Res-Care 10-Q

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 September 30, 2006


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

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

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 a large accelerated filer, an accelerated filer, or non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12-b of the Act (Check one):

Large accelerated filer: o Accelerated filer: þ Non-accelerated filer: o

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

The number of shares outstanding of the registrant’s common stock, no par value, as of October 31, 2006, was 27,780,854.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

RES-CARE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)


	September 30		December 31
	2006		2005
ASSETS
Current assets:
Cash and cash equivalents	$	6,652	$	9,894
Short-term investments		—		27,650
Accounts receivable, net of allowance for doubtful accounts of $10,571 in 2006 and $9,279 in 2005		196,089		160,821
Refundable income taxes		—		343
Deferred income taxes		11,403		12,353
Non-trade receivables		8,829		3,629
Prepaid expenses and other current assets		10,998		7,037

Total current assets		233,971		221,727

Property and equipment, net		74,701		74,175
Goodwill		370,332		281,016
Other intangible assets		28,018		7,422
Other assets		13,646		16,689

	$	720,668	$	601,029

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable	$	40,935	$	40,592
Accrued expenses		79,975		63,268
Current portion of long-term debt and obligations under capital leases		4,847		4,554
Accrued income taxes		4,021		—

Total current liabilities		129,778		108,414

Long-term liabilities		28,086		27,893
Long-term debt and obligations under capital leases		210,514		152,584
Deferred gains		4,483		3,865
Deferred income taxes		6,785		6,275

Total liabilities		379,646		299,031

Commitments and contingencies

Minority interests		230		—

Shareholders’ equity:
Preferred shares, authorized 1,000,000 shares, no par value, except 48,095 shares designated as Series A with stated value of $1,050 per share, 48,095 shares issued and outstanding in 2006 and 2005		46,609		46,609
Common shares, no par value, authorized 40,000,000 shares, issued 28,723,857 in 2006 and 2005, outstanding 27,776,854 shares in 2006 and 26,946,078 shares in 2005		50,198		49,603
Additional paid-in capital		73,742		63,605
Retained earnings		168,693		140,987
Accumulated other comprehensive income		1,550		1,194

Total shareholders’ equity		340,792		301,998

	$	720,668	$	601,029

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					Nine Months Ended
	September 30					September 30
	2006		2005			2006			2005
Revenues	$	336,261	$	275,780		$	983,774		$	796,005
Facility and program expenses		301,250		246,468			880,460			712,773

Facility and program contribution		35,011		29,312			103,314			83,232

Corporate general and administrative expenses		13,857		11,980			41,435			34,545


Operating income		21,154		17,332			61,879			48,687

Interest expense, net		4,505		4,633			13,168			13,690

Income from continuing operations before income taxes		16,649		12,699			48,711			34,997
Income tax expense		6,089		4,317			18,754			11,899

Income from continuing operations		10,560		8,382			29,957			23,098
Income (loss) from discontinued operations, net of tax		59		(753	)		(2,251	)		(2,472	)

Net income		10,619		7,629			27,706			20,626

Net income attributable to preferred shareholders		1,572		1,169			4,127			3,185

Net income attributable to common shareholders	$	9,047	$	6,460		$	23,579		$	17,441


Basic earnings per common share:
From continuing operations	$	0.33	$	0.26		$	0.93		$	0.74
From discontinued operations		0.00		(0.02	)		(0.07	)		(0.08	)

Basic earnings per common share	$	0.33	$	0.24		$	0.86		$	0.66


Diluted earnings per common share:
From continuing operations	$	0.32	$	0.26		$	0.91		$	0.73
From discontinued operations		0.00		(0.02	)		(0.07	)		(0.08	)

Diluted earnings per common share	$	0.32	$	0.24		$	0.84		$	0.65


Weighted average number of common shares:
Basic		27,689		26,570			27,481			26,336
Diluted		28,122		27,235			28,108			27,014

See accompanying notes to condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES

