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APRIA HEALTHCARE GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Edgar Online, Inc.
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 four core service lines: home respiratory therapy, home
medical equipment, home infusion therapy, including total parenteral nutrition
services, and enteral nutrition services. 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 540 locations throughout the United States. We
have two reportable operating segments:



  •   home respiratory therapy and home medical equipment; and




  •   home infusion therapy, which includes enteral nutrition.

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:

• 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. Our strategic growth plan may involve,

         the acquisition of other companies such as our 2007 acquisition of Coram
         and our March 2011 acquisition of the assets of Praxair Healthcare
         Services' home healthcare services division in the United States. Since

our acquisition of Coram in December 2007, we have grown our revenue and

Generate more leads quickly and affordably.

         patient census in the home infusion therapy segment and expanded our
         platform for further cross-selling opportunities. Our acquisition of

Praxair's homecare business in the United States in March 2011 expanded

our geographic footprint and market share in several key markets in the

southeastern, south central and western areas of the country. Since

January 1, 2010, we have expanded our home respiratory therapy and home

medical equipment sales force by 30%, of which 8% relates to the

acquisition of Praxair assets. This expansion has allowed us to more

efficiently cover each market served by promoting our products and

services to physicians, hospital discharge planners and managed care

organizations. On an ongoing basis, we continually evaluate the size of

         our sales force.



• 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 enables us to sign preferred provider

agreements and participating Health Maintenance Organization ("HMO")

agreements with managed care organizations. Managed care represented

         approximately 71% of our total net revenues for the nine months ended
         September 30, 2012.



• Leverage our national distribution infrastructure. With approximately 540

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

Generate more leads quickly and affordably.

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.



• 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,

Generate more leads quickly and affordably.

clinical respiratory, ambulatory infusion services, pharmacy dispensing,

and clinical consultant pharmacist services. We have more than 20 years of

         continuous accreditation by The Joint Commission - longer than any other
         homecare provider.




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We review our business on an ongoing basis in the light of current and
anticipated market conditions and other factors and, from time to time, may
undertake restructuring efforts and/or engage in dispositions of our existing
assets or businesses in order to optimize our overall business, performance or
competitive position. From time to time, we may also engage in acquisitions of
new assets and/or businesses, some of which may be significant. We also continue
to seek opportunities to streamline our organizational structure and operations.
For example, we have recently initiated certain steps designed to further
separate our two reporting units to enable them to function more autonomously
and achieve certain operating efficiencies. We expect these efforts to continue
throughout 2013. Any such transactions could result in material reductions of
our assets, revenues or profitability or otherwise have a material adverse
effect on our results of operations, cash flow and capital resources. In
addition, we could incur costs, expenses, impairment and/or restructuring
charges associated with such transactions, which could be material.

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, 2011.

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, our policies, procedures and programs subject to
these laws. We also maintain various educational and internal 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 or of organizations we acquire. 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, among other factors, 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 Law 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,
2012, approximately 28% and 29% of our net revenues were reimbursed by the
Medicare and state Medicaid programs, respectively. No other third-party payor
represented more than 9% of our total net revenues for the three and nine months
ended September 30, 2012. 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 7% and 8% of total net revenues for the
three and nine months ended September 30, 2012, respectively.

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



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("MMA"); the Deficit Reduction Act of 2005 ("DRA"); MIPPA, which became law in
2008 and the comprehensive healthcare reform law signed in March 2010 ("the
Reform Package"). These Acts and their implementing regulations and guidelines
contain numerous provisions that are significant to us and continue to have an
impact on our operations today.

Budget Control Act of 2011. On August 2, 2011, the Budget Control Act of 2011
was signed into law. The Budget Control Act of 2011 authorized increases in the
United State's debt limit of at least $2.1 trillion, established caps on funding
appropriations estimated to reduce federal spending by $917 billion over the
next ten years, and created the Joint Select Committee on Deficit Reduction
("Joint Committee"), a bipartisan Congressional committee instructed to develop
legislation to reduce the federal deficit by at least another $1.5 trillion over
the ten-year period of fiscal years 2012 - 2021. The Joint Committee was not
limited in what it could propose to reduce the federal deficit. If the proposal
had been issued by November 23, 2011, it would have been subject to special,
expedited procedures in Congress. Because Congress and the President failed to
enact legislation reducing the deficit by at least $1.2 trillion over the
ten-year period of fiscal years 2012 - 2021 by the January 15, 2012 deadline,
automatic spending reductions in fiscal years 2013 - 2021 through sequestration,
the required cancellation of budgetary resources, have been triggered. Under
sequestration, certain federal programs are protected, including Medicaid.
However, payments to Medicare providers and suppliers would be reduced by an
amount not to exceed 2% beginning in 2013. Such a reduction would be applicable
to both competitively bid and non-competitively bid markets and products. On
November 29, 2011, a bill titled To Amend to Exempt the Medicare Program from
Fallback Sequestration Under the Budget Control Act of 2011 (H.R. 3519) was
introduced in the House of Representatives and referred to the House Committee
on the Budget. The bill would exempt payments to Medicare providers and
suppliers from the automatic spending reductions beginning in 2013. The bill is
currently pending in the House Committee on the Budget. At this time, we cannot
predict whether Congress will pass this bill or other legislation averting or
limiting the automatic spending reductions in fiscal years 2013 - 2021 or, if
Congress does pass such legislation, whether the President will sign the
legislation into law. Any reduction in provider and supplier reimbursement rates
under federal healthcare programs could have a material adverse effect on our
financial condition and results of operations.

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. We, along with other winning contract suppliers, began
providing services under Round 1 on July 1, 2008. However, on July 15, 2008,
MIPPA was enacted which 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. Changes mandated by MIPPA
include requirements for the government to administer the program more
transparently, exemption of certain DMEPOS products from the program and a new
implementation schedule.

Under MIPPA, the initial CBAs and product categories subject to rebidding in the
Round 1 Rebid are very similar to those of Round 1. However, MIPPA excluded
Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories as a
competitive bidding product category in Round 1 and permanently excluded Group 3
Complex Rehabilitative Power Wheelchairs and Related Accessories as a
competitive bidding product category.

We received contract offers for a substantial majority of the Round 1 Rebid bids
we submitted. The rates took effect on January 1, 2011 for the Round 1 Rebid
markets. CMS reports that the average price reduction for all products in all
Round 1 Rebid CBAs was 32%. Based on 2008 data provided to bidders 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 accounted
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. Approximately $22 million of our net revenues for the year
ended December 31, 2011 was generated by the products and CBAs included in the
Round 1 Rebid.

In April 2012, CMS announced the product categories to be included in the
"recompete" of the Round 1 Rebid contracts and an associated schedule. The Round
1 Rebid Recompete will include additional products and CMS has elected to group
products in an all-new way, such as a "Respiratory Equipment" category which
includes oxygen therapy, sleep therapy and nebulizers, and a "General Home
Equipment" category which includes a variety of home medical equipment,
accessories and supplies. CMS began bidder education for this phase on
August 16, 2012 and expects to conduct bidding in the fourth quarter of 2012.
New rates for the Round 1 Rebid Recompete are scheduled to take effect on
January 1, 2014.

Notwithstanding the changes MIPPA requires, competitive bidding imposes a
significant risk to DMEPOS suppliers under the rules governing the program. 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



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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 and
Reform Package implementation schedule, we will experience a reduction in
reimbursement, as will most if not all other DMEPOS suppliers in the impacted
areas. In addition, there is an increasing risk that the competitive bidding
prices will become a benchmark for reimbursement from other payors, as evidenced
by the Administration's fiscal budget proposal which would cap state Medicaid
reimbursement levels for certain durable medical equipment services and products
at competitive bid rates using an as-yet-undetermined methodology. Neither MIPPA
nor the Reform Package prevents 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.

The Reform Package also includes changes to the Medicare DMEPOS competitive
bidding program. Significantly, Round 2 of the competitive bidding program was
expanded from 70 to 91 of the largest MSAs. Round 2 includes the majority of the
same product categories as Round 1, but CMS expanded the program by
(i) combining standard power wheelchairs and manual wheelchairs into a single
new product category, (ii) including Negative Pressure Wound Therapy as a
category in all Round 2 markets and (iii) including the Support Surfaces (Group
2 mattresses and overlays) category in all Round 2 markets rather than a subset.
We estimate that approximately $141 million of our net revenues for the fiscal
year ending December 31, 2011 is subject to competitive bidding in this round.

In November 2011, CMS announced the bidding timeline for Round 2. Bidder
registration subsequently began in December 2011, and the bid submission process
ended on March 30, 2012. CMS expects to announce Single Payment Amounts ("SPAs")
and begin the contracting process in the fall of 2012. CMS anticipates making
announcements about the contract suppliers in the spring of 2013. The new Round
2 rates and guidelines are currently scheduled to take effect in July of 2013.
We cannot estimate the impact of potential Round 2 rate reductions on our
revenues until more specific information is published by CMS and its
contractors, but it could be material.

The Reform Package also gives the Secretary of Health and Human Services
additional authority to apply competitive bid pricing to non-bid areas via a
rulemaking process and that could occur by 2016. In addition, efforts to repeal
the competitive bidding program altogether or mandate significant program
changes continue. In March 2011, the Fairness in Medicare Bidding Act of 2011
("FIMBA") was introduced into the U.S. House of Representatives and referred to
the House Subcommittee on Health. FIMBA would repeal the program without
specifying a reduction in the industry's current reimbursement levels. Other
efforts are underway by independent economists who seek to alter certain
critical aspects of the program. Specifically, those efforts are designed to
change the way in which CMS conducts the auction process itself, establishes the
single payment rates, determines supplier capacity needed and related aspects
which, if adopted by CMS in their entirety or in part, would change how the
program would be administered. In September 2012, a bill titled "Medicare DMEPOS
Market Pricing Program Act of 2012" was introduced in Congress and referred to
the Committee on Energy and Commerce and the Committee on Ways and Means. The
bill would repeal the current DMEPOS Competitive Bidding program as designed and
replace it with a modified auction program. We cannot predict whether these or
other efforts to repeal or amend the program will be successful, or their
potential impact on us.

