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EXCEL - IDEA: XBRL DOCUMENT - ROTECH HEALTHCARE INCFinancial_Report.xls
EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO SECTION 302 - ROTECH HEALTHCARE INCa20120331ex312.htm
EX-32.1 - CERTIFICATION OF CEO AND CFO PURSUANT TO SECTION 906 - ROTECH HEALTHCARE INCa20120331ex321.htm
EX-99.1 - INFORMATION REGARDING FORWARD-LOOKING STATEMENTS - ROTECH HEALTHCARE INCa2011123110kexhibit991.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 302 - ROTECH HEALTHCARE INCa20120331ex311.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________________ 
FORM 10-Q
______________________________________ 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2012
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 000-50940
______________________________________ 
ROTECH HEALTHCARE INC.
(Exact name of registrant as specified in its charter)
______________________________________ 
Delaware
 
030408870
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
2600 Technology Drive, Suite 300, Orlando, Florida
 
32804
(Address of principal executive offices)
 
(Zip Code)
(407) 822-4600
(Registrant’s telephone number, including area code)
______________________________________ 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
¨
  
Accelerated filer
 
ý
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
  
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of May 8, 2012 the registrant had 25,907,310 shares of common stock outstanding.




TABLE OF CONTENTS
 
 
Page No.
 
 
PART I—FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II—OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 



2



PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

ROTECH HEALTHCARE INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 
 
March 31,
2012
 
December 31,
2011
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
20,279

 
$
30,473

Accounts receivable, net of allowance for doubtful accounts of $19,185 at March 31, 2012 and $14,450 at December 31, 2011
76,458

 
76,027

Other receivables
3,117

 
3,466

Income taxes receivable
115

 
62

Inventories
10,256

 
12,188

Prepaid expenses
3,021

 
3,535

Total current assets
113,246

 
125,751

Property and equipment, net
106,515

 
104,871

Intangible assets (less accumulated amortization of $14,344 at March 31, 2012 and $13,356 at December 31, 2011)
23,564

 
22,122

Restricted cash
7,465

 
7,465

Other assets, including debt issue costs
16,361

 
16,835

 
$
267,151

 
$
277,044

Liabilities and Stockholders’ Deficiency
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
26,580

 
$
20,133

Accrued expenses and other current liabilities
20,864

 
20,913

Accrued interest
12,795

 
14,215

Deferred revenue
8,512

 
8,342

Current portion of long-term debt
2,072

 
1,514

Total current liabilities
70,823

 
65,117

Deferred tax liabilities, net
283

 
280

Other long-term liabilities
1,582

 
754

Long-term debt, less current portion
511,553

 
511,065

Series A convertible redeemable preferred stock, stated value $20 per share, 1,000,000 shares authorized, 141,324 shares issued and outstanding at March 31, 2012 and December 31, 2011
3,081

 
3,017

Commitments and contingencies (Note 7)

 


Stockholders’ deficiency:
 
 
 
Common stock, par value $.0001 per share, 50,000,000 shares authorized, 25,907,310 shares issued and outstanding at March 31, 2012 and December 31, 2011
3

 
3

Additional paid-in capital
507,849

 
507,511

Accumulated deficit
(828,023
)
 
(810,703
)
Total stockholders’ deficiency
(320,171
)
 
(303,189
)
 
$
267,151

 
$
277,044

See accompanying notes to unaudited condensed consolidated financial statements.

3



ROTECH HEALTHCARE INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
 
 
Three months ended
 
March 31,
 
2012
 
2011
Net revenues
$
116,957

 
$
121,006

Costs and expenses:
 
 
 
Cost of net revenues
37,236

 
39,098

Selling, general and administrative
68,660

 
62,631

Provision for doubtful accounts
10,977

 
5,239

Depreciation and amortization
2,471

 
2,374

Total costs and expenses
119,344

 
109,342

Operating (loss) income
(2,387
)
 
11,664

Other expense (income):
 
 
 
Interest expense, net
14,837

 
14,567

Other income, net

 
(862
)
Loss on debt extinguishment

 
1,216

Total other expense
14,837

 
14,921

Loss before income taxes
(17,224
)
 
(3,257
)
Income tax expense (benefit)
32

 
(64
)
Net loss
(17,256
)
 
(3,193
)
Accrued dividends on convertible redeemable preferred stock
64

 
106

Net loss attributable to common stockholders
$
(17,320
)
 
$
(3,299
)
Net loss per common share:
 
 
 
Basic and diluted
$
(0.67
)
 
$
(0.13
)
Weighted average shares outstanding:
 
 
 
Basic and diluted
25,907,310

 
25,644,113

See accompanying notes to unaudited condensed consolidated financial statements.


4



ROTECH HEALTHCARE INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
 
Three months ended
 
March 31,
 
2012
 
2011
Net loss
$
(17,256
)
 
$
(3,193
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Provision for doubtful accounts
10,977

 
5,239

Depreciation and amortization
16,025

 
16,024

Loss on debt extinguishment

 
1,216

Deferred income taxes
3

 
(101
)
Other
328

 
(21
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(11,408
)
 
(14,844
)
Other receivables
349

 
(1,337
)
Income taxes receivable
(53
)
 
(10
)
Inventories
1,979

 
(2,242
)
Prepaid expenses
514

 
(1,286
)
Other assets
(59
)
 
(2,026
)
Accounts payable and accrued expenses
6,461

 
5,550

Other long-term liabilities
168

 
21

Accrued interest
(1,420
)
 
158

Deferred revenue
170

 
(109
)
Net cash provided by operating activities
6,778

 
3,039

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(14,862
)
 
(12,878
)
Identifiable intangible assets associated with equipment purchases
(84
)
 
(263
)
Cash paid for asset purchases
(1,000
)
 
(2,486
)
Withdrawals from restricted cash

 
4,162

Net cash used in investing activities
(15,946
)
 
(11,465
)
Cash flows from financing activities:
 
 
 
Payments on capital leases
(504
)
 
(145
)
Proceeds from long-term borrowing

 
284,771

Retirement of long-term borrowing

 
(287,000
)
Debt issue costs
(91
)
 
(7,479
)
Proceeds from stock option exercises

 
56

Payments of dividends on Series A convertible redeemable preferred stock
(431
)
 
(435
)
Net cash used in financing activities
(1,026
)
 
(10,232
)
Decrease in cash and cash equivalents
(10,194
)
 
(18,658
)
Cash and cash equivalents, beginning of period
30,473

 
63,046

Cash and cash equivalents, end of period
$
20,279

 
$
44,388

See accompanying notes to unaudited condensed consolidated financial statements.

5



ROTECH HEALTHCARE INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands, except share and per share data)
 
(1)
Basis of Presentation
The unaudited condensed consolidated financial statements include the accounts of Rotech Healthcare Inc. and its subsidiaries and have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q. In the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results of operations for the interim periods presented have been reflected herein. Interim results are not necessarily indicative of results to be expected for the full year. The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make assumptions that affect the amounts reported in the financial statements and accompanying notes. In general, management’s estimates are based upon historical experience and various other assumptions that we believe to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011. There have been no material changes to our significant accounting policies as disclosed in our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.
The Company has evaluated significant events and transactions that occurred after March 31, 2012 through the date of filing this report on Form 10-Q.
As used in these notes, unless otherwise specified or the context otherwise requires, references to “the Company”, “we”, “our” and “us” refer to the business and operations of Rotech Healthcare Inc. and its subsidiaries.
For all periods presented herein, there were no differences between net (loss) earnings and comprehensive (loss) earnings.
Immaterial Error Correction
During the quarter ended March 31, 2012, management identified an error made in certain programming logic within its billing system. As a result of this error, we determined that we have been overpaid on certain specific Medicare claim types since January 1, 2009. The amount of the overpayment for each of the impacted prior periods is approximately $2,200, $2,000 and $1,800 for the years ended December 31, 2009, 2010 and 2011, respectively. The programming logic that caused this error has been disabled in our billing system and we are not aware of any other overpayment issues as a result of this or any other programming error. Management has evaluated the amount and nature of these adjustments and concluded that they are not material to either the Company's prior annual or quarterly financial statements.  As such, we have corrected the historical financial statement amounts as included in this filing and we will likewise revise our historical financial statement amounts in future filings that contain such financial statements, including the Company's Annual Report on Form 10-K for the year ending December 31, 2012. The adjustment to correct the previously reported amounts as included in this filing are as follows:
Condensed Consolidated Balance Sheets
Accounts payable increased $6,000 from $14,133 to $20,133 as of December 31, 2011
Total current liabilities increased from $59,117 to $65,117 as of December 31, 2011
Accumulated deficit increased $6,000 from $804,703 to $810,703 as of December 31, 2011
Total stockholders' deficiency increased from $297,189 to $303,189 as of December 31, 2011
Condensed Consolidated Statements of Operations
Net revenues decreased $500 from $121,506 to $121,006 for the three months ended March 31, 2011
Operating income decreased from $12,164 to $11,664 for the three months ended March 31, 2011
Loss before income taxes increased from $2,757 to $3,257 for the three months ended March 31, 2011
Net loss increased from $2,693 to $3,193 for the three months ended March 31, 2011
Net loss attributable to common stockholders increased from $2,799 to $3,299 for the three months ended March 31, 2011
Net loss per common share basic and diluted increased from ($0.11) to ($0.13)
Condensed Consolidated Statements of Cash Flows
Net loss increased from $2,693 to $3,193 for the three months ended March 31, 2011
Changes in accounts payable and accrued expenses increased from $5,050 to $5,550 for the three months ended March 31, 2011

6



On May 7, 2012, we voluntarily refunded $6,452, including the above described prior period amounts and $452 attributed to the three months ended March 31, 2011, to the appropriate Durable Medical Equipment Medicare Administrative Contractors (DME MACs). As of March 31, 2012, the overpayment amount is included as a liability in accounts payable in the accompanying unaudited Condensed Consolidated Balance Sheet.
(2)
Liquidity
We completed a refinancing of our former 9.5% Senior Subordinated Notes due 2012 (the “Senior Subordinated Notes”) in March 2011 with the issuance of $290,000 in aggregate principal amount of 10.5% Senior Second Lien Notes due 2018 (the “Senior Second Lien Notes”). We completed a refinancing of our former payment-in-kind term loan facility (the “Senior Facility”) in October 2010 with the issuance of $230,000 in aggregate principal amount of 10.75% Senior Secured Notes due 2015 (the “Senior Secured Notes”).
We are highly leveraged. As of March 31, 2012, we had $513,625 of long-term debt outstanding. Our Senior Secured Notes ($225,074) mature in October 2015 and our Senior Second Lien Notes ($285,319) mature in March 2018. Although we are highly leveraged, management believes, based upon our current cash projections that our current cash balances, cash generated from our operations and available credit under our revolving credit facility will be sufficient to meet our working capital, capital expenditure and other cash obligations for the next twelve months.