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


	Nine Months Ended
	September 30
	2006			2005
Cash flows from operating activities:
Net income	$	27,706		$	20,626
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		12,643			10,318
Impairment charges		1,110			—
Amortization of discount on notes and deferred debt issuance costs		736			652
Share-based compensation		1,371			—
Deferred income taxes, net		1,460			1,052
Tax benefit from exercise of stock options		—			1,368
Excess tax benefits from share-based compensation		(2,627	)		—
Provision for losses on accounts receivable		4,319			3,548
Changes in operating assets and liabilities		(24,050	)		(10,759	)

Cash provided by operating activities		22,668			26,805


Cash flows from investing activities:
Purchases of property and equipment		(11,746	)		(8,502	)
Acquisitions of businesses		(108,430	)		(31,975	)
Proceeds from sales of assets		13			64
Proceeds from sales and maturities of short-term investments		66,850			353,660
Purchases of short-term investments		(39,200	)		(320,425	)

Cash used in investing activities		(92,513	)		(7,178	)


Cash flows from financing activities:
Repayments of long-term debt and capital leases		(4,441	)		(42,430	)
Borrowings of long-term debt		40,000			13,000
Short-term borrowings — three months or less, net		19,500			—
Proceeds from sale and leaseback transactions		2,651			—
Debt issuance costs		(468	)		—
Excess tax benefits from share-based compensation		2,627			—
Proceeds received from exercise of stock options		6,734			4,491

Cash provided by (used in) financing activities		66,603			(24,939	)


Decrease in cash and cash equivalents		(3,242	)		(5,312	)

Cash and cash equivalents at beginning of period		9,894			28,404

Cash and cash equivalents at end of period	$	6,652		$	23,092

See accompanying notes to condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

September 30, 2006
(Unaudited)

Note 1. Basis of Presentation

Res-Care, Inc. is a human service company that provides residential, therapeutic, job training and educational supports to people with developmental or other disabilities, to youth with special needs, to adults who are experiencing barriers to employment and to older people who need home care assistance. 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 (GAAP) for comprehensive annual 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 interim periods are not necessarily indicative of the results that may be expected for a full year.

Our preparation of the accompanying condensed consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

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, 2005.

Note 2. Reclassifications

Beginning January 1, 2006, depreciation and amortization expenses attributable to our operating segments have been reclassified to facility and program expenses. Depreciation and amortization expenses attributable to the corporate office are reflected in general and administrative expenses. Prior period financial information provided has been conformed to this presentation.

During the first quarter of 2006, we ceased providing community services in the District of Columbia (the District). In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the withdrawal has been accounted for as discontinued operations. Accordingly, the results of our community services operations in the District for all periods presented and the related exit costs have been classified as discontinued operations, net of income taxes, in the accompanying condensed consolidated statements of income. Additional information regarding the withdrawal can be found in Note 4.

Starting with the second quarter of 2006, we reclassified a portion of our self-insured reserves for professional, general and automobile liability and workers’ compensation risks from current liabilities to long-term liabilities in the condensed consolidated balance sheets. Self-insurance reserve accruals, which are subject to periodic adequacy evaluations, are being classified based on estimated claims payments. Using historical and actuarial information, estimated self-insured claims to be paid after twelve months are included in other long-term liabilities. As a result of the self-insured reserve reclassifications noted above, we also reclassified a portion of our deferred income tax balances between current assets and noncurrent liabilities. The reclassifications had no effect on the reported results of operations, cash flows or compliance with our debt covenants. Prior period financial information has been conformed to this presentation.

Note 3. Acquisitions

On January 3, 2006, our Employment Training Services segment completed the purchase of the operating assets and business of the Workforce Services Group of Affiliated Computer Services, Inc. (Workforce Services), primarily to further our expansion into employment training services and further diversify our funding sources. Workforce Services has contracts in 15 states and Washington, D.C. and provides services to adults who have lost their jobs or face some barrier to employment. Workforce Services offers job development, training and placement through federally funded programs administered by state and local governments and is the largest private provider of these services in the United States. These training services are provided primarily through “one-stop” programs which are convenient service sites that enable job seekers to receive government assistance, employment or training-related services at a single location. The purchase price of $69.8 million was funded through existing cash, short-term investments and borrowings on our senior credit facility. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations.