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, the bidding rules are
complex and it is possible for bidders to be disqualified for technical reasons
other than pricing. 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 or that we will garner additional market share. The Round 1
Recompete includes products which may require the Company to subcontract certain
services or products to be performed on its behalf, and there is no guarantee
that CMS will either approve such subcontracting arrangements or that the
subcontractor will perform its contractual obligations to us. Certain aspects of
the program's oversight and administration remain unclear in CMS' written
regulations that have been promulgated and therefore individual negotiations may
be required between the Company, CMS and/or its contractors and the outcome
outcome of such negotiations cannot be predicted or assured. 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
for the contract term of program, unless we elect to continue to service
existing patients under the "grandfathering provision" of the program's final
rule for certain products or we acquire a winning supplier. Also, CMS takes the
position that it has the authority to determine if an acquired supplier is still
needed to serve the CBA, and there is no guarantee that agency staff will
approve such an acquisition or do so in a timely manner. 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-Urban ("CPI-U")
Adjustments. In addition to the adoption of the DMEPOS competitive bidding
program, the MMA implemented a five-year freeze on annual Consumer Price Index
("CPI") payment increases for most durable medical equipment from 2004 to 2008.
In MIPPA, in order to offset the cost of delaying the implementation of the
DMEPOS competitive bidding program, Congress approved a nationwide average
payment reduction of 9.5%



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in the DMEPOS fee schedule payments for those product categories included in
Round 1, effective January 1, 2009. Product categories subject to competitive
bidding but furnished in non-competitive bid areas were eligible to receive
mandatory annual CPI-U updates beginning in 2010. Competitively bid items and
services in metropolitan areas with contracts in place are not eligible to
receive a CPI-U payment update during a contract period, which is currently a
three-year period.

The DMEPOS items and services that were not in a product category subject to
competitive bidding in Round 1 received a 5.0% CPI-U payment update in 2009. For
2010, the CPI-U was -1.4%. However, annual DMEPOS payment updates were not
permitted to be negative according to statute. Therefore, the CPI update in 2010
was 0%. The Reform Package makes changes to Medicare DMEPOS fee schedule
payments for 2011 and subsequent years. The CPI-U payment update will now be
adjusted annually by a new "multi-factor productivity adjustment" measurement
which may result in negative DMEPOS payment updates. While CPI-U for 2011 was
+1.1%, the "multi-factor productivity adjustment" was -1.2%, so the net result
was a 0.1% decrease in DMEPOS fee schedule payments in 2011 for items and
services not included in an area subject to competitive bidding. The CPI-U for
2012 is +3.6%, but the "multi-factor productivity adjustment" remains -1.2%, so
the net result is a 2.4% increase in DMEPOS fee schedule payments in 2012 for
items and services not included in an area subject to competitive bidding.

Capped Rentals, Oxygen Equipment and CPAP Patient Compliance. Under the DRA,
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. DRA regulations published subsequently
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.

With respect to oxygen equipment, Medicare reimbursement for oxygen equipment is
limited to a maximum of 36 months, after which time the equipment continues to
be owned by the home oxygen provider for as long as the patient's medical need
exists and the provider continues to be responsible for his/her care. Limited
reimbursement is available to providers from months 37 through 60, depending on
the oxygen modality and patient's needs. CMS does 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 did not establish any reimbursement rates for non-routine services
patients may require after the 36-month rental period. In fact, implementing
regulations impose 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. The existing implementing
regulations to the DRA and MIPPA provisions limit supplier replacement of oxygen
equipment during the rental period, and require suppliers to replace equipment
that does not last the useful lifetime of the equipment. After the five year
useful life is reached, the patient may request replacement equipment and, if
he/she can be requalified for the Medicare benefit, a new maximum 36-month
rental period would begin. The supplier may not arbitrarily issue new equipment.

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 36th to the 18th month. The agency sought
public comments, and in a final rule published in November 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 all applicable legislation and regulations 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, 2011, 2012 or 2013 budget proposals nor the Reform
Package included a reduction in the oxygen rental period. However, President
Obama's most recent budget proposal would further reduce the amount state
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durable medical equipment services and products by mandating that state Medicaid
rates be no higher than Medicare rates, including those impacted by the Medicare
DMEPOS competitive bidding program. It is premature to know whether this or
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 DME MACs issued coverage determinations for
positive airway pressure ("PAP") devices, including CPAP and bi-level devices.
Among other changes, the Medicare DME MAC 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 four (4) hours per night on 70%
of nights during a consecutive 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. We adjusted our operational model, patient
care and payment policies to comply with these Medicare requirements. These
requirements 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. However, some commercial and Medicare Advantage payors are now
implementing the same or similar rules as those adopted by Medicare. Despite our
intensive efforts to educate patients about the importance of complying with
their physician-prescribed therapy, some of our patients do not meet the
threshold for compliance. We continue to educate patients and referral sources
concerning the importance of compliance with the patient's prescribed therapy
and the government's need for documentation pertaining to initial and ongoing
medical necessity. However, these and similar LCDs and trends are likely to
continue to significantly impact the PAP industry.

Reimbursement for Inhalation and Infusion Therapy Drugs. As a result of the MMA,
Medicare Part B reimbursement for most drugs, including inhalation drugs, is
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 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.
At this time, however, we cannot predict whether the Medicare reimbursement
methodology for these drugs will change, as these drugs/therapies could be
included in future phases of the DMEPOS competitive bidding program.

Late in the last decade, there were other changes to the reimbursement
methodology for certain inhalation drugs. Beginning in the third quarter of
2007, CMS reduced its reimbursement to providers of Xopenex and albuterol, when
CMS changed its reimbursement methodology for calculating the ASP. We
implemented strategies intended to partially mitigate these negative impacts in
our operations, including the discontinuation of the inhalation drug Xopenex
from our inhalation pharmacies' drug formulary and other formulary changes.

A limited number of infusion therapies, supplies and equipment are covered by
Medicare Part B. The MMA, through the 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 payors with prescription drug plans.

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, the Center
for Medicare and Medicaid Innovation ("CMMI") 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 110th, 111th and 112th Congresses to consolidate home infusion
therapy coverage under Part B. The Medicare Home Infusion Therapy Coverage Act
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's or the CMMI's
work plan or future legislation. In addition to a June 2010 report issued by the
Government Accountability Office ("GAO"), entitled "Home Infusion Therapy:
Differences Between Medicare and Private Insurers' Coverage," testimony before
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Finance Committee in fall 2009 acknowledged the current gap in coverage and
potential benefits of home infusion therapy to the Medicare program and
beneficiaries. In June 2012, the Medicare Payment Advisory Commission
("MedPAC"), in its annual report to Congress, also acknowledged certain coverage
gaps associated with home infusion therapy and concluded that additional
research is warranted. On June 19, 2012, the House Ways and Means Subcommittee
on Health held a hearing that focused on MedPAC's report. Groups such as the
National Home Infusion Association, in comments to the Subcommittee, criticized
MedPAC's report and recommended that there be a demonstration project to examine
the benefit for home infusion therapy. At this time, we cannot predict whether
legislation will be passed or whether CMS and/or the CMMI 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, some of the CMS 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. Although 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.

CMS also requires that all durable medical equipment providers who bill the
Medicare program maintain a surety bond of $50,000 per National Provider
Identifier ("NPI") number which Medicare has approved for billing privileges. We
obtained the required surety bonds for all of our applicable locations before
the October 2009 deadline and, more recently, for acquired companies. 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 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 recent years, CMS has 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's various program integrity efforts will or will not
negatively impact our operations.

In February 2011, CMS released a final rule implementing certain provisions of
the Reform Package intended to prevent fraud, waste and abuse. This final rule
includes new requirements regarding enrollment screening, enrollment application
fees, payment suspension, temporary moratoria on enrollment and supplier
termination. Significantly, as part of the final rule, CMS classified providers
and suppliers as limited, moderate and high risk according to their risk of
fraud, waste and abuse. Currently enrolled DMEPOS suppliers are classified in
the moderate risk category while newly enrolled DMEPOS suppliers are classified
in the high risk category. As such, DMEPOS suppliers will be under greater
scrutiny relative to many other healthcare providers and suppliers. In October
2011, Senators Orrin Hatch and Charles Grassley sent a letter to U.S. Secretary
of Health and Human Services Kathleen Sebelius, asking for an explanation as to
why CMS had yet to impose temporary moratoria on the enrollment of new providers
and suppliers where there is a high risk for fraud. Among the requests made in
this letter was a request for facts in connection with CMS's decision not to
impose a moratorium on DMEPOS suppliers in South Florida. Additionally, CMS
recently implemented a provider and supplier enrollment screening system that
will automate its pre-enrollment risk assessment and screening processes. We
work cooperatively with CMS and its contractors in response to these initiatives
to prevent fraud, waste and abuse but cannot predict whether CMS's various
program integrity efforts will 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 in September 2010. More recently, on
March 14, 2012, CMS issued a final rule revising four of the 30 Medicare
supplier standards that apply to our business. The final rule clarified
regulations concerning direct solicitation of Medicare beneficiaries, addressed
the use of licensed subcontractors to perform certain services on a supplier's
behalf and modified certain state licensure exceptions. The Company's policies
and procedures comply with the revised standards.