(3)
Earnings Per Common Share
Basic earnings per share (EPS) is computed by dividing net earnings attributable to common stockholders by the weighted average number of common shares outstanding for the periods. Diluted EPS reflects the potential dilution of securities that could share in the earnings and are based upon the weighted average number of common and common equivalent shares outstanding during the three months ended March 31, 2012 and 2011. Common equivalent shares related to employee stock options and the Series A convertible redeemable preferred stock (“Series A Preferred”) on an “if converted” basis totaled 3,629,025 and 2,983,201 for the three months ended March 31, 2012 and 2011, respectively, are excluded from the computation of diluted EPS in periods where they have an anti-dilutive effect. We use the treasury stock method to compute the dilutive effects of common equivalent shares.

The reconciliations of net loss attributable to common stockholders and shares outstanding for purposes of calculating basic and diluted EPS for the three months ended March 31, 2012 and 2011 are as follows: 
 
Three months ended
 
March 31,
 
2012
 
2011
Numerator:
 
 
 
Net loss attributable to common stockholders (basic and diluted EPS)
$
(17,320
)
 
$
(3,299
)
Denominator:
 
 
 
Basic weighted average shares outstanding
25,907,310

 
25,644,113

Dilutive stock options

 

Dilutive convertible redeemable preferred stock

 

Diluted weighted average shares outstanding
25,907,310

 
25,644,113

Net loss per common share:
 
 
 
Basic
$
(0.67
)
 
$
(0.13
)
Diluted
$
(0.67
)
 
$
(0.13
)

Each share of our Series A Preferred has a stated value of $20 and entitles the holder to an annual cumulative dividend equal to 9% of its stated value, payable semi-annually at the discretion of our board of directors in cash or in additional shares of Series A Preferred. In the event dividends are declared by our board of directors but not paid for six consecutive periods, the holders of the Series A Preferred are entitled to vote as a separate class to elect one director to serve on our board of directors. Effective December 5, 2003, our board of directors adopted a policy of declaring dividends to the holders of the Series A Preferred under the Rotech Healthcare Inc. Employees Plan on an annual basis, with each such declaration to be made at the meeting of the board of directors following the annual meeting of the shareholders with respect to dividends payable for the preceding year. At the meeting of the board of directors held on June 22, 2010, dividends in the amount of $435 were declared on our Series A Preferred and were paid in January 2011. At the meeting of the board of directors held on June 24, 2011, dividends in the amount of $431 were declared on our Series A Preferred and were paid in January 2012. The Series A Preferred must be redeemed by us on June 26, 2012 at the redemption amount of $20 per share plus any accrued and unpaid dividends. The amount of the mandatory redemption of the outstanding

7



141,324 share of Series A Preferred would be approximately $2,826 plus any accrued unpaid dividends.
(4)
Equipment and Asset Purchases
During the three months ended March 31, 2012 and 2011, we completed $405 and $5,809, respectively, of purchases of new and used rental equipment and inventory from competitors exiting the home health care market which represents a limited subset of the assets and activities used in operating their respective businesses (“Equipment Purchases”).
 
 
Three months ended March 31
 
2012
 
2010
Property and equipment
$
319

 
$
5,103

Inventory
2

 
443

Identifiable intangible assets
84

 
263

Total
$
405

 
$
5,809

During the three months ended March 31, 2012 and 2011, we completed purchases of new and used rental equipment, inventory and other additional assets, including identifiable intangible assets, from competitors exiting the home health care market representing a business combination (“Asset Purchases”) totaling $1,990 and $3,173, respectively, the aggregate cost of which has been recorded as follows:
 
Three months ended March 31
 
2012
 
2011
Property and equipment
$
25

 
$
2,193

Identifiable intangible assets
1,918

 
934

Inventory
47

 
46

Total
$
1,990

 
$
3,173

Pro forma results and other expanded disclosures required by the Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business Combinations, have not been presented as these purchases individually and in the aggregate are not material.
(5)
Intangible Assets
Intangible assets of a reporting unit will be tested for impairment if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
The following table reflects the components of identifiable intangible assets:
 
March 31, 2012
 
December 31, 2011
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Gross Carrying
Amount
 
Accumulated
Amortization
Intangible assets subject to amortization:
 
 
 
 
 
 
 
Customer/physician relationship
$
12,000

 
$
6,000

 
$
12,000

 
$
5,850

Computer software
12,277

 
5,280

 
11,848

 
5,090

Other
11,631

 
3,064

 
9,630

 
2,416

Subtotal
35,908

 
14,344

 
33,478

 
13,356

Intangible assets not subject to amortization:
 
 
 
 
 
 
 
Trade name
1,000

 

 
1,000

 

Medicare licenses
1,000

 

 
1,000

 

Subtotal
2,000

 

 
2,000

 

Total intangible assets
$
37,908

 
$
14,344

 
$
35,478

 
$
13,356


During 2011, we wrote off fully amortized intangibles in the amount of $43. Amortization expense for the three months ended March 31, 2012 and 2011was approximately $988 and $362, respectively. During 2012, we recorded $2,002 of intangible assets primarily related to the Asset Purchases described in Note 4, which are subject to amortization which have a weighted average remaining life of 3 years.

8



Estimated amortization expense for each of the fiscal years ending December 31 is as follows:
 
Amount
2012
$
3,169

2013
3,106

2014
2,118

2015
945

2016
855

(6)
Segment Data
We operate in one reportable segment with three primary product lines: respiratory therapy equipment and services, durable medical equipment, and other products and services. The following table presents net revenues from distribution by each of our three primary product lines:
 
Three Months Ended
 
March 31,
 
2012
 
2011
Respiratory therapy equipment and services
$
101,253

 
$
105,556

Durable medical equipment
12,875

 
12,888

Other
2,829

 
2,562

Net revenue
$
116,957

 
$
121,006

(7)
Other Commitments and Contingencies
We are subject to workers’ compensation and employee health benefit claims, which are primarily self-insured. We do, however, maintain certain stop-loss and other insurance coverage which management believes to be appropriate.
Provisions for estimated settlements relating to workers’ compensation are provided in the applicable period on a case-by-case basis. We review our estimated provisions on a quarterly basis and make changes when necessary. Differences between the amounts accrued and subsequent settlements are recorded in operations in the period of settlement. We estimate claim amounts incurred but not reported relating to health benefit plans in the applicable period and review such amounts on a quarterly basis.
We and our subsidiaries are parties to various legal proceedings in the ordinary course of business. For more information regarding our recent legal proceedings, see Note 8, “Certain Significant Risks and Uncertainties and Significant Events.”
(8)
Certain Significant Risks and Uncertainties and Significant Events
We and others in the health care business are subject to certain inherent risks, including the following:
Substantial dependence on revenues derived from reimbursement by various federal health care programs (including Medicare) and state Medicaid programs, both of which have been significantly reduced in recent years, and which entail exposure to various health care fraud statutes;
Inconsistent timing of payments from Centers for Medicare and Medicaid Services, its contractors and other third-party payors;
Government regulations, government budgetary constraints and proposed legislative, reimbursement and regulatory changes; and
Lawsuits alleging negligence in the provision of healthcare services and related claims.
Such inherent risks require the use of certain management estimates in the preparation of our financial statements and it is reasonably possible that changes in such estimates may occur.
We receive payment for a significant portion of services rendered to patients from the federal government under Medicare and other federally funded programs (including the Veterans Administration (VA)) and from state governments under Medicaid. Revenue derived from Medicare, Medicaid and other federally funded programs represented 56.2% of our patient service revenue for the three months ended March 31, 2012 and 57.2% for the three months ended March 31, 2011.

9




(9)
Debt
Our long-term debt consists of the following:
 
March 31,
2012
 
December 31,
2011
Capital lease obligations with interest implied at fixed rates between 5.0% and 11.0%, due in equal monthly installments with terms expiring from May 2012 through February 2014, collateralized by equipment
$
3,232

 
$
2,556

10.75% Senior Secured Notes, due October 15, 2015, interest payable semi-annually on April 15 and October 15, net of $4,926 and $5,204 unamortized original issue discount at March 31, 2012 and December 31, 2011, respectively
225,074

 
224,796

10.5% Senior Second Lien Notes, due March 15, 2018, interest payable semi-annually on March 15 and September 15, net of $4,681 and $4,773 unamortized original issue discount at March 31, 2012 and December 31, 2011, respectively
285,319

 
285,227

Sub total
513,625

 
512,579

Less current portion
2,072

 
1,514

Total long-term debt
$
511,553

 
$
511,065


On March 17, 2011, we issued $290,000 in aggregate principal amount of Senior Second Lien Notes. The Senior Second Lien Notes were offered and sold in a private placement to Credit Suisse Securities (USA) LLC and Jefferies & Company, Inc. (the “Initial Purchasers”) in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”), and resold by the Initial Purchasers to qualified buyers pursuant to exemptions from registration provided by Rule 144A and Regulation S of the Securities Act. The Senior Second Lien Notes were also offered and sold to certain directors of the Company who are accredited investors as defined in Rule 501(a) under the Securities Act.
The Senior Second Lien Notes were issued at a discount of $5,229 and we incurred transaction costs of approximately $8,916. The discount and transaction costs associated with the Senior Second Lien Notes are being amortized as interest expense over the term of these notes. Interest is payable semi-annually on March 15 and September 15. We used the proceeds from the offering of the Senior Second Lien Notes, together with $24,485 of cash on hand, to repay all of our outstanding Senior Subordinated Notes and pay associated fees and expenses. In conjunction with the closing of the Senior Second Lien Notes on March 17, 2011, we deposited $301,920 with Bank of New York Mellon N.A., as trustee (the “Trustee”), to satisfy our obligation with respect to the Senior Subordinated Notes including the principal amount of $287,000 and accrued interest through April 18, 2011 of $14,920. We were legally released of our liability effective March 17, 2011. Upon completion of the 30-day notice period required under the indenture governing our Senior Subordinated Notes, on April 18, 2011, the Trustee redeemed and canceled the Senior Subordinated Notes. As a result of the termination of the Senior Subordinated Notes we recorded a $1,216 loss on extinguishment of debt related to unamortized debt issuance costs.
The Senior Second Lien Notes will mature on March 15, 2018. In connection with the issuance of the Senior Second Lien Notes, we entered into a registration rights agreement with the Initial Purchasers of the Senior Second Lien Notes, dated March 17, 2011 (the “Senior Second Lien Notes Registration Rights Agreement”). Pursuant to the Senior Second Lien Notes Registration Rights Agreement, we agreed to exchange the Senior Second Lien Notes for freely tradable notes with terms that are substantially identical to the Senior Second Lien Notes. We also agreed, in limited circumstances, to file a shelf registration statement with respect to the Senior Second Lien Notes. On July 12, 2011, we completed the registered exchange offer with respect to the Senior Second Lien Notes.
The indenture governing the Senior Second Lien Notes contains covenants that limit our ability and the ability of our restricted subsidiaries to, among other things: sell assets; pay dividends or make other distributions or repurchase or redeem our stock; incur or guarantee additional indebtedness; incur certain liens; make loans and investments; enter into agreements restricting our subsidiaries’ ability to pay dividends; consolidate, merge or sell all or substantially all of or our assets, and enter into transactions with affiliates. The Senior Second Lien Notes are collateralized by a second priority security interest in substantially all of the Company’s assets. The Senior Second Lien Notes are guaranteed by all of our wholly owned subsidiaries. Each guarantee is full and unconditional and joint and several. We hold all of our assets and conduct all of our operations through our wholly owned subsidiaries and the parent does not have independent assets and operations.

