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 ("TPN") 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 510 locations throughout the United States. We have two reportable operating segments:      •   home respiratory therapy and home medical equipment; and       •   home infusion therapy.  

Recent Events

Refinancing of Debt. On April 5, 2013, we entered into a senior secured credit agreement (the "Senior Secured Term Loan"), among Apria, as borrower, Sky Acquisition LLC, as parent, the other guarantors party thereto from time to time, Bank of America, N.A., as administrative agent, U.S. Bank National Association as collateral agent, certain other agents party thereto and a syndicate of financial institutions and institutional lenders.

  On April 5, 2013, we borrowed $900.0 million in aggregate principal amount of term loans under the Senior Secured Term Loan. At our option we may borrow additional term loans under the Senior Secured Term Loan, subject to certain customary conditions, including consent of the lenders providing such additional term loans, in an amount not to exceed $175.0 million, plus the aggregate principal amount of voluntary prepayments of term loans on or prior to such time, plus additional amounts subject to compliance on a pro forma basis with certain financial ratio tests.  Borrowings under the Senior Secured Term Loan bear interest at a fluctuating rate per annum equal to, at our option (i) a base rate equal to the highest of (a) the federal funds rate plus 1/2 of 1%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America, N.A. as its "prime rate" and (c) the one month LIBOR Rate plus 1.00% (provided that in no event shall such base rate with respect to the initial Term Loans be less than 2.25% per annum), in each case plus an applicable margin of 4.50% or (ii) a LIBOR Rate for the applicable interest period (provided that in no event shall such LIBOR rate with respect to the initial Term Loans be less than 1.25% per annum) plus an applicable margin of 5.50%.  The Senior Secured Term Loan will mature on April 5, 2020 and will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of term loans, with the balance payable on the final maturity date; provided that the Senior Secured Term Loan provides the right for individual lenders to agree to extend the maturity date of their outstanding term loans upon our request and without the consent of any other lender, subject to customary terms and conditions.  All our obligations under the Senior Secured Term Loan (i) are unconditionally guaranteed by our parent and substantially all of its existing and future, direct and indirect, wholly-owned domestic restricted subsidiaries and (ii) are secured, subject to certain exceptions, by substantially all of our assets and the assets of the guarantors.  The Senior Secured Term Loan is entitled to a priority of payment over the Series A-2 Notes in certain circumstances, including upon any acceleration of the obligations in respect of the Senior Secured Term Loan, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Senior Secured Term Loan and the Series A-2 Notes.                                           35

--------------------------------------------------------------------------------

Table of Contents

  The Senior Secured Term Loan includes a financial maintenance covenant that prohibits our consolidated first priority net leverage ratio as of the last day of any test period of four consecutive fiscal quarters (commencing with the test period ending September 30, 2013) from exceeding 5.50 to 1.00.  The Senior Secured Term Loan also includes customary negative covenants that, subject to significant exceptions, limit our ability and the ability of our parent and subsidiaries to, among other things: incur liens; make investments or loans; incur, assume or permit to exist additional indebtedness or guarantees; and pay dividends, make payments or redeem or repurchase capital stock.  Under the terms of the Senior Secured Term Loan, outstanding loans under the Senior Secured Term Loan may be accelerated if more than $75.0 million of the Series A-2 Notes remain outstanding on or after September 2, 2014.  We used proceeds from the borrowings under the Senior Secured Term Loan to: (i) redeem all of our outstanding 11.25% Senior Secured Notes due 2014 (Series A-1) (the "Series A-1 Notes"); (ii) redeem an aggregate principal amount of $160.0 million of our outstanding 12.375% Senior Secured Notes due 2014 (Series A-2) (the "Series A-2 Notes" and, together with the Series A-1 Notes, the "Notes"); and (iii) pay fees and expenses associated with the entering into the Senior Secured Term Loan and the redemption of the Notes.  In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed. Such amounts are included in Loss on Early Retirement of Debt on our Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2013.  Borrowings under the Senior Secured Term Loan, were incurred with an original issue discount of $9.0 million. We incurred $10.6 million of debt issuance costs in connection with the Senior Secured Term Loan.  Internal Restructuring. On July 1, 2013, we separated and transferred the assets and operations of our enteral nutrition business to certain of our wholly-owned subsidiaries to enable it to function more autonomously and achieve certain operating efficiencies. This separation and transfer was part of an ongoing effort to streamline our organizational structure and operations. In connection with the separation and transfer, certain of our subsidiaries entered into transition services agreements in order to facilitate the transition process.  

Strategy

  Our strategy is to position ourselves in the marketplace as a high-quality, cost-efficient 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. Since our acquisition of Coram in          December 2007, we have grown our revenue and 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 of the country. Since          early 2010, we have expanded our home respiratory therapy and home medical

equipment sales force by 20%, of which 8% relates to the acquisition of

Praxair assets. During the same time period, the home infusion therapy

sales force has grown by 35% and become further stratified with dedicated

sales resources allocated to fast-growing therapeutic service lines. This

expansion in both business units has allowed us to more efficiently cover

each market served by promoting our products and services to physicians,

         clinical specialists, hospital discharge planners and managed care          organizations. On an ongoing basis, we continually evaluate the size of          our sales force and the products/services we offer to the market within

the context of changing market conditions, the competitive landscape,

pricing, opportunities and threats. Additionally, this may include exiting

certain products, markets, payors, and hospital agreements or reorganizing

         certain operations of our company.          •   Continue to participate in the managed care market and pursue

opportunities created by healthcare reform. 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 enable 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 six months ended

June 30, 2013. Healthcare reform may create new models of care, such as

Accountable Care Organizations and state insurance exchanges. Our size and

scope of services may give us a competitive advantage in serving these new

         markets.                                            36 

--------------------------------------------------------------------------------

Table of Contents

• Leverage our national distribution infrastructure. With approximately 510

locations and a robust platform supporting shared national services, we

believe that we can efficiently add products, services and patients to our

systems to grow our revenues and leverage our cost structure. For example,

we have successfully leveraged this distribution platform across a number

of product and service offerings, including a continuous positive airway

pressure ("CPAP")/ bi-level supply replenishment program, enteral

nutrition and negative pressure wound therapy ("NPWT") services, and we

are using our nursing capacity to provide infusion services through our

growing network of ambulatory infusion suites. We seek to achieve margin

improvements through operational initiatives focused on the continual

reduction of costs and delivery of incremental efficiencies. At the same

time, we believe that it is essential to consistently deliver superior

customer service in order to increase referrals and retain existing

patients. Performance improvement initiatives are underway in all aspects

of our operations including customer service, patient and referral

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 Improvements

for Patients and Providers 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 (the "Commission"). In

June 2013, 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 Commission

accreditation encompasses our full complement of services including home

health, home medical equipment, clinical respiratory, ambulatory infusion

services, pharmacy dispensing, and clinical consultant pharmacist

services. In June 2013, we celebrated our 25th anniversary of our initial

accreditation by the Commission-more years than any other homecare

provider.

   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. In addition, significant dispositions or restructuring 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. To the extent any such decisions are made, we would likely 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 on Form 10-K for the year ended December 31, 2012.  

