UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2005

OR

For the transition period from                            to                           

Commission file number 0-19878

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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý  No o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

INDEX

OPTION CARE, INC. AND SUBSIDIARIES

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PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Option Care, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)

See notes to condensed consolidated financial statements

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Option Care, Inc. and Subsidiaries

Condensed Consolidated Statements of Income

(Unaudited)

(in thousands, except per share amounts)

See notes to condensed consolidated financial statements

4

Option Care, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

See notes to condensed consolidated financial statements

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Option Care, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2005

(Unaudited)

1.              Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

We completed a 3-for-2 split of our common stock on March 31, 2005 for shareholders of record as of March 17, 2005.  All share and per share amounts in this Quarterly Report on Form 10-Q have been adjusted to reflect the pro forma effects of this stock split.

For further information, refer to the consolidated financial statements and footnotes thereto included in Option Care’s Annual Report on Form 10-K for the year ended December 31, 2004.

2.              Long-Term Debt

On November 2, 2004, we completed a $75 million offering of 2.25% convertible senior notes due 2024 in a private placement to qualified institutional buyers.  The initial purchasers were granted the option to purchase up to an additional $11.3 million principal amount of notes and exercised this option in full on November 9, 2004.  We filed a Registration Statement on Form S-3 with the Securities and Exchange Commission on January 24, 2005 registering the notes and the common stock issuable upon conversion of the notes for resale to the public.

The convertible notes are senior unsecured obligations of Option Care and will be convertible into cash and, if applicable, shares of our common stock based on an initial conversion rate of 55.5278 shares per $1,000 principal amount of notes, which represents an initial conversion price of $18.01 per share, subject to adjustment in certain circumstances.  The conversion rate and conversion price were subsequently adjusted to 83.3763 and $11.99 per share, respectively, pursuant to the terms of the notes as a result of our 3-for-2 common stock split on March 31, 2005 and $0.02 per share dividends paid on June 10, 2005 and September 2, 2005.  Note holders may convert their notes into cash and, if applicable, shares of our common stock prior to the stated maturity only under the following circumstances: (1) during any calendar quarter beginning after December 31, 2004, if the closing sale price of our common stock for each of 20 or more consecutive trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 120% of the conversion price in effect on the last trading day of the immediately preceding calendar quarter; (2) during the five business day period after any five consecutive trading day period in which the average trading price per $1,000 principal amount of notes was equal to or less than 97% of the average conversion value of the notes during the note measurement period; (3) upon the occurrence of specified corporate transactions; or (4) if we have called the notes for redemption.  As of September 30, 2005, no triggering event has occurred that would result in the potential conversion of our notes.   In general, upon conversion, the holder of each note will receive the conversion value of the note payable in cash, up to the principal amount of the note, and common stock for the notes’ conversion value in excess of such principal amount (plus an additional cash payout in lieu of fractional shares).  If the notes are surrendered for conversion in connection with certain fundamental changes that occur before November 1, 2009, holders will in certain circumstances also receive a make-whole premium in addition to the cash and shares that holders are otherwise entitled to receive upon conversion.  The convertible senior notes will mature on November 1, 2024 and will not be redeemable by us prior to November 1, 2009.  Holders of the convertible notes may require us to repurchase all or a portion of the convertible notes for cash on November 1, 2009, 2014 and 2019.  Interest will be paid at 2.25% per annum, payable semi-annually in arrears on May 1 and November 1 of each year to the holders of record at the close of business on the preceding April 15 and October 15, respectively.  The notes are senior unsecured obligations and will rank equally with all of our existing and future senior unsecured indebtedness.

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3.              Earnings Per Share Data

The following table sets forth the computation of basic and diluted earnings per share for the periods indicated.  All share and per share amounts reflect the 3-for-2 stock split effective March 31, 2005 for shareholders of record on March 17, 2005. (in thousands, except per share amounts):

4.              Operating Segments

We have one identifiable business segment, with three service lines: specialty pharmacy services; infusion and related healthcare services; and other.

•                  Specialty pharmacy services involve the distribution of injectible and infused pharmaceuticals to treat a wide range of chronic health conditions.  The pharmaceuticals can be directly distributed to the patient’s home or to their physician’s office for in-office administration.  These pharmaceuticals may require refrigeration during shipping as well as special handling to prevent potency degradation.  Patients receiving treatment usually require special counseling and education regarding their condition and treatment program.

