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

other factors described in our filings with the Securities and Exchange Commission.

CURRENT ASSETS

Cash and cash equivalents

Accounts receivable, less allowance for doubtful accounts of $43,901 and $47,823 at March 31, 2008 and December 31, 2007, respectively

Inventories, net

Deferred income taxes

Deferred expenses

Prepaid expenses and other current assets

 

TOTAL CURRENT ASSETS

PATIENT SERVICE EQUIPMENT, less accumulated depreciation of $453,327 and $453,324 at March 31, 2008 and December 31, 2007, respectively

PROPERTY, EQUIPMENT AND IMPROVEMENTS, net

GOODWILL

INTANGIBLE ASSETS, less accumulated amortization of $8,445 and $7,907 at March 31, 2008 and December 31, 2007, respectively

DEFERRED DEBT ISSUANCE COSTS, net

OTHER ASSETS

 

 

 

 

CURRENT LIABILITIES

Accounts payable

Accrued payroll and related taxes and benefits

Income taxes payable

Other accrued liabilities

Deferred revenue

Current portion of long-term debt

 

TOTAL CURRENT LIABILITIES

LONG-TERM DEBT, net of current portion

DEFERRED INCOME TAXES

INCOME TAXES PAYABLE AND OTHER NON-CURRENT LIABILITIES

 

TOTAL LIABILITIES

COMMITMENTS AND CONTINGENCIES (Note 10)

STOCKHOLDERS’ EQUITY

Preferred stock, $.001 par value: 10,000,000 shares authorized; none issued

Common stock, $.001 par value: 150,000,000 shares authorized; 60,955,680 and 60,844,901 shares issued at March 31, 2008 and December 31, 2007, respectively; 43,865,753 and 43,794,492 shares outstanding at March 31, 2008 and December 31, 2007, respectively

Additional paid-in capital

Treasury stock, at cost; 17,089,927 and 17,050,409 shares at March 31, 2008 and December 31, 2007, respectively

Retained earnings

Accumulated other comprehensive income

 

TOTAL STOCKHOLDERS’ EQUITY

 

 

 

Net revenues:

Fee for service/product arrangements

Capitation arrangements

 

TOTAL NET REVENUES

 

Costs and expenses:

Cost of net revenues:

Product and supply costs

Patient service equipment depreciation

Home respiratory therapy services

Nursing services

Other

 

TOTAL COST OF NET REVENUES

Provision for doubtful accounts

Selling, distribution and administrative

Amortization of intangible assets

 

TOTAL COSTS AND EXPENSES

 

OPERATING INCOME

Interest expense

Interest income and other

 

INCOME BEFORE TAXES

Income tax expense

 

NET INCOME

 

Basic net income per common share

 

Diluted net income per common share

 

OPERATING ACTIVITIES

Net income

Items included in net income not requiring cash:

Provision for doubtful accounts

Depreciation and amortization

Amortization of deferred debt issuance costs

Deferred income taxes

Share-based compensation

Gain on disposition of assets and other

Excess tax benefits from share-based compensation

Changes in operating assets and liabilities

Accounts receivable

Inventories, net

Prepaid expenses and other assets

Accounts payable, exclusive of book-cash overdraft

Accrued payroll and related taxes and benefits

Income taxes payable

Deferred revenue, net of related expenses

Accrued expenses

 

NET CASH PROVIDED BY OPERATING ACTIVITIES

 

INVESTING ACTIVITIES

Purchases of patient service equipment and property, equipment and improvements

Proceeds from disposition of assets

Cash paid for acquisitions

 

NET CASH USED IN INVESTING ACTIVITIES

 

FINANCING ACTIVITIES

Proceeds from revolving credit facilities

Payments on revolving credit facilities

Payments on other long-term debt

Change in book-cash overdraft included in accounts payable

Excess tax benefits from share-based compensation

Issuances of common stock

 

NET CASH USED IN FINANCING ACTIVITIES

 

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

Cash and cash equivalents at beginning of period

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

 

