RES-CARE, INC. 10-Q

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005


o		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: 0-20372

RES-CARE, INC.

(Exact name of registrant as specified in its charter)


KENTUCKY (State or other jurisdiction of incorporation or organization)		61-0875371 (IRS Employer Identification No.)

10140 Linn Station Road Louisville, Kentucky (Address of principal executive offices)		40223-3813 (Zip Code)

Registrant’s telephone number, including area code: (502) 394-2100

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 twelve 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 þ No o.

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

The number of shares outstanding of the registrant’s common stock, no par value, as of July 29, 2005, was 26,463,543.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

RES-CARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)


	June 30		December 31
	2005		2004
ASSETS
Current assets:
Cash and cash equivalents	$	23,484	$	28,404
Short-term investments		52,400		53,235
Accounts receivable, net of allowance for doubtful accounts of $8,009 in 2005 and $8,806 in 2004		151,187		138,202
Deferred income taxes		21,476		20,056
Prepaid expenses and other current assets		7,767		12,338

Total current assets		256,314		252,235

Property and equipment, net		72,333		72,975
Goodwill		272,395		241,789
Other assets		22,271		19,667

	$	623,313	$	586,666

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable	$	36,841	$	37,773
Accrued expenses		92,713		77,715
Current portion of long-term debt		4,619		13,481
Current portion of obligations under capital leases		1,041		989
Accrued income taxes		1,801		1,658

Total current liabilities		137,015		131,616

Long-term liabilities		1,088		1,181
Long-term debt		180,076		166,480
Obligations under capital leases		1,052		1,586
Deferred gains		4,092		4,530
Deferred income taxes		13,027		11,712

Total liabilities		336,350		317,105

Commitments and contingencies
Shareholders’ equity:
Preferred shares		46,609		46,609
Common shares		49,240		48,871
Additional paid-in capital		58,352		54,316
Retained earnings		132,762		119,765

Total shareholders’ equity		286,963		269,561

	$	623,313	$	586,666

See accompanying notes to condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)


	Three Months Ended					Six Months Ended
	June 30					June 30
	2005		2004			2005		2004
Revenues	$	269,642	$	250,844		$	528,302	$	496,026
Facility and program expenses		240,204		225,133			472,643		445,595

Facility and program contribution		29,438		25,711			55,659		50,431

Operating expenses:
Corporate general and administrative		10,441		9,526			20,173		19,233
Depreciation and amortization		3,406		3,054			6,737		6,067
Other expense, net		—		749			—		750

Total operating expenses		13,847		13,329			26,910		26,050


Operating income		15,591		12,382			28,749		24,381

Interest expense, net		4,491		4,956			9,057		10,041

Income before income taxes		11,100		7,426			19,692		14,340
Income tax expense		3,774		2,896			6,695		5,385


Net income		7,326		4,530			12,997		8,955

Non-cash beneficial conversion feature		—		(14,784	)		—		(14,784	)
Net income attributable to preferred shareholders		1,130		—			2,012		—

Net income (loss) attributable to common shareholders	$	6,196	$	(10,254	)	$	10,985	$	(5,829	)


Basic earnings (loss) per share	$	0.24	$	(0.40	)	$	0.42	$	(0.23	)

Diluted earnings (loss) per share	$	0.23	$	(0.40	)	$	0.41	$	(0.23	)


Weighted average number of common shares:
Basic		26,360		25,323			26,254		25,150
Diluted		26,971		25,323			26,940		25,150

See accompanying notes to condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)


	Six Months Ended
	June 30
	2005			2004
Cash flows from operating activities:
Net income	$	12,997		$	8,955
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		6,737			6,067
Amortization of deferred debt issuance costs		651			582
Provision for losses on accounts receivable		2,321			2,592
Changes in operating assets and liabilities		2,335			13,395

Cash provided by operating activities		25,041			31,591


Cash flows from investing activities:
Purchases of property and equipment		(5,454	)		(5,217	)
Acquisitions of businesses, net of cash acquired		(28,681	)		(955	)
Proceeds from sales of assets		—			32
Purchases of short-term investments		(239,925	)		(45,000	)
Redemptions of short-term investments		240,760			—

Cash used in investing activities		(33,300	)		(51,140	)


Cash flows from financing activities:
Repayments of long-term debt		(13,245	)		(3,620	)
Borrowings of long-term debt		13,000			—
Proceeds received from exercise of stock options		3,584			3,541
Net proceeds from the issuance of preferred stock		—			46,609

Cash provided by financing activities		3,339			46,530


(Decrease) increase in cash and cash equivalents	$	(4,920	)	$	26,981

See accompanying notes to condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

June 30, 2005
(Unaudited)

Note 1. Basis of Presentation

Res-Care, Inc. and subsidiaries are primarily engaged in the delivery of residential, therapeutic, job training and educational supports services to various populations with special needs. All references in these financial statements to “ResCare,” “our company”, “we,” “us,” or “our” mean Res-Care, Inc. and unless the context otherwise requires, its consolidated subsidiaries.

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

For further information, refer to the consolidated financial statements and footnotes thereto in our annual report on Form 10-K for the year ended December 31, 2004.

Note 2. Reclassification

Certain auction rate securities have been reclassified from cash equivalents to short-term investments. Auction rate securities are variable rate securities tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate securities have rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28, 35, or 49 days. The securities trade at par and are callable at par on any payment date at the option of the issuer. Investment earnings paid during a given period are based upon the reset rate determined during the prior auction.

Although these securities are issued and rated as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. We have historically classified these instruments as cash equivalents if the period between interest rate resets was 90 days or less, which was based on our ability to either liquidate our holdings or roll our investment over to the next reset period.

In March 2005, we determined that our investments in auction rate securities should be classified as short-term investments. Previously, such investments had been classified as cash equivalents. In addition, “Purchases (redemptions) of short-term investments” and “Proceeds from sales and maturities of short-term investments”, included in the accompanying Condensed Consolidated Statements of Cash Flows, have been revised to reflect the purchase and sale of auction rate securities during the periods presented.

Note 3. Long-term Debt

Long-term debt consists of the following:


	June 30		December 31
	2005		2004
	(In thousands)
10.625% senior notes due 2008	$	150,000	$	150,000
Term loan due 2008		28,000		15,000
5.9% convertible subordinated note, paid in March 2005		—		12,759
Notes payable and other		6,695		2,202

		184,695		179,961
Less current portion		4,619		13,481

	$	180,076	$	166,480

Note 4. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings (loss) per common share:


	Three Months Ended					Six Months Ended
	June 30					June 30
	2005		2004			2005		2004
	(In thousands, except per share data)
Net income (loss) attributable to common shareholders	$	6,196	$	(10,254	)	$	10,985	$	(5,829	)


Weighted average number of common shares used in basic earnings per common share		26,360		25,323			26,254		25,150
Effect of dilutive securities:
Stock options		611		—			686		—

Weighted average number of common shares and dilutive potential common shares used in diluted earnings per common share		26,971		25,323			26,940		25,150


Basic earnings (loss) per share	$	0.24	$	(0.40	)	$	0.42	$	(0.23	)

Diluted earnings (loss) per share	$	0.23	$	(0.40	)	$	0.41	$	(0.23	)

During the second quarter of 2005, we issued options to purchase 10,000 shares of common stock at $12.27 per share.

Note 5. Segment Information

Commencing January 1, 2005, as a result of integrating the former Youth Services operating segment into our existing segments, Youth Services is no longer an operating segment. As a result of the dissolution of this segment, as well as the expansion of our job training and placement programs for disadvantaged job seekers, we now have the following three reportable segments: (i) Disabilities Services, (ii) Job Corps Training Services and (iii) Employment Training Services. Disclosures of financial information for each segment follow. Segment disclosures for the three months and six months ended June 30, 2004 have been restated to reflect the change in the composition of our reportable operating segments effective January 1, 2005.