10



Additionally, on March 17, 2011 we entered into a credit agreement with Credit Suisse AG, as administrative agent, Credit Suisse Securities (USA) LLC and Jefferies Finance LLC, as joint bookrunners and joint lead arrangers, and Jefferies Finance LLC, as documentation agent (the"Original Credit Agreement"). On March 7, 2012, we entered into an amendment to the Original Credit Agreement that extended the final maturity date from March 17, 2012 to March 17, 2014 (the Original Credit Agreement, as amended, the "Credit Agreement"). The Credit Agreement provides for a revolving credit facility commitment of up to $10,000 provided that the maximum outstanding aggregate principal balance at any one time does not exceed $10,000 (the “Revolving Credit Facility”). There was no debt outstanding under the Revolving Credit Facility as of March 31, 2012 or December 31, 2011.
The Revolving Credit Facility contains customary covenants similar to those in our indentures governing our Senior Secured Notes and Senior Second Lien Notes. The Revolving Credit Facility also includes a maximum leverage ratio above which level we would be precluded from making any additional draws. As of March 31, 2012 and December 31, 2011, we were below the maximum leverage ratio threshold, as defined within the Credit Agreement.
All borrowings under the Revolving Credit Facility are secured by a first priority security interest in substantially all of the Company’s assets. The interest rate per annum applicable to the Revolving Credit Facility is adjusted LIBOR or, at our option, the alternate base rate, which is the higher of (a) the prime rate, (b) the federal funds effective rate plus 0.50%, and (c) the adjusted LIBOR plus 1.0% in each case, plus the applicable margin (as defined below). The applicable margin in the case of LIBOR advances is 5.0% and in the case of alternate base rate advances is 4.0%. The default rate on the Revolving Credit Facility is 2.0% above the otherwise applicable interest rate. We are also obligated to pay a commitment fee of 0.75% on the unused portion of our Revolving Credit Facility.
On October 6, 2010, we issued $230,000 in aggregate principal amount of Senior Secured Notes. The Senior Secured Notes were offered and sold in a private placement to Credit Suisse Securities (USA) LLC (the “Initial Purchaser”) in reliance on the exemption from registration provided by the Securities Act, and resold by the Initial Purchaser to qualified buyers pursuant to exemptions from registration provided by Rule 144A and Regulation S of the Securities Act.
The Senior Secured Notes were issued at a discount of $6,465 and we incurred transaction costs of approximately $8,002. The discount and transaction costs associated with the Senior Secured Notes are being amortized as interest expense over the term of those notes. Interest is payable semi-annually on April 15 and October 15.
The Senior Secured Notes will mature on October 15, 2015. In connection with the issuance of the Senior Secured Notes, we entered into a registration rights agreement with the Initial Purchaser of the Senior Secured Notes, dated October 6, 2010 (the “Senior Secured Notes Registration Rights Agreement”). Pursuant to the Senior Secured Notes Registration Rights Agreement, we agreed to exchange the Senior Secured Notes for freely tradable notes with terms that are substantially identical to the Senior Secured Notes. We also agreed, in limited circumstances, to file a shelf registration statement with respect to the Senior Secured Notes. On January 14, 2011, we completed the registered exchange offer with respect to the Senior Secured Notes.
The indenture governing the Senior Secured Notes contains covenants that limit our ability and the ability of our restricted subsidiaries to, among other things: sell assets; pay dividends or make other distributions or repurchase or redeem our stock; incur or guarantee additional indebtedness; incur certain liens; make loans and investments; enter into agreements restricting our subsidiaries’ ability to pay dividends; consolidate, merge or sell all or substantially all of our assets, and enter into transactions with affiliates. The Senior Secured Notes are secured by a first priority security interest in substantially all of the Company’s assets. The Senior Secured Notes are guaranteed by all of our wholly owned subsidiaries. Each guarantee is full and unconditional and joint and several. We hold all of our assets and conduct all of our operations through our wholly owned subsidiaries and we do not have independent assets and operations.
We have outstanding letters of credit totaling $7,465 as of March 31, 2012 and December 31, 2011. Our letters of credit were cash collateralized at 100% of their face amount as of March 31, 2012 and December 31, 2011. The cash collateral for these outstanding letters of credit is included in restricted cash in our accompanying condensed consolidated balance sheet as of March 31, 2012 and December 31, 2011.
The fair value of our Senior Secured Notes and Senior Second Lien Notes at March 31, 2012 and December 31, 2011 are based on quoted market prices in an active market which are Level 1 inputs. The estimated fair value of the Senior Secured Notes at March 31, 2012 and December 31, 2011 was $234,255 and $236,164, respectively. The estimated fair value of the Senior Second Lien Notes at March 31, 2012 and December 31, 2011 was $197,563 and $233,015, respectively.
(10)
Income Taxes
We recorded a net tax expense of $32 and a net tax benefit of $64 for the three months ended March 31, 2012 and 2011, respectively. The current year to date tax expense is primarily the result of an increase of $3 in our liabilities recorded for uncertain tax positions and a current state tax expense of $29. We have provided a full valuation allowance against our remaining net deferred tax assets as of March 31, 2012 because management’s judgment is that it is more likely than not that the net deferred tax assets will not be realized based on cumulative book losses.

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At March 31, 2012, we had available federal net operating loss (NOL) carryforwards of approximately $239,035 net of the de-recognition recorded as a result of the change in ownership interest under Section 382 of the Internal Revenue Code that occurred on December 31, 2006. These remaining NOLs fully expire in 2032. NOL carryforwards and credits are subject to review and possible other adjustments by the Internal Revenue Service and may be further limited by the occurrence of certain events, including other significant changes in ownership interests as was the case in 2006. The effect of an ownership change is the imposition of an annual limitation on the use of the NOL carryforwards attributable to periods before the change.
We recorded a liability of $249 for unrecognized tax benefits related to various federal and state income tax matters at both March 31, 2012 and December 31, 2011. If recognized, all of these amounts would impact our effective tax rate. There is no difference between the total amount of unrecognized tax benefit and the amount that would impact the effective tax rate based on the current valuation allowance on the deferred tax assets. We do not expect that the amounts of unrecognized tax benefits will change significantly within the next 12 months.
We are currently open to audit under the statute of limitations by the Internal Revenue Service for all years ended December 31, 2002 to present. However, we are only open to additional tax assessments under the Internal Revenue Code statute of limitations for the years ended December 31, 2008 to present. The IRS commenced examinations of the Company’s U.S. income tax return for 2008 in the third quarter of 2011 and for 2010 in the first quarter of 2012. As of March 31, 2012, the IRS has closed the examinations and did not propose any adjustments. Our state income tax returns are open to audit and additional tax assessments for the years ended December 31, 2002 to present as applicable under the various state statutes of limitations.
There is $34 and $31 of accrued interest related to uncertain tax positions as of March 31, 2012 and December 31, 2011, respectively. No penalties have been accrued. We account for interest and penalties related to uncertain tax positions as part of our provision for federal and state income taxes.

(11)
Supplemental Cash Flow and Non-cash Investing and Financing Information

 
For the three months ended
March 31,
 
2012
 
2011
Cash payments for:
 
 
 
Interest
$
15,294

 
$
14,915

Income taxes, net of refunds
71

 
48

Non-cash investing and financing activities:
 
 
 
Property and equipment unpaid and included in accounts payable
8,598

 
6,544

Property and equipment acquired through capital leases
1,190

 

Contingent consideration related to asset purchases
990

 

Purchase price payable for asset purchases included in accounts payable
458

 
687



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Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our consolidated financial statements for the year ended December 31, 2011 and the notes thereto included in our Annual Report on Form 10-K previously filed with the Securities and Exchange Commission. As used herein, unless otherwise specified or the context otherwise requires, references to the “Company”, “we”, “our” and “us” refer to the business and operations of Rotech Healthcare Inc. and its subsidiaries.