Fee for service/product arrangements

Total net revenues

Product and supply costs

Total cost of net revenues

Selling, distribution and administrative expenses

Total costs and expenses

Operating income

Income before taxes

Income tax expense

Net income

Basic net income per common share

Diluted net income per common share

Net income

Deferred income taxes

Deferred revenue, net of deferred expenses

Intangible assets subject to amortization:

Covenants not to compete

Patient referral sources

 

Customer lists

Favorable leases

 

Total

Intangible assets not subject to amortization:

Trade names

 

  Total

 

 

2008

2009

2010

2011

2012

Net income

Issuances of common stock (including non-cash issuances)

Excess tax benefits from share-based compensation

Tax shortfalls on share-based compensation

Restricted stock retained in treasury upon vesting

Share-based compensation

Other comprehensive loss, net of taxes

 

 

 

Expected option term(1)

Expected volatility(2)

Risk-free interest rate(3)

Expected annual dividend yield

Outstanding at January 1, 2008

Granted

Exercised

Forfeited

 

Outstanding at March 31, 2008

 

Vested or expected to vest as of March 31, 2008

Exercisable at March 31, 2008

Outstanding at January 1, 2008

Granted

Exercised

Forfeited

 

Outstanding at March 31, 2008

 

Vested or expected to vest as of March 31, 2008

Exercisable at March 31, 2008

Outstanding at January 1, 2008

Granted

Exercised

Forfeited

 

Outstanding at March 31, 2008

 

Vested or expected to vest as of March 31, 2008

Exercisable at March 31, 2008

Nonvested restricted stock awards and units at January 1, 2008

Granted

Vested and released

Forfeited

 

Nonvested restricted stock awards and units at March 31, 2008

Total gross unrecognized tax benefits at December 31, 2007

Additions for tax positions related to the current year

Additions for tax positions related to prior years

Reductions for tax positions related to prior years

Settlements

Reductions due to lapse in statute of limitations

Other

 

Total gross unrecognized tax benefits at March 31, 2008

 

Aggregate gross increase of $2,400,000 for interest and penalties primarily related to other tax uncertainties taken in prior years and state tax uncertainties involving tax filing positions. The gross increase is an annual expense which will be accrued until the tax uncertainties or related tax uncertainties (in the case of interest and penalties) are extinguished through such means as audit settlements, payment, or the expiration of statutes of limitations.

Aggregate gross decrease of $8,200,000 related 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).

Net income

Numerator for basic and diluted per share amounts — net income available to common stockholders

Denominator for basic per share amounts — weighted average shares

Effect of dilutive securities:

Employee stock options and awards — dilutive potential common shares

 

Denominator for diluted per share amounts — adjusted weighted average shares

 

Basic net income per common share

 

Diluted net income per common share

 

Employee stock options excluded from the computation of diluted per share amounts:

Shares for which exercise price exceeds average market price of common stock

Average exercise price per share that exceeds average market price of common stock

 

achieve strong organic sales growth and increase market share;

leverage our nationwide infrastructure to reduce costs and expand profits;

deliver superior customer service;

attract, develop and advance leaders within the Company;

operate our business ethically; and

maintain independent accreditation at all locations.

A five-year freeze on annual consumer price index payment increases for most durable medical equipment — The freeze commenced in 2004 and will continue through 2008. After 2008, certain durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”) equipment not subject to competitive bidding will be eligible for a consumer price index increase for urban consumers.

Reimbursement reductions for five durable medical equipment categories — Reimbursement for most oxygen and oxygen equipment, standard wheelchairs (including standard power wheelchairs), nebulizers, diabetic supplies consisting of lancets and testing strips, hospital beds, and air mattresses, became based on the median price paid for such items on behalf of beneficiaries of federal employee health benefit plans. Subsequent legislation and CMS regulatory actions have further modified reimbursement methodology for certain items, such as power wheelchairs and oxygen and oxygen equipment, as described below.

Reimbursement reductions for inhalation drugs — Beginning January 2005, Medicare Part B reimbursement for most drugs, including inhalation drugs, became based upon the manufacturer-reported average sales price (“ASP”) (subject to adjustment each quarter), plus 6%, plus a separate dispensing fee per patient episode. CMS publishes the ASP plus 6% payment levels several weeks before 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 sales price 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. Effective July 1, 2007, Medicare no longer reimbursed providers for compounded inhalation drugs. Because our compounding levels were minimal, this change had no significant effect on us. Subsequent regulations and legislation have further modified reimbursement methodologies for certain inhalation therapies, as described below.