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 us 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                                           37 

--------------------------------------------------------------------------------

Table of Contents

  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 six months ended June 30, 2013, approximately 23% and 6% of our net revenues were reimbursed by the Medicare and state Medicaid programs. No other third-party payor represented more than 9% of our total net revenues for the three and six months ended June 30, 2013. 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% of total net revenues for the three and six months ended June 30, 2013, 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 ("MMA"); the Deficit Reduction Act of 2005 ("DRA"); MIPPA, which became law in 2008, the comprehensive healthcare reform law signed in March 2010 ("the Reform Package"), the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012. 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. In August 2011, the Budget Control Act of 2011 was signed into law. The Budget Control Act of 2011 authorized increases in the United States' 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. 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) were triggered. Under sequestration, certain federal programs are protected, including Medicaid. However, effective April 1, 2013, sequestration caused payments to Medicare providers and suppliers to be reduced by 2%. This reduction applies to both competitively bid and non-competitively bid markets and products. Unless Congress takes action to change the law, federal spending will be subject to sequestration until fiscal year 2022. These reductions, along with any further reductions 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 originally 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 then in additional markets after 2009.  Although CMS administered a bid process in 2007 and launched the original Round 1 program in mid-2008, shortly thereafter, MIPPA was enacted. This 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 included 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 ("Competitive Bidding Area") and product categories subject to rebidding in the Round 1 Rebid were 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 and will remain in place through the end of the three-year contract period, December 31, 2013. CMS reported that the average price reduction for all products in all Round 1 Rebid CBAs was 32%. After the price reduction and volume growth/reduction experienced in the Round 1 Rebid markets is accounted for, an estimated $16.6 million of net revenue was subject to competitive bidding in the calendar year ending December 31, 2012.                                           38

--------------------------------------------------------------------------------

Table of Contents

  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 Recompete includes additional products and CMS 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 concluded the bid submission process in the fourth quarter of 2012. New rates for the Round 1 Recompete have not yet been announced, but are scheduled to take effect on January 1, 2014. We estimate that once the additional products which are included in the Round 1 Recompete program are accounted for, the estimated annual total net revenues associated with items subject to competitive bidding in the Round 1 markets will be approximately $20.1 million for the 2012 calendar year, or 0.8% of our annual total net revenues.  Notwithstanding the changes implemented by MIPPA, 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 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 has been phased in across the country, we have experienced a reduction in reimbursement, as have all other DMEPOS contract suppliers participating in the bidding program in 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 2013 and 2014 fiscal budget proposals which would limit state Medicaid reimbursement levels for certain durable medical equipment services and products to Medicare reimbursement rates for the same products and services in the same state. Neither MIPPA nor the Reform Package prevents CMS from adjusting prices for DMEPOS items in non-bid areas. Additionally, the Reform Package requires that all areas of the country are subject either to DMEPOS competitive bidding or payment rate adjustments using competitive bid pricing in a yet- to-be-determined method by 2016. 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 included 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. The bid process for Round 2 ended on March 30, 2012. CMS announced the Single Payment Amounts ("SPAs") on January 30, 2013, at which time the agency began the contract offer process. In early April 2013 CMS announced the Round 2 contract suppliers and issued formal three-year contracts to the same. The new Round 2 rates and guidelines took effect on July 1, 2013. We estimate that approximately $122 million, or approximately 5% of our net revenues for the fiscal year ending December 31, 2012 is subject to Round 2 of the competitive bidding program. CMS reported that the average payment reduction for Round 2 will be 45%. After applying the actual SPAs for each impacted CBA to our actual 2012 revenue for the product categories included in the bidding program, we estimate that the annual Round 2 revenue reduction will be $57 million before any changes in volume are accounted for as a result of the contract offers received and accepted.  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 have repealed 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. This bill was introduced again in April 2013 as the "Medicare DMEPOS Market Pricing Program Act of 2013" and was referred to the same committees as well as to the House Appropriations Committee. The bill would repeal the current DMEPOS competitive bidding program as designed and replace it with a modified auction program. In January 2013, a bill titled "Small Supplier Fairness in Bidding Competition Act of 2013" was introduced to repeal the program and was referred to the House Committee on Small Business. Finally, a bill titled "Transparency and Accountability in Medicare Bidding Act of 2013" was introduced in the House in June 2013 and referred to the House Committee on Energy and Commerce and the Committee on Ways and Means. This legislation would delay by at least six months the implementation of the Round 1 Recompete and of Round 2 of the DMEPOS competitive bidding program, as well as the national mail order program for diabetic testing supplies, in order to give Congress an opportunity to reform the program and also obtain an evaluation of the program by auction experts.                                           39

--------------------------------------------------------------------------------

Table of Contents

  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. In February 2013 we were offered Round 2 competitive bidding contracts for a substantial majority of the CBAs and products for which we submitted bids. However, there is no guarantee that we will garner additional market share as a result of these contracts. Both the Round 1 Recompete and Round 2 of the DMEPOS competitive bidding program include products which may require us 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 us, CMS and/or its contractors. The outcome of such negotiations cannot be predicted or assured. Under the current competitive bidding regulations, in the CBAs, and for the products, for which we do not have competitive bidding contracts, we will generally not be allowed to supply Medicare beneficiaries in the CBA with products subject to competitive bidding for the contract term of the program, unless we elect to continue to service existing patients under the "grandfathering provision" of the program's final rule for certain products. 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 a contract supplier for certain products.  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% 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, except for the mail order diabetes contract, is currently a three-year period. The CPI-U for 2012 was +3.6%, but the "multi-factor productivity adjustment" remained -1.2%, so the net result was a 2.4% increase in DMEPOS fee schedule payments in 2012 for items and services not included in an area subject to competitive bidding. For 2013, the CPI-U is +1.7%, but the adjustment is -0.9%, so the net result is a 0.8% increase in DMEPOS fee schedule payments in 2013 for the same items and services as described above.  The Administration's 2014 fiscal budget proposal would change the way the government calculates measures of inflation for government programs, among other things. As compared to the current CPI method, the switch in the inflation formula would cut spending on government programs by $130 billion over 10 years. At this time, it is unclear how this change, if implemented, would impact annual DMEPOS payment updates. It is possible that such a change, if implemented, could have an adverse impact on our business, financial condition, results of operations, cash flow, capital resources and liquidity.  Capped Rentals, Oxygen Equipment and PAP 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 PAP 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. The provider that billed Medicare for the 36th month continues to be responsible for the patient's care, even in a Competitive Bidding Area or in the event of a patient's relocation. 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                                           40

--------------------------------------------------------------------------------

Table of Contents

  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 legislative and executive branch efforts to further reduce the maximum rental period for oxygen therapy, equipment and related services. However, President Obama's 2012, 2013 and 2014 budget proposals did not include a reduction in the oxygen rental period; neither did the Reform Package. Nonetheless, President Obama's 2013 and 2014 fiscal budget proposals would limit the state Medicaid reimbursement levels for certain durable medical equipment services and products, including oxygen therapy, to Medicare reimbursement rates for the same products and services in the same state, 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.  CMS and the durable medical equipment Medicare administrative contractors ("DME MACs") also have 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, 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 coverage requirements when they were implemented. These requirements apply to Medicare Part B fee-for-service (FFS) patients, not to those patients enrolled in Medicare Advantage or commercial health plans, and Medicare Part B FFS represents a smaller portion of the overall PAP patient market. However, some commercial and Medicare Advantage payors have implemented the same, similar or, at times, more arduous rules as those adopted by Medicare. Despite our continuous and 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%. For inhalation drugs specifically, an additional dispensing fee applies. In November 2011, CMS published regulations adopting a price substitution policy also set forth in the MMA whereby reimbursement would be limited to 103% of the Average Manufacturer Price ("AMP") when ASP exceeds AMP by 5% for either the two                                           41

--------------------------------------------------------------------------------

Table of Contents

  previous consecutive quarters or three of the previous four quarters. However, CMS did not apply that price substitution policy during 2012. Instead, CMS amended the regulations in November 2012 to exempt drugs that the FDA reports are in short supply. According to the CMS website, the quarterly ASP price file now includes a column in which CMS will identify those drugs for which an AMP-based payment amount has been substituted, and the amount of that payment. 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 whether they will increase or decrease, because 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. Nor are such infused drugs included in the Medicare DMEPOS competitive bidding program in any phase of bidding that is currently underway. Reimbursement for such drugs 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. However, in a first quarter 2013 written response to an OIG report concerning Part B infusion drug reimbursement, CMS expressed an interest in including these drugs / therapies in future phases of the DMEPOS competitive bidding program. Such inclusion could occur no earlier than the Recompete of Round 2, which does not take effect until July 2016. Since CMS has not announced any definitive plans, at this time we cannot predict whether the Medicare reimbursement methodology for these drugs will in fact change, nor can we predict when these changes would occur or their potential impact on us.  Late in the last decade, there were other changes to the reimbursement methodology for certain inhalation drugs. When CMS changed its reimbursement methodology for calculating the ASP, CMS reduced its reimbursement to providers of Xopenex and albuterol. 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 GAO, entitled "Home Infusion Therapy: Differences Between Medicare and Private Insurers' Coverage," testimony before the Senate 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. During the same month, 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. In early 2013, President Obama signed into law legislation requiring a demonstration project providing Medicare coverage for items and services related to the in-home administration of intravenous immune globulin ("IVIG"). The broader industry continues to collect cost-benefit data that will provide an objective basis for Congress, CMS and/or the CMMI to make a decision to fund other such demonstration projects. At this time, we cannot predict whether additional legislation will be passed or whether CMS and/or the CMMI will include other demonstration projects in a future work plan.  In February 2013, the OIG released a report entitled, "Part B Payments for Drugs Infused Through Durable Medical Equipment". The report compared the ASP of each DME infused drug to its AWP-based Medicare payment amount for every year between 2005 and 2011. The report found that, overall, Medicare payment amounts for DME infusion drugs exceeded ASPs by 54 to 122 percent annually. The report also found that Medicare spending on DME infusion drugs would have been reduced by 44% ($344 million) between 2005 and 2011, had payment been based on ASPs. However, the report found that                                           42