Following the implementation of a three-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 January 1, 2010. CMS selected the four RAC contractors for the permanent RAC
program, and it is currently underway. Prior to initiating any audits, RACs are
required to obtain CMS's pre-approval of the issue that will be subject to
audit, and then post the approved audit issue on their websites. All RACs have
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audit issues on their websites. The currently posted approved audit issues
include those which apply to durable medical equipment 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. Absent an exception, states were required to implement their
RAC programs by January 1, 2012. In addition, in March of 2010, President Obama
issued a presidential memorandum announcing a government-wide program expanding
the use of "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 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 significantly throughout 2010, accelerated in 2011 and in the
first half of 2012; it is expected to continue to increase for the foreseeable
future as additional ZPICs become operational across the country. The industry
trade associations and certain Congressional committees of jurisdiction are
advocating for more standardized audit procedures, contractor transparency and
consistency surrounding all government audit activity directed toward the DMEPOS
industry and other healthcare segments.

Other Issues

• 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 DME MAC Supplier Manuals

provide that clinical information from the "patient's medical record" is

required to justify the initial and ongoing medical necessity for the

provision of DME. DME MAC medical directors, CMS staff and government

         subcontractors have 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. Moreover, auditors' interpretations of

these policies are inconsistent and subject to individual interpretation.

This is then translated to individual supplier significant error rates and

aggregated into a DMEPOS industry error rate, which is significantly

higher than other Medicare provider/supplier types. High error rates lead

to further audit activity and regulatory burdens. In fact, DME MACs have

continued to conduct extensive pre-payment reviews across the DME industry

and have determined a wide range of error rates. For example, error rates

for CPAP claims have ranged from 30% to 80%. DME MACs have repeatedly

         cited medical necessity documentation insufficiencies or technical
         deficiencies as the primary reason for claim denials. If these or other
         burdensome positions are generally adopted by auditors, DME MACs, other
         contractors or CMS in administering the Medicare program, or if

non-government payors were to adopt similar positions, 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 significant refunds and other

payments to Medicare and our future revenues from Medicare may be

significantly reduced. We have adjusted certain operational policies to

address the current expectations of Medicare, its contractors and certain

other payors. We cannot predict the adverse impact, if any, these

interpretations of the documentation requirements or our revised policies

might have on our operations, referral source relationships, cash flow and

         capital resources, but such impact could be material.




     •   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. Aside from a recent announcement

by CMS to use the authority to reduce retail payment rates for diabetic

supplies, 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 increased government audits and changes in Medicare reimbursement
that have been enacted to date are reflected in our results of operations for
the applicable periods through September 30, 2012. We cannot estimate the
combined possible impact of all retroactive audit activities, 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. However, given the
recent significant increases in industry audit volume and the increasing
regulatory burdens associated with responding to those audits, it is likely that
the negative pressures from legislative and regulatory changes will continue and
accelerate.



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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 and extended payment practices 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. We periodically
evaluate 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. On
June 28, 2012, the United States Supreme Court upheld the Reform Package
provision expanding Medicaid eligibility to new populations as constitutional,
but only so long as the expansion of the Medicaid program is optional for the
states. States that choose not to expand their Medicaid programs to newly
eligible populations can only lose the new federal Medicaid funding included in
the Reform Package but cannot lose their eligibility for existing federal
Medicaid matching payments. In view of the Supreme Court decision, some states
have announced plans to reduce their Medicaid enrollments, which may have a
negative impact on our revenues. 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 states will consider similar or
other reimbursement reductions, whether or how healthcare reform provisions
pertaining to Medicaid will ultimately be implemented 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 ("ARRA") 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 ARRA, throughout our operations,
and we have educated our workforce about these requirements. With such a large
workforce that relies on mobile technology for daily operations HIPAA privacy or
data security is always a concern. We face potential administrative, civil and
possible criminal sanctions if we do not comply with the existing or new laws
and regulations dealing with the privacy and security of PHI. Imposition of any
such sanctions could have a material adverse effect on our operations. Recently
a Company-owned laptop containing PHI was stolen from a locked vehicle. The
Company is thoroughly investigating the incident and, as applicable and required
by law, has notified individuals and government authorities. The Company also
has provided the option of complimentary credit monitoring to affected
individuals. At this time there have been no claims against the Company related
to this incident, although the Company cannot predict whether such claims will
occur in the future. The Company is taking additional steps to minimize the
chances of a reoccurrence of this type of incident.

Enforcement of Healthcare Fraud and Abuse Laws. In recent years, the federal
government has made a policy decision to significantly increase and accelerate
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.



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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 annual statement in which they
attest that they have adopted a formal corporate compliance program which meets
the state's specific requirements; we comply with that annual 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
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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 and/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.

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, and such changes may require us to
modify our operations, particularly in multi-state service areas. 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. 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.

The 2010 mid-term election changed the composition of Congress and affected
certain priorities related to healthcare, and the 2012 election outcome could
result in additional changes in priorities. Congress is debating the potential
to repeal or amend the Reform Package altogether. A number of other parties,
including some State governments, challenged the Reform Package. On June 28,
2012, the United States Supreme Court upheld the constitutionality of the
requirement in the Reform Package that individuals maintain health insurance or
pay a penalty under Congress's taxing power. The Supreme Court also upheld the
Reform Package provision expanding Medicaid eligibility to new populations as
constitutional, but only so long as the expansion of the Medicaid program is
optional for the states. 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. Also, the government
has begun to promulgate the implementing rules and regulations of the Reform
Package, including additional requirements related to our business and that of
our customers. Until those rules are more clearly understood, and due to
uncertainties regarding the ultimate features of additional reform initiatives
and their enactment and implementation over the next few years, we cannot
predict whether any such reforms will have a material adverse effect on our
results of operations, cash flow, capital resources and liquidity.

Key Factors and Trends Expected to Impact our Business in 2012


Although other factors and trends will likely impact us, including some we do
not foresee at this time, our performance in 2012 will continue to be impacted
by the following key factors and trends:



• Changes in outsourcing strategy. As a part of our ongoing review of our

outsourcing strategy, we determined in 2010 to return certain of the

outsourced functions to our personnel and facilities in the United States.

Consequently, we have experienced increased administrative costs because

we no longer have the full benefit of the favorable offshore labor rates

and we have increased our personnel related to these functions at higher

         than historical levels.




     •   Increasing Audit Activity. We, along with others in the industry,

experienced a very significant increase in audits in 2011 and the first

three quarters of 2012. We believe that such increased audit activity will

continue to be the case for the foreseeable future. Such audits are

designed to measure industry and provider claim error rates, primarily

relating to medical necessity documentation in the treating physician's

records for various DMEPOS items. Such audits are labor-intensive to

respond to and are likely to result in refunds to the government.

Additionally, commercial insurers have increased their post-payment audit

         volume in 2012 as well.




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Results of Operations

Three Months Ended September 30, 2012 and 2011


Net Revenues. Net revenues in the three months ended September 30, 2012 were
$608.5 million, compared to $584.9 million in the three months ended
September 30, 2011, an increase of $23.6 million or 4.0%. Revenue for the three
months ended September 30, 2012 increased primarily due to increased volume in
the home infusion therapy segment and the home respiratory therapy and home
medical equipment segment.

We expect pricing and reimbursement pressure to continue from governmental and
commercial payors. Public policy changes, reimbursement and pricing reductions
may result in our withdrawal from providing certain products or serving specific
geographical areas altogether. See "Business - 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 for the three months ended September 30, 2012 was 57.7%, compared to
59.0% for the three months ended September 30, 2011. The decline in gross profit
margin percentage is primarily due to a decrease in the home infusion therapy
segment margin percentage due to a decline in the gross profit margin associated
with specialty and enteral revenue and an increase in specialty revenue as a
percentage of infusion segment net revenue. Our specialty revenue has a lower
gross profit margin as a percentage of net revenue than our other infusion
therapy revenue.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on
management's estimate of the net realizable value of accounts receivable.
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 adjusts
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 2.2% and 2.5% in the three months ended
September 30, 2012 and September 30, 2011, respectively. The decrease in the
provision for doubtful account in the three months ended September 30, 2012, is
the result of expectations for our overall cash collection rates.

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 and regional and corporate support
functions. These expenses are generally less sensitive to fluctuations in
revenue growth than operating costs.

Selling, distribution and administrative expenses were $307.1 million, or 50.5%,
of total net revenues, for the three months ended September 30, 2012, compared
to $307.8 million, or 52.6% of total net revenues, for the three months ended
September 30, 2011.

Selling, distribution and administrative expenses decreased by $0.7 million for
the three months ended September 30, 2012 compared to the three months ended
September 30, 2011. The decrease was comprised of a decrease in labor costs of
$2.5 million partially offset by an increase in other operating expenses of $1.8
million. For the three months ended September 30, 2012, the corporate costs
included in selling, distribution and administrative expense were $49.9 million.
For the three months ended September 30, 2011 the corporate costs included in
selling, distribution and administrative expenses were $53.1 million.

The decrease in labor costs of $2.5 million was primarily due to a decrease in incentive compensation as a result of not meeting certain targets in 2012.


The increase in other operating expenses of $1.8 million was primarily due to an
increase in professional fees related to certain corporate matters and an
increase in our infusion general and professional liability self-insurance
reserve. These increases were partially offset by a reduction in depreciation
expense primarily due to the impairment of property, plant and equipment in the
fourth quarter of 2011, a decrease in professional fees related to our decision
to return certain outsourced functions relating to documentation, billing and
collections back to Apria personnel, and a decrease in travel and entertainment
related costs.

Non-Cash Impairment of Intangible Asset.Impairment of intangible assets for the
three months ended September 30, 2012 was $280.0 million related to the Apria
trade name. This impairment was the result of a decrease in the carrying value
of the trade name due to lowered estimates of future net revenues and operating
results in our home respiratory therapy/home medical equipment reporting unit
and a review of our current operating structure in our home infusion therapy
reporting unit, which will likely result in the reporting unit ceasing to use
the Apria trade name for the sale of enteral products in the next twelve months.
As a result, there was a $200.0 million charge to our home respiratory
therapy/home medical equipment reporting unit and $80.0 million charge to our
home infusion therapy reporting unit.