			Job Corps		Employment
		Disabilities	Training		Training		All			Consolidated
		Services	Services		Services		Other ⁽¹⁾			Totals
		(In thousands)
Three months ended June 30:

2005
Revenues	$	213,550	$	37,677	$	16,059	$	2,356		$	269,642
Operating income		21,104		3,999		1,486		(10,998	)		15,591
Total assets		428,124		38,111		31,634		125,444			623,313
Capital expenditures		1,704		—		15		849			2,568
Depreciation and amortization		2,088		—		26		1,292			3,406

2004
Revenues	$	201,795	$	36,600	$	10,867	$	1,582		$	250,844
Operating income		18,605		4,044		961		(11,228	)		12,382
Total assets		372,885		33,687		20,341		140,283			567,196
Capital expenditures		1,442		—		8		1,384			2,834
Depreciation and amortization		1,705		—		8		1,341			3,054

Six months ended June 30:

2005
Revenues	$	420,597	$	74,972	$	28,717	$	4,016		$	528,302
Operating income		40,068		7,955		2,704		(21,978	)		28,749
Capital expenditures		3,022		—		44		2,388			5,454
Depreciation and amortization		4,130		—		53		2,554			6,737

2004
Revenues	$	401,707	$	70,914	$	20,332	$	3,073		$	496,026
Operating income		36,800		7,754		1,931		(22,104	)		24,381
Capital expenditures		2,511		—		12		2,694			5,217
Depreciation and amortization		3,443		—		16		2,608			6,067


⁽¹⁾		All Other is comprised of our international operations, charter schools and corporate general and administrative expenses.

Note 6. Stock-Based Employee Compensation

As permitted by Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123 (SFAS 148), we continue to account for our stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Stock-based employee compensation cost is not reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common shares on the date of the grant. The following table illustrates the effect on net income attributable to common shareholders and earnings per common share if we had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation to stock-based employee compensation.


	Three Months Ended					Six Months Ended
	June 30					June 30
	2005		2004			2005		2004
	(In thousands, except per share data)
Net income (loss) attributable to common shareholders, as reported	$	6,196	$	(10,254	)	$	10,985	$	(5,829	)

Deduct: Total stock-based employee compensation expense determined under fair value method of all awards, net of related tax effects		252		533			504		1,067

Net income (loss) attributable to common shareholders, pro forma	$	5,944	$	(10,787	)	$	10,481	$	(6,896	)


Basic earnings (loss) per common share:
As reported	$	0.24	$	(0.40	)	$	0.42	$	(0.23	)

Pro forma	$	0.23	$	(0.43	)	$	0.40	$	(0.27	)


Diluted earnings (loss) per common share:
As reported	$	0.23	$	(0.40	)	$	0.41	$	(0.23	)

Pro forma	$	0.22	$	(0.43	)	$	0.39	$	(0.27	)

Note 7. Legal Proceedings

From time to time, we, or a provider with whom we have a management agreement, become a party to legal and/or administrative proceedings involving state program administrators and others that, in the event of unfavorable outcomes, may adversely affect revenues and period to period comparisons.

In July 2000, American International Specialty Lines Insurance Company, or AISL, filed a Complaint for Declaratory Judgment against us and certain of our subsidiaries in the U.S. District Court for the Southern District of Texas, Houston Division. In the Complaint, AISL sought a declaration of what insurance coverage was available to ResCare in the case styled In re: Estate of Trenia Wright, Deceased, et al. v. Res-Care, Inc., et al., which was filed in Probate Court No. 1 of Harris County, Texas (the Lawsuit). After the filing, we entered into an agreement with AISL whereby any settlement reached in the Lawsuit would not be dispositive of whether the claims in the Lawsuit were covered under the insurance policies issued by AISL. AISL thereafter settled the Lawsuit for $9.0 million. It is our position

that: (i) the Lawsuit initiated coverage under policies of insurance in more than one policy year, thus affording adequate coverage to settle the Lawsuit within coverage and policy limits, (ii) AISL waived any applicable exclusions for punitive damages by its failure to send a timely reservation of rights letter and (iii) the decision by the Texas Supreme Court in King v. Dallas Fire Insurance Company, 85 S.W.3d 185 (Tex. 2002) controls. Prior to the Texas Supreme Court’s decision in the King case, summary judgment was granted in favor of AISL but the scope of the order was unclear. Based on the King decision, the summary judgment was set aside. Thereafter, subsequent motions for summary judgment filed by both AISL and ResCare were denied. The case was tried, without a jury, in late December 2003. On March 31, 2004, the Court entered a judgment in favor of AISL in the amount of $5.0 million. It is our belief that the Court improperly limited the evidence ResCare could place in the record at trial and the type of claims it could present. Accordingly, an appeal of the Court’s decision has been filed with the Fifth Circuit Court of Appeals and a supersedeas bond has been filed with the Court of $6.0 million. The Court has set oral arguments for the week of August 29, 2005. We have not made any provision in our condensed consolidated financial statements for any potential liability that may result from final adjudication of this matter, as we do not believe it is probable that an unfavorable outcome will result from this matter. Based on the advice of counsel, we do not believe it is probable that the ultimate resolution of this matter will result in a material liability to us nor have a material adverse effect on our consolidated financial condition, results of operations or liquidity.

On September 2, 2001, in a case styled Nellie Lake, Individually as an Heir-at-Law of Christina Zellner, deceased; and as Personal Representative of the Estate of Christina Zellner v. Res-Care, Inc., et al., in the U.S. District Court of the District of Kansas at Wichita, a jury awarded noneconomic damages to Ms. Lake in the amount of $100,000, the statutory maximum, as well as $5,000 for economic loss. In addition, the jury awarded the Estate of Christina Zellner $5,000 of noneconomic damages and issued an advisory opinion recommending an award of $2.5 million in punitive damages. The judge, however, was not required to award the amount of punitive damages recommended by the jury and on February 4, 2002, entered a punitive damage judgment in the amount of $1 million. Based on the advice of counsel, we appealed the award of punitive damages, based on numerous appealable errors at trial and have since settled the case, without any contribution from AISL, for approximately $750,000. Prior to settlement, in July 2002 we filed a Declaratory Judgment action against AISL in the United States District Court for the Western District of Kentucky, Louisville Division, alleging that the policy should be interpreted under Kentucky law, thus affording us coverage for $650,000 that AISL contends is not covered by insurance. We have since sought leave of court to amend our complaint for breach of contract, bad faith insurance practices, as well as unfair claims practices under applicable Kentucky statutes. In addition, we have filed a motion for judgment on the pleadings in regard to its declaration of rights action. In the interim, AISL filed a motion to transfer this action to the District of Kansas which was granted. We filed a writ of mandamus with the Sixth Circuit Court of Appeals asking that the Western District of Kentucky be required to retain jurisdiction, which was denied. AISL filed a motion for summary judgment, which was also denied. Our motion to amend our complaint was granted. Based on the advice of counsel, we believe any damages resulting from this matter are covered by insurance. We previously established a reserve in our condensed consolidated financial statements for any potential liability that may reasonably result from final adjudication of this matter. Further, we believe that recovery of the settlement is probable and, therefore we do not believe that the ultimate resolution of this matter will have a material adverse effect on our consolidated financial condition, results of operations or liquidity.