•                  Infusion and related healthcare services primarily involve the intravenous administration of medications at the patient’s home or other non-hospital sites such as one of our infusion suites.  Infusion pharmacy services treat a wide range of acute and chronic health conditions, including infections, dehydration, cancer, pain and nutritional deficiencies.  All of our company-owned pharmacies provide infusion pharmacy services.  Some of these pharmacies also provide related healthcare services, such as home health nursing, home hospice services, respiratory therapy services and durable medical equipment.

•                  Other revenue consists of royalties and other fees generated from our franchised pharmacy network, software licensing and support revenue generated by our subsidiary, Management by Information, Inc. (“MBI”) and other miscellaneous revenue.

5.              Significant Customers and Concentration of Credit Risk

We generate the majority of our revenue from managed care contracts and other agreements with commercial third party payors by providing health care services to their members.  Our principal managed care contract is with Blue Cross and Blue Shield of Florida, to whose members we provide infusion pharmacy services and specialty pharmacy services.  The contract may be terminated by either party on 90 days’ notice and, unless terminated, renews annually each September for an additional one-year term.  We also generate revenue from government healthcare programs such as Medicare and Medicaid.

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The following table sets forth information regarding revenue and accounts receivable related to our most significant payors as of the dates and for the periods presented:

(1)          No other payor represents 10% or more of our revenue or accounts receivable as of the dates and for the periods presented.

6.              Seasonal Revenue Trends

Synagis®, one of the specialty pharmaceuticals that we provide to patients, is seasonal.  Synagis® is a drug used for the prevention of respiratory synctial virus (RSV) in high-risk pediatric patients. RSV infection is a seasonal condition, with the season generally lasting from October through April.

Option Care’s quarterly Synagis® revenue for the year 2004 and the first three quarters of 2005 was as follows (amounts in thousands):

7.              Acquisitions

During the quarter ended September 30, 2005, we completed two acquisitions of home infusion pharmacy businesses.  We acquired the assets of the home infusion business of Northwestern Memorial Hospital in Chicago and the assets of our franchise operating in Las Vegas and surrounding areas.  These acquisitions further our goal of expanding our national presence of company-owned infusion pharmacies.  We used $20.2 million in cash upon closing these transactions and may owe up to $7.4 million in additional consideration in 2006, contingent upon the financial performance of the acquired businesses.  We anticipate that any additional consideration will be recorded as goodwill.  Concurrent with our payment of the purchase price for the Las Vegas franchise, we recorded a gain of approximately $500,000 on the early termination and settlement of their pre-existing franchise agreement.  The results of operations of these businesses have been consolidated as of their acquisition dates.  We recorded $18.5 million in goodwill from these transactions, all of which we anticipate will be deductible for income tax purposes.  In addition to the two acquisitions completed in the quarter ended September 30, 2005, we paid additional consideration of $300,000 related to one of our 2004 acquisitions.

We completed two acquisitions of home infusion pharmacies in the quarter ended March 31, 2005 and three during the quarter ended June 30, 2005.  Of these five acquisitions, two were of current franchisees, one was a former franchisee and the other two were independent home infusion providers.  Each acquisition was in support of our goal of expanding the size and geographical coverage of our business, and the results of operations of each was consolidated as of the effect date of its acquisition.  We used cash of $7.1 million in the quarter ended March 31, 2005 and $18.7 million in the quarter ended June 30, 2005 to complete these acquisitions and recorded goodwill of $6.6 million and $13.3 million in each respective quarter, all of which is expected to be deductible for income tax purposes.

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The following table sets forth the allocation of purchase price, in aggregate, for the acquisitions we completed in the quarter and nine months ended September 30, 2005.  This allocation includes approximately $300,000 in additional consideration paid during the quarter and nine months ended September 30, 2005 related to prior year acquisitions.  For certain of our acquisitions, the allocation of purchase price is tentative and subject to adjustment based on final valuation of the acquired assets (amounts in thousands):

(1)   The actual cash paid at closing for acquisitions completed in the quarter ended September 30, 2005 was $19,693, which was net of franchise termination fees valued at $506.

(2)   Liabilities assumed includes estimated additional consideration payable in future periods.

