provide any other services to the Company absent express agreement. In addition, in the absence of an express agreement to provide investment banking or other financial advisory services to the Company, and without regard to whether such services were provided, BMP is entitled to receive a fee equal to 1.0% of the aggregate transaction value upon the consummation of any acquisition, divestiture, disposition, merger, consolidation, restructuring, refinancing, recapitalization, issuance of private or public debt of equity securities (including an initial public offering of equity securities), financing or similar transaction by the Company.

At any time in connection with or in anticipation of a change of control of the Company, a sale of all or substantially all of the Company’s assets or an initial public offering of common equity of the Company or its successor, BMP may elect to receive, in consideration of BMP’s role in facilitating such transaction and in settlement of the termination of the services, a single lump sum cash payment equal to the then-present value of all then-current and future annual management fees payable under the transaction and management fee agreement, assuming a hypothetical termination date of the agreement to be the twelfth anniversary of such election. The transaction and management fee agreement will continue until the earlier of the twelfth anniversary of the date of the agreement or such date as the Company and BMP may mutually determine. The Company has agreed to indemnify BMP and its affiliates, directors, officers, employees, agents and representatives from and against all liabilities relating to the services contemplated by the transaction and management fee agreement and the engagement of BMP pursuant to, and the performance of BMP and its affiliates of the services contemplated by, the transaction and management fee agreement.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Intelenet Agreement: In May 2009, the Company entered into the Master Service Agreement (“Intelenet Agreement”) with Intelenet Global Services Private Limited (“Intelenet”), an Indian company affiliated with the Sponsor, regarding the outsourcing of certain functions relating to billing, collections and other administrative and clerical services. The Company presently expects to make payments to Intelenet of approximately $71 million over a seven-year period that began in the second quarter of 2009. One of the members of its board of directors, Mr. Patrick Bourke, is an employee of the Sponsor and also serves on the board of directors of Intelenet. During the nine months ended September 30, 2010, the Company paid approximately $13.9 million to Intelenet.

Equity Healthcare Agreement: Effective as of January 1, 2010, the Company entered into an employer health program agreement with Equity Healthcare LLC (“Equity Healthcare”), an affiliate of the Sponsor, pursuant to which Equity Healthcare will provide to the Company certain negotiating, monitoring and other services in connection with our health benefit plans. In consideration for Equity Healthcare’s services, the Company will pay Equity Healthcare a fee of $2 per participating employee per month. As of September 30, 2010, the Company had approximately 6,700 employees enrolled in Equity Healthcare health benefit plans.

NOTE 13 — FINANCIAL GUARANTEES

The Company conducts substantially all of its business through its subsidiaries. Substantially all of the Company’s wholly-owned domestic subsidiaries (the “Guarantors”) fully and unconditionally guarantee the Series A-1 Notes and Series A-2 Notes on a senior secured basis. The Guarantors also guarantee our ABL Facility. See also Note 6—Long-Term Debt.

The following unaudited condensed consolidated financial statements quantify the financial position as of September 30, 2010 and December 31, 2009, the operations for the three and nine months ended September 30, 2010 and 2009, the cash flows for the nine months ended September 30, 2010 and 2009. These condensed consolidated financial statements present financial information for the parent issuer, the guarantor subsidiaries, the non-guarantor subsidiaries and consolidating adjustments, consisting of the entries that eliminate the investment in subsidiaries and intercompany balances and transactions.

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED BALANCE SHEETS

September 30, 2010

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	164,780		$	—		$	519	$	(13,501	)	$	151,798
Short-term investments		253			—			—		—			253
Accounts receivable less allowance for doubtful accounts		—			307,561			831		—			308,392
Inventories, net		—			69,164			326		—			69,490
Deferred income taxes		12,158			75,852			—		—			88,010
Deferred expenses		—			3,219			—		—			3,219
Intercompany		247,203			254,536			—		(501,739	)		—
Prepaid expenses and other current assets		4,405			20,696			11		—			25,112
Intercompany loan		360,000			—			—		(360,000	)		—

TOTAL CURRENT ASSETS		788,799			731,028			1,687		(875,240	)		646,274
PATIENT SERVICE EQUIPMENT, less accumulated depreciation		—			175,317			25		—			175,342
PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET		35,132			44,061			28		—			79,221
GOODWILL		—			760,247			—		—			760,247
INTANGIBLE ASSETS, NET		460,000			119,992			—		—			579,992
DEFERRED DEBT ISSUANCE COSTS, NET		56,510			—			—		—			56,510
INTERCOMPANY RECEIVABLE		350,000			—			—		(350,000	)		—
INVESTMENT IN SUBSIDIARIES		377,614			606			—		(378,220	)		—
OTHER ASSETS		3,142			4,242			—		—			7,384

TOTAL ASSETS	$	2,071,197		$	1,835,493		$	1,740	$	(1,603,460	)	$	2,304,970

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	—		$	102,079		$	257	$	(13,501	)	$	88,835
Accrued payroll and related taxes and benefits		7,530			55,033			127		—			62,690
Other accrued liabilities		49,565			76,216			750		—			126,531
Deferred revenue		—			27,176			—		—			27,176
Intercompany		111,694			390,045			—		(501,739	)		—
Current portion of long-term debt		—			361,575			—		(360,000	)		1,575

TOTAL CURRENT LIABILITIES		168,789			1,012,124			1,134		(875,240	)		306,807
LONG-TERM DEBT, net of current portion		1,017,500			350,757			—		(350,000	)		1,018,257
DEFERRED INCOME TAXES		191,371			73,338			—		—			264,709
INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES		9,232			21,660			—		—			30,892

TOTAL LIABILITIES		1,386,892			1,457,879			1,134		(1,225,240	)		1,620,665
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Common stock		—			—			—		—			—
Additional paid-in capital		687,561			437,616			—		(437,616	)		687,561
(Accumulated deficit) retained earnings		(3,256	)		(60,002	)		606		59,396			(3,256	)

TOTAL STOCKHOLDERS’ EQUITY		684,305			377,614			606		(378,220	)		684,305

	$	2,071,197		$	1,835,493		$	1,740	$	(1,603,460	)	$	2,304,970

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED BALANCE SHEETS

December 31, 2009

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	150,364		$	7,208		$	591	$	—		$	158,163
Short-term investments		23,673			—			—		—			23,673
Accounts receivable less allowance for doubtful accounts		7			251,149			977		—			252,133
Inventories, net		—			68,007			260		—			68,267
Deferred income taxes		17,497			69,519			—		—			87,016
Deferred expenses		—			3,049			—		—			3,049
Intercompany		606,473			381,071			—		(987,544	)		—
Prepaid expenses and other current assets		5,213			19,149			—		—			24,362

TOTAL CURRENT ASSETS		803,227			799,152			1,828		(987,544	)		616,663
PATIENT SERVICE EQUIPMENT, less accumulated depreciation		—			198,770			38		—			198,808
PROPERTY, EQUIPMENT AND IMPROVEMENTS, NET		28,393			51,805			29		—			80,227
GOODWILL		—			759,197			—		—			759,197
INTANGIBLE ASSETS, NET		460,000			122,259			—		—			582,259
DEFERRED DEBT ISSUANCE COSTS, NET		63,110			—			—		—			63,110
INTERCOMPANY RECEIVABLE		350,000			2,902			—		(352,902	)		—
INVESTMENT IN SUBSIDIARIES		380,455			538			—		(380,993	)		—
OTHER ASSETS		4,911			3,872			—		—			8,783

TOTAL ASSETS	$	2,090,096		$	1,938,495		$	1,895	$	(1,721,439	)	$	2,309,047

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	—		$	123,597		$	259	$	—		$	123,856
Accrued payroll and related taxes and benefits		20,893			45,843			106		—			66,842
Other accrued liabilities		20,799			78,977			992		—			100,768
Deferred revenue		—			27,253			—		—			27,253
Intercompany		157,140			470,404			—		(627,544	)		—
Current portion of long-term debt		77			361,613			—		(360,000	)		1,690

TOTAL CURRENT LIABILITIES		198,909			1,107,687			1,357		(987,544	)		320,409
LONG-TERM DEBT, net of current portion		1,020,402			351,956			—		(352,902	)		1,019,456
DEFERRED INCOME TAXES		183,105			75,925			—		—			259,030
INCOME TAXES PAYABLE & OTHER NON-CURRENT LIABILITIES		8,949			22,472			—		—			31,421

TOTAL LIABILITIES		1,411,365			1,558,040			1,357		(1,340,446	)		1,630,316
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Common stock		—			1			—		(1	)		—
Additional paid-in capital		684,445			396,766			—		(396,766	)		684,445
(Accumulated deficit) retained earnings		(5,714	)		(16,312	)		538		15,774			(5,714	)

TOTAL STOCKHOLDERS’ EQUITY		678,731			380,455			538		(380,993	)		678,731

	$	2,090,096		$	1,938,495		$	1,895	$	(1,721,439	)	$	2,309,047

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2010

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
Operating net revenue	$	—		$	523,707		$	2,307	$	—		$	526,014
Income from subsidiaries		55,774			—			—		(55,774	)		—

TOTAL NET REVENUES		55,774			523,707			2,307		(55,774	)		526,014
TOTAL COST OF NET REVENUES		—			206,824			1,160		—			207,984
Provision for doubtful accounts		—			10,943			38		—			10,981
Selling, distribution and administrative		59,658			266,611			662		(55,774	)		271,157
Amortization of intangible assets		230			805			—		—			1,035

TOTAL COSTS AND EXPENSES		59,888			485,183			1,860		(55,774	)		491,157
OPERATING (LOSS) INCOME		(4,114	)		38,524			447		—			34,857
Interest expense		32,445			291			—		—			32,736
Interest income and other		(15,857	)		15,389			218		—			(250	)

(LOSS) INCOME BEFORE TAXES		(20,702	)		22,844			229		—			2,371
Income tax (benefit) expense		(32,496	)		34,972			—		—			2,476

NET INCOME (LOSS)		11,794			(12,128	)		229		—			(105	)
Equity in income of subsidiaries, net of tax		(11,899	)		229			—		11,670			—

NET (LOSS) INCOME	$	(105	)	$	(11,899	)	$	229	$	11,670		$	(105	)

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2010

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
Operating net revenue	$	—		$	1,547,124		$	5,944	$	—		$	1,553,068
Income from subsidiaries		170,889			—			—		(170,889	)		—

TOTAL NET REVENUES		170,889			1,547,124			5,944		(170,889	)		1,553,068
TOTAL COST OF NET REVENUES		—			615,807			3,101		—			618,908
Provision for doubtful accounts		—			39,511			290		—			39,801
Selling, distribution and administrative		161,363			795,394			1,870		(170,889	)		787,738
Amortization of intangible assets		688			3,089			—		—			3,777

TOTAL COSTS AND EXPENSES		162,051			1,453,801			5,261		(170,889	)		1,450,224
OPERATING INCOME		8,838			93,323			683		—			102,844
Interest expense		97,640			331			—		—			97,971
Interest income and other		(50,352	)		49,463			334		—			(555	)

(LOSS) INCOME BEFORE TAXES		(38,450	)		43,529			349		—			5,428
Income tax (benefit) expense		(42,747	)		45,717			—		—			2,970

NET INCOME (LOSS)		4,297			(2,188	)		349		—			2,458
Equity in income of subsidiaries, net of tax		(1,839	)		349			—		1,490			—

NET INCOME (LOSS)	$	2,458		$	(1,839	)	$	349	$	1,490		$	2,458

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2009

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
Operating net revenue	$	—		$	517,476		$	2,039	$	—		$	519,515
Income from subsidiaries		52,128			—			—		(52,128	)		—