The reimbursement methodology for non-compounded, infused drugs administered through Durable Medical Equipment (“DME”), such as infusion pumps, was not affected by this 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.

Establishment of a competitive bidding program for Medicare Part B — The MMA required implementation of a competitive bidding program for certain DME, and on April 10, 2007, CMS published a final rule implementing such a Medicare Part B competitive bidding program. By statute, CMS is required to implement the DME competitive bidding program over time, with the first phase establishing competitive bidding in 10 of the largest metropolitan statistical areas (“MSAs”), for 2008, with 70 additional markets to be added in 2009, and nationwide implementation in 2010. Our bids for the first round were submitted by the CMS deadline, and CMS has indicated that the first round will go live on July 1, 2008. On January 8, 2008, CMS announced the 70 MSAs and eight product categories for the second round of the competitive bidding program. CMS anticipates that the exact Competitive Bidding Areas (“CBAs”) for the second round will be further defined later in 2008 as it launches the formal bid process in the summer of 2008, with implementation in 2009.

Competitive bidding imposes a significant risk to suppliers of DME. If a DME 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 DME items supplied in that CBA for the time period covered by the competitive bidding program (unless a supplier is covered by the “grandfathering” provision for existing oxygen or capped rental patients discussed below or acquires a winning bidder). Because the applicable statute mandates savings and CMS’ bidding rules require that bids must be less than current Medicare allowable rates, a DME supplier awarded one of the winning bids for the CBA will receive lower Medicare payment rates than those in existence prior to competitive bidding. In addition, there is a risk that the new competitive bidding prices will become a new benchmark for reimbursement from private payors. As competitive bidding is phased in across the country, we will likely experience a substantial reduction in reimbursement, as will most if not all other DME suppliers.

Based upon criteria described in the final rule governing competitive bidding, CMS identified both the 10 MSAs and product categories for the initial phase of the program. We service nine of the ten markets included in the list of initial CBAs. The only market we do not service of the original ten CBAs is Puerto Rico. Nine of the 10 product categories selected for the first phase are common to all nine domestic markets. The tenth product category is specific to the Miami and Puerto Rico markets only. In the first phase, CMS accepted bids from suppliers for the following product categories: Oxygen Supplies and Equipment; Standard Power Wheelchairs, Scooters and Related Accessories; Complex Rehabilitative Power Wheelchairs and Related Accessories; Mail-Order Diabetic Supplies; Enteral Nutrients, Equipment and Supplies; Continuous Positive Airway Pressure Devices, Respiratory Assist Devices and Related Supplies and Accessories; Hospital Beds and Related Accessories; Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories; Walkers and Related Accessories; and (Miami and Puerto Rico only) Support Surfaces (group 2 mattresses and overlays).

The bidding process for the first round of competitive bidding was complex and subject to deadline extensions. The deadline for suppliers to submit bids for participation in the first round of the program was originally 60 days after issuance of the Request for Bids. However, after issuing the Request for Bids in mid-May 2007, CMS and its Competitive Bidding Implementation Contractor, extended the deadline for bid submission three times in response to concerns raised by individual suppliers, industry associations and Congress about difficulties experienced with the bid process and Internet-based application process. The revised deadline for submission was September 25, 2007, and we submitted timely bids. Suppliers also must be accredited entities to take part in the program. The accreditation deadline was October 31, 2007; we were already an accredited entity at that time.

In late March 2008, CMS individually contacted suppliers as part of its initial effort to offer competitive bidding contracts to qualified bidders. Qualified bidders are defined as those bidders who meet minimum accreditation and financial standards and submitted a price that was low enough to ensure that they would be included in the bid array to calculate the Single Payment Amounts, the Medicare allowed payment amount for competitive bidding items, on a market-specific basis. On March 20, 2008, CMS issued the single payment amounts for the 10 product categories for the first round and the number of contracts offered to suppliers per CBA. As required by the Medicare statute, these rates are below the historic fee schedule rates, and also are below the value that CMS and the industry anticipated. CMS offered us contracts in several CBAs for the first round of competitive bidding; we accepted the contracts for certain product categories and declined others due to the unacceptably low Single Payment Amounts in certain markets, which would not adequately cover the cost of providing services to patients in those markets. The process is not yet complete, and CMS has not yet published a list of winning suppliers. In fact, we are continuing to receive, evaluate and negotiate contract offers from CMS. It is our understanding that the process will be completed some time in May 2008.