Introduction
Background
We are one of the largest providers of home medical equipment and related products and services in the United States, with a comprehensive offering of respiratory therapy and durable home medical equipment and related services. We provide home medical equipment and related products and services principally to older patients with breathing disorders, such as chronic obstructive pulmonary diseases (COPD), which include chronic bronchitis, emphysema, obstructive sleep apnea and other cardiopulmonary disorders. We provide equipment and services in 49 states through approximately 420 operating locations located primarily in non-urban markets.
Our revenues are principally derived from respiratory equipment rental and related services, which accounted for 86.6% and 87.2% of net revenues for the three months ended March 31, 2012 and 2011, respectively. Revenues from respiratory equipment rental and related services include rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy systems, nebulizer equipment and sleep disorder breathing therapy systems, and the sale of nebulizer medications. We also generate revenues through the rental and sale of durable medical equipment, which accounted for 11.0% and 10.7% of net revenues for the three months ended March 31, 2012 and 2011, respectively. Revenues from rental and sale of durable medical equipment include hospital beds, wheelchairs, walkers, patient aids and ancillary supplies. We derive our revenues principally from reimbursement by third-party payors, including Medicare, Medicaid, the Veterans Administration (VA) and private insurers.
Executive Summary
We face significant financial and Medicare reimbursement related challenges that continue to negatively affect our financial position. We anticipate that we will continue to face such challenges in the near and long-term future. Most of these difficulties result from our highly leveraged capital structure, while others are the result of significant Medicare reimbursement reductions applicable to our industry, as well as current conditions in the capital markets.
In light of these challenges, our operational focus is on reducing our cost structure while maintaining internal growth and seeking opportunities to gain market share through selective asset and equipment purchases from competitors exiting the home medical equipment market. In particular:
During the first three months of 2012, we purchased $2.4 million of new and used rental equipment, inventory and certain identifiable intangible assets from competitors exiting the home medical equipment market. Some of the equipment purchased in these transactions is currently on rent and located in patients’ homes. We believe that we will be successful in continuing to identify additional asset and equipment purchase opportunities and that we will be able to successfully transition a high percentage of the associated patients onto service with our Company. During the three months ended March 31, 2012, we have recognized approximately $7.6 million of revenues associated with patients transitioned onto service with our Company through asset and equipment purchases.
During the first three months of 2011, we purchased $9.0 million of new and used rental equipment and inventory from competitors exiting the home medical equipment market. Some of the equipment purchases in these transactions is currently on rent and located in patients’ homes. During the three months ended March 31, 2011, we have recognized approximately $4.9 million of revenues associated with patients transitioned onto service with our Company through equipment purchases.
During 2011, we completed implementation of our new order intake system. In conjunction with our new electronic medical record system implemented in 2009, we have redesigned our front-end order intake processes. As a result, we have been able to automate and consolidate many of our historically paper-based processes. Although we have incurred some temporary incremental costs associated with this system implementation, we believe that this new intake system will allow for improvements in our operating efficiency.
We expect that we will continue to evaluate and explore strategic alternatives and opportunities as they may arise, including potential acquisitions, business combination transactions, strategic partnerships or similar transactions. In addition,

13



either in connection with or independent of such a transaction, we expect that we may engage in financing activities through public or private offerings of equity, debt or convertible securities, including common stock, preferred stock, warrants, convertible notes or other instruments. We may repurchase our common stock from time to time in open market purchases or in privately negotiated transactions subject to the limitations provided in our respective debt agreements.  The timing and actual number of shares repurchased is at the discretion of management of the Company and will depend on a variety of factors, including stock price, corporate and regulatory requirements, market conditions, the relative attractiveness of other capital deployment opportunities and other corporate priorities. 
On June 28, 2011, we submitted our application for relisting of our common stock on the NASDAQ Global Market. The application review by NASDAQ’s Listing Qualifications department for compliance with all NASDAQ Stock Market standards is substantially complete. However, we do not currently meet the $4.00 per share minimum bid price required for initial listing on the NASDAQ Global Market. While we intend to satisfy all of NASDAQ’s requirements for relisting, there can be no assurance that our application will be approved, or of when or if our common shares will be listed on the NASDAQ Stock Market or another stock exchange. Our common stock will continue to trade on the OTC Bulletin Board under our current symbol, ROHI, during the NASDAQ listing process.
Reimbursement by Third-Party Payors
We derive substantially all of our revenues from reimbursement by third-party payors, including Medicare, Medicaid, the VA and private insurers. Revenue derived from Medicare, Medicaid and other federally funded programs represented 56.2% and 57.2% of our patient service revenue for the three months ended March 31, 2012 and 2011, respectively. Our business has been, and may continue to be, significantly impacted by changes mandated by Medicare legislation.
Under existing Medicare laws and regulations, the sale and rental of our products generally are reimbursed by the Medicare program according to prescribed fee schedule amounts calculated using statutorily-prescribed formulas. Significant legislation affecting home medical equipment (HME) reimbursement has been signed into law, including the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (collectively, the “PPACA”), Medicare Improvement for Patients and Providers Act of 2008 (MIPPA), Medicare, Medicaid and State Children’s Health Insurance Program Extension Act of 2007 (“SCHIP Extension Act”), the Deficit Reduction Act of 2005 (DRA) and the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA), contain provisions that negatively impact reimbursement for the primary HME products that we provide. The PPACA, MIPPA, the SCHIP Extension Act, DRA and MMA provisions (each of which is discussed in more detail below), when fully implemented, could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations.
The PPACA includes, among other things, annual, non-deductible fees on any entity that manufacturers or imports certain prescription drugs and biologics, beginning in 2011; a deductible excise tax on any entity that manufactures or imports medical devices offered for sale in the United States, with limited exceptions, beginning in 2013; new face-to-face encounter requirements for HME and home health services; and a requirement that by 2016, the competitive bidding process must be nationalized or prices in non-competitive bidding areas must be adjusted to match competitive bidding prices.
MIPPA retroactively delayed the implementation of competitive bidding for eighteen months and decreased the 2009 fee schedule payment amounts by 9.5% for product categories included in competitive bidding.
The SCHIP Extension Act, which went into effect April 1, 2008, reduced Medicare reimbursement amounts for covered Medicare Part B drugs, including inhalation drugs that we provide.
The DRA capped the Medicare rental period for oxygen equipment at 36 months of continuous use, after which time title of the equipment would transfer to the beneficiary. For purposes of this cap, the DRA provided for a new 36-month rental period that began January 1, 2006 for all oxygen equipment. With the passage of MIPPA, transfer of title of oxygen equipment at the end of the 36-month rental cap was repealed, although the rental cap remained in place.
The MMA significantly reduced reimbursement for inhalation drug therapies beginning in 2005, reduced payment amounts for five categories of HME, including oxygen, beginning in 2005, froze payment amounts for other covered HME items through 2007, established a competitive bidding program for HME and implemented quality standards and accreditation requirements for HME suppliers.
We cannot predict the impact that any federal legislation enacted in the future will have on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations.
Further, changes in the law or new interpretations of existing laws could have a dramatic effect on permissible activities, the relative costs associated with doing business and the amount of reimbursement by government and other third-party payors.

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Reimbursement we receive from Medicare and other government programs is subject to federal and state statutory and regulatory requirements, administrative rulings, interpretations of policy, implementation of reimbursement procedures, renewal of VA contracts, retroactive payment adjustments and governmental funding restrictions. Our levels of revenue and profitability, like those of other health care companies, are affected by the continuing efforts of government payors to contain or reduce the costs of health care, including competitive bidding initiatives, measures that impose quality standards as a prerequisite to payment, policies reducing certain HME payment rates and restricting coverage and payment for inhalation drugs, and refinements to payments for oxygen and oxygen equipment.
(1) Competitive Bidding Program for HME. On April 2, 2007, the Centers for Medicare & Medicaid Services (CMS), the agency responsible for administering the Medicare program, issued its final rule implementing a competitive bidding program for certain HME products under Medicare Part B. This nationwide competitive bidding program is designed to replace the existing fee schedule payment methodology. Under the competitive bidding program, suppliers compete for the right to provide items to beneficiaries in a defined geographic region. CMS selects contract suppliers that agree to receive as payment the “single payment amount” calculated by CMS after bids are submitted. Round 1 of the competitive bidding program began on July 1, 2008 in ten high-population competitive bidding areas (CBAs). As a winning bidder in nine of the ten competitive bidding areas, we signed contracts with CMS to become a contracted supplier for the Round 1 contract period of July 1, 2008 through June 30, 2011. The competitive bidding program was scheduled to expand to 70 additional CBAs for a total of 80 CBAs in 2009 and additional areas thereafter.
However, on July 15, 2008, the United States Congress, following an override of a Presidential veto, enacted MIPPA. MIPPA retroactively delayed the implementation of competitive bidding for eighteen months, and terminated all existing contracts previously awarded. MIPPA included a 9.5% nationwide reduction in reimbursement effective January 1, 2009 for the product categories included in competitive bidding, as a budget-neutrality offset for the eighteen month delay.
On January 16, 2009, CMS published an interim final rule with comment period (IFC) addressing the MIPPA provisions that affect Round 1 of the competitive bidding program. This IFC announced the delay of Round 1 of the program from 2007 to 2009. The round one competition, also known as the Round 1 rebid, occurred in the same CBAs as the 2007 Round 1 bidding, excluding Puerto Rico. The product categories for 2009 were the same as those selected for the 2007 round one bidding, with the exception of negative pressure wound therapy and Group 3 complex rehabilitative wheelchairs. The IFC also announced the delay of Round 2 of the program from 2009 to 2011, the national mail order program until after 2010 and competition in additional areas, other than mail order, until after 2011. Suppliers are required to meet all applicable eligibility, financial, quality and accreditation standards. The MIPPA changes that were addressed in this IFC did not alter the fundamental requirements of the final regulation for the competitive bidding program published on April 10, 2007.
On July 2, 2010, CMS announced the single payment amount for each of the respective Round 1 rebid CBAs and product categories and began offering contracts to certain bidders in the CBAs. We were awarded and accepted 17 contracts. In addition, on July 1 and September 9, 2011, we completed two acquisitions in two of the Round 1 rebid CBAs. As part of these acquisitions, we assumed six additional competitive bid contracts, for a total of 23, as follows:
7 CBAs for oxygen supplies and equipment;
6 CBAs for enteral nutrients, equipment and supplies;
5 CBAs for continuous positive airway pressure, respiratory assist devices and related supplies and accessories;
2 CBA for walkers;
1 CBA for hospital beds and related supplies; and
2 CBAs for standard power wheelchairs, scooters and related accessories.
CMS announced the participating providers in November 2010. The contracts became effective on January 1, 2011 and have a term of three years. The average reduction from current Medicare payment rates in this round of competitive bidding across the CBAs is 32%. Suppliers that were not contracted by CMS may continue to provide certain capped rental and oxygen equipment for those beneficiaries that were patients at the time the program began and are known as “grandfathered suppliers”. In the CBAs and product categories where we are not a contracted supplier, we continue to service our Medicare patients as grandfathered suppliers under applicable guidelines. Based upon CMS release information, it appears that approximately 70% of existing providers across the Round 1 Rebid CBAs were not awarded competitive bidding contracts and are therefore not able to provide competitive bid products to new Medicare patients during the term of these contracts in the respective CBAs. We have experienced significant volume increases within the CBAs where we were awarded contracts, which we attribute in part to an increase in market share, and we believe that the revenue associated the these volume increases will more than offset the impact of the associated reductions in reimbursement rates over time. The application of the new competitive bid rates in the Round 1 rebid reduced our net revenue by approximately $1.3 million per quarter.
In addition, on November 2, 2010, CMS finalized certain changes impacting competitive bidding and current payment policies for certain items of durable medical equipment, prosthetics, orthotics and supplies, including:

15



Implementation of certain statutory provisions under MIPPA and the PPACA, including: (1) the subdivision of metropolitan statistical areas (MSAs) with populations over 8,000,000 into smaller CBAs, as required under MIPPA; (2) the addition of 21 MSAs to the 70 MSAs already designated as included in Round 2, for a total of 91 MSAs, as required under the PPACA; and (3) the implementation of payment policies adopted under the PPACA for power wheelchairs, which eliminated the lump sum purchase option for standard power wheelchairs furnished on or after January 1, 2011, and adjusted the amount of the capped rental payments for power wheelchairs. Effective January 1, 2011, rental payments under the adjusted fee schedule are 15% (instead of 10%) of the purchase price for the first three months and 6% (instead of 7.5%) for the remaining rental months not to exceed 13 months; and
The establishment of an appeals process for competitive bidding contract suppliers that are notified that they are in breach of contract.
CMS also solicited comments on whether to reduce the maximum number of payments a contract supplier would receive beyond the 13-month (for capped rental) and 36-month (for oxygen and oxygen equipment) caps when a beneficiary who is receiving the equipment from a non-contract supplier elects to switch to the contract supplier. To date CMS has not made any changes.
CMS is currently undertaking Round 2 of competitive bidding in 91 additional markets, with contracts expected to be effective in July 2013. Our Medicare revenues from the product categories in the 91 additional markets to be included in Round 2 of competitive bidding were approximately $54.0 million in 2011. The PPACA legislation requires CMS to expand competitive bidding further to additional geographic markets (certain markets may be excluded at the discretion of CMS) or to use competitive bid pricing information to adjust the payment amounts otherwise in effect for areas that are not competitive bidding areas by January 1, 2016.
(2) Certain Clinical Conditions, Accreditation Requirements and Quality Standards. The MMA required establishment and implementation of new clinical conditions of coverage for HME products and quality standards for HME suppliers. Some clinical conditions have been implemented, such as the requirement for a face-to-face visit by treating physicians for beneficiaries seeking power mobility devices. CMS published its quality standards and criteria for accrediting organizations for HME suppliers in 2006 and revised some of these standards in October 2008. As an entity that bills Medicare and receives payment from the program, we are subject to these standards. We have revised our policies and procedures to ensure compliance in all material respects with the quality standards. These standards, which are applied by independent accreditation organizations, include business-related standards, such as financial and human resources management requirements, which would be applicable to all HME suppliers, and product-specific quality standards, which focus on product specialization and service standards. The product specific standards address several of our products, including oxygen and oxygen equipment, CPAP and power and manual wheelchairs and other mobility equipment.
Currently, all of our operating locations are accredited by the Joint Commission (formerly referred to as the Joint Commission on Accreditation of Healthcare Organizations). The Joint Commission is a CMS recognized accrediting organization. Round 1 re-bid competitive bid suppliers were required to be accredited by September 30, 2009.
On January 2, 2009, CMS published its final rule on surety bond requirements for HME suppliers, effective March 3, 2009. For each National Provider Identifier (NPI) number subject to Medicare billing privileges, suppliers must obtain a surety bond in the amount of $50,000. Each of our 425 operating locations is required to have its own NPI number. There may be an upward adjustment for suppliers that have had adverse legal actions imposed on them in the past. HME suppliers already enrolled in Medicare were required to obtain a surety bond by October 2, 2009, and newly enrolled suppliers or those changing ownership were subject to the provisions of the new rule on May 4, 2009. We maintain surety bonds covering all of our NPI numbers at each of our operating locations.
(3) Reduction in Payments for HME and Inhalation Drugs. The MMA changes also included a reduction in reimbursement rates beginning in January 2005 for oxygen equipment and certain other HME items (including wheelchairs, nebulizers, hospital beds and air mattresses) based on the percentage difference between the amount of payment otherwise determined for 2002 and the 2002 median reimbursement amount under the Federal Employee Health Benefits Program (FEHBP) as determined by the Office of the Inspector General of the Department of Health and Human Services (OIG). The FEHBP adjusted payments remained “frozen” through 2008. With limited exceptions, items that were not included in competitive bidding received a 5% update for 2009. As discussed above, for 2009, MIPPA included a 9.5% nationwide reduction in reimbursement for the product categories included in competitive bidding, as a budget neutrality offset for the eighteen month delay.
The MMA also revised the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. Historically, prescription drug coverage under Medicare has been limited to drugs furnished incident to a physician’s services and certain self-administered drugs, including inhalation drug therapies. Prior to MMA, Medicare reimbursement for covered drugs, including the inhalation drugs that we provide, was limited to 95 percent of the published

16



average wholesale price (AWP) for the drug. MMA established new payment limits and procedures for drugs reimbursed under Medicare Part B. Beginning in 2005, inhalation drugs furnished to Medicare beneficiaries are reimbursed at 106 percent of the volume-weighted average selling price (ASP) of the drug, as determined from data provided each quarter by drug manufacturers under a specific formula described in MMA. Implementation of the ASP-based reimbursement formula resulted in a significant reduction in payment rates for inhalation drugs. Given the overall reduction in payment for inhalation drugs dispensed through nebulizers, CMS established a dispensing fee for inhalation drugs shipped to a beneficiary beginning in 2005. The current dispensing fee is $57 for the first 30-day period in which a Medicare beneficiary uses inhalation drugs and $33 for each subsequent 30-day period. The dispensing fee for a 90-day supply of inhalation drugs is $66. The dispensing fee has remained unchanged since 2006. Future changes from quarterly updates to ASP pricing, as well as any future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations.
Furthermore, because the ASP amounts vary from quarter to quarter, changes in market forces influence the Medicare payment rate. In late 2006, the US Food and Drug Administration approved a first-time generic formulation for DuoNeb. The introduction of this generic product into the market has contributed to the reduction of the ASP for DuoNeb from $1.079 in the fourth quarter of 2007 to $0.300 in the second quarter 2012. The impact of this reduction to our profit margins, profitability, operating cash flows and results of operations was partially mitigated through the dispensing of generic DuoNeb and changes in nebulizer product mix.
(4) Reduction in Payments for Oxygen and Oxygen Equipment. The DRA which was signed into law on February 8, 2006, made certain changes to the way Medicare Part B pays for certain of our HME products, including oxygen and oxygen equipment. For oxygen equipment, prior to the DRA, Medicare made monthly rental payments indefinitely, provided medical need continued. The DRA capped the Medicare rental period for oxygen equipment at 36 months of continuous use, after which time ownership of the equipment would transfer to the beneficiary. For purposes of this cap, the DRA provided for a new 36-month rental period that began January 1, 2006 for all oxygen equipment. In addition to the changes in the duration of the rental period for capped rental items and oxygen equipment, the DRA permitted payments for servicing and maintenance of the products after ownership transfers to the beneficiary.
On November 1, 2006, CMS released a final rule to implement the DRA changes, which went into effect January 1, 2007. Under the rule, CMS clarified the DRA’s 36-month rental cap on oxygen equipment. CMS also revised categories and payment amounts for the oxygen equipment and contents during the rental period and for oxygen contents after equipment ownership by the beneficiary as described below. With the passage of MIPPA on July 15, 2008, transfer of title to oxygen equipment at the end of the 36-month rental cap was repealed, although the rental cap remained in place. Effective January 1, 2009, after the 36th continuous month during which payment is made for the oxygen equipment, the equipment is to continue to be furnished during any period of medical need for the remainder of the reasonable useful lifetime of the equipment. The reasonable useful lifetime for stationary or portable oxygen equipment begins when the oxygen equipment is first delivered to the beneficiary and continues until the point at which the stationary or portable oxygen equipment has been used by the beneficiary on a continuous basis for five years (60 months) provided there are no breaks in service due to medical necessity. Computation of the reasonable useful lifetime is not based on the age of the equipment. During the capped rental period from months 37 through 60 of continuous use, payment is made only for oxygen and for certain reasonable and necessary maintenance and servicing (for parts and labor not covered by the supplier’s or manufacturer’s warranty) (as discussed in more detail below).
Payment for Rental Period. The 2012 and 2011 rate for stationary oxygen equipment is $176.06 and $173.31, respectively. The 2012 and 2011 monthly portable oxygen add-on amount is $29.43 and $28.74, respectively. The 2012 monthly payment amount for oxygen-generating portable oxygen equipment remains unchanged at $51.63 from 2011.
Payment for Contents after 36-Month Rental Cap. Payment is based on the type of equipment owned and whether it is oxygen-generating. CMS pays separate monthly payments $77.45 each for stationary and portable oxygen content. If the beneficiary uses both stationary and portable equipment that is not oxygen-generating, the monthly payment amount for oxygen contents is $154.90. For stationary or portable oxygen equipment that is oxygen-generating, there will be no monthly payment for contents.
Payment for maintenance and service after 36-Month Rental Cap. CMS pays for one in-home, maintenance and service visit for oxygen concentrators and transfilling equipment every six months, beginning six months after the end of the 36-month rental cap. This payment will be made if the supplier visits the beneficiary’s home, performs any necessary maintenance and service, and inspects the equipment to ensure that it will function safely for the next six months. CMS pays for such in-home maintenance and service visits every six months until medical necessity ends or the beneficiary elects to obtain new equipment. Beginning July 1, 2010, the six-month maintenance and service payment rate is capped at 10% of the cost of acquiring a stationary oxygen concentrator, which resulted in a payment of $66 for calendar year 2010. For calendar year 2011 and subsequent years, the maintenance and servicing fee is adjusted by the covered item update for DME, which resulted in a payment of