--------------------------------------------------------------------------------

Table of Contents

  for as many as one third of DME infusion drugs in each year, the payment amounts were below their ASPs, meaning that Medicare may be underpaying suppliers for those drugs. In the report, the OIG offered the following recommendations to CMS: (1) seek a legislative change requiring DME infusion drugs to be paid using the ASP methodology or (2) include DME infusion drugs in the next round of the DMEPOS competitive bidding program. CMS stated in its response to the OIG report that it is interested in including DME infusion drugs in a future round of the competitive bidding program but has not publicly commented on when this might occur. In addition, in order to preserve beneficiary access, and in the absence of wholesale reform of the Medicare home infusion therapy benefit, the government's adoption of the ASP methodology for infusion drugs would require an offset by establishing a reasonable dispensing fee to cover the extensive non-drug cost of serving beneficiaries, not unlike what CMS implemented for Part B inhalation therapies in 2003. Due to the complexities of the issue and the current competitive bidding timelines, at this time we cannot predict whether the Medicare reimbursement methodology for DME infusion drugs will change or, if so, when it will change.  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 continue to do so for any new locations. In addition, the National Supplier Clearinghouse 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 March 2013, the OIG released a report entitled, "Surety Bonds Remain an Underutilized Tool to Protect Medicare from Supplier Overpayments". In the report, the OIG found that CMS did not have accurate surety bond information for all suppliers. Additionally, the OIG found that CMS has yet to recover millions of dollars in supplier debt resulting from overpayments. In its response to the OIG report, CMS stated that it will make appropriate updates and improvements in conjunction with the OIG's recommendations. We believe our surety bonds are complete and accurate, but despite our best efforts, we cannot predict what follow-up activities CMS may undertake or new requirements it may implement in the future, or their impact on us.  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 and more recently in March 2013, Senate representatives of key committees with jurisdiction over Medicare/Medicaid sent letters to U.S. Secretary of Health and Human Services Kathleen Sebelius, asking for an explanation as to why CMS has not yet imposed temporary moratoria on the enrollment of new providers and suppliers where there is a high risk for fraud. Additionally, CMS is implementing a provider and supplier enrollment screening system that automates its pre-enrollment risk assessment and screening processes. In March 2013, CMS announced that if Medicare claims are submitted with dates of service on or after May 1, 2013, if a referring physician/supplier were not registered in this system, submitted claims would be denied. According to CMS about                                           43

--------------------------------------------------------------------------------

Table of Contents

  1% of physicians nationwide are not registered. However, on April 25, 2013, CMS announced a temporary delay in implementing ordering and referring denial edits. We have undertaken extensive efforts to ensure that our referral sources are registered with the system, but a small percentage remain unregistered. 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 late 2010. In early 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. Our 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 FFS program, Congress required HHS to establish the RAC initiative as a permanent, nationwide program. 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 now posted CMS-approved 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 known as Medicaid Integrity Contractors ("MICs"). 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. We cannot at this time quantify any negative impact that the expansion of the RAC program or other similar programs may have on us.  Another group of auditors is the 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 has increased significantly since 2010 and is expected to continue to increase for the foreseeable future due to increased federal funding. The industry trade associations and certain Congressional committees of jurisdiction continue to advocate for more standardized and rational audit procedures, contractor transparency and consistency surrounding all government audit activity directed toward the DMEPOS industry and other healthcare segments.  CMS also has implemented the Comprehensive Error Rate Testing ("CERT") program to measure the rate of improper payments in the Medicare FFS program. During each annual reporting period, CERT contractors randomly select a sample of claims, stratified by claim type, submitted to Carriers, MACs, DME MACs and Fiscal Intermediaries. CERT contractors then request documentation from the provider or supplier that submitted each of the claims. Based on the claims review conducted by the CERT contractors and on an annual basis, the CERT contractors calculate an improper payment rate that is considered to be reflective of all paid claims in the Medicare FFS program during the year. The 2011 Medicare FFS improper payment rate was 8.6%, representing nearly $29 billion in allegedly improper payments. The projected improper payment amount for DMEPOS during the 2011 period was approximately 68%, with approximately 91% representing not fraud but technical errors due to insufficient documentation to meet the new and changing auditing standards.  The American Taxpayer Relief Act of 2012 extended the recoupment period for overpayments from three years to five years. This further expands the scope of audit activity, which is already paper-intensive, administratively burdensome and redundant. Appeals are protracted over many months. We cannot predict the impact of all governmental auditing activities and ever-changing rules issued by the same on our business, but it may be material.  

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                                            44 

--------------------------------------------------------------------------------

Table of Contents

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 2012 and the first half of 2013,

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

industry and have determined a wide range of error rates with only

marginal improvement over time. 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.          •   Face-to-Face Requirements. In November 2012, CMS issued a Final Rule          pertaining to additional face-to-face documentation requirements and          certain DMEPOS that would be subject to an incremental requirement for

suppliers to obtain a Written Order Prior to Delivery (WOPD). The rule was

promulgated as part of the Reform Package. In the Final Rule, CMS outlined

the general requirements to be included in patients' medical records as

maintained by their physicians or healthcare practitioners in order to

justify the medical necessity for DMEPOS. However, in the absence of

additional supplier and referral source education issued by CMS, and due

         to an ongoing lack of clarity surrounding the new requirements, in late          June, CMS announced that the new requirements will not be enforced until

October 1, 2013. CMS expects to launch additional supplier and referral

         source education in the Summer of 2013, and we will adjust both our          policies/procedures and IT systems accordingly to comply with the new          regulations. We cannot predict the adverse impact, if any, 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 2012 announcement

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

supplies, a plan made moot by recent legislation, 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 June 30, 2013. 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 ongoing, 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.  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 delayed 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. In June 2012, the United States Supreme Court                                           45

--------------------------------------------------------------------------------

Table of Contents

  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 Health Information Technology for Economic and Clinical Health ("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. In January 2013, the U.S. Department of Health and Human Services released the HIPAA regulations (the "Omnibus Rule") implementing the statutory amendments under the HITECH Act. The effective date of the Omnibus Rule was March 26, 2013, with a compliance date of September 23, 2013 for most provisions. Among the numerous changes the Omnibus Rule makes to the HIPAA privacy and security regulations, several specific provisions in the Omnibus Rule are likely to have significant impact. By way of example, the Omnibus Rule:    

• replaces the current "significant risk of harm" standard with a "low

probability of compromise" standard for determining whether a security

incident is reportable, which may result in more breach notifications

          being made.          •   expands the definition of "marketing" and, in turn, extends the range of

         marketing activities requiring prior written authorization.    

• removes an exception in the HIPAA Privacy Rule that has protected Covered

Entities from liabilities associated with acts of Business Associates,

         even where the Covered Entity has complied with its contractual          obligations and had no knowledge of the wrongdoing.    

• makes clear the direct liability that flows to Business Associates as a

result of the modifications to the HITECH Act.