On June 21, 2002, we were notified that our mental health services subsidiary was the subject of an investigation concerning allegations relating to services provided by the subsidiary under various programs sponsored by Medicaid. The subsidiary under investigation is a non-core operation that

provides skills training to persons with severe mental illness in Texas. The mental health operation, which was acquired in a 1999 transaction, was managed by its founders under a management contract until September 30, 2003 and represents less than 0.5% of the total revenues of the Disabilities Services division. During the third quarter of 2002, we received a Civil Investigative Demand from the Texas Attorney General (TAG) requesting the production of a variety of documents relating to the subsidiary. The aforementioned investigation was a result of a Civil False Claims Act lawsuit filed under seal by a former employee of the subsidiary on June 18, 2001, on behalf of the employee, the United States Government and the State of Texas. The lawsuit, styled United States of America and State of Texas, ex rel. Jennifer Hudnall vs. The Citadel Group, Inc., et al. was filed in the United States District Court for the Northern District of Texas, Dallas Division. On June 21, 2002, the seal was partially lifted for the sole purpose of informing us of the lawsuit. In March 2003, the TAG intervened in the case and in May 2003 filed a separate complaint under seal. In July 2003, the U.S. Department of Justice notified us that they were not intervening in the case but would remain a real party in interest. On November 6, 2003, the U.S. District Court lifted the seal, thus making the lawsuit public. We cooperated with the TAG in providing requested documents and engaged special counsel to conduct an internal investigation of the allegations. Based on the results of our investigation, we believe that the subsidiary complied with the applicable rules and regulations governing the provision of mental health services in the State of Texas. In June, 2005, the lawsuit was settled without any admission of wrongdoing for an amount previously reserved in our consolidated financial statements.

In July 2002, Lexington Insurance Company (Lexington) filed a Complaint for Declaratory Action against one of our subsidiaries, EduCare Community Living Corporation – Gulf Coast, in the U.S. District Court for the Southern District of Texas, Houston Division. In the Complaint, Lexington sought a declaration of what insurance coverage was available in the case styled William Thurber and Kathy Thurber, et al v. EduCare Community Living Corporation – Gulf Coast (EduCare), which was filed in the 23^rd Judicial District Court of Brazoria County, Texas. After the filing, we entered into an agreement with Lexington whereby any settlement reached in Thurber would not be dispositive of whether the claims were covered by insurance. Lexington and EduCare thereafter contributed $1.0 million and $1.5 million, respectively, and settled the Thurber lawsuit. In the declaratory judgment action, Lexington contends that the $1.0 million previously paid satisfies all coverage obligations. Both EduCare and Lexington filed motions for summary judgment and the Court on January 10, 2005, entered a judgment in favor of Lexington. EduCare has appealed the judgment and Lexington has filed a cross-appeal for the denial of their attorney fees in the amount of $127,000. After consulting with outside counsel, we expect $1.0 million of our contribution to the settlement to be reimbursed by Lexington under the primary policy. We previously established a reserve of $0.5 million in the condensed consolidated financial statements for any potential liability that may reasonably result from final adjudication of this matter. Further, we believe that recovery of the net $1.0 million of the settlement is probable and, therefore, based on the advice of counsel, we do not believe that the ultimate resolution of this matter will have a material adverse effect on our consolidated financial condition, results of operations or liquidity.

In August 1998, with the approval of the State of Indiana, we relocated approximately 100 individuals from three of our larger facilities to community-based settings. In June 1999, in a lawsuit styled Omega Healthcare Investors, Inc. v. Res-Care Health Services, Inc., the lessor of these facilities filed suit against us in U.S. District Court, Southern District of Indiana, alleging in connection therewith breach of contract, conversion and fraudulent concealment. In January 2001, January 2002 and July 2002, Omega filed amended complaints alleging wrongful conduct in the appraisal process for the 1999 purchase of three other facilities located in Indiana, for conversion of the Medicaid certifications of the

1998 Indiana facilities and a facility in Kentucky that downsized in 1999, and for breach of contract in allowing the Kentucky facility to be closed. The parties had filed various motions for partial summary judgment. The Court denied Omega’s motion seeking summary judgment on breach of contract on the termination of the three Indiana facility leases in 1998, the Kentucky lease termination and the 1999 purchase of three facilities in Indiana. In addition, the Court has granted ResCare’s motion on the “unjust enrichment” and “conversion” of the Medicaid certifications, as well as the lease termination of the Kentucky facility and the alleged wrongful conduct in the appraisal process. The case previously set for trial in October 2004 has been rescheduled for October 2005. On the advice of counsel, we believe that the amount of damages being sought by the plaintiffs is now approximately $3.7 million. We established a reserve in our condensed consolidated financial statements for any potential liability that may reasonably result from final adjudication of this matter. Further, we believe that this lawsuit is without merit and will defend it vigorously. We do not believe it is probable that the ultimate resolution of this matter will have a material adverse effect on our consolidated financial condition, results of operations or liquidity.

In addition, we are a party to various other legal and/or administrative proceedings arising out of the operation of our facilities and programs and arising in the ordinary course of business. We believe that, generally, these claims are without merit. Further, many of such claims may be covered by insurance. We do not believe the results of these proceedings or claims, individually or in the aggregate, will have a material adverse effect on our consolidated financial condition, results of operations or liquidity.

Note 8. Impact of Recently Issued Accounting Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) (SFAS 123(R)), Share-Based Payments, which is a revision of SFAS 123. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25 and amends SFAS 95, Statement of Cash Flows. Generally, the approach to accounting for share-based payments in SFAS123(R) is similar to the approach described in SFAS 123 which, as discussed above and as allowed by SFAS 123, we have applied for pro forma purposes in the notes to the condensed consolidated financial statements. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS 123(R) is effective for public companies at the beginning of the first annual period beginning after June 15, 2005.

SFAS 123(R) permits public companies to account for share-based payments using one of two methods: modified-prospective method or modified-retrospective method. Under the modified-prospective method, compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date.

Under the modified-retrospective method, which includes the requirements of the modified prospective method described above, companies are permitted to restate, based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

We plan to adopt SFAS 123(R) no later than January 1, 2006 using the modified-prospective method. Currently, we use the Black-Scholes formula to estimate the value of stock options granted to employees and expect to continue to use this acceptable option valuation model upon the required adoption of SFAS 123(R) for all unvested options at the date of adoption. We are still evaluating other allowable valuation models for future awards. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as previously described in the disclosure of pro forma net income and earnings per share. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current rules. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.

Note 9. Change in Estimate

Effective April 1, 2005, we changed the rate used to discount our estimates of workers’ compensation claims reserves. The rate was decreased from 6.0% to 5.0%, reflecting our claims payment experience and the current interest rate environment. The decrease in the discount rate decreased net income for the quarter by approximately $0.3 million, or $0.01 per diluted share.

Note 10. Acquisitions

During the six months ended June 30, 2005, we completed nine acquisitions with aggregate estimated annual revenues of approximately $33.5 million for an aggregate purchase price of approximately $33.2 million, which was funded through $28.7 million in cash and $4.5 million in promissory notes issued to sellers. The acquisitions are consistent with our strategic goals of expanding our core disabilities services to greater populations and to leverage existing capacity in our operations. As a result of these acquisitions, goodwill increased $30.6 million from December 31, 2004. Intangible assets were assigned a value of approximately $2.7 million for these acquisitions, principally for customer contracts and non-competition agreements. The allocations of purchase price are preliminary and will be subjected to further analysis during the second half of 2005.

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

Overview

The following Management’s Discussion and Analysis (“MD&A”) Section is intended to help the reader understand ResCare’s financial performance and condition. MD&A is provided as a supplement to, and should be read in conjunction with, our Condensed Consolidated Financial Statements and the accompanying notes. All references in this MD&A to “ResCare”, “our company”, “we”, “us”, or “our” mean Res-Care, Inc. and unless the context otherwise requires, its consolidated subsidiaries. The individual sections of MD&A are:

	•		Our Business — a general description of our business and revenue sources.

	•		Application of Critical Accounting Policies — a discussion of accounting policies that require critical judgments and estimates.

	•		Quarter in Review — highlights of the past quarter.

	•		Results of Operations — an analysis of our consolidated results of operations for the periods presented including analysis of our operating segments.

	•		Financial Condition, Liquidity and Capital Resources — an analysis of cash flows, sources and uses of cash and financial position.

	•		Contractual Obligations and Commitments — a tabular presentation of our contractual obligations and commitments for future periods.

	•		Certain Risk Factors — a discussion of various factors and forces that may impact future performance and results.