TOTAL NET REVENUES		52,128			517,476			2,039		(52,128	)		519,515
TOTAL COST OF NET REVENUES		—			244,655			1,000		—			245,655
Provision for doubtful accounts		—			13,232			24		—			13,256
Selling, distribution and administrative		56,336			259,765			594		(52,128	)		264,567
Amortization of intangible assets		230			(445	)		—		—			(215	)

TOTAL COSTS AND EXPENSES		56,566			517,207			1,618		(52,128	)		523,263
OPERATING (LOSS) INCOME		(4,438	)		269			421		—			(3,748	)
Interest expense		31,738			317			—		—			32,055
Interest income and other		(16,143	)		15,407			206		—			(530	)

(LOSS) INCOME BEFORE TAXES		(20,033	)		(15,455	)		215		—			(35,273	)
Income tax (benefit) expense		1,463			(13,755	)		—		—			(12,292	)

NET (LOSS) INCOME		(21,496	)		(1,700	)		215		—			(22,981	)
Equity in income of subsidiaries, net of tax		(1,485	)		215			—		1,270			—

NET (LOSS) INCOME	$	(22,981	)	$	(1,485	)	$	215	$	1,270		$	(22,981	)

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2009

(Unaudited)


	Issuer			Guarantor Subsidiaries		Non- Guarantor Subsidiaries		Consolidating Adjustments			Consolidated
	(in thousands)
Operating net revenue	$	—		$	1,552,435	$	6,039	$	—		$	1,558,474
Income from subsidiaries		153,477			—		—		(153,477	)		—

TOTAL NET REVENUES		153,477			1,552,435		6,039		(153,477	)		1,558,474
TOTAL COST OF NET REVENUES		—			652,958		3,207		—			656,165
Provision for doubtful accounts		—			38,692		68		—			38,760
Selling, distribution and administrative		148,369			794,271		1,796		(153,477	)		790,959
Amortization of intangible assets		603			2,137		—		—			2,740

TOTAL COSTS AND EXPENSES		148,972			1,488,058		5,071		(153,477	)		1,488,624
OPERATING INCOME		4,505			64,377		968		—			69,850
Interest expense		95,996			628		—		—			96,624
Interest income and other		(56,073	)		54,578		474		—			(1,021	)

(LOSS) INCOME BEFORE TAXES		(35,418	)		9,171		494		—			(25,753	)
Income tax (benefit) expense		(7,495	)		1,185		—		—			(6,310	)

NET (LOSS) INCOME		(27,923	)		7,986		494		—			(19,443	)
Equity in income of subsidiaries, net of tax		8,480			494		—		(8,974	)		—

NET (LOSS) INCOME	$	(19,443	)	$	8,480	$	494	$	(8,974	)	$	(19,443	)

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2010

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries			Consolidating Adjustments			Consolidated
	(in thousands)
OPERATING ACTIVITIES
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES	$	10,053		$	97,545		$	(59	)	$	(13,501	)	$	94,038

INVESTING ACTIVITIES
Purchases of patient service equipment and property, equipment and improvements		(15,416	)		(69,253	)		(13	)		—			(84,682	)
Purchases of short term investments		(8,087	)		—			—			—			(8,087	)
Maturities of short term investments		31,507			—			—			—			31,507
Proceeds from disposition of assets		27			607			—			—			634
Cash paid for acquisitions		—			(2,260	)		—			—			(2,260	)

NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES		8,031			(70,906	)		(13	)		—			(62,888	)

FINANCING ACTIVITIES
Payments on other long-term debt		—			(1,314	)		—			—			(1,314	)
Change in book-cash overdraft included in accounts payable		—			(32,533	)		—			—			(32,533	)
Debt issuance costs		(3,590	)		—			—			—			(3,590	)
Cash paid on profit interest units		(78	)		—			—			—			(78	)

NET CASH USED IN FINANCING ACTIVITIES		(3,668	)		(33,847	)		—			—			(37,515	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		14,416			(7,208	)		(72	)		(13,501	)		(6,365	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		150,364			7,208			591			—			158,163

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	164,780		$	—		$	519		$	(13,501	)	$	151,798

APRIA HEALTHCARE GROUP INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2009

(Unaudited)


	Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries			Consolidating Adjustments		Consolidated
	(in thousands)
OPERATING ACTIVITIES
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES	$	46,826		$	93,309		$	(41	)	$	—	$	140,094

INVESTING ACTIVITIES
Purchases of patient service equipment and property, equipment and improvements		(12,264	)		(89,634	)		(28	)		—		(101,926	)
Purchase of short-term investments		(27,875	)		—			—			—		(27,875	)
Maturities of short-term investments		1,746			—			—			—		1,746
Proceeds from disposition of assets		43			6,785			—			—		6,828
Cash paid for acquisitions		—			(1,161	)		—			—		(1,161	)

NET CASH USED IN INVESTING ACTIVITIES		(38,350	)		(84,010	)		(28	)		—		(122,388	)

FINANCING ACTIVITIES
Payments on Bridge Credit Agreement		(1,010,000	)		—			—			—		(1,010,000	)
Proceeds from ABL Facility		630			—			—			—		630
Payments on ABL Facility		(6,630	)		—			—			—		(6,630	)
Payments on other long-term debt		—			(2,170	)		—			—		(2,170	)
Proceeds from issuance of Series A-1 Notes		700,000			—			—			—		700,000
Proceeds from issuance of Series A-2 Notes		317,500			—			—			—		317,500
Change in book-cash overdraft included in accounts payable		—			(4,644	)		—			—		(4,644	)
Debt issuance costs		(18,495	)		—			—			—		(18,495	)
Equity contributions		2,075			—			—			—		2,075

NET CASH USED IN FINANCING ACTIVITIES		(14,920	)		(6,814	)		—			—		(21,734	)

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		(6,444	)		2,485			(69	)		—		(4,028	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		159,393			8,260			365			—		168,018

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	152,949		$	10,745		$	296		$	—	$	163,990

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. Our forward-looking statements reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties such as the current global economic uncertainty, including the tightening of the credit markets and the recent significant declines and volatility in our global financial markets, that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in the “Risk Factors” and “Forward-Looking Statements” sections of this quarterly report on Form 10-Q. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the related notes and other information included in this quarterly report on Form 10-Q. References in this report to the “Company,” “we,” “us” and “our” refer to Apria Healthcare Group Inc. and its subsidiaries, unless otherwise noted or the context requires otherwise.

Overview. We have three core service lines: home respiratory therapy, home medical equipment and home infusion therapy. In these core service lines, we offer a variety of patient care management programs, including clinical and administrative support services, products and supplies, most of which are prescribed by a physician as part of a care plan. We provide these services to patients through approximately 500 locations throughout the United States. We have two reportable operating segments:

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home respiratory therapy and home medical equipment; and

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home infusion therapy.

On October 28, 2008, the Company was acquired (the “Merger”) by private investment funds affiliated with The Blackstone Group (“Blackstone” or the “Sponsor”).

Strategy. Our strategy is to position ourselves in the marketplace as a high-quality provider of a broad range of healthcare services and patient care management programs to our customers. The specific elements of our strategy are to:

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Grow profitable revenue and market share. We are focused on growing profitable revenues and increasing market share in our core home infusion therapy and home respiratory therapy service lines. We have undertaken a series of steps towards this end. Through our acquisition of Coram in December 2007, we considerably increased our home infusion capabilities and expanded our platform for further cross-selling opportunities. Since January 1, 2007, we have expanded our home respiratory therapy and home medical equipment sales force by 41%. This focus has allowed us to more effectively market our products and services to physicians, hospital discharge planners and managed care organizations.

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Continue to participate in the managed care market. We participate in the managed care market as a long-term strategic customer group because we believe that our scale, expertise, nationwide presence and array of home healthcare products and services will enable us to sign preferred provider agreements with managed care organizations. Managed care represented approximately 70% of our total net revenues for the nine months ended September 30, 2010.

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Leverage our national distribution infrastructure. With approximately 500 locations and a robust platform supporting shared national services, we believe that we can efficiently add products, services and patients to our systems to grow our revenues and leverage our cost structure. For example, we have successfully leveraged this distribution platform across a number of product and service offerings, including a continuous positive airway pressure (“CPAP”)/ bi-level supply replenishment program, enteral nutrition and negative pressure wound therapy (“NPWT”) services, and we are using our nursing capacity to provide infusion services through our growing network of ambulatory infusion suites. We seek to achieve margin improvements through operational initiatives focused on the continual reduction of costs and delivery of incremental efficiencies. At the same time, we believe that it is essential to consistently deliver superior customer service in order to increase referrals and retain existing patients. Performance improvement initiatives are underway in all aspects of our operations including customer service, patient satisfaction, logistics, supply chain, clinical services and billing/collections. We believe that by being responsive to the needs of our patients and payors we can provide ourselves with opportunities to take market share from our competitors.

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Continue to lead the industry in accreditation. The Medicare Improvement for Patients Act of 2008 (“MIPPA”) made accreditation mandatory for Medicare providers of durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”), effective October 1, 2009, per Centers for Medicare and Medicaid Services (“CMS”) regulation. We were the first durable medical equipment provider to seek and obtain voluntary accreditation from The Joint Commission. In June 2010, we completed a nationwide independent triennial accreditation renewal process conducted by The Joint Commission and, the Commission renewed our accreditation for another three years. The Joint Commission accreditation encompasses our full complement of services including home health, home medical equipment, clinical respiratory, ambulatory infusion services, pharmacy dispensing, and clinical consultant pharmacist services. We have more than 18 years of continuous accreditation by The Joint Commission—longer than any other homecare provider.

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Execute our strategic initiatives to drive profitability. For the past several years, we have successfully engaged in a range of cost savings initiatives to ease pressure on our revenue that has been and continues to be caused by Medicare and Medicaid reimbursement changes. These initiatives are designed to improve customer service, delivery and vehicle routing services, streamline the billing and payment process, effectively manage purchasing costs and improve the overall experience of the patients we serve. We launched a substantial cost reduction plan in late 2007. To date, we have made significant progress across a number of the identified initiatives targeting expected annual savings of approximately $172 million, of which we realized approximately $144 million through September 30, 2010.

Recent Developments. Exchange offer for Series A-1 Notes and Series A-2 Notes: In August 2010, we completed our registered exchange offer with respect to the Series A-1 Notes and Series A-2 Notes.

Outsourcing Initiatives Review: In August 2010, based on a review of key outsourcing initiatives, we refined our initial decisions concerning certain billing, collections and other administrative functions that were outsourced or designated to be outsourced to third parties. Based on our review, it was determined that certain of such functions should instead be performed by us. Accordingly, we are in the process of transitioning certain services presently outsourced to third parties back to us and expect to be substantially completed with that transition by June 30, 2011. In connection with that transition, we expect to incur associated one-time costs presently estimated to be $10 million. Further consolidation and outsourcing of billing, collections and other administrative functions are being evaluated on an ongoing basis.

Announcement of Single Payment Amounts (“SPAs”) and Contract Offer Process Related to Round 1 Rebid of the Medicare DMEPOS Competitive Bidding Program: In early July 2010, CMS announced the new SPAs for each of the product categories included in the Round 1 Rebid. CMS then began the contracting process with suppliers by issuing contract offer letters to qualified providers. We received and accepted contract offers for a substantial majority of the bids we submitted as announced by CMS on November 3, 2010. For example, for the oxygen product category, we won eight of our nine submitted bids; for the CPAP/bilevel category, we won seven of our nine bids and for enteral nutrition, we won all nine of our nine bids. A complete list of contract winners is available on the CMS website at www.cms.gov/DMEPOSCompetitiveBid. The new rates are still expected to take effect in January 2011. Approximately $21 million of our net revenues for the fiscal year ended December 31, 2009 was generated by the products and competitive bidding areas (“CBAs”) included in the Round 1 Rebid. We estimate that the initial results of the Round 1 Rebid would reduce our net revenues in the fiscal year ending December 31, 2011 by approximately $8 million, assuming the current contracts and no changes in volume. Assuming that Round 2 would include the same product categories and bidding rules and the markets currently being proposed by CMS, we estimate that approximately $110 million of our net revenues for the fiscal year ending December 31, 2011 would be subject to competitive bidding. Although the bidding process for Round 2 is currently scheduled to commence in 2011, the new Round 2 rates and guidelines are not scheduled to take effect until January 2013. Therefore, we cannot estimate the impact of potential Round 2 rate reductions on our business until more specific information is published by CMS and its contractors.