We are unable to predict what percentage of the market we may capture for any given product category in any given CBA. In cases where we do not receive and accept a contract for a particular CBA or product category, we have the option, for all product categories other than enteral nutrition and diabetic supplies, to continue servicing Medicare beneficiaries presently on service with us in that CBA if we agree to continue providing service to those patients at the new reduced rates of reimbursement and satisfy certain other conditions under the “grandfathering” provisions of the final competitive bidding rule described below. For the CBAs and products for which we do not currently expect to receive a contract, we have determined to act as a grandfathered supplier for most, but not all, product categories. In addition, we will be able to provide and be reimbursed for services to Medicare beneficiaries not currently on service with us in a CBA if we acquire a winning bidder and assume that bidder’s contract with CMS’s approval. We have not yet made any final decisions concerning whether to acquire any winning bidders in the CMAs where Apria was not a successful bidder.

The new payment levels will go into effect for the selected DMEPOS product categories in the initial 10 CBAs beginning July 1, 2008. Contracts with winning bidders for the first round of competitive bidding are expected to be three years in length, except for diabetic supplies, which are 21 months in length. Consequently, the contract period for mail order diabetic supplies is expected to be from July 1, 2008 to March 31, 2010 and the contract period for all other first round product categories is expected to be from July 1, 2008 to June 30, 2011. New competitive bidding periods in the initial ten markets are expected to begin after the initial contracts end. Due to the documented problems that arose with the CMS provider selection process in round one, there are legislative and administrative efforts to delay implementation of round one and/or round two of competitive bidding or to add additional winning contractors. We cannot predict whether or to what extent these efforts will be successful or what their ultimate impact will be.

The final rule governing competitive bidding, among other things, generally requires Medicare beneficiaries who live in a CBA to receive equipment and services that are included within the competitive bidding program exclusively from suppliers who are awarded contracts by CMS, with a few exceptions. The reimbursement rate for the items and services will be the single payment rate that is determined through the bid process. The revenue associated with the items subject to competitive bidding in the initial year of the program represents less than 2% of our 2007 total net revenue. The original CMS estimation for the average weighted level of payment cuts was a 10% to 15% reduction in payment for products and services included in round one. We estimated that this would have caused less than a 0.3% decline in our 2007 total net revenue if 2007 had been the initial year of competitive bidding. However, the actual impact of the initial year of competitive bidding on our total net revenue will likely be different given the March 2008 announcement by CMS that the average, weighted level of cuts will be 26%. We now estimate, without giving effect to the possibility that we may elect to acquire one or more winning bidders in CBAs where Apria was not the successful bidder, that the competitive bidding reductions will result in a decline of approximately 0.4% in our 2008 total net revenue from the level we would have expected if competitive bidding had not been in effect.

In the second and subsequent years of competitive bidding, we expect that the adverse financial impact will increase substantially in amounts that cannot currently be determined. If we are selected as a winning contract supplier in any CBA during any of the subsequent competitive bidding periods, we believe that our geographic coverage, clinical marketing programs and purchasing strength provide competitive advantages to maintain and enhance market share, but at lower reimbursement rates. However, there is no guarantee that we will be selected as a winning contract supplier and be awarded a competitive bidding contract by CMS in any of the second round CBAs or subsequent rounds of bidding in the first ten markets. If we are not selected as a contract supplier for a particular CBA, we will generally not be allowed to supply Medicare beneficiaries with products subject to competitive bidding within that CBA for the contract period, unless we elect to continue providing service to existing patients under the “grandfathering” provision of the final rule or acquire a winning bidder. Under the grandfathering provision, a supplier may continue to supply certain existing patients that were serviced prior to the implementation of competitive bidding even if the supplier was not awarded a contract, provided certain conditions are met. Because of our combination of both managed care and traditional business, we believe we can nevertheless maintain a favorable overall market position even if we are not selected as a contract supplier for a particular CBA.