	•		Forward—Looking Statements — cautionary information about forward-looking statements and a description of certain risks and uncertainties that could cause our actual results to differ materially from historical results or our current expectations or projections.

Our Business

We receive revenues primarily from the delivery of residential, training, educational and support services to various populations with special needs. As of January 1, 2005, we have three reportable operating segments: (i) Disabilities Services; (ii) Job Corps Training Services and (iii) Employment Training Services. Management’s discussion and analysis of each segment is included below. Further information regarding our segments is included in Note 5 of the Notes to Condensed Consolidated Financial Statements.

Revenues for our Disabilities Services operations are derived primarily from state Medicaid programs and from management contracts with private operators, generally not-for-profit providers, who contract with state government agencies and are also reimbursed under the Medicaid program. We also

provide respite, therapeutic and other services on an as-needed basis or hourly basis through our periodic in-home services programs that are reimbursed on a unit-of-service basis. Reimbursement varies by state and service type, and may be based on a variety of methods including flat-rate, cost-based reimbursement, per person per diem, or unit-of-service basis. Generally, rates are adjusted annually based upon historical costs experienced by us and by other service providers, or economic conditions and their impact on state budgets. At facilities and programs where we are the provider of record, we are directly reimbursed under state Medicaid programs for services we provide and such revenues are affected by occupancy levels. At most facilities and programs that we operate pursuant to management contracts, the management fee is negotiated with the provider of record.

We operate vocational training centers under the federal Job Corps program administered by the Department of Labor (DOL) through our Job Corps Training Services operations. Under Job Corps contracts, we are reimbursed for direct facility and program costs related to Job Corps center operations, allowable indirect costs for general and administrative costs, plus a predetermined management fee. The management fee can take the form of a fixed contractual amount or be computed based on certain performance criteria. All of such amounts are reflected as revenue, and all such direct costs are reflected as facility and program costs. Final determination of amounts due under Job Corps contracts is subject to audit and review by the DOL, and renewals and extension of Job Corps contracts are based in part on performance reviews.

We operate job training and placement programs that assist disadvantaged job seekers in finding employment and improving their career prospects through our Employment Training Services operations. These programs are funded through performance-based or fixed-fee contracts from local and state governments.

Application of Critical Accounting Policies

Our discussion and analysis of the financial condition and results of operations are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.

We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements. Management has discussed the development, selection, and application of our critical accounting policies with our Audit Committee.

Valuation of Accounts Receivable

Accounts receivable consist primarily of amounts due from Medicaid programs, other government agencies and commercial insurance companies. An estimated allowance for doubtful accounts receivable is recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, we consider a number of factors, including historical loss rates, age of the accounts, changes in collection patterns, the status of

ongoing disputes with third-party payors, general economic conditions and the status of state budgets. Complex rules and regulations regarding billing and timely filing requirements in various states are also a factor in our assessment of the collectibility of accounts receivable. Actual collections of accounts receivable in subsequent periods may require changes in the estimated allowance for doubtful accounts. Changes in these estimates are charged or credited to the results of operations in the period of the change of estimate. There were no material changes in our method of providing for reserves for doubtful accounts during 2005.

Reserves for Insurance Risks

We self-insure a substantial portion of our professional, general and automobile liability, workers’ compensation and health benefit risks. Provisions for losses for these risks are based upon actuarially determined estimates. The allowances for these risks include an amount determined from reported claims and an amount based on past experiences for losses incurred but not reported. Estimates of workers’ compensation claims reserves are discounted using a discount rate of 5% at June 30, 2005, which compares to a discount rate of 6% used at December 31, 2004. The decrease in the discount rate of 100 basis points increased the reserve, and resulting expense, by approximately $0.5 million. These liabilities are necessarily based on estimates and, while we believe that the provision for loss is adequate, the ultimate liability may be more or less than the amounts recorded. The liabilities are reviewed quarterly and any adjustments are reflected in earnings in the period known. Except as discussed above regarding the discount rate, there were no material changes in our method of providing reserves for insurance risks during 2005.

Legal Contingencies

We are party to numerous claims and lawsuits with respect to various matters. The material legal proceedings in which ResCare is currently involved are described in Note 7 to the Condensed Consolidated Financial Statements. We provide for costs related to contingencies when a loss is probable and the amount is reasonably determinable. We confer with outside counsel in estimating our potential liability for certain legal contingencies. While we believe our provision for legal contingencies is adequate, the outcome of legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that exceed our estimates. There were no material changes to our method of providing reserves for legal contingencies during 2005.

Valuation of Long-Lived Assets

We regularly review the carrying value of long-lived assets with respect to any events or circumstances that indicate a possible inability to recover their carrying amount. Indicators of impairment include, but are not limited to, loss of contracts, significant census declines, reductions in reimbursement levels and significant litigation. Our evaluation is based on cash flow, profitability and projections that incorporate current or projected operating results, as well as significant events or changes in the reimbursement and regulatory environment. If circumstances suggest the recorded amounts cannot be recovered, the carrying values of such assets are reduced to fair value based upon various techniques to estimate fair value. We recorded no material asset valuation losses during 2005.

Goodwill

With respect to businesses we have acquired, we evaluate the costs of purchased businesses in excess of net assets acquired (goodwill) for impairment at least annually as of year end, unless significant changes in circumstances indicate a potential impairment may have occurred sooner. We are required to test goodwill on a reporting unit basis. We use a fair value approach to test goodwill for impairment and recognize an impairment charge for the amount, if any, by which the carrying amount of goodwill exceeds its implicit fair value. Fair values are established using a weighted average of comparative market multiples in the current market conditions and discounted cash flows.

Discounted cash flow computations depend on a number of factors including estimates of future market growth and trends, forecasted revenue and costs, expected periods the assets will be utilized, appropriate discount rates and other variables. We base our fair value estimates on assumptions we believe to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates. The discount rate used as of December 31, 2004, the date of our annual impairment evaluation, was 10.3%. A variance in the discount rate could have a significant impact on the variance analysis. In addition, we make certain judgments about the selection of comparable companies used in determining market multiples in valuing our reporting units, as well as certain assumptions to allocate shared assets and liabilities to calculate values for each of our reporting units. No valuation losses were recorded during 2005.

Revenue Recognition

Disabilities Services. Revenues are derived primarily from state Medicaid programs, other government agencies, commercial insurance companies and from management contracts with private operators, generally not-for-profit providers, who contract with state agencies and are also reimbursed under the Medicaid programs. Revenues are recorded at rates established at or before the time services are rendered. Revenue is recognized in the period services are rendered.

Job Corps Training Services. Revenues include amounts reimbursable under cost reimbursement contracts with the DOL for operating Job Corps centers. The contracts provide reimbursement for all facility and program costs related to operations, allowable indirect costs for general and administrative costs, plus a predetermined management fee, normally a combination of fixed and performance-based. Final determination of amounts due under the contracts is subject to audit and review by the applicable government agencies. Revenue is recognized in the period associated costs are incurred and services are rendered.

Employment Training Services. Revenues are derived primarily through performance-based or fixed-fee contracts with local and state governments. Revenue is recognized in the period in which services are rendered.

Laws and regulations governing the government programs and contracts are complex and subject to interpretation. As a result, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term. For each operating segment, expenses are subject to examination by agencies administering the contracts and services. We believe that adequate provisions have been made for potential adjustments arising from such examinations. There were no material changes in the application of our revenue recognition policies during 2005.

Quarter in Review

Revenues for the quarter were $269.6 million, net income was $7.3 million, and cash provided from operations was $4.4 million. These items are discussed in more detail in the following sections of the MD&A.

The following highlights some of the events of the past quarter:

	•		For the quarter ended June 30, 2005, the Disabilities Services segment acquired six new operations which complement our core business in this division. These operations are expected to generate annual revenues of approximately $33.5 million and provide services to approximately 1,500 consumers.