   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 continually educate our workforce about these requirements. With such a large workforce that increasingly relies on mobile technology for daily operations, HIPAA privacy or data security is always a concern. We face potential administrative, civil and 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. In 2012, one of our owned laptops containing PHI was stolen from a locked vehicle. We thoroughly investigated the incident and, as applicable and required by law, notified individuals, the media and government authorities. We also provided the option of complimentary credit monitoring to affected individuals. In May 2013, subsequent to providing the required notice, we received a letter from the U.S. Department of Health and Human Services Office for Civil Rights ("OCR") initiating a compliance review. We are cooperating with OCR by providing information and materials requested in the letter to evidence compliance. OCR has the authority to enter into resolution agreements and to impose civil monetary penalties for failure to comply. Civil monetary penalties can range from $100 to $50,000 for each violation with a maximum penalty of $1,500,000 for identical violations in a calendar year. At this point in time, it is too early to predict when OCR will complete its compliance review or what actions OCR may take. At this time there have been no other claims against us related to this incident, although we cannot predict whether such claims will occur in the future. We are 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 through pre- and post-payment audit activities 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.                                           46 

--------------------------------------------------------------------------------

Table of Contents

  Anti-Kickback Statutes. As a provider of services under the Medicare and Medicaid programs, we must comply with a provision of the federal Social Security Act, commonly known as the "federal anti-kickback statute." The federal anti-kickback statute prohibits the offer or receipt of any bribe, kickback or rebate in return for the referral or arranging for the referral of patients, products or services covered by federal healthcare programs. Federal healthcare programs have been defined to include plans and programs that provide health benefits funded by the United States Government, including Medicare, Medicaid and TRICARE (formerly known as the Civilian Health and Medical Program of the Uniformed Services or CHAMPUS), among others. Some courts and the OIG interpret the statute to cover any arrangement where even one purpose of the remuneration is to influence referrals. Violations of the federal anti-kickback statute may result in civil and criminal penalties and exclusion from participation in federal healthcare programs.  Due to the breadth of the federal anti-kickback statute's broad prohibition, there are a few statutory exceptions that protect various common business transactions and arrangements from prosecution. In addition, the OIG has published safe harbor regulations that outline other arrangements that also are deemed protected from prosecution under the federal anti-kickback statute, provided all applicable criteria are met. The failure of an activity to meet all of the applicable safe harbor criteria does not necessarily mean that the particular arrangement violates the federal anti-kickback law, but these arrangements will be subject to greater scrutiny by enforcement agencies.  Some states have enacted statutes and regulations similar to the federal anti-kickback statute, but which apply not only to the federal healthcare programs, but also to any payor source of the patient. These state laws may contain exceptions and safe harbors that are different from those of the federal law and that may vary from state to state. A number of states in which we operate have laws that prohibit fee-splitting arrangements between healthcare providers, if such arrangements are designed to induce or encourage the referral of patients to a particular provider. Additionally, several states have passed laws further regulating interactions between healthcare providers and physician referral sources. For example, the state of New York requires 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.                                           47

--------------------------------------------------------------------------------

Table of Contents

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.  In May 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 ("FERA"). Among other things, FERA modifies the federal False Claims Act by expanding liability to contractors and subcontractors who do not directly present claims to the federal government. FERA also expanded the False Claims Act liability for what is referred to as a "reverse false claim" by explicitly making it unlawful to knowingly conceal or knowingly and improperly avoid or decrease an obligation owed to the federal government.  A number of states have enacted false claims acts that are similar to the federal False Claims Act. Even more states are expected to do so in the future because Section 6031 of the DRA amended the federal law to encourage these types of changes in law at the state level. In addition, there is a corresponding increase in state-initiated false claims enforcement efforts.  Other Fraud and Abuse Laws. HIPAA created, in part, two new federal crimes: "Healthcare Fraud" and "False Statements Relating to Healthcare Matters." The Healthcare Fraud statute prohibits executing a knowing and willful scheme or artifice to defraud any healthcare benefit program. A violation of this statute is a felony and may result in fines and/or imprisonment. The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.  The increased public focus on waste, fraud and abuse and their related cost to society will likely result in additional Congressional hearings, CMS regulatory changes 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.  In June 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                                           48 

--------------------------------------------------------------------------------

Table of Contents

  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 is in the process of promulgating the implementing rules and regulations of the Reform Package, including additional requirements related to our business, our role as an employer and our customers' business. Recently, for example, the Internal Revenue Service ("IRS) announced a one-year delay in the employer mandate and the reporting requirements associated with it. Until the 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.  

Results of Operations

Three Months Ended June 30, 2013 and 2012

Net Revenues. Net revenues in the three months ended June 30, 2013 were $620.6 million compared to $607.7 million in the three months ended June 30, 2012. Revenue for the three months ended June 30, 2013 increased primarily due to increased volume in the home infusion therapy segment partially offset by decreased volume in the home respiratory and home medical equipment segment.

  We expect to continue to face pricing pressures from Medicare and Medicaid, such as Medicare competitive bidding or government sequestrations, as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See "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 June 30, 2013 was 56.0%, compared to 57.8% for the three months ended June 30, 2012. The decline in gross profit margin percentage is primarily due to an increase in the revenue of the home infusion therapy segment as a percent of total net revenue and a decrease in the home infusion therapy segment margin percentage due to an increase in specialty revenue as a percent of infusion therapy segment net revenue. Our specialty revenue has a lower gross profit margin as a percentage of net revenue than our other infusion therapy revenue. Our home infusion therapy segment has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment. Additionally, the gross profit margin in our home respiratory therapy/home medical equipment segment declined slightly.  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 2.1% and 3.4% in the three months ended June 30, 2013 and June 30, 2012, respectively. The decrease in the provision for doubtful accounts in the quarter ended June 30, 2013, is the result of improved 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 $293.5 million, or 47.3%, of total net revenues for the three months ended June 30, 2013 compared to $308.8 million, or 50.8%, of total net revenues for the three months ended June 30, 2012.

  Selling, distribution and administrative expenses decreased by $15.3 million for the three months ended June 30, 2013 compared to the three months ended June 30, 2012. The decrease was comprised of a decrease in labor costs of $8.2 million and a $7.1 million decrease in other operating expenses. For the three months ended June 30, 2013 and 2012, the corporate costs included in selling, distribution and administrative expense were $50.5 million and $49.4 million, respectively.                                           49 

--------------------------------------------------------------------------------

Table of Contents

  The decrease in labor costs of $8.2 million was primarily due to a net decrease in salaries and related benefits resulting from headcount decreases associated with strategic reductions in workforce in our home respiratory therapy/home medical equipment business segment, offset partially by increases in our home infusion therapy segment due to growth.  The decrease in other operating expenses of $7.1 million was primarily due to lower legal fee expense, banking costs, employee travel, advertising, outside answering services, and depreciation on plant, property, and equipment. These decreases were partially offset by a favorable settlement of a prior acquisition in the three months ended June 30, 2012 not recurring in 2013.  

Amortization of Intangible Assets. Amortization of intangible assets was $0.2 million and $0.5 million in the three months ended June 30, 2013 and June 30, 2012, respectively. The decrease primarily resulted from assets becoming fully amortized during 2012.

Interest Expense. Interest expense decreased $1.7 million, or 5%, to $32.2 million in the three months ended June 30, 2013 from $33.9 million in the three months ended June 30, 2012.

  Loss on Early Retirement of Debt. In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed in the three months ended June 30, 2013.  Interest Income and Other. Interest income and other increased to $0.6 million for the three months ended June 30, 2013 from $0.1 million in the three months ended June 30, 2012.  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 on a discrete basis 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 (2.6)% for the three months ended June 30, 2013, compared to (2.3)% for the three months ended June 30, 2012. For the three months ended June 30, 2013 and 2012, our effective tax rate differed from federal and state statutory rates primarily due to the accrual of a valuation allowance against substantially all of our net deferred tax assets.

  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.  Beginning with the year ended December 31, 2011, we accrued a valuation allowance against substantially all of our net deferred tax assets since we determined that it is more likely than not that substantially all of the our net deferred tax assets will not be realized. We intend to maintain our valuation allowance until sufficient positive evidence exists to support the reversal of all or a portion of its valuation allowance.  

We increased our valuation allowance by $13.1 million to $251.9 million at June 30, 2013 from $238.8 million at March 31, 2013 to offset corresponding increases in our net deferred tax assets for the three months ended June 30, 2013.