8.              Franchise-related Revenue

Our franchise-related revenue includes: (1) royalties; (2) vendor rebates and administration fees; and (3) franchise settlements and related fees.  Our franchise-related revenue has fluctuated and may continue to fluctuate over time, primarily as a result of franchise acquisitions and terminations.  During the quarter and nine months ended September 30, 2005, we recorded $500,000 and $3.0 million in franchise settlement revenue, respectively, compared to $100,000 and $1.1 million in the corresponding prior year periods.  The current year settlement revenue primarily related to settling the future royalty obligations of franchisees we acquired during the year, with the settlement gain equaling the present value of the excess of the estimated future royalties receivable under the terminated franchise agreement over current market rates.  The prior year settlement revenue was primarily related to our settlement with a franchisee that terminated its franchise agreement early and left our network.

The following table sets forth our franchise-related revenue for the periods indicated (amounts in thousands):

9.              Stock-based Compensation

Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, encouraged, but did not require, companies to record compensation cost for stock-based compensation plans at fair value.  We have chosen to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  Accordingly, compensation expense for stock options is measured as the excess, if any, of the quoted market price of our common stock at the date of grant over the amount an employee must pay to acquire the stock.  We grant options at fair market value and therefore recognize no compensation expense when options are granted.  Likewise, our Employee Stock Purchase Plan was structured to qualify under Section 423 of the Internal Revenue Code. Therefore, no compensation expense is recognized from employees’ purchase of shares under this plan.

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The following table sets forth our net income and net income per common share for the three and nine months ended September 30, 2005 and 2004, had compensation cost for our stock-based compensation plan been determined based on FASB Statement No. 123.  All share and per share amounts in the following table have been adjusted to reflect the pro forma effects of the 3-for-2 split of our common stock that became effective March 31, 2005 for shareholders of record on March 17, 2005 (in thousands, except per share amounts):

The fair value of options granted under our stock option plan during the three and nine months ended September 30, 2005 and 2004 was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions (as pro forma adjusted for our 3-for2 stock split on March 31, 2005):

10.       Recently Issued Accounting Pronouncement

On December 16, 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, which will change the way we account for employee stock options in future periods.  SFAS No. 123(R), which is a revision to SFAS No. 123, Accounting for Stock-Based Compensation, supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.  Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123, but with certain enhancements to improve the accuracy of fair value estimates.  However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.  Pro forma disclosure is no longer an alternative.

SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:

•                  A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.

•                  A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

Initially, the SEC announced that SFAS No. 123(R) must be adopted in the first interim or annual period beginning after June 15, 2005.  Subsequently, on April 14, 2005, the SEC announced that calendar year-end companies will be allowed to delay implementation of the new standard until their first interim period beginning after December 15, 2005.  We will adopt SFAS No. 123(R) in our fiscal quarter ending March 31, 2006.  Adoption of SFAS No. 123(R) may materially affect our results of operations for periods following adoption, but will have no effect on our financial condition.

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11.       Quarterly Dividends

Our Board of Directors initiated a quarterly dividend policy on May 11, 2004.  During the quarter ended September 30, 2005, our Board of Directors declared a $0.02 per share cash dividend paid on September 2, 2005 to shareholders of record as of August 19, 2005.  During the nine months ended September 30, 2005, we have paid cash dividends totaling $0.0533 per share.  During the corresponding period in 2004, we paid cash dividends totaling $0.0267 per share.

12.       Subsequent Events

Effective October 1, 2005, we entered into a joint venture with Legacy Health Systems to operate an infusion pharmacy business in the Portland, Oregon market.  Concurrent with our entry into this joint venture, we also acquired the assets and ongoing operations of Legacy VNA’s home health agency business.  Our initial combined cash investment in these businesses was $1.5 million.  This joint venture and acquisition expand our national presence to include the Portland, Oregon market.

Effective November 1, 2005, we entered into a joint venture with The University Home Care Services Corporation to operate an infusion pharmacy business in Columbus, Ohio.  Our existing infusion pharmacy business in that market is being merged into the joint venture.  Our initial investment into the joint venture was $1.3 million in cash, plus the inventory and other assets of our existing Columbus, Ohio pharmacy.   The objective of this joint venture is the expansion of revenue and improvement of our position in the Columbus, Ohio market.