	•		During the quarter, our Employment Training Services segment was awarded a $14.5 million, two-year contract with three one-year renewal options to run the Northlands Job Corps Center in Vergennes, Vermont. The Northlands Job Corps Center serves approximately 280 students in northwest Vermont. In addition, Employment Training Services was awarded a $29.5 million, two-year contract with three one-year renewal options to continue operating the Guthrie Job Corps Center in Guthrie, Oklahoma.

Results of Operations


	Three Months Ended						Six Months Ended
	June 30						June 30
	2005			2004			2005			2004
	(Dollars in thousands)
Revenues:
Disabilities Services	$	213,550		$	201,795		$	420,597		$	401,707
Job Corps Training Services		37,677			36,600			74,972			70,914
Employment Training Services		16,059			10,867			28,717			20,332
Other		2,356			1,582			4,016			3,073

Consolidated	$	269,642		$	250,844		$	528,302		$	496,026


Labor Cost as % of Revenues:
Disabilities Services		62.6	%		63.0	%		63.0	%		62.9	%
Job Corps Training Services		49.7	%		49.4	%		50.0	%		50.3	%
Employment Training Services		53.7	%		41.6	%		54.3	%		42.5	%
Consolidated		62.2	%		62.1	%		62.6	%		62.6	%

Operating Income:
Disabilities Services	$	21,104		$	18,605		$	40,068		$	36,800
Job Corps Training Services		3,999			4,044			7,955			7,754
Employment Training Services		1,486			961			2,704			1,931
Corporate and Other		(10,998	)		(11,228	)		(21,978	)		(22,104	)

Consolidated	$	15,591		$	12,382		$	28,749		$	24,381


Operating Margin:
Disabilities Services		9.9	%		9.2	%		9.5	%		9.2	%
Job Corps Training Services		10.6	%		11.0	%		10.6	%		10.9	%
Employment Training Services		9.3	%		8.8	%		9.4	%		9.5	%

Consolidated

Consolidated revenues for the second quarter and six months ended June 30, 2005 increased 7% over the same periods in 2004. As more fully described in the segment discussions below, these increases are attributed primarily to growth in our periodic in-home services, growth in our job training and placement programs and revenue from acquisitions.

Operating income for the second quarter of 2005 and the six months ended June 30, 2005, increased 26% and 18%, respectively, over the same periods in 2004. These increases are attributed to the growth areas described above, and favorable cost control trends in the second quarter of 2005.

As a percentage of total revenues, corporate general and administrative expenses for the second quarter and six months ended June 30, 2005, were 3.9% and 3.8%, respectively, generally consistent with 3.8% and 3.9% for the year earlier periods.

Net interest expense decreased $0.5 million for the second quarter of 2005 and $1.0 million for the six months ended June 30, 2005, compared to the same periods in 2004. This decrease is primarily due to increased interest income from cash and short-term investments of approximately $0.3 million and $0.7 million as compared to the prior year periods, respectively.

Our effective income tax rate for the second quarter and six months ended June 30, 2005 is 34%, as compared to 39% and 37.6%, in the comparable periods of 2004, respectively. The effective rates for 2005 and 2004 are lower than the statutory rate principally due to non-taxable investment income and the benefit of jobs credits. The prior year period did not include the benefit of the jobs tax credits due to a delay in passage of related legislation.

Net income for the quarter increased 62% to $7.3 million, versus $4.5 million for the year earlier period. For the six months ended June 30, 2005, net income increased 45% to $13.0 million, versus $9.0 million in 2004. Diluted earnings per share for the quarter and six months were $0.23 and $0.41, respectively, as compared to a loss per common share of $0.40 and $0.23 for the comparable periods in 2004. The loss per common share in 2004 is related to the non-cash beneficial conversion feature related to the issuance of convertible preferred stock.

Disabilities Services

Disabilities Services revenues for the quarter and six months ended June 30, 2005, increased by 6% and 5%, respectively, over the same periods in 2004. Periodic in-home services revenues increased $7.3 million from the year earlier quarter and $10.6 million over the year earlier six months. Operating margin increased for the quarter from 9.2% in the same period of 2004 to 9.9% in the same period in 2005. For the six months ended June 30, 2005, operating margin increased from 9.2% to 9.5% over the year earlier period. These increases were due primarily to continued growth in the higher margin periodic in-home services. Additionally, labor costs decreased slightly as a percent of revenues for the second quarter and remained essentially the same for the six months ended June 30, 2005. Further, insurance costs, including workers’ compensation, decreased as a percent of revenue approximately 36 basis points in the second quarter compared to the prior year.

Job Corps Training Services

Job Corps Training Services revenues increased 3% and 6%, respectively, for the quarter and six months ended June 30, 2005 over the same periods in 2004. The increase for the second quarter is attributable to increased spending across various Job Corps centers. The increase for the six-month period is primarily attributable to the addition of the Homestead Job Corps center in April 2004 which resulted in incremental revenues of approximately $2.7 million. Operating margins decreased slightly from the comparable period in 2004 due in part to changes in the DOL’s incentive-based payments. The performance criteria in place in 2005 are more restrictive than in 2004 in an effort by the DOL to contain costs.

Employment Training Services

Employment Training Services revenues increased 48% and 41%, respectively, in the second quarter and six months ended June 30, 2005 over the same periods in 2004 and operating income for this segment increased 55% for the quarter and 40% for the six months ended June 30, 2005, over the year earlier periods. These increases are due primarily to the acquisition of the operations of TTI America (TTI) in the fourth quarter of 2004 and a new contract in New York City. TTI and the New York City contract added combined revenues of $8.1 million and $13.5 million in the second quarter and six months ended June 30, 2005, respectively. Operating margin increased slightly over the year earlier periods due to the items mentioned above, offset by start-up expenses on the New York City contract.

Financial Condition, Liquidity and Capital Resources

Total assets increased 6% in 2005 over 2004. As described below, accounts receivable increased from revenues associated with the acquisitions and contract awards during the first half of 2005. During the first half of 2005, we completed nine acquisitions with aggregate estimated annual revenues of $33.5 million. As a result of these acquisitions, goodwill increased $30.6 million from December 31, 2004.

During the six months ended June 30, 2005, cash, cash equivalents and short-term investments decreased by $5.8 million. Cash provided by operating activities for the six months ended June 30, 2005 was $25.0 million compared to $31.6 million for 2004. The decrease in 2005 from 2004 was primarily the result of growth in Employment Training Services and related accounts receivable growth.

Days revenue in net accounts receivable were 50 days at June 30, 2005 compared with 48 days at December 31, 2004. Net accounts receivable at June 30, 2005 increased to $151.2 million, compared to $138.2 million at December 31, 2004. The increase in net accounts receivable is primarily due to revenue growth associated with the acquisitions and contract awards. Of the total net accounts receivable balance at June 30, 2005, approximately 6% were greater than 360 days as compared to 7% at December 31, 2004.

During the six months ended June 30, 2005, cash used in investing activities was $33.3 million primarily from acquisitions of $28.7 million. For the same period in 2004, cash used in investing activities was $51.1 million, primarily from the purchase of short-term investments of $45.0 million.

Financing activities for the six months ended June 30, 2005 resulted in cash provided of $3.3 million, primarily related to repayments on short-term debt being funded by long-term debt and proceeds from the exercise of stock options.

Our capital requirements relate primarily to our plans to expand through selective acquisitions and the development of new facilities and programs, and our need for sufficient working capital for general corporate purposes. Since most of our facilities and programs are operating at or near capacity, and budgetary pressures and other forces are expected to limit increases in reimbursement rates we receive, our ability to continue to grow at the current rate depends directly on our acquisition and development activity. We have historically satisfied our working capital requirements, capital expenditures and scheduled debt payments from our operating cash flow and utilization of our credit facility. The funds provided by the issuance of preferred stock in June 2004 are an additional source of financing for our acquisition and development activities.