                                           50  

--------------------------------------------------------------------------------

Table of Contents

Segment Net Revenues and EBIT

  Segment financial results are based on directly assignable net revenues, cost of goods sold, bad debt expenses and selling, distribution and administrative costs, where available. Costs that are not directly assignable, such as corporate costs and certain selling, distribution and administrative expenses, are allocated based on various metrics including billed census, headcount and branch locations by segment, among others.  

During the fourth quarter of 2012, we revised our allocation to reporting segments. This allocation is based on how we currently manage and discuss our operations.

  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)                                     June 30, 2013           Net Revenues            June 30, 2012           Net Revenues Operating Segment Home respiratory therapy and home medical equipment                                       $            290,665                  46.8 %    $           303,428                   49.9 % Home infusion therapy                                        329,958                  53.2                  304,244                   50.1  Total                                           $            620,623                 100.0 %    $           607,672                  100.0 %                                                                                                       EBIT                                                        Three Months Ended        Percentage of        Three Months Ended         Percentage of (in thousands)                                           June 30, 2013           Net Revenues            June 30, 2012           Net Revenues Operating Segment Home respiratory therapy and home medical equipment   $                 44                    -  %    $           (10,733 )                 (3.5 )% Home infusion therapy                                               40,526                  12.3 %                 32,098                   10.6 %  Total                                                 $             40,570                            $            21,365   

See definition and 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 decreased $12.7 million, or 4.2%, to $290.7 million in the three months ended June 30, 2013 from $303.4 million in the three months ended June 30, 2012. Revenues for the home respiratory therapy and home medical equipment segment decreased to 46.8% of total revenue in the three months ended June 30, 2013 from 49.9% in the three months ended June 30, 2012.  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 3.1% in the three months ended June 30, 2013 compared to the three months ended June 30, 2012. The decrease in revenue resulted primarily from a decrease in other respiratory therapy (primarily nebulizers and ventilators) revenue due to a planned decrease in volume and a decrease in sleep apnea revenue due to a decrease in 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 decreased by 10.4% in the three months ended June 30, 2013 compared to the three months ended June 30, 2012. The decrease was primarily due to a planned decrease in the volume of home medical equipment products partially offset by 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 June 30, 2013 was $0.0 million compared to a negative $10.7 million in the three months ended June 30, 2012. EBIT was 0.0% of segment net revenues in the three months ended June 30, 2013 compared to a negative 3.5% of segment net revenues in the three months ended June 30, 2012. The increase in the EBIT as a percentage of segment net revenues for the three months ended June 30, 2012 to the three months ended June 30, 2013 is primarily due to a decrease in sales, distribution and administrative costs as a percentage of net revenue partially offset by an increase in the provision for doubtful accounts as a percentage of net revenues and a decrease in the gross margin as a percentage of net revenues in the three months ended June 30, 2013 compared to the three months ended June 30, 2012.                                           51

--------------------------------------------------------------------------------

Table of Contents

  Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $25.7 million, or 8.5% to $329.9 million for the three months ended June 30, 2013 from $304.2 million in the three months ended June 30, 2012. Revenues for the home infusion therapy segment increased to 53.2% of total revenue in the three months ended June 30, 2013 from 50.1% in the three months ended June 30, 2012.  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. When classifying a pharmaceutical product or service as "specialty," we consider the following factors: the product or service's cost; its ability to treat complex and chronic diseases; its special handling, storage and delivery requirements; its categorization as one of our biological drugs; and, in some cases, a product's limited distribution channels. Our use of the term "specialty" to define a portion of our business may not be comparable to that used by other industry participants, including our competitors.  EBIT for the home infusion therapy segment in the three months ended June 30, 2013 was $40.5 million compared to $32.1 million in the three months ended June 30, 2012. EBIT was 12.3% of segment net revenues in the three months ended June 30, 2013 compared to 10.6% of segment net revenues in the three months ended June 30, 2012. The increase in EBIT as a percentage of net segment revenues for the three months ended June 30, 2012 to the three months ended June 30, 2013 is primarily due to a decrease in the provision for doubtful accounts as a percentage of segment net revenues in the three months ended June 30, 2013 compared to the three months ended June 30, 2012. This was offset by a decrease in the gross profit margin in the three months ended June 30, 2013 compared to the three months ended June 30, 2012.  EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense, loss on early retirement of debt and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles ("GAAP") and does not purport to be an alternative net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.  

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

                                         Three Months Ended        Three Months Ended   (in thousands)                        June 30, 2013             June 30, 2012   Net loss                           $            (36,098 )    $            (12.736 )   Interest expense, net                            31,534                    33,809   Loss on early retirement of debt                 44,221                        -   Income tax expense                                  913                       292    EBIT                               $             40,570      $             21,365   

Six Months Ended June 30, 2013 and 2012

Net Revenues. Net revenues in the six months ended June 30, 2013 were $1,235.4 million compared to $1,203.4 million in the six months ended June 30, 2012. Revenue for the six months ended June 30, 2013 increased primarily due to increased volume in the home infusion therapy segment partially offset by decreased volume in the home respiratory and home medical equipment segment.

  We expect to continue to face pricing pressures from Medicare and Medicaid, such as Medicare competitive bidding or government sequestrations, as well as from our managed care customers as these payers seek to lower costs by obtaining more favorable pricing from providers such as us. In addition to the pricing reductions, such changes could cause us to provide reduced levels of certain products and services in the future, resulting in a corresponding reduction in revenue. See "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 six months ended June 30, 2013 was 56.8%, compared to 57.8% for the six months ended June 30, 2012. The decline in gross profit margin percentage is primarily due to an increase in the revenue of the home infusion therapy segment as a percent of total net revenue which has a lower gross profit margin as a percentage of net revenue than the home respiratory and home medical equipment segment.                                           52 

--------------------------------------------------------------------------------

Table of Contents

  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 2.9% and 2.7% in the six months ended June 30, 2013 and June 30, 2012, respectively. Overall cash collections on gross revenue have improved during the six months ended June 30, 2013 compared to the six months ended June 30, 2012. However, the distribution of our actual write-offs has shifted to be more weighted towards bad debts. This shift has resulted in an increase in our allowance for doubtful accounts and bad debt expense  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 $592.6 million, or 48.0%, of total net revenues for the six months ended June 30, 2013 compared to $626.3 million, or 52.0%, of total net revenues for the six months ended June 30, 2012.  Selling, distribution and administrative expenses decreased by $33.7 million for the six months ended June 30, 2013 compared to the six months ended June 30, 2012. The decrease was comprised of a decrease in labor costs of $22.7 million and a $11.0 million decrease in other operating expenses. For the six months ended June 30, 2013 and 2012, the corporate costs included in selling, distribution and administrative expenses were $95.0 million and $99.6 million, respectively.  The decrease in labor costs of $22.7 million was primarily due to a net decrease in salaries and related benefits resulting from headcount decreases associated with strategic reductions in workforce in our home respiratory therapy/home medical equipment business segment, offset partially by increases in our home infusion therapy segment due to growth.  The decrease in other operating expenses of $11.0 million was primarily due to lower legal fee expense, banking costs, employee travel, advertising, outside answering services, and depreciation on plant, property, and equipment. In addition there were lower professional fees due to certain 2012 corporate initiatives and corporate matters not recurring in 2013. These decreases were partially offset by a favorable settlement of a prior acquisition in the six months ended June 30, 2012 not recurring in 2013.  Amortization of Intangible Assets. Amortization of intangible assets was $0.4 million and $1.1 million in the six months ended June 30, 2013 and June 30, 2012, respectively. The decrease primarily resulted from assets becoming fully amortized during 2012.  

Interest Expense. Interest expense decreased $1.0 million, or 1%, to $66.4 million in the six months ended June 30, 2013 from $67.4 million in the six months ended June 30, 2012.