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Amortization of Intangible Assets. Amortization of intangible assets was $0.3 million and $1.2 million in the three months ended September 30, 2012 and September 30, 2011, respectively.


Interest Expense. Interest expense increased $0.6 million, or 1.7%, to $33.8
million in the three months ended September 30, 2012 from $33.2 million in the
three months ended September 30, 2011.

Interest Income and Other. Interest income and other increased to $0.3 million
for the three months ended September 30, 2012 from $(0.2) million in the three
months ended September 30, 2011.

Income Tax Expense/Benefit. Our overall effective tax rate is the ratio of our
tax expense (benefit) over our pre-tax income (loss) for the reporting period.
Our tax expense/benefit is comprised of two items: (1) the tax computed using an
Estimated Annual Effective Tax Rate ("EAETR") and (2) certain tax charges and
benefits which are recognized in the interim period in which they occur.

Our EAETR is determined by taking into account estimated pre-tax income (loss)
and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax
income (loss) at the end of each interim period to compute a year-to-date tax
expense (or benefit). Significant differences in our EAETR compared with
statutory rates can arise from permanent book/tax differences as a percentage of
our estimated pre-tax income (loss).

Our effective tax rate was a benefit of 38.0% for the three months ended
September 30, 2012, compared to a benefit of 59.5% for the three months ended
September 30, 2011. For the three months ended September 30, 2012, our effective
tax rate differed from federal and state statutory rates primarily due to the
change in the valuation allowance against substantially all of our net deferred
tax assets. For the three months ended September 30, 2011, our effective tax
rate differed from federal and state statutory rates primarily due to the tax
rate impact of non-deductible equity compensation and certain other items.

During the three months ended September 30, 2012, net tax benefits totaling $2.5
million were recognized, on a discrete basis, which resulted in an increase in
our effective tax rate above our EAETR. The $2.5 million primarily relates to
the release of tax contingency accruals due to the expiration of the statute of
limitations for uncertain tax positions ("UTPs"). Included in the EAETR is a
deferred tax benefit of $104.0 million recognized for the impairment of the
indefinite life trade name.

During the three months ended September 30, 2011, net tax benefits totaling $3.7
million were recognized, on a discrete basis, which resulted in an increase to
our effective tax rate above our EAETR. The $3.7 million primarily relates to
the release of tax contingency accruals due to a change in tax rules regarding
an uncertain tax position ("UTP") and the expiration of the statute of
limitations for other UTPs.

Our provision for income taxes is based on expected income, permanent book/tax
differences and statutory tax rates 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.

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.

For the three-year period ended December 31, 2011, we sustained a cumulative
book loss, after adjusting for non-recurring items. Therefore, we accrued a
valuation allowance of $224.5 million at December 31, 2011, since we determined
that it is more likely than not that substantially all of our net deferred tax
assets will not be realized. We utilized all available information (including
cumulative consolidated three-year loss information) to determine the necessity
and amount of our valuation allowance at December 31, 2011. We intend to
maintain our valuation allowance until sufficient positive evidence exists to
support the reversal of all or a portion of our valuation allowance.

We decreased our valuation allowance by $.5 million to $235.6 million at September 30, 2012 from $236.1 million at June 30, 2012 to offset corresponding decreases in our net deferred tax assets for the three months ended September 30, 2012.




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Segment Net Revenues and EBIT


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



                                                                        Net Revenues
                                Three Months Ended          Percentage of           Three Months Ended          Percentage of
(in thousands)                  September 30, 2012          Net Revenues            September 30, 2011          Net Revenues
Operating Segment
Home respiratory therapy
and home medical
equipment                      $            298,917                   49.1 %       $            293,370                   50.2 %
Home infusion therapy                       309,556                   50.9                      291,504                   49.8

Total                          $            608,473                  100.0 %       $            584,874                  100.0 %





                                                                                  EBIT
                                  Three Months Ended            Percentage of             Three Months Ended            Percentage of
                                  September 30, 2012            Net Revenues              September 30, 2011            Net Revenues
Operating Segment
Home respiratory therapy
and home medical
equipment(a)                      $          (195,794 )                  (65.5 )%        $            (11,415 )                   (3.9 )%
Home infusion therapy(b)                      (53,957 )                  (17.4 )%                      33,379                     11.5 %

Total                             $          (249,751 )                                  $             21,964




(a) EBIT for the three month period ended September 30, 2012 for the home

respiratory therapy/home medical equipment reporting unit includes a non-cash

impairment charge of $200.0 million.

(b) EBIT for the three month period ended September 30, 2012 for the home

infusion therapy reporting unit includes a non-cash impairment charge of

$80.0 million.



We allocate certain corporate expenses that are not directly attributable to a
product line based upon segment headcount. For the three months ended
September 30, 2012, the corporate costs allocated to the home respiratory
therapy/home medical equipment segment were $30.1 million and the corporate
costs allocated to the home infusion therapy segment were $19.8 million. For the
three months ended September 30, 2011, the corporate costs allocated to the home
respiratory therapy/home medical equipment segment were $37.6 million and the
corporate costs allocated to the home infusion therapy segment were $15.3
million.

See reconciliation of EBIT to net loss included at the end of this section.


Home Respiratory Therapy and Home Medical Equipment Segment. For the home
respiratory therapy and home medical equipment segment total net revenues
increased $5.5 million, or 1.9%, to $298.9 million in the three months ended
September 30, 2012 from $293.4 million in the three months ended September 30,
2011. Revenues for the home respiratory therapy and home medical equipment
segment decreased to 49.1% of total revenue in the three months ended
September 30, 2012 from 50.2% in the three months ended September 30, 2011.

Home respiratory therapy revenues are derived primarily from the provision of
oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers,
respiratory medications and related services. Revenues from the home respiratory
therapy service line decreased by 0.1% in the three months ended September 30,
2012 compared to the three months ended September 30, 2011. The decrease in
revenue resulted primarily from decreases in oxygen revenue as a result of a
decrease in oxygen volume, partially offset by an increase in sleep apnea
revenue as a result of an increase in sleep apnea volume.

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 14.1% in the three
months ended September 30, 2012 compared to the three months ended September 30,
2011. The increase was primarily due to an increase in the volume of negative
pressure wound therapy products.

EBIT for the home respiratory therapy and home medical equipment segment in the
three months ended September 30, 2012 was a negative $195.8 million (including a
non-cash impairment charge of $200.0 million related to our trade name),
compared to a negative $11.4 million in the three months ended September 30,
2011. EBIT was a negative 65.5% of segment net revenues in the three months
ended September 30, 2012, compared to a negative 3.9% of segment net revenues in
the three months ended September 30, 2011. Excluding the total non-cash
impairment charge of $200.0 million, the increase in the EBIT as a percentage of
segment net revenues from a negative 3.9% for the three months ended
September 30, 2011 to 1.4% in the three months ended September 30, 2012 is
primarily due to a decrease in sales, distribution and administrative costs as a
percentage of net revenues, as well as a decrease in provision for doubtful
accounts as a percentage of net revenues in the three months ended September 30,
2012 compared to the three months ended September 30, 2011.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net
revenues increased $18.1 million, or 6.2% to $309.6 million for the three months
ended September 30, 2012 from $291.5 million in the three months ended
September 30, 2011. Revenues for the home infusion therapy segment increased to
50.9% of total revenue in the three months ended September 30, 2012 from 49.8%
in the three months ended September 30, 2011.



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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 and core drugs.

EBIT for the home infusion therapy segment in the three months ended
September 30, 2012 was negative $54.0 million (including a non-cash impairment
charge of $80.0 million related to our trade name), compared to $33.4 million in
the three months ended September 30, 2011. EBIT was negative 17.4% of segment
net revenues in the three months ended September 30, 2012, compared to 11.5% of
segment net revenues in the three months ended September 30, 2011. Excluding the
total non-cash impairment charge of $80.0 million, the decrease in the EBIT as a
percentage of segment net revenues from 11.5% for the three months ended
September 30, 2011 to 8.4% in the three months ended September 30, 2012 is
primarily due to a decrease in the gross profit percentage as a percentage of
net revenue and an increase in the provision for doubtful accounts as a
percentage of revenue, partially offset by a decrease in sales, distribution and
administrative costs as a percentage of net revenues, in the three months ended
September 30, 2012 compared to the three months ended September 30, 2011.

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



                                Three Months Ended        Three Months Ended
        (in thousands)          September 30, 2012        September 30, 2011
        Net loss(a)             $          (175,711 )    $             (4,687 )
        Interest expense, net                33,483                    33,541
        Income tax benefit                 (107,523 )                  (6,890 )

        EBIT(b)                 $          (249,751 )    $             21,964




(a) Net loss for the three month period ended September 30, 2012 reflects the

    following non-cash impairment charge based on the results of impairment
    testing as of September 30, 2012 and the tax impact associated with the
    impairment charge:



(i) Trade name impairment of $280.0 million, $200.0 million of which relates

to the home respiratory therapy/home medical equipment reporting unit and

$80.0 million of which relates to the home infusion therapy reporting

        unit; and




    (ii) Tax benefit of $104.0 million relating to the intangible assets
         impairment.

All of these items resulted in a $176.0 million increase in the net loss in the three and nine months ended September 30, 2012.

(b) EBIT for the three months ended September 30, 2012 includes a $280.0 million

non-cash impairment charge described above.

Nine Months Ended September 30, 2012 and 2011


Net Revenues. Net revenues in the nine months ended September 30, 2012 were
$1,811.9 million, compared to $1,698.0 million in the nine months ended
September 30, 2011, an increase of $113.9 million or 6.7%. Revenue for the nine
months ended September 30, 2012 increased primarily due to increased volume in
the home infusion therapy segment and the home respiratory therapy and home
medical equipment segment, as well as the acquisition of Praxair assets in March
2011.