We have a $135 million senior credit facility due in January 2008 which includes a $100 million revolver and a $35 million term loan. As of June 30, 2005, $28.0 million was drawn on the term loan and we had irrevocable standby letters of credit in the principal amount of $51.1 million issued primarily in connection with our insurance programs. As of June 30, 2005, we had $48.9 million available under the revolver, as our borrowing base under the revolver was $100.0 million on that date. Our borrowing base is a function of our accounts receivable balance as of the reporting date. The facility contains various financial covenants relating to net worth, capital expenditures and rentals and requires us to maintain specified ratios with respect to fixed charge coverage and leverage. We are in compliance with our debt covenants as of June 30, 2005. Our ability to achieve the thresholds provided for in the financial covenants largely depends upon the maintenance of continued profitability and/or reductions of amounts borrowed under the facility, and continued cash collections.

As of June 30, 2005 and December 31, 2004, included in our cash and cash equivalents balance is $9.0 million of cash held on deposit with an insurance carrier as collateral for our insurance program. In accordance with our collateral arrangement with the insurance carrier, such deposit may be exchanged at our discretion for a letter of credit.

Operating funding sources are approximately 79% through Medicaid reimbursement, 14% from the DOL, 4% from other government agencies, and the remaining 3% from various sources including private payors. We believe our sources of funds through operations and available through the credit facility described above will be sufficient to meet our working capital, planned capital expenditure and scheduled debt repayment requirements for the next twelve months.

Contractual Obligations and Commitments

Information concerning our contractual obligations and commercial commitments follows (in thousands):


	Payments Due by Period
Contractual Obligations	Twelve Months Ending June 30
									2011 and
	Total		2006		2007-2008		2009-2010		Thereafter
Long-term Debt	$	184,695	$	4,619	$	29,896	$	150,161	$	19
Capital Lease Obligations		2,093		1,041		847		175		30
Operating Leases		135,300		30,022		43,371		28,686		33,221
Purchase Contracts		¾		¾		¾		¾		¾
Total Contractual Obligations	$	322,088	$	35,682	$	74,114	$	179,022	$	33,270

Other Commercial

Amount of Commitments Expiring per Period

Commitments

Total

Twelve Months Ending June 30

Amounts

2011 and

Committed

2006

2007-2008

2009-2010

Thereafter

Standby Letters-of-Credit

51,088

Certain Risk Factors

We derive virtually all of our revenues from federal, state and local government agencies, including state Medicaid programs. Our revenues therefore are impacted by the size of the governmental appropriations for the services we provide. Budgetary pressures, as well as economic, industry, political and other factors, could influence governments not to increase and in some cases, to decrease appropriations for these services, which could reduce our margins materially. Future federal or state initiatives could institute managed care programs for persons we serve or otherwise make material changes to the Medicaid program as it now exists. Federal, state and local government agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover their contractual obligations with us, they may terminate a contract or defer or reduce our reimbursement. Additionally, there is risk that previously appropriated funds could be reduced through subsequent legislation, although we believe recoveries may be available through legal or other processes. The loss or reduction of reimbursement under our contracts could have a material adverse effect on our operations. This is mitigated by the fact that we operate in 34 states. For the past three years, our aggregate reimbursement rates for disabilities services have not changed by more than one percentage point.

Our historical growth in revenues has been directly related to increases in the number of individuals served in each of our operating segments. This growth has depended largely upon development-driven activities, including the acquisitions of other businesses or facilities, the acquisition of management contract rights to operate facilities, the award of contracts to open new facilities or start new operations or to assume management of facilities previously operated by governmental agencies or other organizations, and the extension or renewal of contracts previously awarded to us. Our future revenues will depend primarily upon our ability to maintain, expand and renew existing service contracts and existing leases, and to a lesser extent upon our ability to obtain additional contracts to

provide services to the special needs populations we serve, through awards in response to requests for proposals for new programs, in connection with facilities being privatized by governmental agencies, or by selected acquisitions.

Our Job Corps contracts are re-bid, regardless of operating performance, at least every five years. We may not be successful in bidding for contracts to operate, or to continue operating, Job Corps centers. Changes in the market for services and contracts, including increasing competition, transition costs or costs to implement awarded contracts, could adversely affect the timing and/or viability of future development activities. Additionally, many of our contracts are subject to state or federal government procurement rules and procedures; changes in procurement policies that may be adopted by one or more of these agencies could also adversely affect our ability to obtain and retain these contracts.

Our revenues and operating profitability depend on our ability to maintain our existing reimbursement levels, to obtain periodic increases in reimbursement rates to meet higher costs and demand for more services, and to receive timely payment. If we do not receive or cannot negotiate increases in reimbursement rates at approximately the same time as our costs of providing services increase, our revenues and profitability could be adversely affected. Changes in how federal and state government agencies operate reimbursement programs can also affect our operating results and financial condition. Government reimbursement, group home credentialing and client Medicaid eligibility and service authorization procedures are often complicated and burdensome, and delays can result from, among other reasons, difficulties in timely securing documentation and coordinating necessary eligibility paperwork between agencies. These reimbursement and procedural issues occasionally cause us to have to resubmit claims several times before payment is remitted and are primarily responsible for our aged receivables. Changes in the manner in which state agencies interpret program policies and procedures, and review and audit billings and costs could also affect our business, results of operations, financial condition and our ability to meet obligations under our indebtedness.

Our cost structure and ultimate operating profitability are directly related to our labor costs. Labor costs may be adversely affected by a variety of factors, including limited availability of qualified personnel in each geographic area, local competitive forces, the ineffective utilization of our labor force, changes in minimum wages or other direct personnel costs, strikes or work stoppages by employees represented by labor unions, and changes in client services models, such as the trends toward supported living and managed care. The difficulty experienced in hiring direct service staff and nursing staff in certain markets from time to time has resulted in higher labor costs in some of our operating units. These higher labor costs are associated with increased overtime, recruitment and retention, training programs, and use of temporary staffing personnel and outside clinical consultants.

Additionally, the maintenance and expansion of our operations depend on the continuation of trends toward downsizing, privatization and consolidation, and our ability to tailor our services to meet the specific needs of the populations we serve. Our success in a changing operational environment is subject to a variety of political, economic, social and legal pressures. Such pressures include a desire of governmental agencies to reduce costs and increase levels of services; federal, state and local budgetary constraints; and actions brought by advocacy groups and the courts to change existing service delivery systems. Material changes resulting from these trends and pressures could adversely affect the demand for and reimbursement of our services and our operating flexibility, and ultimately our revenues and profitability.

Media coverage of the industry, including operators of facilities and programs for persons with mental retardation and other developmental disabilities, has from time to time included reports critical of the current trend toward privatization and of the operation of certain of these facilities and programs. Adverse media coverage about providers of these services in general, and us in particular, could lead to increased regulatory scrutiny in some areas, and could adversely affect our revenues and profitability by, among other things, adversely affecting our ability to obtain or retain contracts, discouraging government agencies from privatizing facilities and programs; increasing regulation and resulting compliance costs; or discouraging clients from using our services.

Changes in the market for insurance, particularly for professional and general liability coverage, may affect our ability to obtain insurance coverage at reasonable rates. Changes in our annual insurance costs and self-insured retention limits depend in large part on the insurance market. The professional and general liability coverage provides for a $1.0 million deductible per occurrence for policy year commencing July 1, 2005, and claims limits of $5.0 million per occurrence up to a $6.0 million annual aggregate limit. The automobile coverage provides for a $1.0 million deductible per occurrence and claims limits of $5.0 million per occurrence up to a $5.0 million aggregate limit. In addition, excess liability limits of $15.0 million have been purchased effective July 1, 2005, to bring the total liability coverage limits to $20.0 million. The excess liability policy covers the general and professional liability program, as well as the automobile liability program. Our workers’ compensation coverage provides for a $1.0 million deductible per occurrence, and claims up to statutory limits. We utilize historical data to estimate our reserves for our insurance programs. If losses on asserted claims exceed the current insurance coverage and accrued reserves, our business, results of operations, financial condition and ability to meet obligations under our indebtedness could be adversely affected.