17



$65.93 for calendar year 2011, and $67.51 for calendar year 2012.
Finally, CMS clarified that though it retains title to the equipment, a supplier is required to continue to furnish needed oxygen equipment and contents for liquid or gaseous equipment after the 36-month rental cap until the end of the equipment’s reasonable useful lifetime. CMS determined the reasonable useful lifetime for oxygen equipment to be five years provided there are no breaks in service due to medical necessity, computed based on the date the equipment is delivered to the beneficiary. On January 27, 2009, CMS posted further instructions on the implementation of the 36-month rental cap, including guidance on payment for oxygen contents after month 36 and the replacement of oxygen equipment that has been in continuous use by the patient for the equipment’s reasonable useful lifetime (as defined above). In accordance with the instructions, and consistent with the final rule published on October 30, 2008, suppliers may bill for oxygen contents on a monthly basis after the 36-month rental cap, and the supplier can deliver up to a maximum of three months of oxygen contents at one time. Additionally, in accordance with these instruction, and consistent with the final rule published on October 30, 2008, we provide replacement equipment to our patients that exceed five years of continuous use.
The ongoing financial impact of the 36-month rental cap will depend upon a number of variables, including, (i) the number of Medicare oxygen customers reaching 36 months of continuous service, (ii) the number of patients receiving oxygen contents beyond the 36-month rental period and the coverage and billing requirements established by CMS for suppliers to receive payment for such oxygen contents, (iii) the mortality rates of patients on service beyond 36 months, (iv) the incidence of patients with equipment deemed to be beyond its reasonable useful life that may be eligible for new equipment and therefore a new rental episode and the coverage and billing requirements established by CMS for suppliers to receive payment for a new rental period, (v) any breaks in continuous use due to medical necessity, and (vi) payment amounts established by CMS to reimburse suppliers for maintenance of oxygen equipment. We cannot predict the impact that any future rulemaking by CMS will have on our business. If payment amounts for oxygen equipment and contents are further reduced in the future, this could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations.
CMS also has authority to make other adjustments to reimbursement for HME. With the passage of the Balanced Budget Act of 1997, CMS may determine to increase or reduce the reimbursement for HME, including oxygen, by up to 15% each year under an inherent reasonableness procedure. The regulation implementing the inherent reasonableness authority establishes a process for adjusting payments for certain items and services covered by Medicare Part B when the existing payment amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and its Medicare contractors to determine whether an existing reimbursement rate is grossly excessive or deficient and to determine what a realistic and equitable payment amount is. Also, under the regulation, CMS and its contractors will not consider a payment amount to be grossly excessive or deficient and make an adjustment if they determine that an overall payment adjustment of less than 15% is necessary to produce a realistic and equitable payment amount. The implementation of the inherent reasonableness procedure itself does not trigger payment adjustments for any items or services and to date, no payment adjustments have occurred or been proposed under this inherent reasonableness procedure.
Though the inherent reasonableness authority has not been exercised, in past years, CMS historically has reduced the published Medicare reimbursement rates for HME to an amount based on the payment amount for the least costly alternative (LCA) treatment that meets the Medicare beneficiary’s medical needs. LCA determinations have been applied to particular products and services by CMS and its contractors through the notice and comment process used in establishing local coverage policies for HME. With respect to its LCA policies, on October 16, 2008, a U.S. District Court in the District of Columbia held that CMS did not have the authority to implement LCA determinations in setting payment amounts for an inhalation drug. This decision was upheld by the U.S. Court of Appeals and, as a result, CMS and its contractors withdrew their LCA policy for the inhalation drug. In addition, CMS instructed its contractors that they may no longer apply LCA policies to any HME. Effective February 4, 2011, all coverage policies have been revised to eliminate their LCA provisions.
During the quarter ended March 31, 2012, management identified an error made in certain programming logic within its billing system. As a result of this error, we determined that we have been overpaid on certain specific Medicare claim types since January 1, 2009. The amount of the overpayment totaled approximately $6.5 million. The programming logic that caused this error has been disabled in our billing system and we are not aware of any other overpayment issues as a result of this or any other programming error. On May 7, 2012, we voluntarily refunded the above described overpayment to the appropriate Durable Medical Equipment Medicare Administrative Contractors (DME MACs) (see “Notes to Unaudited Condensed Consolidated Financial Statements—(1) Basis of Presentation” included herein in Item 1, “Financial Statements”).

18



Results of Operations
The following table shows our results of operations for the three months ended March 31, 2012 and 2011.
 
(unaudited)
 
Three months ended
 
March 31,
 
2012
 
2011
Net revenues
$
116,957

 
$
121,006

Costs and expenses:
 
 
 
Cost of net revenues
37,236

 
39,098

Selling, general and administrative
68,660

 
62,631

Provision for doubtful accounts
10,977

 
5,239

Depreciation and amortization
2,471

 
2,374

Total costs and expenses
119,344

 
109,342

Operating (loss) income
(2,387
)
 
11,664

Other expense (income):
 
 
 
Interest expense, net
14,837

 
14,567

Other income, net

 
(862
)
Loss on debt extinguishment

 
1,216

Total other expense
14,837

 
14,921

Loss before income taxes
(17,224
)
 
(3,257
)
Income tax expense (benefit)
32

 
(64
)
Net loss
(17,256
)
 
(3,193
)
Accrued dividends on convertible redeemable preferred stock
64

 
106

Net loss attributable to common stockholders
$
(17,320
)
 
$
(3,299
)


19



The following table shows our results of operations as a percentage of our net revenues for the three months ended March 31, 2012 and 2011.
 
(unaudited)
 
Three months ended
 
March 31,
 
2012
 
2011
Net revenues
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
Cost of net revenues
31.8
 %
 
32.3
 %
Selling, general and administrative
58.7
 %
 
51.8
 %
Provision for doubtful accounts
9.4
 %
 
4.3
 %
Depreciation and amortization
2.1
 %
 
2.0
 %
Total costs and expenses
102.0
 %
 
90.4
 %
Operating (loss) income
(2.0
)%
 
9.6
 %
Other expense (income):
 
 
 
Interest expense, net
12.7
 %
 
12.0
 %
Other income, net
 %
 
(0.7
)%
Loss on debt extinguishment
 %
 
1.0
 %
Total other expenses
12.7
 %
 
12.3
 %
Loss before income taxes
(14.7
)%
 
(2.7
)%
Income tax expense (benefit)
 %
 
(0.1
)%
Net loss
(14.7
)%
 
(2.6
)%
Accrued dividends on convertible redeemable preferred stock
0.1
 %
 
0.1
 %
Net loss attributable to common stockholders
(14.8
)%
 
(2.7
)%
Three months ended March 31, 2012 as compared to the three months ended March 31, 2011
Total net revenues for the three months ended March 31, 2012 were $117.0 million as compared to $121.0 million for the comparable period in 2011. This net decrease of $4.0 million from the comparable period in 2011 is primarily attributable to:
Decreased nebulizer medication volume and reimbursement totaling approximately $4.1 million;
Decreased net revenue from higher than normal rates of contractual/revenue adjustments totaling approximately $3.9 million resulting largely from delays in obtaining necessary billing paperwork during the implementation of our new order intake system in the second half of 2011; and
Decreased net revenue from Medicare oxygen patients reaching their 36 month rental cap totaling approximately $2.4 million.
These decreases were partially offset by:
Organic growth, primarily in our core oxygen and CPAP product lines totaling approximately $4.0 million; and
Growth associated with patients transitioned onto service with us through equipment and asset purchase transactions totaling $2.7 million.
As of March 31, 2012, revenue generating patients (including patients from equipment and asset purchases) in the core product lines of oxygen and CPAP grew 5% compared to March 31, 2011.
Cost of net revenues totaled $37.2 million for the three months ended March 31, 2012, a decrease of $1.9 million, or 4.8%, from the comparable period in 2011. Cost of net revenues for the three months ended March 31, 2012 and 2011 was comprised of the following:
 

20



 
Three months ended
 
March 31,
 
2012
 
2011
Cost of net revenues:
 
 
 
Product and supply costs
$
22,554

 
$
24,227

Patient service equipment depreciation
12,560

 
12,716

Operating costs
2,122

 
2,155

 
$
37,236

 
$
39,098


The decrease in product and supply costs is primarily attributable to the reduced volume in our nebulizer medication business. Cost of net revenues as a percentage of net revenues was 31.8% for the three months ended March 31, 2012 as compared to 32.3% for the comparable period in 2011.
Selling, general and administrative expenses for the three months ended March 31, 2012 totaled $68.7 million, an increase of $6.0 million, or 9.6%, from the comparable period in 2011. The increase in selling, general and administrative expenses was primarily attributable to:
Incremental salary and benefit costs associated with asset purchases completed since first quarter 2011 totaling approximately $1.3 million;
Annual merit increase and one additional payroll day in first quarter 2012 as compared to the same period in 2011 totaling approximately $1.1 million;
Increased telephone expense of approximately $0.9 million due primarily to the excise tax refund (credit) recorded during the three months ended March 31, 2011;
Increased temporary and contract labor costs totaling approximately $0.9 million primarily associated with addressing the operational backlogs experienced during the implementation of our new order intake system that led to the increase in earned but unbilled accounts receivable as of December 31, 2011;
Additional commissions expense associated with accelerated patient growth in first quarter 2012 as compared to the same period in 2011 totaling approximately $0.6 million; and
Increased vehicle fleet maintenance and fuel costs primarily as a result of higher gas prices totaling approximately $0.6 million.
The provision for doubtful accounts for the three months ended March 31, 2012 totaled $11.0 million, a $5.7 million increase from the comparable period in 2011. As a percentage of net revenues, the provision for doubtful accounts was 9.4% and 4.3% for the three months ended March 31, 2012 and 2011, respectively. This increase is attributable to the factors described below under the heading “Liquidity and Capital Resources.”
Depreciation and amortization for the three months ended March 31, 2012 totaled $2.5 million, an increase of $0.1 million from the comparable period in 2011. This increase was mainly the result of purchased vehicles, including those acquired in conjunction with certain equipment and asset purchase transactions. Depreciation and amortization as a percentage of net revenues increased to 2.1% as compared to 2.0% for the comparable period in 2011.
Net interest expense for the three months ended March 31, 2012 totaled $14.8 million, an increase of $0.3 million from the comparable period in 2011. This increase is primarily the result of the refinancing of the Senior Subordinated Notes with our Senior Second Lien Notes in March 2011. The Senior Second Lien Notes bear interest at 10.5% while the Senior Subordinated Notes bore interest at 9.5%.
Net loss for the three months ended March 31, 2012 was $17.3 million compared to net loss of $3.2 million for the comparable period in 2011. This difference is attributable to the changes in revenue, and costs and expenses described above.
Non-GAAP Financial Measure
We present Adjusted EBITDA as a supplemental measure of our performance that is not required by, or presented in accordance with, generally accepted accounting principles (GAAP) in the United States of America. We define Adjusted EBITDA as net earnings (loss) adjusted for (i) income tax (benefit) expense, (ii) interest expense and (iii) depreciation and amortization, as further adjusted to eliminate the impact of certain items, consistent with definitions provided under our former Senior Facility, that we do not consider indicative of our ongoing operating performance. These further adjustments are itemized below. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. We believe Adjusted EBITDA assists investors and securities analysts in comparing our performance

21



across reporting periods on a consistent basis by excluding items, consistent with definitions provided under our former Senior Facility, that we do not believe are indicative of our core operating performance. However, there may be additional items which are non-recurring as set forth above in Management’s Discussion and Analysis of Financial Condition and Results of Operations. We use Adjusted EBITDA to evaluate the effectiveness of our business strategies. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.
The following table is a reconciliation of Adjusted EBITDA to net loss (in thousands):
 