Incentives for the expansion of Medicare Part C (Medicare Advantage) — The MMA included financial incentives for managed care plans to expand their provision of Medicare Advantage plans in 2006 in an effort to attract more Medicare beneficiaries to managed care models. We maintain contracts to provide home respiratory therapy, home infusion therapy services, home medical equipment and related services to a significant number of managed care companies who maintain Medicare Advantage plans nationwide.

Reimbursement for home infusion therapy under Medicare Part D — 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 nationwide Part D implementation issues experienced by home infusion providers, the industry is continuing to work with CMS and Congress to rectify the coverage and payment limitations that are causing implementation challenges for providers, patients and referral sources. A bill was introduced in Congress in the summer of 2006 to consolidate home infusion therapy coverage under Part B, and a similar bill was reintroduced in 2007. This legislation would provide for infusion benefit coverage in a more comprehensive manner that is analogous to how the therapy is covered by the managed care sector. Industry representatives continue to present the cost-saving advantages of home infusion therapy to members of Congress and the Administration. At this time, we cannot assess whether any of the proposed legislation, or similar legislation that may be introduced in 2008 or 2009, will become law in 2008 or subsequent years.

Beginning with patients who received DMEPOS products and services as of January 2006, ownership of durable medical equipment currently categorized in the capped rental category by CMS, such as hospital beds, wheelchairs, nebulizers, patient lifts and continuous positive airway pressure devices, automatically transfers to the Medicare beneficiary at the end of a maximum rental period. As of January 1, 2006, the maximum rental period 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. 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. We estimate that the reduction in rental revenues for impacted DME products and the loss of the service and maintenance fees in 2007 was approximately $4.0 million and $0.9 million, respectively. The 2007 estimate assumes the loss of the service and maintenance fee component for one quarter as the effect of the loss primarily impacted the latter part of the year.

Reimbursement for oxygen equipment converted from an ongoing rental method to a capped rental and rent-to-purchase method. Reimbursement for rental of oxygen equipment is limited to 36 months, after which time the ownership of the equipment transfers to the patient, who assumes primary responsibility for identifying when repairs or preventive maintenance are needed. The 36-month rental period was retroactively applied to January 1, 2006 for all beneficiaries requiring oxygen as of December 31, 2005. Accordingly, January 2009 is the first month in which the transfer of ownership for oxygen equipment and the new repair and maintenance policy will impact us. The implementing DRA regulations also 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 for patient-owned equipment after title to the equipment transfers. The new reimbursement amounts went into effect January 1, 2007. CMS will annually review the utilization patterns and fee schedule rates and consider whether an adjustment to the payment rates is needed in order to satisfy the statutory mandate of budget neutrality.

Regarding repairs and maintenance of beneficiary-owned oxygen equipment, the implementing DRA regulations permit payment to suppliers for general maintenance and servicing of certain patient-owned oxygen equipment every six months, beginning after the first six months the patient owns the equipment. The first beneficiaries to whom this policy will apply will take title to their equipment in January 2009 and become eligible for maintenance and servicing under this policy beginning in June 2009. 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. CMS declined to offer general maintenance and servicing payments for beneficiary-owned liquid and gas equipment with the exception of a single payment for pick-up and storage or disposal of such equipment that a beneficiary no longer needs. Once title to the oxygen equipment transfers, CMS will also pay for certain other reasonable and necessary but non-routine repairs which remain as yet unspecified by the agency, but CMS will not make separate payment for certain patient support services, which are currently covered by and included in the monthly bundled payment rate for oxygen therapy. We may or may not continue to provide repair and maintenance service on patient-owned equipment and are in the process of evaluating the impact of these changes.

The implementing regulations 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.