The collection of accounts receivable is a significant management challenge and requires continual focus. The limitations of some state information systems and procedures, such as the ability to obtain documentation timely from or disperse funds electronically, may limit the benefits we derive from our automated billing and collection system. We must maintain or continue to improve our controls and procedures for managing our accounts receivable billing and collection activities if we are to collect our accounts receivable on a timely basis. An inability to do so could adversely affect our business, results of operations, financial condition and ability to satisfy our obligations under our indebtedness.

Our ability to generate sufficient cash flows from operations to make scheduled payments on our debt obligations and maintain compliance with various financial covenants contained in our debt arrangements will depend on our future financial performance, which will be affected by a range of economic, competitive and business factors, many of which are outside of our control. If we do not generate sufficient cash flows from operations to satisfy our debt obligations and maintain covenant compliance, we may have to undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital investments or seeking to raise additional capital. We can provide no assurance that any refinancing would be possible, that any assets could be sold, or, if sold, of the timing of the sales and the amount of proceeds realized from those sales, or that additional financing could be obtained on acceptable terms, if at all. Our inability to generate sufficient cash flow to satisfy our debt obligations, maintain covenant compliance or refinance our obligations on commercially reasonable terms would have a material adverse effect on our business, financial condition and results of operations, as well as on our ability to satisfy our obligations under our indebtedness.

We must comply with comprehensive government regulation of our services, including statutes, regulations and policies governing the licensing of our facilities, certification of employees, the quality

of our services, the revenues we receive for our services, and reimbursement for the cost of our services. If we fail to comply with these laws, we can lose contracts and revenues, thereby harming our financial results. State and federal regulatory agencies have broad discretionary powers over the administration and enforcement of laws and regulations that govern our operations. A material violation of a law or regulation could subject us to fines and penalties and in some circumstances could disqualify some or all of the facilities and programs under our control from future participation in Medicaid or other government programs. The Health Insurance Portability and Accountability Act (HIPAA) could also increase potential penalties. Furthermore, future regulation or legislation affecting our programs may require us to change our operations significantly or incur increased costs.

In many cases, although we are operating in compliance with established laws and regulations, state regulatory agencies have broad powers to mandate the types and levels of services we provide to individuals without providing appropriate funding. We are currently experiencing this unfunded, increased regulatory oversight in the District of Columbia and are working with the District agencies to address any issues. This increased regulatory oversight has resulted in higher operating costs, including labor, consulting and maintenance expenditures.

Our success in obtaining new contracts and renewals of our existing contracts depends upon maintaining our reputation as a quality service provider among governmental authorities, advocacy groups for persons with developmental disabilities and their families, and the public. We also rely on government entities to refer clients to our facilities and programs. Negative publicity, changes in public perception, the actions of consumers under our care or investigations with respect to our industry, operations or policies could increase government scrutiny, increase compliance costs, hinder our ability to obtain or retain contracts, reduce referrals, discourage privatization of facilities and programs, and discourage clients from using our services. Any of these events could have a material adverse effect on our financial results and condition.

Our management of residential, training, educational and support programs for our clients exposes us to potential claims or litigation by our clients or other persons for wrongful death, personal injury or other damages resulting from contact with our facilities, programs, personnel or other clients. Regulatory agencies may initiate administrative proceedings alleging violations of statutes and regulations arising from our programs and facilities and seeking to impose monetary penalties on us. We could be required to pay substantial amounts of money to respond to regulatory investigations or, if we do not prevail, in damages or penalties arising from these legal proceedings and some awards of damages or penalties may not be covered by any insurance. If our third-party insurance coverage and self-insurance reserves are not adequate to cover these claims, it could have a material adverse effect on our business, results of operations, financial condition and ability to satisfy our obligations under our indebtedness.

Expenses incurred under federal, state and local government agency contracts for any of our services, as well as management contracts with providers of record for such agencies, are subject to examination by agencies administering the contracts and services. A negative outcome from any of these examinations could increase government scrutiny, increase compliance costs and hinder our ability to obtain or retain contracts. Any of these events could have a material adverse effect on our financial results and condition.

Our revenues and net income may fluctuate from quarter to quarter, in part because annual Medicaid rate adjustments may be announced by the various states at different times of the year and are

usually retroactive to the beginning of the particular state’s fiscal reporting period. Generally, future adjustments in reimbursement rates in most states will consist primarily of cost-of-living adjustments, adjustments based upon reported historical costs of operations, or other negotiated changes in rates. However, many states in which we operate are experiencing budgetary pressures and certain of these states have initiated service reductions, or rate freezes and/or rate reductions. Some reimbursement rate increases must be paid to our direct care staff in the form of wage pass-throughs. Additionally, some states have, from time to time, revised their rate-setting methodologies, which has resulted in rate decreases as well as rate increases. However, in certain states, we have been successful in mitigating rate reductions by initiating programmatic changes that produce cost savings.

Current initiatives at the federal or state level may materially change the Medicaid program as it now exists. Future revenues may be affected by changes in rate-setting structures, methodologies or interpretations that may be proposed or are under consideration in states where we operate. Also, some states have considered initiating managed care plans for persons currently in Medicaid programs. At this time, we cannot determine the impact of such changes, or the effect of various federal initiatives that have been proposed.

Our facility and program expenses may also fluctuate from period to period, due in large part to changes in labor costs and insurance costs. Labor costs are affected by a number of factors, including the availability of qualified personnel, effective management of our programs, changes in service models, state budgetary pressures, severity of weather and other natural disasters. Our annual insurance costs and self-insured retention limits have risen due in large part to the insurance market.

Forward-Looking Statements

Statements in this report that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act. In addition, we expect to make such forward-looking statements in future filings with the Securities and Exchange Commission, in press releases, and in oral and written statements made by us or with our approval. These forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) statements of plans and objectives of ResCare or our management or Board of Directors; (3) statements of future actions or economic performance, including development activities; (4) statements of assumptions underlying such statements; and (5) statements about the limitations on the effectiveness of controls. Words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from those in such statements. Some of the events or circumstances that could cause actual results to differ from those discussed in the forward-looking statements are discussed in the “Certain Risk Factors” section above. Such forward-looking statements speak only as of the date on which such statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date on which such statement is made.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

While we are exposed to changes in interest rates as a result of our outstanding variable rate debt, we do not currently utilize any derivative financial instruments related to our interest rate exposure. At June 30, 2005, we had variable rate debt outstanding of approximately $28.0 million compared to $15.0 million outstanding at December 31, 2004. The variable rate debt outstanding principally relates to the term loan which has an interest rate based on margins over LIBOR or prime, tiered based upon leverage calculations. An increase in the interest rate of 100 basis points on the debt balance outstanding as of June 30, 2005, would increase interest expense approximately $0.3 million annually.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

ResCare’s management, under the supervision and with the participation of the Chairman and Chief Executive Officer (the “CEO”) and Interim Chief Financial Officer (the “CFO”), evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2005. Based on that evaluation, the CEO and CFO concluded that ResCare’s disclosure controls and procedures are effective in timely making known to them material information required to be disclosed in the reports filed or submitted under the Securities Exchange Act. There were no changes in ResCare’s internal controls over financial reporting during the second quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

Limitations on the Effectiveness of Controls

A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, that breakdowns can occur because of simple errors or mistakes, and that controls can be circumvented by the acts of individuals or groups. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Information regarding the legal proceedings is incorporated by reference into this Part II, Item 1 described in Note 7 to the condensed consolidated financial statements set forth in Part I of this report.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

During the quarter ended June 30, 2005, ResCare issued options to purchase 10,000 shares of common stock to employees under the 2000 Stock Option and Incentive Compensation Plans. The table below sets forth information about the grant date, option term, and exercise price of the option grants. The issuance of these options is exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, and ResCare has registered the shares to be issued upon the exercise of options granted under the Plans.