Critical Accounting Policies. We consider the accounting policies that govern revenue recognition and the determination of the net realizable value of accounts receivable to be the most critical in relation to our consolidated financial statements. These policies require the most complex and subjective judgments of management. Additionally, the accounting policies related to goodwill, long-lived assets, share-based compensation and income taxes require significant judgment. These policies are presented in detail in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in our Annual Report for the year ended December 31, 2009.

Government Regulation

We are subject to extensive government regulation, including numerous laws directed at regulating reimbursement of our products and services under various government programs and preventing fraud and abuse, as more fully described below. We maintain certain safeguards intended to reduce the likelihood that we will engage in conduct or enter into arrangements in violation of these restrictions. Corporate contract services and legal department personnel review and approve written contracts subject to these laws. We also maintain various educational and audit programs designed to keep our managers updated and informed regarding developments on these topics and to reinforce to employees our policy of strict compliance in this area. Federal and state laws require that we obtain facility and other regulatory licenses and that we enroll as a supplier with federal and state health programs. Under various federal and state laws, we are required to make filings or submit notices in connection with transactions that might be defined as a change of control of the Company. We are aware of these requirements and routinely make such filings with, and seek such approvals from, the applicable regulatory agencies. Notwithstanding these measures, due to changes in and new interpretations of such laws and regulations, and changes in our business, violations of these laws and regulations may still occur, which could subject us to civil and criminal enforcement actions; licensure revocation, suspension or non-renewal; severe fines and penalties; the repayment of amounts previously paid to us and even the termination of our ability to provide services, including those provided under certain government programs such as Medicare and Medicaid. See “Risk Factors—Risks Relating to Our Business—Continued Reductions in Medicare and Medicaid Reimbursement Rates and the Comprehensive Healthcare Reform Package Could Have a Material Adverse Effect on Our Results of Operations and Financial Condition” and “Risk Factors—Risks Relating to Our Business—Our Failure To Maintain Required Licenses Could Impact Our Operations.”

Medicare and Medicaid Revenues. In the three and nine months ended September 30, 2010 approximately 24% and 6% of our net revenues were reimbursed by the Medicare and state Medicaid programs, respectively. No other third-party payor represented more than 8% of our total net revenues for the three and nine months ended September 30, 2010. The majority of our revenues are derived from rental income on equipment rented and related services provided to patients, sales of equipment, supplies and pharmaceuticals and other items we sell to patients for patient care under fee-for-service arrangements. Revenues derived from capitation arrangements represented 8% of total net revenues for the three and nine months ended September 30, 2010.

Medicare Reimbursement. There are a number of legislative and regulatory initiatives in Congress and at CMS that affect or may affect Medicare reimbursement policies for products and services we provide. Specifically, a number of important legislative changes that affect our business were included in the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”), which was signed into law in December 2003; the Deficit Reduction Act of 2005 (“DRA”), which was signed into law in February 2006; MIPPA, which became law on July 15, 2008 and the comprehensive healthcare reform package enacted by the Federal government in March 2010 (“the Reform Package”). These Acts and their implementing regulations and guidelines contain numerous provisions that were significant to us and continue to have an impact on our operations today, as described below.

DMEPOS Competitive Bidding. The MMA required implementation of a competitive bidding program for certain DMEPOS items. By statute, CMS was required to implement the DMEPOS competitive bidding program over time, with Round 1 of competition occurring in portions of 10 of the largest Metropolitan Statistical Areas (“MSAs”), in 2007, launch of the program in 2008 and in 70 additional markets in 2009, and in additional markets after 2009.

In 2007 and 2008, CMS sought and reviewed bids and developed a plan to implement Round 1 on July 1, 2008. CMS offered us contracts in several CBAs in Round 1; we accepted the contracts for certain product categories and declined others due to unacceptably low SPAs in certain markets, which would not adequately cover the cost of providing quality service to our patients in those areas. We, along with other winning contract suppliers, began providing services under Round 1 on July 1, 2008.

The bidding process for Round 1 was controversial and complex, which resulted in deadline extensions. Moreover, CMS was subject to numerous lawsuits seeking a delay of Round 1. Then on July 15, 2008, MIPPA was enacted which, among other provisions, delayed the DMEPOS competitive bidding program by requiring that Round 1 competition commence in 2009, and required a number of program reforms prior to CMS’ re-launching the program. As a result, contracts that were awarded under Round 1 were terminated. The new “Round 1 Rebid” contracting process opened on October 21, 2009, and bids had to be submitted by December 21, 2009. We submitted our bids and related documentation by the stated deadlines, and CMS informed us of their receipt. In late June 2010, CMS published a Proposed Rule containing several provisions related to the competitive bidding program. The Proposed Rule included the proposed list of 21 additional MSAs to be included in Round 2, as well as provisions relating to the diabetic supply category. Those provisions include a proposed definition of “mail order” and “non-mail order” items and a

proposal for providers to supply a minimum level of product choices to patients. The public comment period on the Proposed Rule closed in August, and a Final Rule was published on November 2, 2010. CMS adjusted certain aspects of the geographic boundaries of three large MSAs, but otherwise the Round 2 markets are now final. In early July 2010, CMS announced the new SPAs for each of the product categories and each of the CBAs included in the Round 1 Rebid. CMS then began the contracting process with suppliers by issuing contract offer letters to qualified providers. The new rates are still expected to take effect in January 2011. Until then, all Medicare beneficiaries in the fee-for-service Medicare program may use any provider in any geographic area, including the CBAs, to obtain home medical equipment and oxygen therapy services and products.

Under MIPPA, the initial CBAs and product categories subject to rebidding are very similar to those of Round 1. MIPPA also excludes Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories as a competitive bidding product category in Round 1 and permanently excludes Group 3 Complex Rehabilitative Power Wheelchairs and Related Accessories as a competitive bidding product category. MIPPA also includes a new provision requiring bids for mail order diabetes testing supplies after Round 1 to include a certain percentage of all types of available diabetic testing strips.

The estimated annual total net revenues associated with the items that would have been subject to competitive bidding in Round 1 of what was to be the initial year of the program represented approximately 1.4% of our annual total net revenues. Although Medicare has not yet published its 2009 expenditures by CBA or product category, based on 2008 data provided during the Round 1 Rebid process, we estimate that after the DRA and MIPPA reimbursement reductions of 2009 and a change in our business mix since 2007 are allocated for, the estimated annual total net revenues associated with items subject to competitive bidding in the Round 1 Rebid is approximately 1.0% of our annual total net revenues. In early July 2010, CMS announced the new SPAs for each of the product categories and each of the CBAs included in the Round 1 Rebid. CMS then began the contracting process with suppliers by issuing contract offer letters to qualified providers. We received contract offers for a substantial majority of the bids we submitted. We did not receive contract offers for certain product categories in certain CBAs, but we expect to file a formal request to review certain of those bids since the bid winners were announced on November 3, 2010. Approximately $21 million of our net revenues for the fiscal year ended December 31, 2009 was generated by the products and CBAs included in the Round 1 Rebid. We estimate that the initial results of the Round 1 Rebid will impact our net revenues in the fiscal year ending December 31, 2011 by approximately $8 million, assuming the current contracts and no changes in volume.

Notwithstanding the changes MIPPA requires, competitive bidding imposes a significant risk to DMEPOS suppliers. Under the rules governing Round 1 and the Round 1 Rebid which proceeded after the delay, if a DMEPOS supplier operating in a CBA is not awarded a contract for that CBA, the supplier generally will not be able to bill and be reimbursed by Medicare for DMEPOS items supplied in that CBA for the time period covered by the competitive bidding program unless the supplier meets certain exceptions or acquires a winning bidder. Because the applicable statutes mandate financial savings from the competitive bidding program, a winning contract supplier will receive lower Medicare payment rates under competitive bidding than the otherwise applicable DMEPOS fee schedule rates. As competitive bidding is phased in across the country under the revised MIPPA implementation schedule, we will likely experience a reduction in reimbursement, as will most if not all other DMEPOS suppliers in the impacted areas. In addition, there is a risk that the new competitive bidding prices will become a benchmark for reimbursement from other payors. MIPPA does not prevent CMS from adjusting prices for DMEPOS items in non-bid areas; however, before using its authority to adjust prices in non-bid areas, MIPPA requires that CMS issue a regulation that specifies the methodology to be used and consider how prices through competitive bidding compare to costs for those items and services in the non-bid areas. In January 2009, CMS released an interim final rule on the DMEPOS competitive bidding program implementing certain MIPPA provisions requiring CMS to conduct the Round 1 Rebid in 2009 and mandating certain changes for both the Round 1 Rebid and subsequent rounds of the program, including (i) a decreased financial documentation burden, (ii) a process for providing feedback to suppliers regarding missing hardcopy documentation (primarily financial in nature, not the electronic bid form itself), and (iii) requiring bidders and, ultimately, contracted providers, to disclose to CMS information regarding accreditation status and subcontracting relationships. This interim final rule also formally exempted certain DMEPOS items (including crutches, canes, walkers, folding manual wheelchairs, blood glucose monitors and infusion pumps that are durable medical equipment) when furnished by hospitals to the hospitals’ own patients during an admission or on the date of discharge. In addition, the regulations permanently exclude Group 3 Complex Rehabilitative Power Wheelchairs and Related Accessories as a competitive bidding product category. The competitive bidding interim final rule became effective on April 18, 2009.

The Reform Package includes changes to the Medicare DMEPOS competitive bidding program. Significantly, Round 2 of the competitive bidding program has been expanded from 70 to 91 of the largest MSAs. CMS has announced that the effective date of the Round 2 pricing will be January 1, 2013; additional details concerning products to be included and other aspects of implementing

Round 2 will not be fully known until after CMS completes a rulemaking process, which was originally scheduled for the summer or fall of 2010. Assuming that Round 2 would include the same product categories, bidding rules and markets currently being proposed by CMS, we estimate that approximately $110 million of our net revenues for the fiscal year ending December 31, 2011 would be subject to competitive bidding. Although the bidding process for Round 2 is currently scheduled to commence in 2011, the new Round 2 rates and guidelines are not scheduled to take effect until January 2013. Therefore, we cannot estimate the impact of potential Round 2 rate reductions on our business until more specific information is published by CMS and its contractors. The Reform Package also gives the Secretary of Health and Human Services the authority to apply competitive bid pricing to non-bid areas, but details of that process are unlikely to be understood until after CMS issues guidance or completes a related rulemaking process.

With respect to the competitive bidding program generally, at a March 2010 Program Advisory and Oversight Committee (“PAOC”) meeting, CMS briefed the PAOC regarding the next round of the DMEPOS competitive bidding program. With review of Round 1 Rebid bids then underway, the briefing focused on certain aspects of Round 2, which is mandated by MIPPA to begin in 2011. CMS expects to make changes to the program through the rulemaking process and anticipated that another proposed rule would be published, with a final rule to be published in the fall of 2010 relating to the Round 2 product categories, and then begin pre-bidding supplier education. Although that deadline may not be met, CMS anticipates that it will announce the Round 2 bidding schedule and begin the bidding process, with bidder registration, in the winter of 2011. CMS plans to complete the bid evaluation process, announce the SPAs and begin the contract process for Round 2 in the spring of 2012. In addition, CMS plans to announce the Round 2 contract suppliers in the summer of 2012. We cannot quantify what negative impact, if any, the revised program, including the expansion of Round 2, will have upon our revenue or operations once the program is reinitiated, but it could be material.