  Loss on Early Retirement of Debt. In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed in the six months ended June 30, 2013.  Interest Income and Other. Interest income and other increased to $1.2 million for the six months ended June 30, 2013 from $0.8 million in the six months ended June 30, 2012.                                           53 

--------------------------------------------------------------------------------

Table of Contents

  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 on a discrete basis 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 (3.2)% for the six months ended June 30, 2013, compared to (3.8)% for the six months ended June 30, 2012. For the six months ended June 30, 2013 and 2012, our effective tax rate differed from federal and state statutory rates primarily due to the accrual of a valuation allowance against substantially all of our net deferred tax assets.  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.  Beginning with the year ended December 31, 2011, we accrued a valuation allowance against substantially all of our net deferred tax assets since we determined that it is more likely than not that substantially all of the our net deferred tax assets will not be realized. We intend to maintain our valuation allowance until sufficient positive evidence exists to support the reversal of all or a portion of its valuation allowance.  

We increased our valuation allowance by $13.4 million to $251.9 million at June 30, 2013 from $238.5 million at December 31, 2012 to offset corresponding increases in our net deferred tax assets for the six months ended June 30, 2013.

Segment Net Revenues and EBIT

  Segment financial results are based on directly assignable net revenues, cost of goods sold, bad debt expenses and selling, distribution and administrative costs, where available. Costs that are not directly assignable, such as corporate costs and certain selling, distribution and administrative expenses, are allocated based on various metrics including billed census, headcount and branch locations by segment, among others.  

During the fourth quarter of 2012, we revised our allocation to reporting segments. This allocation is based on how we currently manage and discuss our operations.

                                           54  

--------------------------------------------------------------------------------

Table of Contents

  The following table sets forth a summary of results of operations by segment:                                                                                        Net Revenues                                                 Six Months Ended        Percentage of         Six Months Ended        Percentage of (in thousands)                                   June 30, 2013          Net Revenues           June 30, 2012          Net Revenues Operating Segment Home respiratory therapy and home medical equipment                                      $          589,190                  47.7 %    $          604,326                  50.2 % Home infusion therapy                                     646,188                  52.3                 599,059                  49.8  Total                                          $        1,235,378                 100.0 %    $        1,203,385                 100.0 %                                                                                              EBIT                                                 Six Months Ended        Percentage of         Six Months Ended         Percentage of (in thousands)                                   June 30, 2013          Net Revenues           June 30, 2012           Net Revenues Operating Segment Home respiratory therapy and home medical equipment                                      $              628                   0.1 %    $          (26,733 )                 (4.4 )% Home infusion therapy                                      72,005                  11.2 %                62,204                   10.4 %  Total                                          $           72,633                            $           35,471   

See definition and 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 decreased $15.1 million, or 2.5%, to $589.2 million in the six months ended June 30, 2013 from $604.3 million in the six months ended June 30, 2012. Revenues for the home respiratory therapy and home medical equipment segment decreased to 47.7% of total revenue in the six months ended June 30, 2013 from 50.2% in the six months ended June 30, 2012.  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 2.3% in the six months ended June 30, 2013 compared to the six months ended June 30, 2012. The decrease in revenue resulted primarily from a decrease in other respiratory therapy (primarily nebulizers and ventilators) revenue due to a planned decrease in volume and a decrease in sleep apnea revenue due to a decrease in 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 decreased by 3.8% in the six months ended June 30, 2013 compared to the six months ended June 30, 2012. The decrease was primarily due to a planned decrease in the volume of home medical equipment products partially offset by an increase in the volume of negative pressure wound therapy products.  EBIT for the home respiratory therapy and home medical equipment segment in the six months ended June 30, 2013 was $0.6 million compared to a negative $26.7 million in the six months ended June 30, 2012. EBIT was 0.1% of segment net revenues in the six months ended June 30, 2013 compared to negative 4.4% of segment net revenues in the six months ended June 30, 2012. The increase in the EBIT as a percentage of segment net revenues for the six months ended June 30, 2012 to the three months ended June 30, 2013 is primarily due to a decrease in sales, distribution and administrative costs as a percentage of net revenue partially offset by an increase in the provision for doubtful accounts as a percentage of net revenues in the six months ended June 30, 2013 compared to the six months ended June 30, 2012.  Home Infusion Therapy Segment. For the home infusion therapy segment, total net revenues increased $47.1 million, or 7.9% to $646.2 million for the six months ended June 30, 2013 from $599.1 million in the six months ended June 30, 2012. Revenues for the home infusion therapy segment increased to 52.3% of total revenue in the six months ended June 30, 2013 from 49.8% in the six months ended June 30, 2012.  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.                                           55 

--------------------------------------------------------------------------------

Table of Contents

  EBIT for the home infusion therapy segment in the six months ended June 30, 2013 was $72.0 million compared to $62.2 million in the six months ended June 30, 2012. EBIT was 11.2% of segment net revenues in the six months ended June 30, 2013 compared to 10.4% of segment net revenues in the six months ended June 30, 2012. The increase in EBIT as a percentage of net segment revenues for the six months ended June 30, 2012 to the six months ended June 30, 2013 is primarily due to a decrease in the provision for doubtful accounts as a percentage of segment net revenues in the six months ended June 30, 2013 compared to the six months ended June 30, 2012. Additionally there was a decrease in the sales, distribution and administrative costs as a percentage of net revenues for the six months ended June 30, 2013 compared to the six months ended June 30, 2012.  EBIT is a measure used by our management to measure operating performance. EBIT is defined as net income (loss) plus interest expense, loss on early retirement of debt and income taxes. EBIT is not a recognized term under Generally Accepted Accounting Principles ("GAAP") and does not purport to be an alternative net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity.  

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

                                           Six Months Ended       Six Months Ended      (in thousands)                       June 30, 2013          June 30, 2012      Net loss                           $         (37,991 )    $         (32,343 )      Interest expense, net                         65,236                 66,624

     Loss on early retirement of debt              44,221                  

  -      Income tax expense                             1,167                  1,190       EBIT                               $          72,633      $          35,471   

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.  Cash Flow. The following table presents selected data from our consolidated statement of cash flows:                                                   Six Months Ended             Six Months Ended (in thousands)                                   June 30, 2013                June 30, 2012 Net cash provided by (used in) operating activities                           $          37,289            $          (1,479 ) Net cash used in investing activities                    (49,122 )                    (62,123 ) Net cash provided by financing activities                                                   606                       58,745  Net decrease in cash and equivalents                     (11,227 )                     (4,857 ) Cash and equivalents at beginning of period                                                 27,080                       29,096  Cash and equivalents at end of period          $          15,853            

$ 24,239

    In the six months ended June 30, 2013, our free cash flow was $(11.8) million. For the six months ended June 30, 2012 our free cash flow was $(63.5) 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, net of proceeds from the sale of patient service equipment and other 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.                                           56 

--------------------------------------------------------------------------------

Table of Contents

  A table reconciling free cash flow to net cash provided by operating activities is presented below:                                                    Six Months Ended             Six Months Ended (in thousands)                                    June 30, 2013                June 30, 2012 Reconciliation - Free Cash Flow: Net loss                                        $         (37,991 )          $         (32,343 ) Non-cash items                                            136,199                       87,593 Change in operating assets and liabilities                                               (60,919 )                    (56,729 )  Net cash provided by (used in) operating activities                                       37,289                       (1,479 ) Less: Purchases of patient service equipment, property, equipment and improvements net of proceeds from sale of patient service equipment and other                    (49,122 )                    (62,002 )  Free cash flow                                  $         (11,833 )          $         (63,481 )   

The Six Months Ended June 30, 2013 Results Compared to the Six Months Ended June 30, 2012

  Net cash provided by operating activities in the six months ended June 30, 2013 was $37.3 million compared to $1.5 million used in the six months ended June 30, 2012, an increase of $38.8 million. The increase in net cash provided by operating activities resulted from a $43.0 million increase in the provision of cash from net income and non-cash items to a $98.2 million provision in 2013 from a $55.2 provision in 2012, partially offset by a $4.2 million increase in cash used related to the change in operating assets and liabilities to a $60.9 million use of cash in 2013 from a $56.7 million use of cash in 2012.  