In January 2006, CMS published a final regulation that shifted payment for certain respiratory assist devices from the current “frequent and substantial” payment category to the “capped rental” category. Under “frequent and substantial” payment, Medicare payment continues for the duration of time the beneficiary requires the device, while “capped rental” payment continues for 13 months. The change in the payment category became effective April 1, 2006. The policy applies to those respiratory assist devices that have a backup rate feature that delivers pressure whenever the user’s spontaneous breathing efforts are insufficient. The first claims received for each Medicare beneficiary with a date of service on or after April 1, 2006, including beneficiaries with existing rental equipment, are counted as the first rental month in the capped rental period. Thus, the first month in which the new categorization impacted our revenue was May 2007. Our estimate for this change in payment categories was a reduction in 2007 revenues of approximately $2.5 million.

In January 2006, CMS announced the designation of four specialty contractors, Durable Medical Equipment Medicare Administrative Contractors (“DME MACs”), which are responsible for handling the administration of all Medicare claims from suppliers of durable medical equipment. CIGNA Government Services, LLC, protested the contract awards made in Regions C and D. The Government Accountability Office denied CIGNA’s protest for Region D but CMS ultimately authorized CIGNA for Region C on January 16, 2007. The following DME MACs are currently processing claims: National Heritage Insurance Company, for Region A (effective July 1, 2006), AdminaStar Federal for Region B (effective July 1, 2006), CIGNA for Region C (effective January 16, 2007), and Noridian Administrative Services for Region D (effective September 30, 2006). The transition caused several challenges for all DME suppliers, such as a slight slowdown in payments from the government’s new DME MACs and an increase in certain denials due to a lack of training resources at the new DME MACs. Industry representatives met with the DME MACs and largely resolved transaction processing challenges. It is difficult at this time to predict whether other changes in claims administration made by the DME MACs may affect DME suppliers in the future, nor can we predict or estimate the potential impact of such changes on collection of our accounts receivable.

In 2007, there were numerous legislative and executive branch efforts to further reduce the maximum rental period for oxygen therapy, equipment and related services. The industry has actively shared its concerns with Congress, CMS, and others on these issues. Legislative proposals were introduced in Congress in 2007 that would have repealed the current oxygen reimbursement cap and equipment ownership mandate of the DRA, as well as amended or modified existing laws and regulations pertaining to the competitive bidding program and coverage of infusion therapy services. The President’s 2007, 2008 and 2009 healthcare budget proposals sought to reduce the maximum rental period for oxygen equipment from the now-mandated 36 months to 13 months, which was recommended by the OIG in a limited study of the oxygen benefit published in 2006. There are other initiatives to reduce the rental period to 13 months or to implement a reduction to the monthly payment rate, but it is uncertain whether any of these initiatives will ultimately be approved by Congress. For example, in September 2006, the OIG-published report entitled “Medicare Home Oxygen: Equipment Cost and Servicing,” which was the result of an audit survey conducted by the OIG beginning in the fall of 2005. The survey’s stated objective was to study the average acquisition cost of oxygen concentrators and the nature and frequency of servicing of this single oxygen modality. The final report included a recommendation that Congress consider further reductions to oxygen payment levels, including the possibility of limiting the maximum rental period for oxygen equipment from the DRA-mandated 36 months to 13 months. The industry has analyzed the report and shared concerns about the narrow scope of the report and its findings with the OIG, CMS, members of Congress and other government agencies. It is uncertain whether or when any of these efforts will be repeated or successful in 2008.

In October 2006, CMS issued the 2007 Healthcare Procedure Coding System list for Medicare Part B medications. The 2007 list included new codes for certain compounded medications. The coding and reimbursement changes 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. According to the state licensing agencies associated with the states in which our inhalation pharmacies operate, the pharmacies conform to current quality and sterility standards. CMS stated that patient safety and sterility issues were found at other providers’ pharmacies, which motivated it to change the policies concerning compounded medications.

In response to the 2006 efforts of three Program Safeguard Contractors that oversee DME suppliers, CMS considered issuing a National Coverage Decision for certain inhalation drug therapies. In the third quarter of 2007, CMS concluded that it would not issue a National Coverage Decision. Rather, CMS indicated that it would continue to defer decisions about the medical necessity of individual respiratory drugs to the local contractors. We cannot predict if or when CMS may reconsider this issue and how any subsequent National Coverage Decisions might impact our operations. Future decisions with respect to the coverage of inhalation drugs may have a materially adverse impact on us.