Nevertheless, we believe that our geographic coverage, clinical marketing programs and purchasing strength provide competitive advantages to maintain and enhance market share under Medicare competitive bidding. However, there is no guarantee that we will be selected as a winning contract supplier in any phase of the program and be awarded competitive bidding contracts by CMS. Under the current competitive bidding regulations, if we are not selected as a winning contract supplier for a particular CBA, we will generally not be allowed to supply Medicare beneficiaries in the CBA with products subject to competitive bidding, unless we elect to continue to service existing patients under the “grandfathering provision” of the most recent final rule or we acquire a winning supplier. Because of our combination of both managed care and traditional business, we believe we can nevertheless maintain a favorable overall market position in a particular CBA even if we are not selected as a contract supplier.

Medicare Fee Schedule for DMEPOS and Consumer Price Index (“CPI”) Adjustments. In addition to the adoption of the DMEPOS competitive bidding program, the MMA implemented a five-year freeze on annual CPI payment increases for most durable medical equipment from 2004 to 2008. In MIPPA, in order to offset the cost of, or “pay for,” the delay in the implementation of the DMEPOS competitive bidding program, Congress approved a nationwide average payment reduction of 9.5% in the DMEPOS fee schedule for those product categories included in Round 1, effective January 1, 2009. These product categories could be subjected to a legislated CPI update in 2014, except if the item is still subject to competitive bidding or CMS has otherwise adjusted the payment rate.

The MIPPA legislation also authorized nationwide CPI increases from 2009 to 2013 for those DMEPOS items that were not subject to competitive bidding in July 2008. The CPI update for 2009 for non-competitively bid items was 5%. For 2010, the CPI was -1.4%, however, the annual DMEPOS updates cannot be negative. Accordingly, the CPI update in 2010 is 0%. The Reform Package makes changes to the Medicare durable medical equipment consumer price index adjustment for 2011 and each subsequent year based upon the CPI reduced by a new productivity adjustment which may result in negative updates. Accordingly, the CPI-U update for DMEPOS will be 1.1% in January 2011, but the aforementioned productivity adjustment is expected to be approximately the same, and so the net result is a 0 to .1% CPI increase in 2011.

Capped Rentals and Oxygen Equipment. Under the DRA, beginning with Medicare beneficiaries who received DMEPOS products and services as of January 2006, ownership of certain durable medical equipment categorized by CMS in the “capped rental” category (e.g., hospital beds, wheelchairs, nebulizers, patient lifts and CPAP devices) automatically transfers to the Medicare beneficiary at the end of a maximum rental period. As of January 1, 2006, the maximum rental period for this category became 13 months. Therefore, the first month in which the new policy had an impact on our revenue was February 2007. In addition, the service and maintenance fee, which had been paid to suppliers twice yearly after the rental period ended in order to cover various non-equipment service costs for patients who require use of the equipment, was eliminated for those patients who commenced service on or after January 1, 2006. However, the DRA provides for additional payments for maintenance and service of the item for repair parts and labor not covered by a supplier’s or manufacturer’s warranty. Implementing regulations also imposed other repair and replacement obligations on suppliers with respect to equipment that does not last the useful lifetime of the equipment, which CMS has generally defined as being five years.

With respect to oxygen equipment, the DRA converted Medicare reimbursement for oxygen equipment from an ongoing rental method to a capped rental and rent-to-purchase methodology and limited reimbursement for rental of oxygen equipment to the current 36-month maximum. The DRA mandated that, after the 36-month rental period, the ownership of the equipment would transfer to the Medicare beneficiary, who would assume primary responsibility for identifying when repairs or preventive maintenance are needed. However, MIPPA repealed the mandatory title transfer for oxygen equipment. The existing implementing regulations to the DRA and MIPPA provisions also limit supplier replacement of oxygen equipment during the rental period, and require suppliers to replace beneficiary-owned equipment that does not last the useful lifetime of the equipment, which CMS has generally defined as being five years. As a result, the equipment will continue to be owned by the home oxygen provider for as long as the patient’s medical need exists, after which time it will be returned to the home oxygen provider.

The 36-month rental period was retroactively applied to January 1, 2006 for all beneficiaries requiring oxygen as of December 31, 2005. Accordingly, Medicare services provided on or after January 1, 2009 were the first Medicare claims in which the rental cap impacted us. DRA regulations, which remain intact despite the repeal of mandatory title transfer, established new payment classes for oxygen equipment, including transfilling and portable equipment, new monthly rental reimbursement rates, and new reimbursement rates for the delivery of oxygen contents, if applicable. On November 19, 2008, CMS published revised regulations implementing DRA and MIPPA. Under the revised regulations, suppliers must continue furnishing oxygen equipment after the 36-month rental cap period during any period of medical need for the remainder of the reasonable useful lifetime of the equipment, with certain limited exceptions. CMS also specified that a new period of continuous use will not begin following the 36-month rental cap period until the end of the equipment’s reasonable useful lifetime, unless the equipment is replaced because it is lost, stolen, irreparably damaged, or is replaced after the reasonable useful life expires. CMS has provided that the reasonable useful lifetime of oxygen equipment is five years (60 months). Therefore, a new oxygen capped rental period (36 months) may begin after the five year (60 months) useful lifetime of the oxygen equipment. However, at least one Durable Medical Equipment Medicare Administrative Contractor (“DMEMAC”) has provided that a patient must request that the supplier provide the new oxygen equipment and the supplier may not arbitrarily issue new equipment. Among other provisions, CMS also stated that it would not reimburse suppliers for oxygen tubing, cannulas and supplies patients may need between the 37th and 60th months of oxygen therapy and requires that the initial supplier of oxygen therapy make arrangements with another supplier if a patient relocates temporarily or permanently outside of the initial supplier’s service area. In addition, CMS stated that it would not establish any reimbursement rates for non-routine services patients may require after the 36-month rental period. Our policies and procedures conform to the pertinent implementing regulations of the DRA and MIPPA.

Regarding repairs and maintenance of oxygen equipment, CMS revised its regulations so that for services provided on or after January 1, 2009, the implementing regulations permitted payment in calendar year 2009 only to suppliers for general maintenance and servicing of certain oxygen equipment every six months, beginning after the first six-month period elapsed after the initial 36-month rental period. The final rule governing repairs and maintenance of oxygen equipment limits payment for general maintenance and servicing visits to 30 minutes of labor based on rates the Medicare contractors establish. With respect to equipment parts, CMS has stated that payments will not be made for equipment parts and that the supplier is responsible for replacing the parts on equipment from the supplier’s inventory in order to meet the patient’s medical need for oxygen. CMS issued guidance in November 2009 continuing the general maintenance and servicing payments for certain oxygen equipment.

In a Proposed Rule issued in June 2010, CMS proposed to change the threshold rental month from which the original oxygen supplier would continue to be responsible for serving a patient, regardless of his/her move outside of the supplier’s service area, from the 36^th to the 18^th month. The agency sought public comments, and in a Final Rule published on November 2, 2010, the agency indicated that it would not change its current policy but would continue to study the issue. We cannot speculate on any future changes CMS may make to its repair, maintenance and service, supply or other fee schedules related to oxygen. We may or may not continue to provide repair and maintenance service on oxygen equipment that has met the cap. We routinely evaluate the impact of the changes caused by both the DRA and MIPPA and adjust our operating policies accordingly.

In recent years, there have been several legislative and executive branch efforts to further reduce the maximum rental period for oxygen therapy, equipment and related services. Former President Bush’s 2007, 2008 and 2009 healthcare budget proposals sought to reduce the maximum rental period for oxygen equipment from the DRA-mandated 36 months to 13 months, which was recommended by the U.S. Department of Health and Human Services’ (“HHS”) Office of Inspector General (“OIG”) in a limited study of the oxygen benefit published in 2006 entitled “Medicare Home Oxygen: Equipment Cost and Servicing.” Neither President

Obama’s 2010 budget proposal nor the Reform Package included a reduction in the oxygen rental period. However, it is premature to know whether future budgets or proposals will contain such a provision or any other provisions based on these or future studies released by one or more government agencies.

Over the course of 2008, CMS and the DMEMACs issued coverage determinations for positive airway pressure (“PAP”) devices, including CPAP and bi-level devices. Among other changes, the new Medicare DMEMAC local coverage determinations (“LCDs”) require additional documentation of clinical benefit of the PAP devices for continued coverage of the device beyond the first three months of therapy. Specifically, for PAP devices with initial dates of service on or after November 1, 2008, documentation of clinical benefit must be demonstrated by: (1) a face-to-face clinical re-evaluation by the treating physician (between the 31st and 90th day) with documentation that symptoms of obstructive sleep apnea are improved; and (2) objective evidence of adherence to use of the PAP device, reviewed by the treating physician. The LCDs define adherence to therapy as the use of the PAP device greater than or equal to 4 hours per night on 70% of nights during a consecutive thirty (30) day period anytime during the first three months of initial usage. If the clinical benefit requirements are not met, then continued coverage of the PAP device and related accessories are denied by Medicare as not medically necessary. We believe these requirements effectively require suppliers to supply PAP devices that monitor patient compliance and record hours of use, which adds to our expense structure without a corresponding increase in payments from Medicare. Beginning in late 2008 and continuing into 2010, we have adjusted our operational model, patient care and payment policies to comply with these new Medicare requirements. These requirements only apply to Medicare Part B fee-for-service patients, not to those patients enrolled in Medicare Advantage or commercial health plans, and Medicare Part B fee-for-service represents a smaller portion of the overall PAP patient market. Despite our intensive efforts to educate patients about the importance of complying with their physician-prescribed therapy, some of our Medicare Part B patients do not meet the threshold for compliance. In order to reduce the impact of the LCDs, we are continuing to educate patients and referral sources concerning the importance of compliance with the patient’s prescribed therapy. However, these and similar LCDs are likely to continue to impact the PAP industry.

Reimbursement for Inhalation and Infusion Therapy Drugs. As a result of the MMA, beginning January 2005, Medicare Part B reimbursement for most drugs, including inhalation drugs, became based upon the manufacturer-reported ASP (subject to adjustment each quarter), plus 6%, plus a separate dispensing fee per patient episode. CMS publishes the ASP plus 6% payment levels in the month that precedes the first day of each quarter, and we have no way of knowing if the quarterly ASPs will increase or decrease since manufacturers report applicable ASP information directly to CMS. Since 2006, dispensing fees have remained at $57.00 for a 30-day supply for a new patient, $33.00 for each 30-day supply thereafter, and $66.00 for each 90-day supply.

The Medicare reimbursement methodology for non-compounded, infused drugs administered through durable medical equipment, such as infusion pumps, was not affected by this MMA change. It remains based upon either 95% of the October 1, 2003 Average Wholesale Price (“AWP”) or, for those drugs whose AWPs were not published in the applicable 2003 compendia, at 95% of the first published AWP. Also, coding and reimbursement changes pertaining to compounded medications, issued in 2007, did not have a material impact on us due to the extremely low volume of patient-specific, physician-prescribed compounding that was performed by our inhalation pharmacies.