We expect pricing and reimbursement pressure to continue from governmental and
commercial payors. Public policy changes, reimbursement and pricing reductions
may result in our withdrawal from certain products or geographical areas. See
"Business - 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 for the nine months ended September 30, 2012 was 57.8%, compared to 59.2%
for the nine months ended September 30, 2011. The decline in gross profit margin
percentage is primarily due to a decrease in the home infusion therapy segment
margin percentage due to a decline in the gross profit margin associated with
specialty and enteral revenue and an increase in specialty revenue as a
percentage of infusion segment net revenue. Our specialty revenue has a lower
gross profit margin as a percentage of net revenue than our other infusion
therapy revenue.

Provision for Doubtful Accounts. The provision for doubtful accounts is based on
management's estimate of the net realizable value of accounts receivable.
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 adjusts
for changes in billing practices, cash collection protocols or practices, or
changes in general economic conditions, contractual



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issues with specific payors, new markets or products. The provision for doubtful
accounts, expressed as a percentage of total net revenues, was 2.5% and 3.0% in
the nine months ended September 30, 2012 and September 30, 2011, respectively.
The decrease in the provision for doubtful account in the nine months ended
September 30, 2012, is the result of expectations for our overall cash
collections rates.

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 and regional and corporate support
functions. These expenses are generally less sensitive to fluctuations in
revenue growth than operating costs.

Selling, distribution and administrative expenses were $933.4 million, or 51.5%,
of total net revenues for the nine months ended September 30, 2012 compared to
$907.5 million, or 53.4%, of total net revenues for the nine months ended
September 30, 2011.

Selling, distribution and administrative expenses increased $25.9 million for
the nine months ended September 30, 2012 compared to the nine months ended
September 30, 2011. The increase was comprised of an increase in labor costs of
$23.8 million and an increase in other operating expenses of $2.1 million. For
the nine months ended September 30, 2012, the corporate costs included in
selling, distribution and administrative expense were $149.5 million. For the
nine months ended September 30, 2011 the corporate costs included in selling,
distribution and administrative expenses were $161.5 million.

The increase in labor costs of $23.8 million was primarily due to an increase in
salaries and related benefits resulting from headcount increases associated with
our decision to return certain outsourced functions relating to documentation,
billing and collections back to Apria personnel, increases in infusion headcount
to support growth in our infusion revenue and labor costs related to the
acquisition of Praxair assets in March of 2011. These increases were partially
offset by a decrease in incentive compensation as a result of not meeting
certain targets in 2012.

The increase in other operating expenses of $2.1 million was primarily a result
of an increase in professional fees related to certain corporate matters and an
increase in our infusion general and professional liability self insurance
reserve. These increases were partially offset by a decrease in costs associated
with the acquisition of Praxair assets, the favorable settlement of a dispute
related to the Praxair transaction and a decrease in professional fees resulting
from our decision to return certain outsourced functions relating to
documentation, billing and collections back to Apria personnel. The decrease in
expenses related to the acquisition of Praxair assets was primarily related to
2011 expenses associated with the closing of certain Praxair facilities and
professional fees attributable to the acquisition.

Non-Cash Impairment of Intangible Asset. Impairment of intangible assets for the
nine months ended September 30, 2012 was $280.0 million related to the Apria
trade name. This impairment was the result of a decrease in the carrying value
of the trade name due to lowered estimates of future net revenues and operating
results in our home respiratory therapy/home medical equipment reporting unit
and a review of our current operating structure in our home infusion therapy
reporting unit, which will likely result in the reporting unit ceasing to use
the Apria trade name for the sale of enteral products in the next twelve months.
As a result, there was a $200.0 million charge to our home respiratory
therapy/home medical equipment reporting unit and $80.0 million charge to our
home infusion therapy reporting unit.

Amortization of Intangible Assets. Amortization of intangible assets was $1.5 million and $3.4 million in the nine months ended September 30, 2012 and September 30, 2011, respectively.


Interest Expense. Interest expense increased $2.1 million, or 2.0%, to $101.2
million in the nine months ended September 30, 2012 from $99.1 million in the
nine months ended September 30, 2011.

Interest Income and Other. Interest income and other increased to $1.1 million for the nine months ended September 30, 2012 from $0.1 million in the nine months ended September 30, 2011.


Income Tax Expense/Benefit. Our overall effective tax rate is the ratio of our
tax expense (benefit) over our pre-tax income (loss) for the reporting period.
Our tax expense/benefit is comprised of two items: (1) the tax computed using an
Estimated Annual Effective Tax Rate ("EAETR") and (2) certain tax charges and
benefits which are recognized in the interim period in which they occur.

Our EAETR is determined by taking into account estimated pre-tax income (loss)
and permanent book/tax differences. Our EAETR is applied to year-to-date pre-tax
income (loss) at the end of each interim period to compute a year-to-date tax
expense (or benefit). Significant differences in our EAETR compared with
statutory rates can arise from permanent book/tax differences as a percentage of
our estimated pre-tax income (loss).



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Our effective tax rate was a benefit of 33.8% for the nine months ended
September 30, 2012, compared to a benefit of 37.4% for the nine months ended
September 30, 2011. For the nine months ended September 30, 2012, the Company's
effective tax rate differed from federal and state statutory rates primarily due
to the change in the valuation allowance against substantially all of our net
deferred tax assets. For the nine months ended September 30, 2011, our effective
tax rate differed from federal and state statutory rates primarily due to the
tax rate impact of non-deductible equity compensation and certain other items.

During the nine months ended September 30, 2012, net tax benefits totaling $2.3
million were recognized, on a discrete basis, which resulted in a increase of
our effective tax rate above our EAETR. The $2.3 million primarily relates to
the release of tax contingency accruals due to the expiration of the statute of
limitations for uncertain tax positions ("UTPs"). Included in the EAETR is a
deferred tax benefit of $104.0 million recognized for the impairment of the
indefinite life trade name.

During the nine months ended September 30, 2011, net tax benefits totaling $3.0
million were recognized, on a discrete basis, which resulted in an increase to
our effective tax rate above our EAETR. The $3.0 million primarily relates to
the release of tax contingency accruals due to a change in tax rules regarding
an uncertain tax position ("UTP") and the expiration of the statute of
limitations for other UTPs.

Our provision for income taxes is based on expected income, permanent book/tax
differences and statutory tax rates 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.

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.

For the three-year period ended December 31, 2011, we sustained a cumulative
book loss, after adjusting for non-recurring items. Therefore, we accrued a
valuation allowance of $224.5 million at December 31, 2011, since we determined
that it is more likely than not that substantially all of our net deferred tax
assets will not be realized. We utilized all available information (including
cumulative consolidated three-year loss information) to determine the necessity
and amount of our valuation allowance at December 31, 2011. We intend to
maintain our valuation allowance until sufficient positive evidence exists to
support the reversal of all or a portion of our valuation allowance.

We increased our valuation allowance by $11.1 million to $235.6 million at September 30, 2012 from $224.5 million at December 31, 2011 to offset corresponding increases in our net deferred tax assets for the nine months ended September 30, 2012.




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Segment Net Revenues and EBIT


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



                                                                         Net Revenues
                                 Nine Months Ended           Percentage of           Nine Months Ended           Percentage of
(in thousands)                   September 30, 2012          Net Revenues            September 30, 2011          Net Revenues
Operating Segment
Home respiratory therapy
and home medical equipment      $            902,278                   49.8 %       $            862,040                   50.8 %
Home infusion therapy                        909,580                   50.2                      835,925                   49.2

Total                           $          1,811,858                  100.0 %       $          1,697,965                  100.0 %





                                                                               EBIT
                                  Nine Months Ended            Percentage of            Nine Months Ended           Percentage of
(in thousands)                    September 30, 2012           Net Revenues            September 30, 2011           Net Revenues
Operating Segment
Home respiratory therapy
and home medical equipment       $           (204,518 )                
(22.7 )%       $           (43,627 )                  (5.1 )%
Home infusion therapy                          (9,762 )                  (1.1 )%                    86,483                    10.3 %

Total                            $           (214,280 )                                $            42,856




(a) EBIT for the nine month period ended September 30, 2012 for the home

respiratory therapy/home medical equipment reporting unit includes a non-cash

impairment charge of $200.0 million.

(b) EBIT for the nine month period ended September 30, 2012 for the home infusion

therapy reporting unit includes a non-cash impairment charge of $80.0

million.



We allocate certain corporate expenses that are not directly attributable to a
product line based upon segment headcount. For the nine months ended
September 30, 2012, the corporate costs allocated to the home respiratory
therapy/home medical equipment segment were $96.6 million and the corporate
costs allocated to the home infusion therapy segment were $52.9 million. For the
nine months ended September 30, 2011, the corporate costs allocated to the home
respiratory therapy/home medical equipment segment were $116.7 million and the
corporate costs allocated to the home infusion therapy segment were $44.8
million.

See reconciliation of EBIT to net loss included at the end of this section.


Home Respiratory Therapy and Home Medical Equipment Segment. For the home
respiratory therapy and home medical equipment segment total net revenues
increased $40.3 million, or 4.7%, to $902.3 million in the nine months ended
September 30, 2012 from $862.0 million in the nine months ended September 30,
2011. Revenues for the home respiratory therapy and home medical equipment
segment decreased to 49.8% of total revenue in the nine months ended
September 30, 2012 from 50.8% in the nine months ended September 30, 2011.