 
Three months ended
 
March 31,
 
2012
 
2011
Net loss
$
(17,256
)
 
$
(3,193
)
Income tax expense (benefit)
32

 
(64
)
Interest expense
14,842

 
14,718

Depreciation and amortization, including patient service equipment depreciation
15,031

 
15,090

Non-cash equity-based compensation expense
338

 
33

Restructuring related costs(1)
240

 
6

Settlement costs(2)

 
18

Loss on extinguishment of debt(3)

 
1,216

Intake system implementation(4)
8,345

 

 
$
21,572

 
$
27,824

 

(1) 
Restructuring related costs generally consist of severance and location closure costs.
(2) 
Settlement costs incurred outside our ordinary course of business which we do not believe reflect the current and ongoing cash charges related to our operating cost structure.
(3) 
We redeemed our 9.5% Senior Subordinated Notes due April 2012 on March 17, 2011, and recorded a $1.2 million loss on extinguishment of debt related to unamortized debt issue costs.
(4) 
During the second half of 2011, we completed implementation of our new order intake system. In conjunction with our electronic medical record system implemented in 2009, we have redesigned our front-end order intake processes. As a result, we have been able to automate and consolidate many of our historically paper-based processes. However, during the six month implementation process, we experienced extended delays in obtaining certain required payor-specific documentation required to release claims. Such delays were caused by unanticipated operational backlogs associated with our conversion to the new order intake system. These operational backlogs caused our earned but unbilled accounts receivable to increase to approximately $30.5 million during the first quarter of 2012. We implemented numerous operational initiatives designed to eliminate this backlog and as of April 30, 2012, we have reduced the total earned but unbilled receivables to $22.0 million. In the process of reducing our earned but unbilled receivables during the first quarter of 2012, we incurred incremental labor expense including overtime and temporary labor costs of approximately $0.5 million, as well as write-offs of accounts receivable associated with insurance and patient balances of approximately $7.8 million recorded during the three months ended March 31, 2012. Management believes that these implementation issues are substantially resolved and the associated increases in labor costs, contractual/revenue adjustments impacting net revenue, and the provision for doubtful accounts recorded during the three months ended March 31, 2012 are not indicative of our current operating performance and are not expected to recur.
Adjusted EBITDA should not be considered as a measure of financial performance under GAAP, and the items excluded from EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:
Adjusted EBITDA does not reflect our cash expenditures, future requirements for capital expenditures or contractual commitments;
Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
Adjusted EBITDA does not reflect significant interest expense, or the cash requirements necessary to service interest or principal payments on our debts;

22



although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;
non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it as an expense when evaluating our ongoing operating performance for a particular period;
Adjusted EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations; and
other companies in our industry may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.
Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. We compensate for these limitations by relying primarily on our GAAP results and using Adjusted EBITDA only supplementally.
Liquidity and Capital Resources
Net cash provided by operating activities was $6.8 million for the three months ended March 31, 2012, as compared to $3.0 million for the same period in 2011. Our working capital requirements relate primarily to the working capital needed for general corporate purposes. Cash flows and cash on hand were sufficient to fund operations, capital expenditures and required repayments of debt during the three months ended March 31, 2012. Based on current conditions, we believe that the cash generated from our operations and cash balances will be sufficient to meet our working capital, capital expenditure and other cash needs during the next twelve months, including payment of interest amounts on our Senior Secured Notes and Senior Second Lien Notes when due. In addition, we have $10.0 million available under our revolving credit facility which expires March 17, 2014.
Accounts receivable before allowance for doubtful accounts increased to $95.6 million at March 31, 2012 from $90.5 million at December 31, 2011. Allowances for contractual adjustments and doubtful accounts as a percentage of accounts receivable totaled 34.5% and 31.3% as of March 31, 2012 and December 31, 2011, respectively. Days sales outstanding (DSO) in accounts receivable (calculated as of each period end by dividing net accounts receivable by the 90-day rolling average of net revenue) were 58.8 days at March 31, 2012, compared to 58.7 days at December 31, 2011 and 57.8 days at March 31, 2011. There are several factors that continue to impact our DSO:
Significant increases in the number of claims subject to prepayment review, primarily by the Durable Medical Equipment Medicare Administrative Contractors (DME MACs) and Zone Program Integrity Contractors (ZPICs);
Temporary delays in obtaining certain required payor-specific documentation required to release claims. Such delays were caused by unanticipated operational backlogs associated with our conversion to a new order intake system, as further described below;
Increased patient co-payments and deductibles due from customers who are finding it difficult to pay their out-of-pocket charges due to loss of insurance coverage, increases in deductibles and co-payment amounts or reductions in their investment or employment income;
Lengthened initial collection cycles for patients transitioned onto service with our Company through Equipment Purchases. When we purchase equipment from competitors and transition their patients onto service with our Company, we are required to obtain revised paperwork from the patient’s physician, which requires additional resources and time to obtain and thereby extends the collection cycle during the transition period; and
More stringent patient collection standards. We have implemented more stringent collection standards with respect to balances due from patients including enhanced internal collection efforts and utilization of a third-party collection resource. While these changes may result in higher DSO, we believe that our efforts will ultimately result in greater collection of amounts due from patients.
As a result of the impact of the above factors, we increased our overall reserve level for doubtful accounts during the quarter ended March 31, 2012. We continue to work with our third-party vendor to reduce our overall levels of bad debt, as well as internal initiatives to secure co-payment and deductibles amounts from patients.

23



The following tables set forth the percentage breakdown of our accounts receivable by payor and aging category as of March 31, 2012 and December 31, 2011:
March 31, 2012
 
Accounts receivable by payor and aging category:
Government
 
Managed Care
and Other
 
Patient
Responsibility
 
Total
Aged 0-90 days
38
%
 
20
%
 
12
%
 
70
%
Aged 91-180 days
5
%
 
4
%
 
7
%
 
16
%
Aged 181-360 days
3
%
 
3
%
 
6
%
 
12
%
Aged over 360 days
%
 
1
%
 
1
%
 
2
%
Total
46
%
 
28
%
 
26
%
 
100
%
December 31, 2011
 
Accounts receivable by payor and aging category:
Government
 
Managed Care
and Other
 
Patient
Responsibility
 
Total
Aged 0-90 days
37
%
 
20
%
 
8
%
 
65
%
Aged 91-180 days
7
%
 
5
%
 
7
%
 
19
%
Aged 181-360 days
5
%
 
3
%
 
7
%
 
15
%
Aged over 360 days
%
 
%
 
1
%
 
1
%
Total
49
%
 
28
%
 
23
%
 
100
%
Included in accounts receivable are earned but unbilled receivables of $22.2 million at March 31, 2012 and $28.1 million at December 31, 2011. These amounts include $3.7 million at March 31, 2012 and $3.6 million at December 31, 2011 of receivables for which a prior authorization is required but has not yet been received. Delays, ranging from a day 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. In addition to the aforementioned delays, we are required to obtain revised documentation for patients transitioned onto service with us through equipment purchases which results in increased initial billing cycles for these patients. Earned but unbilled receivables are aged from the date of service and are considered in our analysis of historical performance and collectability.
Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review.
Management performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the health care industry and third-party reimbursement, it is possible that management’s estimates could change, which could have an impact on our financial condition, revenues, profit margins, profitability, operating cash flows and results of operations.
We derive a significant portion of our revenues from the Medicare and Medicaid programs and from managed care health plans. Payments for services rendered to patients covered by these programs may be less than billed charges. Revenue is recognized at net realizable amounts estimated to be paid by customers and third-party payors. Our billing system contains payor-specific price tables that reflect the fee schedule amounts in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. For Medicare and Medicaid revenues, as well as most other managed care and private payors, final payment is subject to administrative review and audit. Management makes estimated provisions for adjustments, which may result from administrative review and audit, based upon historical experience. Management closely monitors its historical collection rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information management believes to be available. However, due to the complexities involved in these estimations, actual payments we receive could be different from the amounts we estimate and record.

24



Collection of receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We manage billing and collection of accounts receivable through our own billing and collection centers. In addition, we utilize third-party collection resources to manage collection of amounts due from patients. Our primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We record bad debt expense based on a percentage of revenue using historical Company-specific data. The percentage and amounts used to record bad debt expense and the allowance for doubtful accounts are supported by various methods including current and historical cash collections, bad debt write-offs, and aging of accounts receivable. Accounts are written off against the allowance when all collection efforts (including payor appeals processes) have been exhausted. We routinely review accounts receivable balances in conjunction with our historical contractual adjustment and bad debt rates and other economic conditions which might ultimately affect the collectability of patient accounts when we consider the adequacy of the amounts we record as provision for doubtful accounts. Significant changes in payor mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and results of operations. Further, even if our billing procedures comply with all third-party payor requirements, some of our payors may experience financial difficulties, may delay payments or may otherwise not pay accounts receivable when due, which would result in increased write-offs or provisions for doubtful accounts. If we are unable to collect our accounts receivable on a timely basis, our revenues, profitability and cash flow likely will significantly decline.
Because of continuing changes in the health care industry and third-party reimbursement, it is possible that management’s estimates could change, which could have an impact on revenues, profit margins, profitability, operating cash flows and results of operations. Our future liquidity may be materially adversely impacted by health care reform.
Net cash used in investing activities was $15.9 million for the three months ended March 31, 2012, as compared to $11.5 million for the same period in 2011. We currently have no contractual commitments for capital expenditures over the next twelve months other than to acquire equipment as needed to supply our patients. Our business requires us to make significant capital expenditures relating to the purchase and maintenance of the medical equipment used in our business. Cash paid for capital expenditures totaled approximately $14.9 million for the three months ended March 31, 2012 as compared to $12.9 million for the same period in 2011, including $0.4 million and $4.1 million paid for equipment purchases from competitors exiting the home health care market, respectively. Some of the equipment purchased in these transactions is currently on rent and located in a patient’s home. As such, we have the opportunity to transition such patients onto service with our Company. We also paid $1.0 million and $2.5 million for the three months ended March 31, 2012 and 2011, respectively, for asset purchases from competitors. During the three months ended March 31, 2011 cash used in investing activities included a $4.2 million reduction in our surety bond and letter of credit collateral included in restricted cash.
Refer to the “Notes to Unaudited Condensed Consolidated Financial Statements—(9) Debt” included herein in Item 1, “Financial Statements,” for a complete description of our outstanding indebtedness.
We have outstanding letters of credit totaling $7.5 million as of March 31, 2012 and December 31, 2011. Our letters of credit were cash collateralized at 100% of their face amount as of March 31, 2012 and December 31, 2011. The cash collateral for these outstanding letters of credit is included in restricted cash in our consolidated balance sheet as of March 31, 2012 and December 31, 2011.
Cash flows from financing activities primarily relate to our debt facilities and outstanding debt. Our outstanding debt includes the following:
$225.1 million in aggregate principal amount of Senior Secured Notes, the proceeds of which were used to repay our Senior Facility. The notes mature on October 15, 2015. Interest of 10.75% is payable semi-annually in arrears on April 15 and October 15 of each year. Accrued interest on the Senior Secured Notes totaled $11.3 million and $5.2 million at March 31, 2012 and December 31, 2011, respectively.
$285.3 million in aggregate principal amount of Senior Second Lien Notes, the proceeds of which were used to repay our Senior Subordinated Notes. The notes mature on March 15, 2018. Interest of 10.5% is payable semi-annually in arrears on March 15 and September 15 of each year. We made our regularly scheduled March 15 interest payment of $15.2 million during the three months ended March 31, 2012. Accrued interest on the Senior Second Lien Notes totaled $1.4 million and $9.0 million at March 31, 2012 and December 31, 2011, respectively.
Off-balance Sheet Arrangements and Contractual Obligations
We do not have off-balance sheet arrangements (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

25



Critical Accounting Policies
Refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as presented in our Annual Report on Form 10-K for the year ended December 31, 2011 regarding our critical accounting policies.