Although CMS had considered issuing a National Coverage Decision (“NCD”) for certain inhalation drug therapies, in the third quarter of 2007, CMS issued a NCD that stated that no national coverage policy was appropriate at that time. Rather, CMS stated that it would continue to defer decisions about the medical necessity of individual respiratory drugs to the local contractors. Thereafter, in April of 2008, the DMEMACs finalized proposed LCD policies for several respiratory drugs, including Xopenex^® and DuoNeb^®¹. Each of these two drugs was subjected to a separate “least costly alternative” (“LCA”) policy which would have changed the reimbursement methodology in a way that would effectively have eliminated Medicare beneficiary access to these drugs which are frequently used to treat COPD. After complaints were filed by Medicare beneficiaries in the Federal District Court for the District of Columbia, CMS announced that it planned to withdraw the LCA for Xopenex. On November 5, 2008, the plaintiffs in the Xopenex case filed a Motion to Voluntarily Dismiss all claims in the litigation. Subsequent to the filing of the complaint in the DuoNeb case, CMS postponed the LCA for DuoNeb until November 1, 2008. In November 2008, the Federal District Court for the District of Columbia enjoined CMS’s LCA for DuoNeb, saying that the Medicare program’s policy of paying for only “the least costly alternative” was not permitted under the Medicare law and finding that Medicare and some of its contractors had unlawfully limited payments for DuoNeb. The court made two distinct findings on the merits, in summary: (1) with limited exceptions (e.g., a public health emergency) CMS does not have the authority to deviate from the 106% ASP calculation for a covered Part B drug, and (2) the

¹	Xopenex is a registered trademark of Sepracor, Inc., and DuoNeb is a registered trademark of Dey Labs, LLC.

“reasonable and necessary” language in Section 1862 refers to coverage only and cannot be applied to reimbursement determinations. The court reasoned that CMS’s position would have given the Secretary of HHS significant discretion to determine the amount paid for every item and service covered by Medicare, without reference to the detailed formulas established in the laws enacted by Congress. This decision was appealed by the government in the U.S. Court of Appeals for the District of Columbia. In December 2009, the U.S. Court of Appeals for the District of Columbia upheld the District Court’s ruling in all regards and confirmed the distinction between Medicare coverage and reimbursement by ruling that the Medicare statute precludes the Secretary from issuing a coverage determination that sets the reimbursement rate for a covered drug based on the “least costly alternative”. This decision has national implications for the coverage of inhalation drugs. The time period for the government to file an appeal of the Court of Appeals’ decision has expired, and the government did not appeal.

A limited number of infusion therapies, supplies and equipment are covered by Medicare Part B. The MMA, through the new Medicare Part D program, provided expanded coverage for certain home infusion therapy drugs, but excluded coverage for the corresponding supplies and clinical services needed to safely and effectively administer these drugs. We have contracted with a limited number of Medicare Part D prescription drug plans in order to provide continuity of care for certain patients.

Due to ongoing Part D and Part B coverage and payment issues associated with home infusion therapy, the industry is continuing to work with CMS and Congress to rectify the Medicare coverage and payment limitations that restrict Medicare beneficiary and referral source access to quality home infusion therapy services. Bills were introduced in the 111th Congress in January 2009 (as they were in both the 109th and 110th Congress) to consolidate home infusion therapy coverage under Part B. The Medicare Home Infusion Coverage Act of 2009 would provide for Medicare infusion benefit coverage in a more comprehensive manner that is analogous to how the therapy is covered by the managed care sector, including Medicare Advantage plans. Industry representatives continue to present the cost-saving and patient care advantages of home infusion therapy to CMS, members of Congress and the Obama Administration in an effort to, at a minimum, include a formal demonstration project in either CMS’ work plan or future legislation. Testimony before the Senate Finance Committee in September 2009 acknowledged the current gap in coverage and potential benefits of home infusion therapy to the Medicare program and beneficiaries. At this time, we cannot predict whether legislation will be passed or whether CMS will include a demonstration project in a future work plan.

Enrollment and Accreditation of Durable Medical Equipment Suppliers; Surety Bond Requirements. While we support the elimination of fraudulent suppliers and are working with CMS to support these initiatives, we also note that a number of initiatives and developments with respect to the enrollment and accreditation of providers could impact our operations in the future. For example, all durable medical equipment providers who bill the Medicare program for DMEPOS services and products are required by MIPPA to be accredited. We and all of our branches currently are accredited. If we or any of our branches lose accreditation, or if any of our new branches are unable to become accredited, that could have a material adverse effect on our results of operations, cash flow and capital resources.

In July 2007, CMS issued a proposed rule requiring all DMEPOS suppliers to provide CMS with a surety bond of at least $65,000 for each National Provider Identifier (“NPI”) number the supplier holds. On January 2, 2009, CMS issued the final rule, requiring a surety bond of $50,000 by October 2, 2009 per NPI number which Medicare has approved for billing privileges. Apria obtained the required surety bonds for all of its applicable locations before the deadline and received confirmation from the National Supplier Clearinghouse (“NSC”) that the NSC has recorded the bonds properly in its records. In addition, the NSC prescribes an elevated bond amount of $50,000 per occurrence of an adverse legal action within the 10 years preceding enrollment, reenrollment or revalidation. The rule, effective March 3, 2009, is designed to ensure that Medicare can recover any erroneous payment amounts or civil money penalties up to $50,000 that result from fraudulent or abusive supplier billing practices.

In October 2008, CMS announced enhancements to its program integrity initiatives designed to identify and prevent waste, fraud and abuse. The initiatives include: (i) conducting more stringent reviews of DMEPOS suppliers’ applications, including background checks of new DMEPOS suppliers’ principals and owners to ensure they have not been suspended by Medicare; (ii) making unannounced site visits to suppliers and home health agencies to ensure they are active, legitimate businesses; (iii) implementing extensive pre- and post-payment claims review; (iv) verifying the relationship between physicians who order a large volume of DMEPOS equipment and the beneficiaries for whom they ordered these services; and (v) identifying and visiting beneficiaries to ensure appropriate receipt of Medicare-reimbursable items and services. We work cooperatively with CMS and its contractors in response to these initiatives but cannot predict whether CMS’ various program integrity efforts will or will not negatively impact our operations.

In August 2010, CMS released a final rule imposing more stringent standards for DMEPOS suppliers, which introduced several new enrollment standards and expanded some existing standards and participation requirements, all of which DMEPOS suppliers must meet to establish and maintain billing privileges in the Medicare program. These standards became effective on September 27, 2010.

Following the implementation of a 3-year demonstration program using Recovery Audit Contractors (“RACs”) to detect and correct improper payments in the Medicare fee-for-service program, the Tax Relief and Health Care Act of 2006 required HHS to establish the RAC initiative as a permanent, nationwide program by no later than January 1, 2010. CMS selected the four RAC contractors for the permanent RAC program and the permanent RAC program is currently underway. Prior to initiating any audits, RACs are required to obtain CMS’ pre-approval of the issue that will be subject to audit, and then post the approved audit issue on their websites. All RACs have now posted CMS-approved audit issues on their websites. The currently posted approved audit issues include those which apply to Durable Medical Equipment (“DME”) suppliers. States have also implemented similar state Medicaid audit programs, often know as Medicaid Integrity Contractors (“MICs”). The Reform Package expands the RAC program to include Medicare Parts C and D in the program. In addition, the Reform Package requires states to establish contracts with RACs to identify underpayments and overpayments and to recoup overpayments made for services provided under State Medicaid programs. In addition, in March of 2010, President Obama issued a presidential memorandum announcing a government-wide program expanding the use “payment recapture audits” in order to reclaim improper payments. We cannot at this time quantify any negative impact that the expansion of the RAC program or other similar programs may have on us.

Also in October 2008, CMS announced the establishment of new Zone Program Integrity Contractors (“ZPICs”), who are responsible for ensuring the integrity of all Medicare-related claims. The ZPICs assumed the responsibilities previously held by Medicare’s Program Safeguard Contractors (“PSCs”). Industry-wide, ZPIC audit activity increased in the third quarter of 2010 and is expected to continue to increase for the foreseeable future. The industry trade association is advocating for more contractor transparency and consistency surrounding all government audit activity directed toward the DMEPOS industry.

Other Issues

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Medical Necessity & Other Documentation Requirements. In order to ensure that Medicare beneficiaries only receive medically necessary and appropriate items and services, the Medicare program has adopted a number of documentation requirements. For example, the DMEMAC Supplier Manuals provide that clinical information from the “patient’s medical record” is required to justify the medical necessity for the provision of DME. We have implemented policies and procedures to meet Medicare’s documentation requirements. However, some DMEMAC and other government auditors have recently taken the position, among other things, that the “patient’s medical record” refers not to documentation maintained by the DME supplier but instead to documentation maintained by the patient’s physician, healthcare facility or other clinician, and that clinical information created by the DME supplier’s personnel and confirmed by the patient’s physician is not sufficient to establish medical necessity. It may be difficult, and sometimes impossible, for us to obtain documentation from other healthcare providers. If these or other burdensome positions are generally adopted by auditors, DMEMACs, other contractors or CMS in administering the Medicare program, we would have the right to challenge these positions as being contrary to law. If these interpretations of the documentation requirements are ultimately upheld, however, it could result in our making refunds and other payments to Medicare and our future revenues from Medicare may be reduced. We cannot currently predict the adverse impact, if any, these interpretations of the Medicare documentation requirements might have on our operations, cash flow and capital resources, but such impact could be material.

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Inherent Reasonableness. The Balanced Budget Act of 1997 granted authority to HHS to increase or reduce Medicare Part B reimbursement for home medical equipment, including oxygen, by up to 15% each year under an “inherent reasonableness” authority. Pursuant to that authority, CMS published a final rule that established a process by which such adjustments may be made. The rule applies to all Medicare Part B services except those paid under a physician fee schedule, a prospective payment system, or a competitive bidding program. Neither HHS nor CMS has issued any subsequent communication or information for several years and therefore, we cannot predict whether or when HHS would exercise its authority in this area or predict any negative impact of any such change.

The impact of changes in Medicare reimbursement that have been enacted to date are reflected in our results of operations for the applicable periods through September 30, 2010. We cannot estimate the combined possible impact of all legislative, regulatory and contemplated reimbursement changes that could have a material adverse effect on our results of operations, cash flow, and capital

resources. Moreover, our estimates of the impact of certain of these changes appearing in this “Government Regulation” section are based on a number of assumptions and are subject to uncertainties and there can be no assurance that the actual impact was not or will not be different from our estimates.

Medicaid Reimbursement. State Medicaid programs implement reimbursement policies for the items and services we provide that may or may not be similar to those of the Medicare program. Budget pressures on these state programs often result in pricing and coverage changes that may have a detrimental impact on our operations and/or financial performance. States sometimes have interposed intermediaries to administer their Medicaid programs, or have adopted alternative pricing methodologies for certain drugs, biologicals, and home medical equipment under their Medicaid programs that reduce the level of reimbursement received by us without a corresponding offset or increase to compensate for the service costs incurred. For example, Medi-Cal adopted a regulation that limits the amounts a provider can bill for certain durable medical equipment and medical supplies. In March 2009, the California Association of Medical Product Suppliers (“CAMPS”) initiated a lawsuit to invalidate this regulation as having been adopted in violation of California’s Administrative Procedure Act. On August 3, 2009, the court entered a decision denying CAMPS’ petition. CAMPS has appealed the court’s decision. If the regulation is ultimately upheld, it would most likely result in our making refunds and other payments to Medi-Cal, and our future revenues from Medi-Cal may be reduced. Historically, when such regulatory or administrative burdens have been imposed, or such alternative pricing methodologies were adopted, we have sometimes elected to stop accepting new Medicaid patient referrals for the affected drugs, biologicals, and home medical equipment. We are currently evaluating the possibility of stopping or reducing our Medicaid business in a number of states with reimbursement or administrative policies that make it difficult for us to safely care for patients or conduct operations profitably. Moreover, the Reform Package increases Medicaid enrollment over a number of years and imposes additional requirements on states which, combined with the current economic environment and state deficits, could further strain state budgets and therefore result in additional policy changes or rate reductions. We cannot currently predict the adverse impact, if any, that any such change to or reduction in our Medicaid business might have on our operations, cash flow and capital resources, but such impact could be material. In addition, we cannot predict whether other states will consider similar or other reimbursement reductions, whether healthcare reform provisions pertaining to Medicaid will ultimately be passed into law or whether any such changes would have a material adverse effect on our results of operations, cash flow and capital resources.