The $4.2 million increase in cash used by the change in operating assets and liabilities consisted primarily of the following:

            •    $18.8 million increase in cash used by accounts payable to a $10.0              million use of cash in the six months ended June 30, 2013 from a $8.8              million provision of cash in the six months ended June 30, 2012. The              increase was primarily due to the timing of payments on invoices.             •    $15.3 million increase in cash used by prepaid expenses and other              assets to a $7.4 million use of cash in the six months ended June 30,              2013 from a $7.9 million provision of cash in the six months ended              June 30, 2012. The increase was primarily due to the reduction of              certain prepaid balances in the prior year.             •    $8.8 million increase in cash used by accrued expenses to a $4.4              million use of cash in the six months ended June 30, 2013 from a $4.4              million provision of cash in the six months ended June 30,

2012. The

             increase was primarily due to the timing of payments on

invoices.   Offset by:            •    $33.0 million decrease in cash used by accounts receivable to a $25.8              million use of cash in the six months ended June 30, 2013 from 

a $58.8

              million use of cash in the six months ended June 30, 2012. The              decrease was primarily due to our continuing focus on

improvement of</p>

              our billing and collections function.             •    $6.8 million decrease in cash used by inventories to a $4.9 million              use of cash in the six months ended June 30, 2013 from a $11.7

million

             use of cash in the six months ended June 30, 2012. The

decrease was

              primarily due to planned reduction of retail inventories.   Net cash used in investing activities in the six months ended June 30, 2013 was $49.1 million, compared to $62.1 million in the six months ended June 30, 2012. The primary use of funds in 2013 was $70.5 million to purchase patient service equipment and property equipment and improvements; $56.2 million related to patient service equipment to support revenue growth; and $14.3 million related to property equipment and improvements, primarily due to additions to our information systems software and hardware. This was partially offset by proceeds from the sale of patient service equipment and other of $21.3 million. The primary use of funds in 2012 was $85.1 million to purchase patient service equipment and property equipment and improvements; $69.6 million related to patient service equipment; and $15.5 million related to property equipment and improvements, primarily due to additions to our information systems software and hardware. This was partially offset by proceeds from the sale of patient service equipment and other of $23.1 million.  In 2013, net cash provided by financing activities in the six months ended June 30, 2013 was $0.6 million compared to $58.7 million provision of cash in the six months ended June 30, 2012. Cash provided in financing activities in 2013 was primarily related to proceeds from the Senior Secured Term Loan and net borrowings on our ABL facility, partially offset by                                           57

--------------------------------------------------------------------------------

Table of Contents

  payments on the Series A-1 and A-2 Notes, debt issuance costs related to the Senior Secured Term Loan premium on early retirement of the Series A-1 and A-2 Notes, and original issue discount associated with the Senior Secured Term Loan. Cash provided in 2012 was primarily related to the net borrowings on our ABL facility.  Accounts Receivable. Accounts receivable before allowance for doubtful accounts decreased to $392.5 million as of June 30, 2013 from $397.4 million at December 31, 2012. 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 49 days at June 30, 2013 and 51 days at December 31, 2012. The decrease in accounts receivable and days sales outstanding are primarily due to favorable overall cash collections partially offset by an increase in patient pay accounts receivable due to the normal seasonality of patient deductibles and copays.  Accounts aged in excess of 180 days expressed as percentages of total receivables for certain major payor categories, and in total, are as follows:                                      June 30, 2013        December 31, 2012             Total                           20.6 %                   21.8 %             Medicare                        12.8 %                   17.2 %             Medicaid                         4.5 %                   15.7 %             Patient self pay                29.2 %                   31.5 %             Managed care/other              22.7 %                   22.5 %   Unbilled Receivables. Included in accounts receivable are earned but unbilled receivables of $52.1 million at June 30, 2013 and $56.8 million at December 31, 2012. 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. We maintain inventory and patient service equipment at levels we believe will provide for the needs of our patients.  Long-term Debt.  Senior Secured Term Loan. On April 5, 2013, we entered into a senior secured credit agreement (the "Senior Secured Term Loan"), among Apria, as borrower, Sky Acquisition LLC, as parent, the other guarantors party thereto from time to time, Bank of America, N.A., as administrative agent, U.S. Bank National Association as collateral agent, certain other agents party thereto and a syndicate of financial institutions and institutional lenders.  On April 5, 2013, we borrowed $900.0 million in aggregate principal amount of term loans under the Senior Secured Term Loan. At our option we may borrow additional term loans under the Senior Secured Term Loan, subject to certain customary conditions, including consent of the lenders providing such additional term loans, in an amount not to exceed $175.0 million, plus the aggregate principal amount of voluntary prepayments of term loans on or prior to such time, plus additional amounts subject to compliance on a pro forma basis with certain financial ratio tests.  Borrowings under the Senior Secured Term Loan bear interest at a fluctuating rate per annum equal to, at our option (i) a base rate equal to the highest of (a) the federal funds rate plus 1/2 of 1%, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America, N.A. as its "prime rate" and (c) the one month LIBOR Rate plus 1.00% (provided that in no event shall such base rate with respect to the initial Term Loans be less than 2.25% per annum), in each case plus an applicable margin of 4.50% or (ii) a LIBOR Rate for the applicable interest period (provided that in no event shall such LIBOR rate with respect to the initial Term Loans be less than 1.25% per annum) plus an applicable margin of 5.50%.  The Senior Secured Term Loan will mature on April 5, 2020 and will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of term loans, with the balance payable on the final maturity date; provided that the Senior Secured Term Loan provides the right for individual lenders to agree to extend the maturity date of their outstanding term loans upon our request and without the consent of any other lender, subject to customary terms and conditions.                                           58

--------------------------------------------------------------------------------

Table of Contents

  All of our obligations under the Senior Secured Term Loan (i) are unconditionally guaranteed by our parent and substantially all of its existing and future, direct and indirect, wholly-owned domestic restricted subsidiaries and (ii) are secured, subject to certain exceptions, by substantially all of our assets and the assets of the guarantors.  The Senior Secured Term Loan is entitled to a priority of payment over the Series A-2 Notes in certain circumstances, including upon any acceleration of the obligations in respect of the Senior Secured Term Loan, the Series A-2 Notes or any bankruptcy or insolvency event or default with respect to Apria or any guarantor of the Senior Secured Term Loan and the Series A-2 Notes.  The Senior Secured Term Loan includes a financial maintenance covenant that prohibits our consolidated first priority net leverage ratio as of the last day of any test period of four consecutive fiscal quarters (commencing with the test period ending September 30, 2013) to exceed 5.50 to 1.00.  The Senior Secured Term Loan also include customary negative covenants that, subject to significant exceptions, limit our ability and the ability of our parent and subsidiaries to, among other things: incur liens; make investments or loans; incur, assume or permit to exist additional indebtedness or guarantees; and pay dividends, make payments or redeem or repurchase capital stock.  Under the terms of the Senior Secured Term Loan, outstanding loans under the Senior Secured Term Loan may be accelerated if more than $75.0 million of the Series A-2 Notes remain outstanding on or after September 2, 2014.  We used proceeds from the borrowings under the Senior Secured Term Loan to: (i) redeem all of our outstanding 11.25% Senior Secured Notes due 2014 (Series A-1) (the "Series A-1 Notes"); (ii) redeem an aggregate principal amount of $160.0 million of our outstanding 12.375% Senior Secured Notes due 2014 (Series A-2) (the "Series A-2 Notes" and, together with the Series A-1 Notes, the "Notes"); and (iii) pay fees and expenses associated with the entering into the Senior Secured Term Loan and the redemption of the Notes.  In connection with the redemption of the Series A-1 Notes and a portion of the Series A-2 Notes, we paid $24.6 million of premiums to the holders of such Series A-1 Notes and Series A-2 Notes. In addition, we wrote-off $19.6 million of unamortized debt issuance costs related to the Series A-1 Notes and the portion of the Series A-2 Notes that were redeemed. Such amounts are included in Interest Expense on our Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2013.  Borrowings under the Senior Secured Term Loan were incurred with an original issue discount of $9.0 million. We incurred $10.6 million of debt issuance costs in connection with the Senior Secured Term Loan.  Series A-1 Notes and Series A-2 Notes. Series A-1 Notes and Series A-2 Notes were issued by us in May 2009 and August 2009, respectively. On April 5, 2013, all Series A-1 Notes and $160.0 million of Series A-2 Notes were refinanced using the proceeds of the Senior Secured Term Loan as described above. As of June 30, 2013, we had $157.5 million of aggregate principal amount of the Series A-2 Notes outstanding. 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 its restricted subsidiaries to:      •   incur additional debt;       •   pay dividends and make other distributions;       •   make certain investments;       •   repurchase our stock;       •   incur certain liens;       •   enter into transactions with affiliates;       •   merge or consolidate;    

• enter into agreements that restrict the ability of our subsidiaries to

         make dividends or other payments to us; and       •   transfer or sell assets.  