Effective November 3, 2005, we sold the assets of our wholly-owned subsidiary, Management by Information, Inc. (“MBI”) to Definitive Homecare Solutions, Ltd., which is the largest software provider in the home infusion industry.  The sale price was $1.9 million.

13.       Comprehensive Income

Net income was our only component of comprehensive income for the three and nine months ended September 30, 2005 and 2004.

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD LOOKING STATEMENTS

The following discussion should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2004. The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Certain information included in this Quarterly Report on Form 10-Q and other materials filed or to be filed by us with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by us) contain statements that are or will be forward-looking, such as statements relating to acquisitions and other business development activities, future capital expenditures and the effects of future regulation and competition. Such forward-looking information involves important risks and uncertainties that could significantly affect anticipated results in the future and, accordingly, such results may differ from those expressed in any forward-looking statements made by us, or on our behalf. These risks and uncertainties include, but are not limited to, uncertainties affecting our businesses and our franchisees relating to acquisitions and divestitures (including continuing obligations with respect to completed transactions), sales and renewals of franchises, government and regulatory policies (including federal, state and local efforts to reform the delivery of and payment for healthcare services), general economic conditions (including economic conditions affecting the healthcare industry in particular), the pricing and availability of equipment and services, technological developments and changes in the competitive environment in which we operate.  For a more comprehensive description of risks applicable to our business, see Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2004.

OVERVIEW

We provide specialty pharmacy services and infusion pharmacy and other related healthcare services to patients at home or at other alternate sites such as infusion suites and physician’s offices.  We contract with managed care organizations and other third party payors who reimburse us for the services we provide to their subscriber members.  Our services are provided through our national network of company-owned and independently-owned franchised pharmacies and our two central, high-volume drug distribution facilities.

We have three service lines: specialty pharmacy services, infusion and related healthcare services, and other. Specialty pharmacy services involve the distribution of injectible and infused pharmaceuticals to treat a wide range of chronic health conditions.  The pharmaceuticals can be directly distributed to the patient’s home or to their physician’s office for in-office administration.  Depending on therapy type, we may also administer specialty pharmaceuticals to patients at our ambulatory infusion centers. These pharmaceuticals may require refrigeration during shipping as well as special handling to prevent potency degradation.  Patients receiving treatment usually require special counseling and education regarding their condition and treatment program.  Infusion and related services primarily involves the intravenous administration of medications at the patient’s home or other non-hospital site such as one of our infusion suites.  Infusion pharmacy services treat a wide range of acute and chronic health conditions, including

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infections, dehydration, cancer, pain and nutritional deficiencies.  All of our company-owned pharmacies provide infusion therapies. Some of these pharmacies also provide related healthcare services, such as home health nursing, home hospice services, respiratory therapy services and durable medical equipment.  Other revenue consists primarily of royalties and other fees generated from our franchised pharmacy network and the software licensing and support revenue generated by our subsidiary, MBI, the assets of which were sold effective November 3, 2005.

Summarized information about revenues and gross profit for each of our service lines is provided in the following table (amounts in thousands):

REVENUE

GROSS PROFIT

The majority of our revenue is generated from managed care contracts and other agreements with commercial third party payors.  Our principal managed care contract is with Blue Cross/Blue Shield of Florida. For the three and nine months ended September 30, 2005, approximately 14% of our revenue was generated from this contract compared to 17% and 16%, respectively, for the corresponding prior year periods.  As of September 30, 2005 and December 31, 2004, respectively, 8% and 7% of our accounts receivable were due from Blue Cross Blue Shield of Florida. The contract may be terminated by either party on 90 days’ notice and, unless terminated, renews annually each September for an additional one-year term.

We also generate revenue from government healthcare programs such as Medicare and Medicaid.  For the three and nine months ended September 30, 2005, approximately 15% and 17% of our revenue, respectively, was generated from government healthcare programs compared to 17% and 19% for the corresponding prior year periods.  As of September 30, 2005 and December 31, 2004, respectively, 21% and 18% of our total accounts receivable were due from government healthcare programs.

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RESULTS OF OPERATIONS

The following table shows the results of our operations for the three and nine months ended September 30, 2005 and 2004, expressed in amounts and percentages of revenue (amounts in thousands):