HIPAA. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) is comprised of a number of components pertaining to the privacy and security of certain protected health information (“PHI”), as well as the standard formatting of certain electronic health transactions. Many states have similar, but not identical, restrictions. Existing and any new laws or regulations have a significant effect on the manner in which we handle healthcare related data and communicate with payors. Among other provisions, the HITECH Act of the American Recovery and Reinvestment Act of 2009, includes additional requirements related to the privacy and security of PHI, clarifies and increases penalties of HIPAA and provides State Attorneys General with HIPAA enforcement authority. We have adopted a number of policies and procedures to conform to HIPAA requirements, as modified by the HITECH Act of the American Recovery and Reinvestment Act of 2009, throughout our operations and educated our workforce about HIPAA provisions. We face potential administrative, civil and criminal sanctions if we do not comply with the existing or new laws and regulations. Imposition of these sanctions could have a material adverse effect on our operations.

Enforcement of Healthcare Fraud and Abuse Laws. In recent years, the federal government has made a policy decision to significantly increase the financial resources allocated to enforcing the healthcare fraud and abuse laws. Moreover, Congress adopted a number of additional provisions in the Reform Package that are designed to reduce healthcare fraud and abuse. In addition, private insurers and various state enforcement agencies have increased their level of scrutiny of healthcare claims in an effort to identify and prosecute fraudulent and abusive practices in the healthcare area. From time to time, we may be the subject of investigations or a party to additional litigation which alleges violations of law. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

Anti-Kickback Statutes. As a provider of services under the Medicare and Medicaid programs, we must comply with a provision of the federal Social Security Act, commonly known as the “federal anti-kickback statute.” The federal anti-kickback statute prohibits the offer or receipt of any bribe, kickback or rebate in return for the referral or arranging for the referral of patients, products or services covered by federal healthcare programs. Federal healthcare programs have been defined to include plans and programs that provide health benefits funded by the United States Government, including Medicare, Medicaid and TRICARE (formerly known as the Civilian Health and Medical Program of the Uniformed Services or CHAMPUS), among others. Some courts and the OIG interpret the statute to cover any arrangement where even one purpose of the remuneration is to influence referrals. Violations of the federal anti-kickback statute may result in civil and criminal penalties and exclusion from participation in federal healthcare programs.

Due to the breadth of the federal anti-kickback statute’s broad prohibition, there are a few statutory exceptions that protect various common business transactions and arrangements from prosecution. In addition, the OIG has published safe harbor regulations that outline other arrangements that also are deemed protected from prosecution under the federal anti-kickback statute, provided all applicable criteria are met. The failure of an activity to meet all of the applicable safe harbor criteria does not necessarily mean that the particular arrangement violates the federal anti-kickback law, but these arrangements will be subject to greater scrutiny by enforcement agencies.

Some states have enacted statutes and regulations similar to the federal anti-kickback statute, but which apply not only to the federal healthcare programs, but also to any payor source of the patient. These state laws may contain exceptions and safe harbors that are different from those of the federal law and that may vary from state to state. A number of states in which we operate have laws that prohibit fee-splitting arrangements between healthcare providers, if such arrangements are designed to induce or encourage the referral of patients to a particular provider. Additionally, several states have passed laws further regulating interactions between healthcare providers and physician referral sources. In late 2009, the state of New York enacted a requirement for certain healthcare providers to file a formal statement in which they attest that they have adopted a formal corporate compliance program which meets the state’s specific requirements; we complied with that requirement. Possible sanctions for violations of these restrictions include exclusion from state-funded healthcare programs, loss of licensure, and civil and criminal penalties. Such statutes vary from state to state, are often vague and often have been subject to only limited court or regulatory agency interpretation.

Marketing Laws. Because of our drug compounding and oxygen services, we may be subject to new and increasingly common state laws and regulations regarding our marketing activities and the nature of our interactions with physicians and other healthcare entity customers. These laws may require us to comply with certain codes of conduct, limit or report certain marketing expenses, disclose certain physician and customer arrangements, and ensure the appropriate licensure of certain sales personnel. There have also been similar federal legislative and regulatory initiatives. Violations of these laws and regulations, to the extent applicable, could subject us to civil and criminal fines and penalties, as well as possible exclusion from participation in federal healthcare programs, such as Medicare and Medicaid. From time to time, we may be the subject of investigations or audits or be a party to litigation which alleges violations of these laws. If any of those matters were successfully asserted against us, there could be a material adverse effect on our business, financial position, results of operations or prospects.

Physician Self-Referral. Certain provisions of the Omnibus Budget Reconciliation Act of 1993 (the “Stark Law”) prohibit healthcare providers such as us, subject to certain exceptions, from submitting claims to the Medicare and Medicaid programs for designated health services if we have a financial relationship with the physician making the referral for such services or with a member of such physician’s immediate family. The term “designated health services” includes several services commonly performed or supplied by us, including durable medical equipment and home health services. In addition, “financial relationship” is broadly defined to include any ownership or investment interest or compensation arrangement pursuant to which a physician receives remuneration from the provider at issue. The Stark Law prohibition applies regardless of the reasons for the financial relationship and the referral; and therefore, unlike the federal anti-kickback statute, an intent to violate the law is not required. Like the federal anti-kickback statute, the Stark Law contains a number of statutory and regulatory exceptions intended to protect certain types of transactions and business arrangements from penalty.

In order to qualify an arrangement under a Stark Law exception, compliance with all of the exception’s requirements is necessary. Violations of the Stark Law may result in loss of Medicare and Medicaid reimbursement, civil penalties and exclusion from participation in the Medicare and Medicaid programs.

In addition, a number of the states in which we operate have similar prohibitions against physician self-referrals, which may not necessarily be limited to Medicare or Medicaid services and may not include the same statutory and regulatory exceptions found in the Stark Law.

False Claims. The federal False Claims Acts impose civil and criminal liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the federal civil False Claims Act may result in treble damages, civil monetary penalties and exclusion from the Medicare, Medicaid and other federally funded healthcare programs. If certain criteria are satisfied, the federal civil False Claims Act allows a private individual to bring a qui tam suit on behalf of the government and, if the case is successful, to share in any recovery. Federal False Claims Act suits brought directly by the government or private individuals against healthcare providers, like us, are increasingly common and are expected to continue to increase.

The federal government has used the federal False Claims Act to prosecute a wide variety of alleged false claims and fraud allegedly perpetrated against Medicare and state healthcare programs. The government and a number of courts also have taken the position that claims presented in violation of certain other statutes, including the federal anti-kickback statute or the Stark Law, can be considered a violation of the federal False Claims Act, based on the theory that a provider impliedly certifies compliance with all applicable laws, regulations and other rules when submitting claims for reimbursement.

On May 20, 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 (“FERA”). Among other things, FERA modifies the federal False Claims Act by expanding liability to contractors and subcontractors who do not directly present claims to the federal government. FERA also expanded the False Claims Act liability for what is referred to as a “reverse false claim” by explicitly making it unlawful to knowingly conceal or knowingly and improperly avoid or decrease an obligation owed to the federal government.

A number of states have enacted false claims acts that are similar to the federal False Claims Act. Even more states are expected to do so in the future because Section 6031 of the DRA amended the federal law to encourage these types of changes in law at the state level. In addition, there is a corresponding increase in state-initiated false claims enforcement efforts.

Other Fraud and Abuse Laws. HIPAA created, in part, two new federal crimes: “Healthcare Fraud” and “False Statements Relating to Healthcare Matters.” The Healthcare Fraud statute prohibits executing a knowing and willful scheme or artifice to defraud any healthcare benefit program. A violation of this statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.

The increased public focus on waste, fraud and abuse and their related cost to society will likely result in additional Congressional hearings, CMS regulatory changes or new laws. The Reform Package also provides for new regulatory authority, additional fines and penalties. At this time, we cannot predict whether these or other reforms will ultimately become law, or the impact of such reforms on our business operations and financial performance.

Certification of Compliance Agreement. Pursuant to the merger agreement to acquire Coram, we assumed Coram’s obligations. On August 22, 2007, Coram entered into a three-year Compliance Agreement with the OIG which obligated Coram to maintain a compliance program to monitor and ensure compliance with federal healthcare program requirements and submit timely reports to the government regarding the same. Violation of the terms of the Compliance Agreement could have resulted in the imposition of penalties and sanctions, including disqualification from Medicare and other reimbursement programs. After submitting our final report to the OIG (as required under the Compliance Agreement), the OIG issued a closure letter to us dated September 21, 2010 and that the Compliance Agreement has concluded to the satisfaction of the OIG. The Company and its Coram division will continue to implement an enterprise-wide corporate compliance program which is grounded in existing laws, rules and regulations and guidelines for healthcare organizations issued by the OIG.

Facility and Clinician Licensure. Various federal and state authorities and clinical practice boards regulate the licensure of our facilities and clinical specialists working for us, either directly as employees or on a per diem or contractual basis. Regulations and requirements vary from state to state, and in some states, we are required to make filings in connection with transactions that may be defined as a change of control. Moreover, several states are currently contemplating the establishment or expansion of facility licensure related to the home healthcare industry. We are committed to complying with all applicable licensing requirements and maintain centralized functions to manage over 4,500 facility licenses and/or permits that are required to operate our business.

Healthcare Reform Legislation. Economic, political and regulatory influences are causing fundamental changes in the healthcare industry in the United States. Various healthcare reform proposals are formulated and proposed by the legislative and administrative branches of the federal government on a regular basis. In addition, some of the states in which we operate periodically consider various healthcare reform proposals. Even with the passage of the Reform Package, we anticipate that federal and state governments will continue to review and assess alternative healthcare delivery systems and payment methodologies and public debate of these issues will continue in the future. A number of parties, including some State governments, have begun to challenge the Reform Package, and we

cannot predict the outcome of such challenges, if any. The mid-term elections may also change the composition of the Congress and thus the priorities related to healthcare. Changes in the law or new interpretations of existing laws can have a substantial effect on permissible activities, the relative costs associated with doing business in the healthcare industry and the amount of reimbursement by governmental and other third-party payors. Due to uncertainties regarding the ultimate features of reform initiatives and their enactment and implementation, we cannot predict which, if any, of such reform proposals will be adopted, or when they may be adopted, or that any such reforms will not have a material adverse effect on our results of operations, cash flow, capital resources and liquidity.

Results of Operations

Three Months Ended September 30, 2010 and 2009

Net Revenues. Net revenues increased $6.5 million, or 1.3%, to $526.0 million in the three months ended September 30, 2010 from $519.5 million in the three months ended September 30, 2009. The increase in revenue was due primarily to an increase in home infusion therapy revenue. The increase was primarily offset by a decrease in revenue due to the non-renewal or termination of, or changes to, certain payor contracts. We expect to continue to strategically evaluate our payor contracts.

We also expect to continue to face pricing pressures from Medicare and Medicaid as well as from our managed care customers as these payors seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See “—Government Regulation.”