Subject to certain exceptions, the indenture governing the Series A-2 Notes permits us and our restricted subsidiaries to incur additional indebtedness, including senior indebtedness and secured indebtedness.

                                       59

--------------------------------------------------------------------------------

Table of Contents

  Substantially all of our 100%-owned subsidiaries (the "Guarantors") jointly and severally, unconditionally guarantee the Series A-2 Notes on a senior secured basis. The Guarantors also guarantee our 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 Senior Secured Term Loan 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 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 June 30, 2013, there was $30.0 million outstanding under the ABL Facility, outstanding letters of credit totaled $23.5 million and additional availability under the ABL Facility, subject to the borrowing base, was $196.5 million. As of June 30, 2013, the available borrowing base did not constrain our ability to borrow the entire $196.5 million of available borrowing capacity under our ABL Facility. At June 30, 2013, we were in compliance with all of the financial covenants required by the credit agreement governing the ABL Facility. Under the terms of our ABL Facility, loans outstanding under the ABL Facility may be accelerated if any Series A-2 Notes remain outstanding on or after August 1, 2014.  

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-2 Notes and under the credit agreements governing our ABL Facility and the Senior Secured Term Loan, 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, loss on early retirement of debt, 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-2 Notes and the credit agreements governing our ABL Facility and the Senior Secured Term Loan.  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-2 Notes and in the credit agreements governing our ABL Facility and the Senior Secured Term Loan. 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.                                           60 

--------------------------------------------------------------------------------

Table of Contents

  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)                                 June 30, 2013                     June 30, 2013 Net loss(a)                                 $            (36,098 )           $            (266,064 ) Interest expense, net(b)                                  31,534                           132,131 Loss on early retirement of debt(c)                                                   44,221                            44,221 Income tax expense (benefit)                                 913                          (130,928 ) Depreciation and amortization                             29,903                           112,179 Non-cash impairment charges(d)                                -                            350,000 Non-cash items(e)                                          7,647                            24,410 Costs incurred related to initiatives and non-recurring items(f)                                                   9,979                            36,311 Other adjustments(g)                                       1,749                             6,996 Projected cost savings and synergies(h)                                                 934                             1,991  Adjusted EBITDA                             $             90,782             $             311,247     

(a) Net loss for the twelve months ended June 30, 2013 reflects the following

non-cash impairment charges based on the results of our 2012 annual

impairment testing and the tax impact associated with the impairment charge:

           (i)  Trade name impairment of $350.0 million, $270.0 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 $130.9 million relating to the intangible impairment.  

All of these items resulted in a $219.1 million increase in our net loss in the twelve months ended June 30, 2013.

  Net loss for the twelve months ended June 30, 2013 consists of the following quarterly net loss amounts: $(175,711) for the three months ended September 30, 2012; $(52,362) for the three months ended December 31, 2012; $(1,893) for the three months ended March 31, 2013; and $(36,098) for the three months ended June 30, 2013.    

(b) Reflects $32.2 million of interest expense, net of $0.6 million of interest

income for the three months ended June 30, 2013. Reflects $134.0 million of

interest expense, net of $1.8 million of interest income for the twelve

months ended June 30, 2013.

(c) Reflects $24.6 million of premiums paid to the holder of the redeemed Series

A-1 Notes and the portion of the Series A-2 Notes that were redeemed for the

three and twelve months ended June 30, 2013. Reflects $19.6 million of

unamortized debt issuance costs related to the Series A-1 Notes and the

portion of the Series A-2 Notes that were redeemed in the three and twelve

months ended June 30, 2013.

(d) Reflects the $350.0 million non-cash impairment described in (a) above.

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

                                                 Three Months Ended               Twelve Months Ended (in thousands)                                  June 30, 2013                    June 30, 2013 Profit interest units compensation expense                                      $             1,424             $               4,699 Loss on patient service equipment, disposition of assets and other(i)                         6,223                            19,711  Total non-cash items                         $             7,647             $              24,410             (i)  Primarily represents the net book value of our patient service             equipment upon sale, disposal or write-off, which is a non-cash             expense included within cost of net revenues in our

consolidated

            statements of operations.     (f) Costs incurred related to initiatives and non-recurring items are comprised     of the following:                                                  Three Months Ended               Twelve Months Ended (in thousands)                                  June 30, 2013                    June 30, 2013 Costs and expenses related to initiatives(i)                               $             9,671             $              30,677 Executive severance and retention(ii)                                                308                             5,634  Total costs incurred related to initiatives and non-recurring items                                        $             9,979             $              36,311                                             61 

--------------------------------------------------------------------------------

Table of Contents

(i) Primarily represents salaries and wages, severance, relocation

            consulting fees and other expenses for the three and twelve months             ended June 30, 2013, primarily related to five projects:             (1) professional fees related to certain corporate matters;             (2) strategic reductions in workforce in our home respiratory therapy             and home medical equipment business; (3) transition of our enteral             business to the infusion division; (4) a new billing and

collections

             system for our home infusion therapy business; and (5) 

centralization

            of our admissions process for our home infusion therapy business.    

(ii) Represents executive severance and retention expense for the three and

            twelve months ended June 30, 2013.    

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

$1.8 million and $7.0 million for the three and twelve months ended June 30,

2013.

(h) 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 six months ended June 30, 2013 and June 30, 2012, we purchased certain assets of a business for $0.0 million and $0.1 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.  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, 2013 and 12-month periods in subsequent periods.                                                 Less                                         More                                              than                                         than (in millions)                               1 Year       1-3 Years       3-5 Years      5 Years      Totals Senior Secured Term Loan(1)                $      5$        18$        18$    859$   900 Interest Payments on Senior Secured Term Loan(1)                                          30             120             117          143         410 Operating Leases                                 29              94              50           15         188 Purchase Obligations(2)                          19              68              50           29         166 Series A-2 Notes(3)                              -              158              -            -          158 Interest Payments on Series A-2 Notes(3)         10              19              -            -           29 Amended ABL Facility(4)(5)                       30              -               -            -           30 Fees on ABL Facility(4)(5)                        1               1              -            -            2 Capitalized Leases(6)                            -               -               -            -           - Unrecognized Tax Benefits(7)                     -               -               -            -           - 

Total Contractual Cash Obligations $ 124$ 478 $

    235     $  1,046$ 1,883

(1) On April 5, 2013, we entered into a senior secured credit agreement and

borrowed $900.0 million in aggregate principal amount of term loans ("Senior

Secured Term Loan") from the lenders under this credit agreement. Interest

payments on the Senior Secured Term Loan will total approximately $61

million annually until the term note matures on April 1, 2020. The effective

     interest rate at April 5, 2013 was 6.75%. Additionally, there is a 1%      paydown feature on the original principal of the loan due quarterly.  

(2) The purchase obligations primarily relate to approximately $136 million we

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

and approximately $30 million we expect to pay under an agreement with Serco

(formerly Intelenet). However, if we terminated the agreements, the required

     obligation to vendors could be reduced to approximately $14.6 million for      Dell Systems and $6.7 million for Serco.   (3)  Represents aggregate interest payments on $157.5 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 $19

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

interest rate on the Series A-2 Note is 12.375%. During the three months

ended June 30, 2013, we redeemed all of our outstanding Series A-1 Notes and

an aggregate principal amount of $160.0 million of the outstanding Series

     A-2 Notes.                                            62 

--------------------------------------------------------------------------------

Table of Contents (4) 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. 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.

(5) 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.   (6) Less than $1 million.   

(7) Gross unrecognized tax benefits of $7.3 million are included within "Income

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

section of our June 30, 2013 consolidated balance sheet. The entire $7.3

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.

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."  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:

23158