Home respiratory therapy revenues are derived primarily from the provision of
oxygen systems, obstructive sleep apnea equipment, home ventilators, nebulizers,
respiratory medications and related services. Revenues from the home respiratory
therapy service line increased by 2.7% in the nine months ended September 30,
2012 compared to the nine months ended September 30, 2011. The increase in
revenue resulted primarily from an increase in sleep apnea revenue offset by a
decrease in oxygen revenue as a result of an increase in sleep apnea volume and
a decrease in oxygen volume and the acquisition of Praxair assets in March 2011.

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 16.7% in the nine
months ended September 30, 2012 compared to the nine months ended September 30,
2011. The increase was primarily due to an increase in the volume of negative
pressure wound therapy products.

EBIT for the home respiratory therapy and home medical equipment segment in the
nine months ended September 30, 2012 was a negative $204.5 million (including a
non-cash impairment charge of $200.0 million related to our trade name),
compared to a negative $43.6 million in the nine months ended September 30,
2011. EBIT was a negative 22.7% of segment net revenues in the nine months ended
September 30, 2012, compared to a negative 5.1% of segment net revenues in the
nine months ended September 30, 2011. Excluding the total non-cash impairment
charge of $200.0 million, the increase in the EBIT as a percentage of segment
net



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revenues from a negative 5.1% for the nine months ended September 30, 2011 to a
negative 0.5% in the nine months ended September 30, 2012 is primarily due to a
decrease in sales, distribution and administrative costs as a percentage of net
revenues, as well as a decrease in provision for doubtful accounts as a
percentage of net revenues in the nine months ended September 30, 2012 compared
to the nine months ended September 30, 2011.

Home Infusion Therapy Segment. For the home infusion therapy segment, total net
revenues increased $73.7 million, or 8.8% to $909.6 million for the nine months
ended September 30, 2012 from $835.9 million in the nine months ended
September 30, 2011. Revenues for the home infusion therapy segment increased to
50.2% of total revenue in the nine months ended September 30, 2012 from 49.2% in
the nine months ended September 30, 2011.

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 and core drugs.

EBIT for the home infusion therapy segment in the nine months ended
September 30, 2012 was negative $9.8 million (including a non-cash impairment
charge of $80.0 million related to our trade name), compared to $86.5 million in
the nine months ended September 30, 2011. EBIT was negative 1.1% of segment net
revenues in the nine months ended September 30, 2012, compared to 10.3% of
segment net revenues in the nine months ended September 30, 2011. Excluding the
total non-cash impairment charge of $80.0 million, the decrease in the EBIT as a
percentage of segment net revenues from 10.3% for the nine months ended
September 30, 2011 to 7.7% in the nine months ended September 30, 2012 is
primarily due to a decrease in the gross profit percentage as a percentage of
net revenue and an increase in the provision for doubtful accounts as a
percentage of revenue, partially offset by a decrease in sales, distribution and
administrative costs as a percentage of net revenues, in the nine months ended
September 30, 2012 compared to the nine months ended September 30, 2011.

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



                                 Nine Months Ended        Nine Months Ended
        (in thousands)          September 30, 2012        September 30, 2011
        Net loss(a)             $          (208,054 )    $            (35,148 )
        Interest expense, net               100,107                    99,028
        Income tax benefit                 (106,333 )                 (21,024 )

        EBIT(b)                 $          (214,280 )    $             42,856




(a) Net loss for the nine month period ended September 30, 2012 reflects the

    following non-cash impairment charge based on the results of impairment
    testing as of September 30, 2012 and the tax impact associated with the
    impairment charge:



(i) Trade name impairment of $280.0 million, $200.0 million of which relates

to the home respiratory therapy/home medical equipment reporting unit and

$80.0 million of which relates to the home infusion therapy reporting

        unit; and




    (ii) Tax benefit of $104.0 million relating to the intangible assets
         impairment.

All of these items resulted in a $176.0 million increase in the net loss in the three and nine months ended September 30, 2012.

(b) EBIT for the nine months ended September 30, 2012 includes a $280.0 million

non-cash impairment charge described above.

Liquidity and Capital Resources


Our principal source of liquidity is our operating cash flow, which is
supplemented by our Amended ABL Facility (as defined below), which provides for
revolving credit of up to $250.0 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 and cash
equivalents, and Amended ABL Facility, will continue to be sufficient to fund
our operations and growth strategies for at least the next 12 months.

In the nine months ended September 30, 2012, our free cash flow was $(9.3)
million. For the nine months ended September 30, 2011 our free cash flow was
$(22.3) 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. Free cash flow is a financial measure
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.



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



                                               Nine Months Ended              Nine Months Ended
(in thousands)                                September 30, 2012             September 30, 2011
Reconciliation - Free Cash Flow:
Net loss(a)                                   $          (208,054 )          $           (35,148 )
Non-cash items(b)                                         335,069                        166,830
Change in operating assets and
liabilities                                               (15,282 )                      (39,900 )

Net cash provided by operating
activities                                                111,733                         91,782
Less: Purchases of patient service
equipment and property, equipment and
improvements                                             (121,008 )                     (114,089 )

Free cash flow                                $            (9,275 )          $           (22,307 )




(a) Net loss for the nine months period ended September 30, 2012 reflects the

following non-cash impairment charge based on the results of the Company's

impairment testing as of September 30, 2012 and the tax impact associated

with the impairment charge:



(i) Trade name impairment of $280.0 million, $200.0 million of which relates to
the home respiratory therapy/home medical equipment reporting unit and $80.0
million of which relates to the home infusion therapy reporting unit; and

(ii) Tax benefit of $104.0 million relating to the intangible assets impairment.

All of these items resulted in a $176.0 million increase in our net loss in the nine months ended September 30, 2012.

(b) The nine months ended September 30, 2012 includes a $280.0 million non-cash

impairment charge described above.

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



                                              Nine Months Ended              Nine Months Ended
(in thousands)                               September 30, 2012             September 30, 2011
Net cash provided by operating
activities                                   $           111,733            $            91,782
Net cash used in investing
activities                                              (120,943 )                     (137,405 )
Net cash used in financing
activities                                                (4,358 )                       (5,587 )

Net decrease in cash and equivalents                     (13,568 )                      (51,210 )
Cash and equivalents at beginning
of period                                                 29,096                        109,137

Cash and equivalents at end of
period                                       $            15,528            $            57,927


The Nine Months Ended September 30, 2012 Results Compared to the Nine Months Ended September 30, 2011


Net cash provided by operating activities in the nine months ended September 30,
2012 was $111.7 million compared to $91.8 million in the nine months ended
September 30, 2011, an increase of $19.9 million. The increase in net cash
provided by operating activities resulted from a $24.6 million decrease in the
cash used related to the change in operating assets and liabilities to a $15.3
million use of cash in 2012 from a $39.9 million use of cash in 2011, partially
offset by a $2.6 million decrease in the provision of cash from non-cash items
in 2012.

The $24.6 million decrease in cash used by the change in operating assets and liabilities consisted primarily of the following:

$22.8 million decrease in cash used by accounts receivable to a $71.6

             million use of cash in the nine months ended September 30, 

2012 from a

$94.4 million use of cash in the nine months ended September 

30, 2011.

             The decrease was primarily due to our decision to return 

certain

             outsourced functions relating to documentation, billing and
             collections back to Apria personnel, and the implementation of 

a new

             billing and admission system for our home infusion therapy segment.




        •    $10.5 million increase in cash provided by prepaid expenses and other
             assets to a $8.6 million provision of cash in the nine months ended
             September 30, 2012 from a $1.9 million use of cash in the nine months
             ended September 30, 2011. The increase was primarily the

result of our

             decision to reduce certain prepaid vendor balances in 2012.




        •    $9.6 million decrease in cash used by income taxes to a $1.7 million
             use of cash in the nine months ended September 30, 2012 from a $11.3
             million use of cash in the nine months ended September 30, 2011. The
             decrease was primarily due to a reduction in the release of our tax
             contingency accruals for the nine months ended September 30, 2012 as
             compared to the nine months ended September 30, 2011.

Reductions to

             our tax contingency accruals resulted from changes in tax law and the
             expiration of statutes of limitations.




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Offset by:



        •    $11.2 million decrease in cash provided by accrued payroll and related
             taxes and benefits to a $7.4 million provision of cash in the nine
             months ended September 30, 2012 from a $18.6 million provision of cash
             in the nine months ended September 30, 2011. The decrease was
             primarily due to a decrease in incentive compensation as a result of
             not meeting certain targets in 2012 and the timing of payments.




        •    $9.8 million decrease in cash provided by inventories to a $8.5
             million use of cash in the nine months ended September 30, 2012 from a
             $1.3 million provision of cash in the nine months ended

September 30,

             2011. The increase was primarily due to timing of inventory purchases
             and sales.


Net cash used in investing activities in the nine months ended September 30,
2012 was $120.9 million, compared to $137.4 million in the nine months ended
September 30, 2011. The primary use of funds in 2012 was $121.0 million to
purchase patient service equipment and property equipment and improvements;
$98.8 million related to patient service equipment to support revenue growth;
and $22.2 million related to property equipment and improvements, primarily due
to additions to our information systems software and hardware. The primary use
of funds in 2011 was $114.1 million to purchase patient service equipment and
property equipment and improvements; $84.8 million related to patient service
equipment; and $29.3 million related to property equipment and improvements,
primarily due to additions to our information systems software and hardware.
Additionally, net cash used in investment activities of $23.3 million related
primarily to the acquisition of Praxair assets in March 2011.

In 2012, net cash used by financing activities in the nine months ended
September 30, 2012 was $4.4 million compared to $5.6 million use of cash in the
nine months ended September 30, 2011. Cash used in financing activities in 2012
primarily related to net borrowings on our ABL facility. In 2011, net cash used
in financing activities primarily reflected cash paid on profit interests and
capitalized leases related to pumps.