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin in the three months ended September 30, 2010 was 60.5%, compared to 52.7% in the three months ended September 30, 2009. Included in cost of revenue in the three months ended September 30, 2009 was intangible asset amortization related to our patient backlog of $42.2 million, which was fully amortized during the year ended December 31, 2009 and did not recur in 2010, and the favorable impact of certain cost of goods sold adjustments. Excluding the impact of intangible asset amortization and the favorable impact of certain cost of goods sold adjustments, the overall gross profit margin percentage for the three months ended September 30, 2009 would have been 60.7%. The decline in gross profit margin percentage is primarily due to an increase in the revenue of the home infusion therapy segment as a percent of total company revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenues than the home respiratory therapy and home medical equipment segment. This decline in the gross profit margin percentage is partially offset by our ability to obtain favorable pricing on the purchase of products.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable after considering actual write-offs of specific receivables. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management may adjust for changes in billing practices, cash collection protocols or practices, or changes in general economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 2.1% and 2.6% in the three months ended September 30, 2010 and the three months ended September 30, 2009, respectively.

Selling, Distribution and Administrative Expenses. Selling, distribution and administrative expenses are comprised of expenses incurred in direct support of operations and those associated with administrative functions. Expenses incurred by the operating locations include salaries and other expenses in the following functional areas: selling, distribution, clinical services, warehousing and repair. Many of these operating costs are directly variable with revenue growth patterns. Some are also very sensitive to market-driven price fluctuations such as facility lease and fuel costs. The administrative expenses include overhead costs incurred by the operating locations, regional and corporate support functions. These expenses are generally less sensitive to fluctuations in revenue growth than operating costs.

Selling, distribution and administrative expenses, expressed as a percentage of total net revenues was 51.5% for the three months ended September 30, 2010 compared to 50.9% for the three months ended September 30, 2009.

Selling, distribution and administrative expenses increased by $6.6 million for the three months ended September 30, 2010 over the three months ended September 30, 2009. The increase was comprised of a $3.0 million decrease in labor and other related expenses offset by an increase in other operating expenses of $9.6 million. The decrease in labor and other related expenses was due to reduced salaries and termination benefits as a result of headcount reductions due primarily to the outsourcing of certain functions relating to documentation, billing, reimbursement, and information technology, and lower management incentive compensation program expense as a result of not meeting certain targets in 2010. These decreases were partially offset by an increase in labor expenses due to increases in our home respiratory therapy and home medical equipment sales force and an increase in infusion labor expense to support the growth in our infusion revenue. The increases in other operating expenses of $9.6 million were primarily due to an increase in professional fees and expenses related to the outsourcing of certain functions relating to billing, collections and other administrative and clerical services. In addition, we incurred increased professional fees related to 2010 corporate initiative projects, an increase in depreciation related to information technology assets, and an increase in travel and marketing expenses related to sales force expansion and operations training. The increases in other operating expenses were partially offset by expenses associated with other corporate initiative projects that occurred in 2009 that did not recur in 2010.

Amortization of Intangible Assets. Amortization of intangible assets was $1.0 million in the three months ended September 30, 2010 and $(0.2) million in the three months ended September 30, 2009. The amortization expense primarily results from the revaluation of intangible assets as a result of the Merger, including the finalization of the intangible asset valuation in 2009.

Interest Expense. Interest expense increased $0.6 million, or 2.1%, to $32.7 million in the three months ended September 30, 2010 from $32.1 million in the three months ended September 30, 2009. This increase is primarily due to higher amortization of deferred debt costs related to the issuance and registration of $700.0 million of our 11.25% Senior Secured Notes due 2014 (Series A-1) (the “Series A-1 Notes”) and $317.5 million of our 12.375% Senior Secured Notes due 2014 (Series A-2) (the “Series A-2 Notes”).

Interest Income and Other. Interest income and other decreased $0.3 million, or 52.8%, to $0.2 million in the three months ended September 30, 2010 from $0.5 million in the three months ended September 30, 2009.

Income Tax Expense. Our effective tax rate was 104.4% for the three months ended September 30, 2010 compared with 34.9% for the three months ended September 30, 2009. Differences in our effective tax rate compared with federal and state statutory rates and fluctuations in our effective tax rate between comparative accounting periods stem primarily from the impact of non-deductible equity compensation as a percentage of pretax income or loss.

Our provision for income taxes is based on expected income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining the provision for income taxes. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, allocation of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately reflect our potential obligations under generally accepted accounting principles.

Segment Net Revenues and EBIT

For a reconciliation of segment net revenues and EBIT to net income, please see Note 11—Segments.

The following table sets forth a summary of results of operations by segment:


*(dollars in thousands)*	Three Months Ended September 30, 2010		Percentage of Net Revenues			Three Months Ended September 30, 2009		Percentage of Net Revenues
Net revenues:
Home respiratory therapy and home medical equipment	$	270,223		51.4	%	$	284,592		54.8	%
Home infusion therapy		255,791		48.6			234,923		45.2

Total net revenues	$	526,014		100.0	%	$	519,515		100.0	%


	Three Months Ended September 30, 2010
*(dollars in thousands)*	Home Respiratory Therapy and Home Medical Equipment			Percentage of Segment Net Revenues			Home Infusion Therapy		Percentage of Segment Net Revenues			Total
EBIT	$	3,129			1.2	%	$	31,611		12.4	%	$	34,740

	Three Months Ended September 30, 2009
*(dollars in thousands)*	Home Respiratory Therapy and Home Medical Equipment			Percentage of Segment Net Revenues			Home Infusion Therapy		Percentage of Segment Net Revenues			Total
EBIT	$	(20,418	)		7.2	%	$	16,767		7.1	%	$	(3,651	)

We allocate certain expenses that are not directly attributable to a product line based upon segment headcount.

Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues decreased $14.4 million, or 5.0%, to $270.2 million in the three months ended September 30, 2010 from $284.6 million in the three months ended September 30, 2009. Revenues for the home respiratory therapy and home medical equipment segment decreased to 51.4% of total revenue in the three months ended September 30, 2010 from 54.8% in the three months ended September 30, 2009.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, home ventilators, obstructive sleep apnea equipment, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line decreased by 5.9% in the three months ended September 30, 2010 compared to the three months ended September 30, 2009. The decrease in revenue resulted primarily from decreases in oxygen, sleep apnea and other respiratory revenue, primarily due to the termination of or changes to certain payor contracts.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues increased by 0.3% in the three months ended September 30, 2010 compared to the three months ended September 30, 2009. The increase was primarily due to an increase in volume offset by a decrease in revenue due to the termination of or changes to certain payor contracts.

EBIT for the home respiratory and home medical equipment segment in the three months ended September 30, 2010 was $3.1 million compared to $(20.4) million in the three months ended September 30, 2009. EBIT was 1.2% of segment net revenues in the three months ended September 30, 2010 compared to a negative 7.2% of segment net revenues in the three months ended September 30, 2009. EBIT for the three months ended September 30, 2009 included $34.2 million of amortization expense related to our patient backlog intangible asset which was fully amortized during the year ended December 31, 2009. Adjusting for the impact of this $34.2 million of amortization in the three months ended September 30, 2009, EBIT would have been $13.8 million or 4.8% of segment net revenues. The decrease in the EBIT from 4.8% for the three months ended September 30, 2009 to 1.2% in the three months ended

September 30, 2010 is primarily due to a decrease in the gross profit margin and an increase in the sales, distribution and administrative costs as a percentage of segment net revenues in the three months ended September 30, 2010 compared to the three months ended September 30, 2009.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $20.9 million, or 8.9% to $255.8 million for the three months ended September 30, 2010 from $234.9 million in the three months ended September 30, 2009. Revenues for the home infusion therapy segment increased to 48.6% of total revenue in the three months ended September 30, 2010 from 45.2% in the three months ended September 30, 2009.

The home infusion therapy segment involves the administration of drugs or nutrients directly into the body intravenously through a needle or catheter. Infusion therapy services also include administering enteral nutrients directly into the gastrointestinal tract through a feeding tube. The growth in home infusion therapy revenue resulted primarily from an increase in the overall volume of specialty drugs, core drugs, enteral nutrients and non-core revenue. These increases were partially offset by a decrease in revenue due to the termination of certain payor contracts.

EBIT for the home infusion therapy segment in the three months ended September 30, 2010 was $31.6 million compared to $16.8 million in the three months ended September 30, 2009. EBIT was 12.4% of segment net revenues in the three months ended September 30, 2010 compared to 7.1% of segment net revenues in the three months ended September 30, 2009. EBIT for the three months ended September 30, 2009 included $8.0 million of amortization expense related to our patient backlog intangible asset which was fully amortized during the year ended December 31 2009. Adjusting for the impact of this $8.0 million of amortization in the three months ended September 30, 2009, EBIT would have been $24.8 million or 10.5% of segment net revenues. The increase in EBIT from 10.5% for the three months ended September 30, 2009 to 12.4% for the three months ended September 30, 2010 was primarily due to improvements in the gross profit margin, and decreases in sales, distribution and administrative costs and the provision for doubtful accounts as a percentage of segment net revenues in the three months ended September 30, 2010 compared to the three months ended September 30, 2009.

Nine Months Ended September 30, 2010 and 2009

Net Revenues. Net revenues decreased $5.4 million, or 0.3%, to $1,553.1 million in the nine months ended September 30, 2010 from $1,558.5 million in the nine months ended September 30, 2009. The decrease in revenue was due primarily to the non-renewal or termination of, or changes to, certain payor contracts. We expect to continue to strategically evaluate our payor contracts. The revenue decrease was partially offset by increases in home infusion therapy revenue. In addition, revenue in the nine months ended September 30, 2009 was positively impacted by the recognition of monthly rental revenue previously deferred for services that were initiated prior to certain 2009 Medicare reimbursement reductions.

Gross Profit. Gross profit margin is defined as total net revenues less total costs of total net revenues divided by total net revenues. The gross profit margin in the nine months ended September 30, 2010 was 60.1%, compared to 57.9% in the nine months ended September 30, 2009. Included in cost of revenue in the nine months ended September 30, 2009 was intangible asset amortization related to our patient backlog intangible asset of $42.2 million, which was fully amortized during the year ended December 31, 2009 and did not recur in 2010, and the favorable impact of certain cost of goods sold adjustments. Excluding the impact of intangible asset amortization and the favorable impact of certain cost of goods sold adjustments, the overall gross profit margin percentage for the nine months ended September 30, 2009 would have been 60.2%. The decline in gross profit margin percentage is primarily due to an increase in the revenue of the home infusion therapy segment as a percent of total company revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenues than the home respiratory therapy and home medical equipment segment. This decline in the gross profit margin percentage is partially offset by our ability to obtain favorable pricing on the purchase of products and the termination of certain low margin or unprofitable payor contracts during 2009.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on management’s estimate of the net realizable value of accounts receivable after considering actual write-offs of specific receivables. Accounts receivable estimated to be uncollectible are provided for by computing a required reserve using estimated future cash receipts based on historical cash receipts collections as a percentage of revenue. In addition, management may adjust for changes in billing practices, cash collection protocols or practices, or changes in general economic conditions, contractual issues with specific payors, new markets or products. The provision for doubtful accounts, expressed as a percentage of total net revenues, was 2.6% and 2.5% in the nine months ended September 30, 2010 and the nine months ended September 30, 2009, respectively.

Selling, distribution and administrative expenses, expressed as a percentage of total net revenues was 50.7% for the nine months ended September 30, 2010 compared to 50.8% for the nine months ended September 30, 2009.