In 2007, there also were changes to the reimbursement methodology for certain inhalation drugs. CMS announced in the second quarter of 2007 that beginning in the third quarter of 2007, it would reimburse providers of inhalation drugs a blended average sales price for the drugs albuterol and Xopenex ^®.¹ On December 29, 2007, the President signed into law the Medicare, Medicaid, and State Children’s Health Insurance Program Extension Act of 2007, which partially reversed the CMS regulatory decision regarding Xopenex and albuterol. Beginning on April 1, 2008, Medicare began to reimburse for Xopenex in the same manner as in the third quarter of 2007— by blending the average sales prices of Xopenex and albuterol, but it will no longer reimburse for albuterol at the blended price.

Subsequently, on April 10, 2008, the DME MACs issued a revision of the Nebulizer LCD which will change the reimbursement methodology for certain inhalation drugs dispensed by Apria’s pharmacies in a way that will effectively eliminate coverage for those drugs. Unless changes are made, the effective date of the revised coverage policy will be July 1, 2008. Both the Department of Health & Human Services and Congress reportedly are reviewing this policy implementation, but we cannot predict what, if any, changes, may be made to it.

We estimate that these two changes to inhalation drug reimbursement will result in a total incremental $12 million decline in revenue for 2008. However, we have undertaken strategies intended to partially mitigate this negative impact.

In late 2006, CMS revised the Local Coverage Determination (“LCD”) for power mobility devices resulting in reductions to the Medicare power mobility devices fee schedule. The revised fee schedule imposes reductions for certain power mobility devices of about 15%. The initial changes took effect November 15, 2006. The reduction in our revenues for 2007 resulting from these fee schedule changes was approximately $1 million. The industry is continuing work with CMS to obtain clarification and modification of the LCD. The industry also believes that Medicare beneficiary access to power mobility will be restricted by this LCD and therefore has requested revisions to the fee schedule.

On July 2, 2007, the Secretary of HHS announced a two-year effort designed to further protect Medicare beneficiaries from fraudulent DME suppliers for certain DMEPOS. The initiative is focused on preventing deceptive companies from operating in South Florida and Southern California. Based on the results of the project, it could be expanded nationwide. Subsequently, on July 27, 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, the supplier holds. The rule would ensure that Medicare can recover any erroneous payment amounts or civil money penalties up to $65,000 that result from fraudulent or abusive supplier billing practices. There is a similar legislative proposal, introduced on February 7, 2008 in the Senate, the provides increased civil and criminal penalties, as well as increasing the amount of the surety bond requirement for DME suppliers to $500,000. In addition, in August 2007, CMS announced that it would require infusion therapy providers in certain South Florida counties to resubmit applications to be enrolled as qualified Medicare suppliers. We fully support the elimination of fraudulent suppliers and are working with CMS to support these initiatives.

On January 25, 2008, CMS proposed regulations expanding and strengthening enrollment requirements that DME suppliers must meet to establish and maintain Medicare billing privileges. These revisions would impose additional requirements in the areas of provider insurance, marketing practices, document retention, facility location, and hours of operation. We submitted comments to the proposal prior to the March 25, 2008 deadline. Although we have not yet had sufficient time to fully evaluate the proposed revisions and their potential impact on our operations, an initial review suggests that there will be no material impact if the proposal is finalized in its current form. It is uncertain whether any or all of these proposed regulations will be finalized, however, and we cannot predict or estimate the impact of the final changes, if any.

Accreditation is becoming mandatory as a condition of enrollment and continuing participation as a Medicare DME supplier, not just for those DME suppliers participating in the competitive bidding program. We and all of our branches are accredited. DME suppliers enrolling in Medicare for the first time between January 1, 2008 and February 28, 2008, must obtain approved accreditation by January 1, 2009. DME suppliers enrolled in the Medicare program prior to January 1, 2008, must obtain approved accreditation by September 30, 2009. 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.