Accounts Receivable. Accounts receivable before allowance for doubtful accounts
increased to $416.8 million as of September 30, 2012 from $391.1 million at
December 31, 2011. Days sales outstanding (calculated as of each period-end by
dividing accounts receivable, less allowance for doubtful accounts, by the
rolling average of total net revenues) were 55 days at September 30, 2012,
compared to 51 days at December 31, 2011. The increase in accounts receivable
and days sales outstanding is primarily due to increased revenue and delays
resulting from the implementation of a new billing and admissions system for our
home infusion therapy segment and the implementation of new HIPPA standards for
processing electronic billing claims by our payors.

Accounts aged in excess of 180 days expressed as percentages of total
receivables for certain major payor categories, and in total, are as follows:



                               September 30, 2012        December 31, 2011
         Total                                22.7 %                   20.0 %
         Medicare                             20.9 %                   15.9 %
         Medicaid                             15.8 %                   20.1 %
         Patient self pay                     35.4 %                   31.5 %
         Managed care/other                   22.1 %                   19.9 %


Unbilled Receivables. Included in accounts receivable are earned but unbilled
receivables of $56.6 million and $63.4 million at September 30, 2012 and
December 31, 2011, respectively. The decrease in unbilled receivables is
primarily due to the implementation of specific initiatives designed to reduce
unbilled receivables, partially offset by delays resulting from the
implementation of a new billing and admissions system for our home infusion
therapy segment. 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 our
analysis of historical performance and collectability.

Inventories and Patient Service Equipment. Inventories consist primarily of
pharmaceuticals and disposable products used in conjunction with patient service
equipment. Patient service equipment consists of respiratory and home medical
equipment that is provided to in-home patients for the course of their care
plan, normally on a rental basis, and subsequently returned to us for
redistribution after cleaning and maintenance is performed.



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The branch locations serve as the primary point from which inventories and
patient service equipment are delivered to patients. Certain products and
services, such as infusion therapy and respiratory medications, bypass the
respiratory/home medical equipment branches and are provided directly to
patients from pharmacies or other central locations. The branches are supplied
with inventory and equipment from central warehouses that service specific areas
of the country. Such warehouses are also responsible for repairs and scheduled
maintenance of patient service equipment, which adds to the frequent movement of
equipment between locations. Further, the majority of our patient service
equipment is located in patients' homes. While utilization varies widely between
equipment types, on the average, approximately 88% of equipment is on rent at
any given time. Inherent in this asset flow is the fact that losses will occur.
Depending on the product type, we perform physical inventories on an annual or
quarterly basis. Inventory and patient service equipment balances in the
financial records are adjusted to reflect the results of these physical
inventories.

Long-term Debt.


Series A-1 Notes and Series A-2 Notes. We issued the Series A-1 Notes and Series
A-2 Notes 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 our ability and the
ability of our 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.

Substantially all of the Company's wholly-owned subsidiaries (the "Guarantors")
jointly and severally, unconditionally guarantee the Series A-1 Notes and the
Series A-2 Notes on a senior secured basis. The Guarantors also guarantee the
Company's ABL Facility.

Amended and Restated ABL Facility. On August 8, 2011, we entered into a senior
secured asset-based revolving credit facility, or ABL Facility, with Bank of
America, N.A., as administrative agent and collateral agent and a syndicate of
financial institutions and institutional lenders. The ABL Facility amended and
restated our prior senior secured asset-based revolving credit facility dated
October 28, 2008, which provided for a revolving credit financing of up to
$150.0 million.

The ABL Facility provides for revolving credit financing of up to $250.0
million, subject to borrowing base availability, with a maturity of the earlier
of (a) five years and (b) 90 days prior to the earliest maturity of our
outstanding Series A-1 Notes and Series A-2 Notes, and includes 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 (i) 85% of
eligible receivables, (ii) the least of (a) 85% of eligible self-pay accounts,
(b) 10% of the borrowing base, (c) $25,000,000 and (d) the aggregate amount of
self-pay accounts collected within the previous 90 days, (iii) the lesser of
(a) 85% of eligible accounts invoiced but unpaid for more than 180 days but less
than 360 days and (b) 10% of eligible accounts invoiced but unpaid for 180 days
or less and (iv) the lesser of (a) 85% of the net orderly liquidation value of
eligible inventory and (b) $35.0 million.

Borrowings under our ABL Facility bear interest at a rate per annum equal to, at
our option, either (a) a base rate determined by reference to the higher of
(1) the prime rate of Bank of America, N.A. and (2) the federal funds effective
rate plus 1/2 of 1% ("Base Rate"), plus an applicable margin (currently 1.25%)
or (b) a LIBOR rate determined by reference to LIBOR, adjusted for statutory
reserve requirements, plus an applicable margin (currently 2.25%). The
applicable margin for borrowings under our ABL Facility is subject to (a) 25
basis points step ups and step downs based on average excess availability under
the ABL Facility and (b) a step down of 25 basis points based on achieving a
consolidated fixed charge coverage ratio greater than 1.75 to 1.00. In addition
to paying interest on outstanding amounts under our ABL Facility, we are
required to pay a commitment fee, in respect of the unutilized



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commitments thereunder, ranging from 0.375% to 0.50% per annum, which fee will
be determined based on utilization of our ABL Facility (increasing when
utilization is low and decreasing when utilization is high). We also pay
customary letter of credit fees equal to the applicable margin on LIBOR loans
and other customary letter of credit and agency fees.

From time to time, we issue letters of credit in connection with our business, including commercial contracts, leases, insurance and workers' compensation arrangements. If the holders of our letters of credit draw funds under such letters of credit, it would increase our outstanding senior secured indebtedness.


As of September 30, 2012, there was $6.0 million outstanding under the ABL
Facility, outstanding letters of credit totaled $23.6 million and additional
availability under the ABL Facility, subject to the borrowing base, was $220.4
million. As of September 30, 2012, the available borrowing base did not
constrain our ability to borrow the entire $220.4 million of available borrowing
capacity under our ABL Facility. At September 30, 2012, we were in compliance
with all of the financial covenants required by the credit agreement governing
the ABL Facility. As of November 12, 2012, there was approximately $59.0 million
outstanding under the ABL Facility.

As market conditions warrant, we and our major equity holders, including the Sponsor and its affiliates, may from time to time, depending upon market conditions, seek to refinance or repurchase our debt securities or loans in privately negotiated or open market transactions, by tender offer or otherwise.


Covenant Compliance. Under the indenture governing our Series A-1 Notes and
Series A-2 Notes and under the credit agreement governing our ABL Facility, our
ability to engage in activities such as incurring additional indebtedness,
making investments, refinancing certain indebtedness, paying dividends and
entering into certain merger transactions is governed, in part, by our ability
to satisfy tests based on Adjusted EBITDA.

"Adjusted EBITDA" is defined as net income (loss), plus interest expense, net,
provision (benefit) for income taxes and depreciation and amortization, further
adjusted for certain other non-cash items, costs incurred related to
initiatives, cost reduction and other adjustment items that are permitted by the
covenants included in the indenture governing the Series A-1 Notes and the
Series A-2 Notes and the credit agreement governing our ABL Facility.

We believe that the presentation of Adjusted EBITDA is appropriate to provide
additional information to investors about the calculation of, and compliance
with, certain financial covenants in the indenture governing our Series A-1
Notes and Series A-2 Notes and in our ABL Facility. Adjusted EBITDA is a
material component of these covenants. We caution investors that amounts
presented in accordance with our definition of Adjusted EBITDA may not be
comparable to similar measures disclosed by other issuers, because not all
issuers and analysts calculate Adjusted EBITDA in the same manner.

Adjusted EBITDA is not a measurement of our financial performance under GAAP and
should not be considered as an alternative to net income or any other
performance measures derived in accordance with GAAP or as an alternative to
cash flows from operating activities as a measure of our liquidity.

The following table provides a reconciliation from our net loss to Adjusted
EBITDA:



                                            Three Months Ended              Twelve Months Ended
(in thousands)                              September 30, 2012              September 30, 2012
Net loss(a)                                 $          (175,711 )          $            (920,230 )
Interest expense, net(b)                                 33,483                          133,074
Income tax benefit                                     (107,523 )                        (60,625 )
Depreciation and amortization                            28,197                          116,566
Non-cash impairment charges(c)                          280,000                          937,868
Non-cash items(d)                                         5,039                           24,399
Costs incurred related to
initiatives and non-recurring
items(e)                                                  9,195                           28,117
Other adjustments (f)                                     1,749                            6,996
Projected cost savings and
synergies(g)                                                368                            8,701

Adjusted EBITDA                             $            74,797            $             274,866




(a) Net loss for the twelve months ended September 30, 2012 reflects the

following non-cash impairment charges based on the results of our 2011 annual

impairment testing, the tax impact associated with the impairment charges and

charges related to deferred tax valuation allowances. Additionally, in the

quarter ended September 30, 2012 we incurred an additional non-cash

impairment charge. Except as noted, all of the impairment charges relate to

    the home respiratory therapy/home medical equipment reporting unit.
    Components by period are as follows:




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Non-cash impairment charges, tax impact associated with impairment charges and
charges related to deferred tax valuation allowances incurred in the quarter
ended December 31, 2011.



  (i) Goodwill impairment of $509.9 million;



(ii) Trade name impairment of $60.0 million ($56.4 million of which relates

            to the home respiratory therapy/home medical equipment 

reporting unit

            and $3.6 million of which relates to the home infusion therapy
            reporting unit);



(iii) Capitated relationships intangible asset impairment of $30.4 million;




  (iv) Patient service equipment impairment of $45.5 million;




  (v) Property, equipment and improvements impairment of $12.1 million;



(vi) Tax benefit relating to the goodwill, intangible and long-lived assets

            impairment of $166.9 million; and



(vii) Valuation allowance against our net deferred tax assets of $220.5

             million.


All of these items resulted in a $711.5 million increase in our net loss in the quarter ended December 31, 2011.