Grant

Options

Option

Grant

Plan

Date

Granted

Term

Price

2000 Stock Option and Incentive Compensation Plan

April 1, 2005

10,000

5 years

12.27

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

(a)

On June 22, 2005, the regular annual meeting of shareholders of the Company was held in Louisville, Kentucky. The common and preferred shareholders present at the meeting, in person and by proxy, were entitled to cast 28,575,289 votes at the meeting, on a common-share equivalent basis, or 91.7% of the 31,162,188 votes that all eligible shareholders were entitled to vote.

(b)

At the annual meeting, the following three directors were elected to serve a three-year term as follows:


NAME	VOTES FOR		VOTES WITHHELD

Michael J. Foster		26,849,589		1,725,700
Olivia F. Kirtley		27,018,764		1,556,525
Robert E. Hallagan		26,864,797		1,710,492

The following director was elected to serve a two-year term as follows:


NAME	VOTES FOR		VOTES WITHHELD

David Braddock		21,327,033		7,248,256

(c)

The Company’s shareholders also approved the following at the annual meeting.

Proposal to approve the 2005 Omnibus Incentive Compensation Plan.


Votes for			25,899,427
Votes against			2,659,454
Votes abstaining			16,408

The ratification of the appointment of KPMG LLP as independent auditors for Res-Care for the 2005 fiscal year.


Votes for			28,179,447
Votes against			393,030
Votes abstaining			2,812

Item 6. Exhibits

(a) Exhibits


10.1		Res-Care, Inc. 2005 Omnibus Incentive Compensation Plan. Exhibit 10.1 to Form S-8 Registration Statement (Reg. No. 333-126282) filed June 30, 2005 is incorporated herein by reference.

10.2		Form of Restricted Stock Award Agreement (filed herewith).

31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended.

31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended.

32.0		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.


		RES-CARE, INC. Registrant

Date: August 4, 2005	By:	/s/ Ronald G. Geary

		Ronald G. Geary Chairman, President and Chief Executive Officer

Date: August 4, 2005	By:	/s/ David W. Miles

		David W. Miles
		Vice President and Controller, Interim Chief Financial Officer


Date On or After Which	Number
Restricted Shares Vest	of Shares that Vest
March 15, 2008		—
March 15, 2009		—
March 15, 2010		—


		Res-Care, Inc.

		By:

				Ronald G. Geary

		Title: Chairman, President and Chief Executive Officer

		Date:


		Participant



		Date:

Date: August 4, 2005

/s/ Ronald G. Geary

Ronald G. Geary

Chairman, President and Chief Executive Officer


		PAGE
		NUMBER
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets — June 30, 2005 and December 31, 2004		2

	Condensed Consolidated Statements of Income — Three Months Ended June 30, 2005 and 2004; Six Months Ended June 30, 2005 and 2004		3

	Condensed Consolidated Statements of Cash Flows — Six Months Ended June 30, 2005 and 2004		4

	Notes to Condensed Consolidated Financial Statements — June 30, 2005		5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14

Item 3.	Quantitative and Qualitative Disclosure about Market Risk		27

Item 4.	Controls and Procedures		27

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		28

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		28

Item 3.	Defaults Upon Senior Securities		28

Item 4.	Submission of Matters to a Vote of Security Holders		28

Item 6.	Exhibits		29

SIGNATURES

EXHIBITS
EX-10.2
EX-31.1
EX-31.2
EX-32

	1.		INCORPORATION OF THE PLAN. This Agreement and the Restricted Shares granted are and shall be in all respects subject to the terms and conditions of the Plan, a copy of which Optionee acknowledges receiving at the time of the execution hereof. The rights of Optionee and the obligations of the Corporation hereunder are subject to the terms and conditions of the Plan, including, without limitation, those dealing with the payment of federal, state and local taxes, and of this Award Agreement. Any decision made, or action taken, by the Board or the Committee arising out of or in connection with the interpretation and administration of the Plan shall be final and conclusive. All capitalized terms used in this Agreement not otherwise defined herein shall have the meanings set forth in the Plan, unless a different meaning is plainly required by the context.

	2.		RESTRICTED STOCK GRANT. Pursuant to the terms of Participant’s Employment Agreement, Corporation hereby grants to the Participant ___(___) shares of the common stock of Corporation, no par value (the “Restricted Shares”) in exchange for the continued employment of the Participant by the Corporation. The Restricted Shares granted hereunder shall be fully paid and nonassessable, in the manner set forth in the Plan.

	3.		RESTRICTED PERIOD.

	•		the death of the Participant;

	•		Permanent disability of Participant as defined in the Employment Agreement; or

	•		Change in Control of the Corporation as defined in the Plan.

	5.		SHARES IN ESCROW. By execution of this Award Agreement, the Participant agrees that the shares shall be deposited by the Corporation’s transfer agent with the Secretary of the Corporation or his/her designee. At the expiration of the Restricted Period, the restrictions in this Award Agreement shall, except as otherwise specifically provided in the Award Agreement, expire and the Corporation shall, subject to the provisions of this Award Agreement, deliver the shares to the Participant free of the restrictions. Such delivery shall be, at Participant’s discretion, either in certificate form or by electronic delivery to Participant’s brokerage account.

	6.		SECTION 83(b) ELECTION. If the Participant files an election under Internal Revenue Code (the “Code”) Section 83(b), the Participant shall contemporaneously furnish the Secretary of the Corporation or his/her designee a copy of the election.

	7.		TAX WITHHOLDING. Participant must make arrangements satisfactory to the Committee to pay to the Corporation any federal, state or local taxes required to be withheld with respect to an Award issued under the Plan at the earlier of (i) the making of an 83(b) election as provided in Section 6, or (ii) upon vesting of the Restricted Shares in accordance with this Agreement, based in each case upon the Committee’s determination of Fair Market Value of the shares taxable at each such date. If a Participant fails to tender or tender in full a check for such tax withholding, the Corporation has the right to deduct any such taxes from any payment of any kind otherwise due to the Participant, including payment of salary or bonus owed to Participant.

	8.		ADJUSTMENT PROVISIONS. The aggregate number of Restricted Shares granted hereunder and subject to restriction from time to time shall be proportionately adjusted as described in Section 3.2 of the Plan.

	9.		EMPLOYMENT OF PARTICIPANT. Neither the adoption of the Plan nor the granting of any Restricted Shares under the Plan shall be deemed to create a contract of employment or impose any obligation on the Corporation as employer to continue the employment of a Participant. In the absence of a written contract to the contrary, a Participant’s employment with the Corporation shall be, and continue to be, “at will”, terminable for any reason or for no reason by either the Participant or the Corporation, with or without notice. If the Participant has a written employment agreement with the Corporation, the terms and conditions of the employment agreement shall remain unaffected by this Award and the Participant’s employment status shall continue to be governed exclusively by the employment agreement.

	10.		NOT INTENDED TO BE DEFERRED COMPENSATION. This Agreement is intended to award restricted stock that is not deferred compensation within the meaning of Section 409A of the Code, and it shall be interpreted and administered consistent with this intent. Therefore, neither the Committee nor Participant shall have or exercise discretion in a way that would delay the inclusion of income of the Restricted Shares Award hereunder (other than the vesting schedule set forth in Section 3), including, but not limited to, substitution of other Restricted Shares, or extension of the Restricted Period as set forth herein.

	11.		REPRESENTATIONS. The Corporation has registered the issuance of the shares. The Participant agrees to comply with all applicable SEC rules, including Rule 144 of the Securities Act of 1933, the Corporation’s applicable securities trading policy and all reporting obligations concerning trades of the Corporation’s stock.

	12.		ENTIRE AGREEMENT. This Agreement and the Plan constitute the entire understanding and agreement between the Corporation and Participant with regard to all matters herein. There are no other agreements, conditions or representations, oral or written, expressed or implied with regard thereto. This Agreement may be amended only in writing, signed by all of the parties.

	(a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	(c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	(d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	(a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize, and report financial information; and

	(b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	(1)		The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

	(2)		The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.