The aggregate purchase price consists of (in thousands):


Cash paid	$	69,000
Transaction costs		808

Total purchase price	$	69,808

The following table summarizes the estimated fair values of the assets acquired at the date of acquisition (in thousands):


Property, plant and equipment	$	1,523
Other intangibles		18,418
Goodwill		50,162
Liabilities assumed		(295	)

Aggregate purchase price	$	69,808

The other intangible assets consist primarily of customer relationships and will be amortized over 15 years. Amortization expense for these intangible assets totaled $0.3 million in the third quarter of 2006 and $0.9 million for the nine months ended September 30, 2006.

Supplemental consolidated pro forma information for the three and nine months ended September 30, 2005, is presented below as though the business combination had been completed as of January 1, 2005. The pro forma financial information does not necessarily reflect the results of operations that would have occurred if ResCare and Workforce Services constituted a single entity during such period.


	Three Months		Nine Months
	Ended		Ended
	Sept. 30, 2005		Sept. 30, 2005
	(In thousands, except per share data)
Revenues	$	316,813	$	917,332
Attributable to common shares:
Income from continuing operations	$	7,327	$	21,043
Net income	$	6,691	$	18,954

Basic earnings per common share:
Income from continuing operations	$	0.28	$	0.80
Net income	$	0.25	$	0.72

Diluted earnings per common share:
Income from continuing operations	$	0.27	$	0.78
Net income	$	0.25	$	0.70

During the first nine months of 2006, we completed 11 additional acquisitions within our Community Services Group. Aggregate consideration for these acquisitions was approximately $41.5 million, including $2.9 million of notes issued. These acquisitions are expected to generate annual revenues of approximately $73 million. Goodwill increased $37 million as a result of these acquisitions. Intangible assets were assigned a value of approximately $4 million, principally for non-competition agreements.

The allocations of purchase price are preliminary and will be subjected to further analysis during the remainder of 2006.

Note 4. Discontinued Operations

During the first quarter of 2006, we ceased providing community services in the District due to high operating costs and substantial losses resulting from changes in regulatory oversight requirements. In accordance with SFAS 144, the withdrawal has been accounted for as discontinued operations. Accordingly, the results of our community services in the District for all periods presented and the related exit costs have been classified as discontinued operations, net of income taxes, in the accompanying condensed consolidated statements of income.

In connection with the withdrawal, we recorded a charge for exit costs totaling $1.6 million during the first quarter ended March 31, 2006. An additional $0.6 million was recorded for impaired assets, which were principally leaseholds and furniture. The following table describes the 2006 activity for the exit liability as of September 30, 2006 (in thousands):


	Beginning							Ending
	Balance at							Balance at
	Jan. 1, 2006		Accruals		Payments			Sept. 30, 2006
One-time benefit arrangements and related costs	$	—	$	246	$	(199	)	$	47
Lease terminations		—		1,310		(126	)		1,184

Total	$	—	$	1,556	$	(325	)	$	1,231

Summarized financial information for the discontinued operations is set forth below (in thousands):


	Three Months Ended						Nine Months Ended
	September 30						September 30
	2006			2005			2006			2005
Revenues	$	(3	)	$	3,641		$	2,893		$	11,718
Facility and program expenses		(162	)		4,781			4,336			15,463

Facility and program income (loss)		159			(1,140	)		(1,443	)		(3,745	)

Exit costs and other write-offs		—			—			(2,217	)		—

Income (loss) from discontinued operations, before income taxes		159			(1,140	)		(3,660	)		(3,745	)
Income tax (expense) benefit		(100	)		387			1,409			1,273

Income (loss) from discontinued operations, net of tax	$	59		$	(753	)	$	(2,251	)	$	(2,472	)

Note 5. Comprehensive Income

The following table sets forth the computation of comprehensive income (in thousands):


	Three Months Ended				Nine Months Ended
	September 30				September 30
	2006		2005		2006		2005
Net income	$	10,619	$	7,629	$	27,706	$	20,626
Foreign currency translation adjustments arising during the period		1		360		356		205