Selling, distribution and administrative expenses decreased by $3.2 million for the nine months ended September 30, 2010 over the nine months ended September 30, 2009. The decrease was comprised of a $31.1 million decrease in labor and other related expenses partially offset by an increase in other operating expenses of $27.9 million. The decrease in labor and other related expenses was due to reduced salaries and termination benefits as a result of headcount reductions due primarily to the outsourcing of certain functions relating to documentation, billing, reimbursement and information technology, and lower management incentive compensation program expense as a result of not meeting certain targets in 2010. These decreases were partially offset by an increase in labor expenses due to increases in our home respiratory therapy and home medical equipment sales force. The increases in other operating expenses of $27.9 million were primarily due to an increase in professional fees and expenses related to the outsourcing of certain functions relating to billing, collections and other administrative and clerical services, and an increase in travel and marketing expense related to sales force expansion and operations training, an increase in depreciation related to information technology assets, a gain in 2009 on the sale of assets to a third party payor which did not recur in 2010, an increase in our sponsor management fee, and professional fees related to 2010 corporate initiative projects. The increase in other operating expenses was partially offset by expense associated with other corporate initiative projects that occurred in 2009 that did not recur in 2010.

Amortization of Intangible Assets. Amortization of intangible assets was $3.8 million in the nine months ended September 30, 2010 and $2.7 million in the nine months ended September 30, 2009. The amortization expense primarily results from the revaluation of intangible assets as a result of the Merger, including the finalization of the intangible asset valuation in 2009.

Interest Expense. Interest expense increased $1.4 million, or 1.4%, to $98.0 million in the nine months ended September 30, 2010 from $96.6 million in the nine months ended September 30, 2009. This increase is primarily due to higher amortization of deferred debt costs related to the $700.0 million Series A-1 Notes and $317.5 million Series A-2 Notes.

Interest Income and Other. Interest income and other decreased $0.4 million, or 45.6%, to $0.6 million in the nine months ended September 30, 2010 from $1.0 million in the nine months ended September 30, 2009.

Income Tax Expense. Our effective tax rate was 54.7% for the nine months ended September 30, 2010 compared with 24.5% for the nine months ended September 30, 2009. Differences in our effective tax rate compared with federal and state statutory rates and fluctuations in our effective tax rate between comparative accounting periods stem primarily from the impact of non-deductible equity compensation as a percentage of pretax income or loss.

Segment Net Revenues and EBIT

For a reconciliation of segment net revenues and EBIT to net income, please see Note 11—Segments.

The following table sets forth a summary of results of operations by segment:


*(dollars in thousands)*	Nine Months Ended September 30, 2010		Percentage of Net Revenues			Nine Months Ended September 30, 2009		Percentage of Net Revenues
Net revenues:
Home respiratory therapy and home medical equipment	$	821,666		52.9	%	$	871,767		55.9	%
Home infusion therapy		731,402		47.1			686,707		44.1

Total net revenues	$	1,553,068		100.0	%	$	1,558,474		100.0	%


	Nine Months Ended September 30, 2010
*(dollars in thousands)*	Home Respiratory Therapy and Home Medical Equipment		Percentage of Segment Net Revenues			Home Infusion Therapy		Percentage of Segment Net Revenues			Total
EBIT	$	21,687		2.6	%	$	81,118		11.1	%	$	102,805

	Nine Months Ended September 30, 2009
*(dollars in thousands)*	Home Respiratory Therapy and Home Medical Equipment		Percentage of Segment Net Revenues			Home Infusion Therapy		Percentage of Segment Net Revenues			Total
EBIT	$	28,209		3.2	%	$	41,840		6.1	%	$	70,049

We allocate certain expenses that are not directly attributable to a product line based upon segment headcount.

Home Respiratory Therapy and Home Medical Equipment Segment. For the home respiratory therapy and home medical equipment segment total net revenues decreased $50.1 million, or 5.7%, to $821.7 million in the nine months ended September 30, 2010 from $871.8 million in the nine months ended September 30, 2009. Revenues for the home respiratory therapy and home medical equipment segment decreased to 52.9% of total revenue in the nine months ended September 30, 2010 from 55.9% in the nine months ended September 30, 2009.

Home respiratory therapy revenues are derived primarily from the provision of oxygen systems, home ventilators, obstructive sleep apnea equipment, nebulizers, respiratory medications and related services. Revenues from the home respiratory therapy service line decreased by 6.0% in the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The decrease in revenue resulted primarily from decreases in sleep apnea, oxygen and other respiratory revenue, primarily due to the termination of or changes to certain payor contracts, as well as the impact of revenue recognized in the three months ended March 31, 2009 that was previously deferred for services performed prior to certain Medicare reimbursement reductions.

Home medical equipment revenues are derived from the rental and sale of equipment to assist patients with ambulation, safety and general care in and around the home. Home medical equipment revenues decreased by 4.4% in the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The decrease was primarily due to the termination of or changes to certain payor contracts.

EBIT for the home respiratory and home medical equipment segment in the nine months ended September 30, 2010 was $21.7 million compared to $28.2 million in the nine months ended September 30, 2009. EBIT was 2.6% of segment net revenues in the nine months ended September 30, 2010 compared to the 3.2% of segment net revenues in the nine months ended September 30, 2009. EBIT for the nine months ended September 30, 2009 included $34.2 million of amortization expense related to our patient backlog intangible asset which was fully amortized during the year ended December 31, 2009. Adjusting for the impact of this $34.2 million of amortization in the nine months ended September 30, 2009, EBIT would have been $62.4 million or 7.2% of segment net revenues. The decrease in the EBIT as a percentage of segment net revenues from 7.2% for the nine months ended September 30, 2009 to 2.6% in the nine months ended September 30, 2010 is primarily due to a decrease in the gross profit margin and increases in the provision for doubtful accounts and in the sales, distribution and administrative costs as a percentage of net revenues in the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $44.7 million, or 6.5% to $731.4 million for the nine months ended September 30, 2010 from $686.7 million in the nine months ended September 30, 2009. Revenues for the home infusion therapy segment increased to 47.1% of total revenue in the nine months ended September 30, 2010 from 44.1% in the nine months ended September 30, 2009.

EBIT for the home infusion therapy segment in the nine months ended September 30, 2010 was $81.1 million compared to $41.8 million in the nine months ended September 30, 2009. EBIT was 11.1% of segment net revenues in the nine months ended September 30, 2010 compared to 6.1% of segment net revenues in the nine months ended September 30, 2009. EBIT for the nine months ended September 30, 2009 included $8.0 million of amortization expense related to our patient backlog intangible asset which was fully amortized during the year ended December 31 2009. Adjusting for the impact of this $8.0 million of amortization in the nine months ended September 30, 2009, EBIT would have been $49.8 million or 7.3% of segment net revenues. The increase in EBIT as a percentage of net segment revenues from 7.3% for the nine months ended September 30, 2009 to 11.1% for the nine months ended September 30, 2010 was primarily due to improvements in the gross profit margin, and decreases in sales, distribution and administrative costs and the provision for doubtful accounts as a percentage of segment net revenues in the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009.

Liquidity and Capital Resources

Our principal source of liquidity is our operating cash flow, which is supplemented by our ABL Facility (as defined below), which provides for revolving credit of up to $150.0 million, subject to borrowing base availability. In recent years, we have generated operating cash flows in excess of our operating needs, which has afforded us the ability to pursue acquisitions and fund patient service equipment purchases to support revenue growth. We believe that our operating cash flow, together with our existing cash, cash equivalents, investments and ABL Facility, will continue to be sufficient to fund our operations and growth strategies for at least the next 12 months.

Our short-term investments consist of certificates of deposit with maturities greater than three months from our purchase date. As of September 30, 2010, the carrying value of our short-term investments approximates fair value and such investments do not individually exceed FDIC insurance limits.

In the nine months ended September 30, 2010, our free cash flow was $9.4 million. For the nine months ended September 30, 2009 our free cash flow was $38.2 million. See discussion below on changes in the components of free cash flow; net cash provided by operations and purchases of patient service equipment and property, equipment and improvements. We use free cash flow as a performance metric which is not calculated in accordance with GAAP. Free cash flow is defined as cash provided by operating activities less purchases of patient service equipment and property, equipment and improvements, exclusive of effects of acquisitions. It is presented as a supplemental performance measure and is not intended as an alternative to any other cash flow measure calculated in accordance with GAAP. Further, free cash flow may not be comparable to similarly titled measures used by other companies.

A table reconciling free cash flow to net cash provided by operating activities is presented below.


*(in thousands)*	Nine Months Ended September 30, 2010			Nine Months Ended September 30, 2009
Reconciliation — Free Cash Flow:
Net income (loss)	$	2,458		$	(19,443	)
Non-cash items		165,571			183,630
Change in operating assets and liabilities		(73,991	)		(24,093	)

Net cash provided by operating activities		94,038			140,094
Less: Purchases of patient service equipment and property, equipment and improvements		(84,682	)		(101,926	)

Free cash flow	$	9,356		$	38,168

Cash Flow. The following table presents selected data from our consolidated statement of cash flows:


*(in thousands)*	Nine Months Ended September 30, 2010			Nine Months Ended September 30, 2009
Net cash provided by operating activities	$	94,038		$	140,094
Net cash used in investing activities		(62,888	)		(122,388	)
Net cash used in financing activities		(37,515	)		(21,734	)

Net decrease in cash and equivalents		(6,365	)		(4,028	)
Cash and equivalents at beginning of period		158,163			168,018

Cash and equivalents at end of period	$	151,798		$	163,990

The Nine Months Ended September 30, 2010 Results Compared to the Nine Months Ended September 30, 2009

Net cash provided by operations in the nine months ended September 30, 2010 was $94.0 million compared to $140.1 million in the nine months ended September 30, 2009, a decrease of $46.1 million. The decrease in net cash provided by operations resulted from a $3.8 million increase in income before non-cash items to $168.0 million in 2010 from $164.2 million in 2009, offset by a $49.9 million increase in the cash used related to the change in operating assets and liabilities to a $74.0 million use of cash in 2010 from a $24.1 million use of cash in 2009.

The $49.9 million increase in cash used by the change in operating assets and liabilities consisted primarily of the following:

•

$72.3 million increase in cash used by accounts receivable to a $96.1 million use of cash in the nine months ended September 30, 2010 from a $23.8 million use of cash in the nine months ended September 30, 2009. The increase in the use of cash is primarily related to a delay in collections due to the outsourcing of our billing and collection process and the impact of a major payor using an intermediary.

•

$5.6 million increase in cash used by income taxes payable to a $2.1 million use of cash in the nine months ended September 30, 2010 from a $3.4 million provision of cash in the nine months ended September 30, 2009. The increase in the use of cash is primarily due to 2010 reductions in the liability for unrecognized tax benefits of $2.1 million as compared to 2009 increases in income taxes payable due to a reconciliation to our filed prior year tax returns of $7.4 million offset by 2009 reductions in the liability for unrecognized tax benefits of $4.0 million.

Offset by:

•

$17.9 million decrease in cash used by accounts payable to a $2.7 million provision of cash in the nine months ended September 30, 2010 from a $15.2 million use of cash in the nine months ended September 30, 2009. The decrease was primarily due to the elimination of book cash overdraft from AP and offset by the timing of payment on certain invoices.

•

$10.5 million decrease in cash used by accrued expenses to a $27.4 million provision of cash in the nine months ended September 30, 2010 from a $16.8 million provision of cash in the nine months ended September 30, 2009. The decrease is due primarily to the timing of payments on certain accruals, including interest on senior debt and other accrued liabilities related to the Coram acquisition.

•

$5.4 million decrease in cash used by prepaid expenses and other assets to a $0.3 million use of cash in the nine months ended September 30, 2010 from a $5.6 million use of cash in the nine months ended September 30, 2009. The decrease is due primarily to the change in prepaid inventory payment terms.

Net cash used in investing activities in the nine months ended September 30, 2010 was $62.9 million, compared to $122.4 million in the nine months ended September&nbs