Forward-Looking Statements
This report contains certain statements that constitute forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995 and the provisions of section 21E of the Securities Exchange Act of 1934, as amended
(the Exchange Act) and section 27A of the Securities Act of 1933, as amended. These forward-looking statements include all
statements regarding the intent, belief or current expectations regarding the matters discussed in this report and all statements
which are not statements of historical fact. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,”
“projects,” “may,” “will,” “could,” “should,” “would,” variations of such words and similar expressions are intended to identify
such forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties,
contingencies and other factors that could cause results, performance or achievements to differ materially from those stated in
this report. For more information about the nature of forward-looking statements and risks that could affect our future results
and the disclosure provided in this Quarterly Report, please see "Certain Significant Risks and Uncertainties and Significant Events” in Note 8 of the Condensed Consolidated Financial Statements in Part I, Item 1 and Exhibit 99.1, Forward-Looking
Statements, which is incorporated herein by reference.
 
Item 3—Quantitative and Qualitative Disclosures About Market Risk
Our debt as of March 31, 2012 was primarily comprised of our 10.75% Senior Secured Notes due 2015 (the “Senior
Secured Notes”) and our 10.5% Senior Second Lien Notes due 2018 (the "Senior Second Lien Notes"). These debts have fixed
interest rates and, as such, changes in market interest rates affect the fair market value of such outstanding debt but do not
impact our earnings or cash flows.

Item 4—Controls and Procedures
Disclosure Controls and Procedures
As required by Rule 13a-15(b) of the Exchange Act, our management, under the supervision and with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our principal executive officer and principal financial officer have concluded, as of the end of such period, that our disclosure controls and procedures were not effective as of the end of the period covered by this Quarterly Report as a result of the material weakness described below.
Internal Control over Financial Reporting
As required by Rule 13a-15(d) of the Exchange Act, our management, under the supervision and with the participation of our principal executive officer and principal financial officer, has evaluated any changes in our internal control over financial reporting that occurred during the fiscal quarter covered by this report.
Management concluded that as of December 31, 2011, internal control over financial reporting was not effective because of a material weakness in review and reconciliation procedures designed to ensure that certain period end balances reflected in our financial statements agreed to the underlying detailed calculations of such amounts. For example, controls designed to ensure that inventory purchasing discounts are reflected in the proper period between inventory and cost of sales as the associated product is utilized were not operating effectively as of December 31, 2011. During February 2012, our management implemented additional review and reconciliation procedures to ensure that underlying supporting schedules for inventory properly include consideration of purchasing discounts and that such schedules are agreed to the associated financial statement balances. In addition, our management performed additional training for the staff responsible for the preparation of these schedules. Our management also assessed all other monthly review and reconciliation procedures and added additional approval processes to ensure that underlying detailed schedules are fully reconciled and agreed to the associated financial statement balances.
During the quarter ended March 31, 2012, management identified an error made in certain programming logic in 2009 within its billing system that resulted from a failure in controls with respect to adequate documentation of system requirements and quality assurance procedures prior to implementation of the associated programming change. Although management has determined that the financial statement impact of this error was not material for the years ended December 31, 2009, 2010 and 2011, or any of the associated quarterly reporting periods, after taking into account qualitative and quantitative factors relating to the misstatement, management has concluded that as of March 31, 2012 there was a reasonable possibility that a material

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misstatement of the company's annual or interim financial statements would not be prevented or detected on a timely basis. As a result, management has concluded that a material weakness existed as of the end of the period covered by this report.

Subsequent to the first quarter of fiscal year 2012 but prior to the filing of this Quarterly Report on Form 10-Q, we implemented certain changes to our internal control over financial reporting to address the material weakness in our internal
control over financial reporting that was identified during our quarterly review process as described above. Specifically, during April 2012, our management implemented additional review and approval procedures to ensure that system requirements impacting our billing system are reviewed and approved by an oversight board comprised of members of senior management.


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PART II—OTHER INFORMATION

Item 1—Legal Proceedings
Information required for Part II, Item 1 is incorporated herein by reference to the discussion under the heading “Certain Significant Risks and Uncertainties and Significant Events” in Note 8 of the Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q. See also Part I, Item 3 “Legal Proceedings” of our 2011 Annual Report on Form 10-K, filed on March 13, 2012.

Item 1A—Risk Factors
The following two risk factors previously included in our Annual Report on Form 10-K filed on March 14, 2012, are revised to read as follows:
We are subject to periodic audits by governmental and private payors and as such we could be subject to fines, criminal penalties or program exclusions which could have a negative impact on revenues and operations.
We are subject to periodic audits by the Medicare and Medicaid programs, and the oversight agencies for these programs have authority to assert remedies against us if they determine we have overcharged the programs or failed to comply with program requirements. These agencies could seek to require us to repay any overcharges or amounts billed in violation of program requirements, or could make deductions from future amounts otherwise due to us from these programs. Further, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (collectively, the “PPACA”) now requires that overpayments be reported and returned within 60 days of identification of the overpayment. Any overpayment retained after this deadline will now be considered an “obligation” for purposes of the False Claims Act and subject to fines and penalties. On May 7, 2012, we voluntarily refunded $6.5 million to the appropriate Durable Medical Equipment Medicare Administrative Contractors (DME MACs) for overpayments that we received during the period from first quarter of 2009 through and including the first quarter of 2012. These overpayments resulted from a programming error in our billing system. Although we believe that we reported and returned these overpayments within the 60-day period specified by PPACA, we cannot guarantee that these overpayments will not result in action by the Centers for Medicare & Medicaid Services (CMS) or a governmental body that is adverse to our company or business. 
In February 2012, CMS proposed a rule to implement the PPACA requirement that would also create a ten-year “look back period,” for reporting and returning the “identified” overpayment. The proposed rule, if finalized, could require us to expand our record keeping, compliance and reporting processes to comply with the rule’s requirements. We could also be subject to fines, criminal penalties or program exclusions. Private payors also reserve rights to conduct audits and make monetary adjustments. See “Business—Government Regulation” for a discussion of recent efforts by government payors to reduce health care costs.
Failure to maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business, operating results and stock price.
Effective internal control over financial reporting is necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our business and operating results could be harmed. The Sarbanes-Oxley Act of 2002, as well as related rules and regulations implemented by the SEC, have required changes in the corporate governance practices and financial reporting standards for public companies. These laws, rules and regulations, including compliance with Section 404 of the Sarbanes-Oxley Act of 2002, have increased our legal and financial compliance costs and made many activities more time-consuming and more burdensome. The costs of compliance with these laws, rules and regulations have adversely affected our financial results. Moreover, we run the risk of non-compliance, which could have a material adverse effect on our financial condition, revenues, profit margins, profitability, operating cash flows, results of operations or the trading price of our stock.
We have in the past discovered, and may in the future discover, areas of our internal control over financial reporting that need improvement. We have devoted significant resources to remediate any deficiencies we have discovered and improve our internal control over financial reporting. Based upon management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2011, management concluded that our internal control over financial reporting was not effective as of such date because of a material weakness in review and reconciliation procedures designed to ensure that certain period end balances reflected in our financial statements agreed to the underlying detailed calculations of such amounts and that associated amounts were reflected in proper accounting periods. Effective in February 2012, our management believes that it has corrected the primary issues that led to this material weakness by implementing the additional review and reconciliation procedures.
In addition to the foregoing, in May 2012, we returned to CMS an amount equal to $6.5 million for overpayments that we received during the period from first quarter of 2009 through and including the first quarter of 2012. These overpayments resulted from a programming error in our billing system. Although we believe that this error has been fully corrected, our management has concluded that our internal controls over financial reporting were not effective as of March 31, 2012 because

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of this error.
We cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations. Ineffective internal control over financial reporting could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.
Item 6—Exhibits
(a) Exhibits:
 
31.1
  
Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2
  
Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
32.1
  
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
101
  
The following materials from the Quarterly Report on Form 10-Q for Rotech Healthcare Inc. for the quarter ended March 31, 2012, formatted in XBRL (Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets at March 31, 2012 and December 31, 2011; (ii) Condensed Consolidated Statements of Operations for the three months ended March 30, 2012 and 2011; (iii) Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2012 and 2011; and (iv) Notes to Condensed Consolidated Financial Statements*.
 
 
*
  
Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
ROTECH HEALTHCARE INC.
 
 
 
 
 
Dated:
May 15, 2012
By:
 
/s/    PHILIP L. CARTER    
 
 
 
 
Philip L. Carter
 
 
 
 
President and Chief Executive Officer
 
 
 
 
 
Dated:
May 15, 2012
By:
 
/s/    STEVEN P. ALSENE    
 
 
 
 
Steven P. Alsene
 
 
 
 
Chief Financial Officer


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Index to Exhibits
 
Exhibit No.
  
Description
31.1
  
Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2
  
Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
32.1
  
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
101
  
The following materials from the Quarterly Report on Form 10-Q for Rotech Healthcare Inc. for the quarter ended March 31, 2012, formatted in XBRL (Extensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets at March 31, 2012 and December 31, 2011; (ii) Condensed Consolidated Statements of Operations for the three months ended March 30, 2012 and 2011; (iii) Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2012 and 2011; and (iv) Notes to Condensed Consolidated Financial Statements*.
 
 
*
  
Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.


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