On February 7, 2008, the “Medicare Fraud Prevention Act of 2008” was introduced in the U.S. Senate. The bill would increase financial penalties and prison sentences for certain civil and criminal violations of the Social Security Act, including making false statements and violating the federal anti-kickback statute. We cannot predict whether this Act, or some revised form of it, will or will not become law.

the reduction in the equipment rental period from 15 to 13 months for certain respiratory equipment such as Continuous Positive Air Pressure Units, Nebulizer Units, Hospital Beds and Wheelchairs (regulation effective date of February 2007);

changing the maximum rental period on certain equipment such as bi-level airway pressure devices from an unlimited rental period to 13 months (regulation effective date of May 2007); and

transfer of equipment ownership from us to the patient at the end of the 13-month rental period (regulation effective date of February 2007).

Home respiratory therapy

Home infusion therapy

Home medical equipment/other

 

Total net revenues

 

Net cash provided by operating activities

Less: Purchases of patient service equipment and property, equipment and improvements

 

Free cash flow

 

Net cash provided by operating activities

Net cash used in investing activities

Net cash used in financing activities

 

Net (decrease) increase in cash and equivalents

Cash and equivalents at beginning of period

 

Cash and equivalents at end of period

 

$4.1 million increase in cash used in accounts receivable, to a $15.0 million use of cash in the three months ended March 31, 2008 from a $10.9 million use of cash in the three months ended March, 31 2007. This increase in use of cash was primarily due to a net increase in accounts receivable primarily related to Coram.

$3.1 million increase in cash used by the change in accrued payroll and related taxes and benefits, to a $13.7 million use of cash in the three months ended March 31, 2008 from a $10.6 million use of cash in the three months ended March 31, 2007. The increase was primarily due to an additional accrual day in 2008, an increase in accrued vacation and the Coram acquisition.

$10.6 million increase in cash used by accrued expenses to a $16.2 million use of cash in the three months ended March 31, 2008 from a $5.6 million use of cash in the three months ended March 31, 2007. The increase was primarily due to $4.5 million in accrued incentive compensation and $5.2 million related to expenses from our Coram acquisition and a pay-down of an installment purchase.

$6.7 million increase in cash used by income taxes payable to a $2.0 million use of cash in the three months ended March 31, 2008 from a $4.7 million provision of cash in the three months ended March 31, 2007. The increase in cash used primarily relates to 2008 reductions in unrecognized tax benefits under FIN 48 and a lower amount of 2008 current tax liabilities due to utilization of Coram’s tax net operating losses.

$3.5 million increase in cash provided by prepaid expenses and other current assets to a $4.4 million provision of cash in the three months ended March 31, 2008 from a $0.9 million provision of cash in the three months ended March 31, 2007. The increase was primarily due to decrease in the prepaid infusion therapy inventory balance of $6.1 million from the prior year and a $2.9 million decrease in prepaid insurance, offset by a $6.5 million increase in the balance of prepaid other, principally due to our Coram acquisition.

$5.2 million increase in cash provided by accounts payable to a $7.0 million provision of cash in the three months ended March 31, 2008 from a $1.8 million provision of cash in the three months ended March 31, 2007. The increase was primarily due to an $10.4 million increase in trade accounts payable offset by a $4.7 million change in book cash overdraft.

Medicare

Medicaid

Self pay

Managed care/other

Total

Apria Healthcare Group Inc. Bylaws, as amended and restated as of February 19, 2008. (a)

Form of Employee Time-Based Stock Appreciation Rights Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Revised Form of Employee Performance-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Registrant’s 2008 Executive Bonus Plan. (b)

Revised Form of Employee Time-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Employment offer letter from Registrant to Daniel E. Greenleaf dated April 7, 2008*

Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a).*

Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-14(a).*

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.*

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.*

Apria Healthcare Group Inc. Bylaws, as amended and restated as of February 19, 2008. (a)

Form of Employee Time-Based Stock Appreciation Rights Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Revised Form of Employee Performance-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Registrant’s 2008 Executive Bonus Plan. (b)

Revised Form of Employee Time-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003 Performance Incentive Plan. (b)

Employment offer letter from Registrant to Daniel E. Greenleaf dated April 7, 2008*

Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a).*

Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-14(a).*

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.*

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.*