Non-cash impairment charge and tax impact associated with impairment charge incurred in the quarter ended September 30, 2012.



       (i)  Trade name impairment of $280.0 million, $200.0 million of which
            relates to the home respiratory therapy/home medical equipment
            reporting unit and $80.0 million which relates to the home infusion
            therapy reporting unit; and




  (ii) Tax benefit of $104.0 million relating to the intangible impairment.

All of these items resulted in a $176.0 million increase in our net loss in the quarter ended September 30, 2012.


Net loss for the twelve months ended September 30, 2012 consists of the
following quarterly net loss amounts: $(712,176) for the three months ended
December 31, 2011; $(19,607) for the three months ended March 31, 2012; $(6,354)
for the three months ended June 30, 2012; and $(175,711) for the three months
ended September 30, 2012.


(b) Reflects $33.8 million of interest expense, net of $0.3 million of interest

income for the three months ended September 30, 2012. Reflects $134.6 million

of interest expense, net of $1.5 million of interest income for the twelve

    months ended September 30, 2012.



(c) In connection with the impairment testing in the quarter ended December 31,

2011 and in the quarter ended September 30, 2012, we recorded non-cash

impairment charges totaling $937.9 million, of which $657.9 million relates

to the quarter ended December 31, 2011 and $280.0 million relates to the

quarter ended September 30, 2012.

Components by period are as follows:

Non-cash impairment charges of $657.9 million incurred in the quarter ended December 31, 2011 are as follows:



  (i) Goodwill impairment of $509.9 million;



(ii) Trade name impairment of $60.0 million ($56.4 million of which relates

            to the home respiratory therapy/home medical equipment 

reporting unit

            and $3.6 million of which relates to the home infusion therapy
            reporting unit);



(iii) Capitated relationships intangible asset impairment of $30.4 million;




  (iv) Patient service equipment impairment of $45.5 million; and




  (v) Property, equipment and improvements impairment of $12.1 million.

Non-cash impairment charge and tax impact associated with impairment charge incurred in the quarter ended September 30, 2012 are as follows:




       (i)  Trade name impairment of $280.0 million, $200.0 million of which
            relates to the home respiratory therapy/home medical equipment
            reporting unit and $80.0 million which relates to the home infusion
            therapy reporting unit.




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(d) Non-cash items are comprised of the following:




                                             Three Months Ended               Twelve Months Ended
(in thousands)                               September 30, 2012               September 30, 2012
Profit interest units compensation
expense                                      $               900             $               3,195
Loss on patient service equipment,
disposition of assets and other(i)                         4,139                            21,204

Total non-cash items                         $             5,039             $              24,399




(i) Primarily represents non-cash losses related to the disposals or write-offs

of patient service equipment.



(e) Costs incurred related to initiatives and non-recurring items are comprised
    of the following:




                                           Three Months Ended               Twelve Months Ended
(in thousands)                             September 30, 2012               September 30, 2012
Costs and expenses related to
initiatives(i)                             $             9,208             $              28,245
Acquisition of Praxair assets(ii)                          (13 )                           1,296
Executive severance and
retention(iii)                                              -                                898
Other(iv)                                                   -                             (2,322 )

Total costs incurred related to
initiatives and non-recurring
items                                      $             9,195             $              28,117




(i) Represents salaries and wages, severance, relocation consulting fees and

other expenses for the three and twelve months ended September 30, 2012,

primarily related to six projects: (1) the offshoring and subsequent

onshoring of certain of our billing and collections functions; (2) a new

billing and collections system for our home infusion therapy business;

(3) professional fees related to certain corporate matters;

(4) centralization of our admissions process for our home infusion therapy

business; (5) a new supply chain management system; and (6) sales force and

operations optimization.

(ii) Represents costs related to the March 4, 2011 acquisition of Praxair assets.

(iii) Represents executive severance and retention expense as a result of the

Merger for the three and twelve months ended September 30, 2012.

(iv) Represents a settlement related to a prior acquisition.

(f) Other adjustment items primarily related to the sponsor management fee of

$1.7 million and $7.0 million for the three and twelve months ended

September 30, 2012.

(g) Represents projected net cost savings and synergies to be realized in

connection with acquisitions and cost saving, restructuring and other similar

initiatives, primarily related to procurement savings.



Business Combinations and Asset Purchases. We periodically acquire complementary
businesses. These transactions are accounted for as purchases and the results of
operations of the acquired companies are included in the accompanying statements
of operations from the dates of acquisition. Covenants not to compete are being
amortized over the life of the respective agreements. Customer lists, favorable
lease arrangements and patient referral sources are being amortized over the
period of their expected benefit. During the nine months ended September 30,
2012 and September 30, 2011, the Company purchased certain assets of a business
for $0.1 million and $23.4 million, respectively.

Inflation. We experience pricing pressures in the form of continued reductions
in reimbursement rates, particularly from managed care organizations and from
governmental payors such as Medicare and Medicaid. We are also impacted by
rising costs for certain inflation-sensitive operating expenses such as labor
and employee benefits, facility and equipment leases, and vehicle fuel. However,
we generally do not believe these impacts are material to our revenues or net
income.



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Contractual Cash Obligations. The following table summarizes the long-term cash
payment obligations to which we are contractually bound. The years presented
below represent a 6-month period ending December 31, 2012 and 12-month periods
in subsequent periods.



                                            Less                                         More
                                            than                                         than
(in millions)                              1 Year       1-3 Years       3-5 Years       5 Years      Totals
Series A-1 Notes                           $    -      $       700     $        -      $      -      $   700
Series A-2 Notes                                -              318              -             -          318
Amended ABL Facility(1)(2)                       6              -               -             -            6
Interest Payments on Series A-1 Notes(3)        39             158              -             -          197
Interest Payments on Series A-2 Notes(4)        20              79              -             -           99
Fees on ABL Facility(2)(5)                      -                3              -             -            3
Operating Leases                                15             102              67            39         223
Capitalized Leases(8)                           -               -               -             -           -
Purchase Obligations(6)                         14              79              64            52         209
Unrecognized Tax Benefits(7)                    -               -               -             -           -

Total Contractual Cash Obligations $ 94$ 1,439 $

   131     $      91     $ 1,755




(1) Borrowings under the Amended ABL Facility bear interest at a rate per annum

equal to, at our option, either (a) a base rate determined by reference to

the higher of (1) the prime rate of Bank of America, N.A. and (2) the federal

    funds effective rate plus 1/2 of 1%, plus an applicable margin of 1.00% to
    1.50% based on the average excess availability (currently 1.00%) or (b) a

LIBOR rate determined by reference to LIBOR, adjusted for statutory reserve

requirements, plus an applicable margin of 2.00% to 2.50% based on average

excess availability (currently 2.00%). The applicable margin for borrowings

under our ABL Facility is subject to step ups and step downs based on average

excess availability under the ABL Facility.

(2) The actual amounts of interest and fee payments under the ABL Facility will

ultimately depend on the amount of debt and letters of credit outstanding and

the interest rates in effect during each period. We are also required to pay

customary letter of credit fees equal to the applicable margin on LIBOR loans

and certain agency fees.

(3) Represents aggregate interest payments on $700.0 million of the Series A-1

Notes issued in May 2009 that is paid semi-annually in May and November.

Interest payments on the Series A-1 Notes will total approximately $79

million annually until the Series A-1 Notes mature on November 1, 2014. The

effective interest rate at September 30, 2012 was 11.25%.

(4) Represents aggregate interest payments on $317.5 million of the Series A-2

Notes issued in August 2009 that is paid semi-annually in May and November.

Interest payments on the Series A-2 Notes will total approximately $39

million annually until the Series A-2 Notes mature on November 1, 2014. The

effective interest rate at September 30, 2012 was 12.375%.

(5) The fees payable on the Amended ABL Facility are based on an assumed fee for

undrawn amounts of 0.50%, which represents the fees payable under the Amended

ABL Facility assuming no borrowings or drawn letters of credit. We are

required to pay a commitment fee on the Amended ABL Facility, in respect of

the unutilized commitments there under, ranging from 0.375% to 0.50% per

annum, which fee is determined based on the utilization of our Amended ABL

Facility (increasing when utilization is low and decreasing when utilization

is high). The fees also include an administrative fee which is paid

quarterly.

(6) The purchase obligations primarily relate to approximately $158 million we

expect to pay under an agreement with Dell Services (formerly Perot Systems)

and approximately $46 million we expect to pay under an agreement with

Intelenet. However, if we terminated the agreements, the required obligation

to vendors could be reduced to approximately $13.4 million for Dell Systems

and $5.5 million for Intelenet.

(7) Gross unrecognized tax benefits of $8.1 million are included within "Income

Taxes Payable and Other Non-current Liabilities" in the total liabilities

section of our September 30, 2012 consolidated balance sheet. The entire $8.1

million amount is not reflected in the contractual cash obligations table

above since we cannot make a reliable estimate of the period in which cash

    payments will occur.


(8) Less than $1 million.


Off-Balance Sheet Arrangements


We are not a party to off-balance sheet arrangements as defined by the
Securities and Exchange Commission. However, from time to time we enter into
certain types of contracts that contingently require us to indemnify parties
against third-party claims. The contracts primarily relate to: (i) certain asset
purchase agreements, under which we may provide customary indemnification to the
seller of the business being acquired; (ii) certain real estate leases, under
which we may be required to indemnify property owners for environmental and
other liabilities, and other claims arising from our use of the applicable
premises; and (iii) certain agreements with our officers, directors and
employees, under which we may be required to indemnify such persons for
liabilities arising out of their relationship with us. In addition, we issued
certain letters of credit under our ABL Facility as described under "Liquidity
and Capital Resources - Long-Term Debt."



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Table of Contents


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 our balance sheets for any of the periods presented.
Wordcount: 21614



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