Comprehensive income	$	10,620	$	7,989	$	28,062	$	20,831

Note 7. Earnings Per Share

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


	Three Months Ended					Nine Months Ended
	September 30					September 30
	2006		2005			2006			2005
	(In thousands, except per share data)
Income from continuing operations	$	10,560	$	8,382		$	29,957		$	23,098
Attributable to preferred shareholders		1,563		1,285			4,462			3,567

Attributable to common shareholders	$	8,997	$	7,097		$	25,495		$	19,531


Income (loss) from discontinued operations, net of tax	$	59	$	(753	)	$	(2,251	)	$	(2,472	)
Attributable to preferred shareholders		9		(116	)		(335	)		(382	)

Attributable to common shareholders	$	50	$	(637	)	$	(1,916	)	$	(2,090	)


Net income	$	10,619	$	7,629		$	27,706		$	20,626
Attributable to preferred shareholders		1,572		1,169			4,127			3,185

Attributable to common shareholders	$	9,047	$	6,460		$	23,579		$	17,441


Weighted average number of common shares used in basic earnings per common share		27,689		26,570			27,481			26,336
Effect of dilutive securities:
Stock options		409		665			548			678
Restricted stock		24		—			79			—


Weighted average number of common shares and dilutive potential common shares used in diluted earnings per common share		28,122		27,235			28,108			27,014


Basic earnings per common share:
From continuing operations	$	0.33	$	0.26		$	0.93		$	0.74
From discontinued operations		0.00		(0.02	)		(0.07	)		(0.08	)

Basic earnings per common share	$	0.33	$	0.24		$	0.86		$	0.66


Diluted earnings per common share:
From continuing operations	$	0.32	$	0.26		$	0.91		$	0.73
From discontinued operations		0.00		(0.02	)		(0.07	)		(0.08	)

Diluted earnings per common share	$	0.32	$	0.24		$	0.84		$	0.65

The average shares listed below were not included in the computation of diluted earnings per common share because to do so would have been anti-dilutive for the periods presented:


	Three Months Ended				Nine Months Ended
	September 30				September 30
	2006		2005		2006		2005
	(In thousands)
Convertible subordinated notes		—		—		—		137
Stock options		165		13		165		13

Note 8. Segment Information

Effective January 1, 2006, in order to better reflect the services provided, the Disabilities Services segment was renamed Community Services.


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

2006
Revenues	$	244,496	$	39,404	$	48,344	$	4,017		$	336,261
Operating income		27,878		4,350		3,393		(14,467	)		21,154
Total assets		494,003		31,706		135,540		59,419			720,668
Capital expenditures		2,068		—		125		1,524			3,717
Depreciation and amortization		2,283		—		502		1,603			4,388

2005 ⁽²⁾
Revenues	$	218,457	$	39,240	$	16,440	$	1,643		$	275,780
Operating income		23,770		4,318		1,460		(12,216	)		17,332
Total assets		437,055		35,217		33,142		90,177			595,591
Capital expenditures		1,911		—		11		1,126			3,048
Depreciation and amortization		2,187		—		26		1,325			3,538

Nine months ended September 30:
2006
Revenues	$	691,130	$	118,733	$	158,848	$	15,063		$	983,774
Operating income		77,336		12,732		12,254		(40,443	)		61,879
Capital expenditures		5,554		—		307		5,885			11,746
Depreciation and amortization		6,688		—		1,347		4,568			12,603

2005 ⁽²⁾
Revenues	$	630,977	$	114,212	$	45,154	$	5,662		$	796,005
Operating income		66,479		12,274		4,164		(34,230	)		48,687
Capital expenditures		4,889		—		55		3,558			8,502
Depreciation and amortization		6,162		—		79		3,933			10,174


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

⁽²⁾		Amounts in 2005 have been restated to exclude the effects of the District, which operations were discontinued effective March 31, 2006. Depreciation and amortization for the District was zero and $40 for the three and nine months ended September 30, 2006, respectively, and $43 and $144 for the same periods in 2005, respectively.

Note 9. Share-Based Payments

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees,(APB No. 25) and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach to accounting for share-based payments in SFAS 123(R) and related interpretations is similar to the approach described in SFAS 123. 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) was effective for public companies at the beginning of the first interim or annual period beginning after June 15, 2005. We adopted SFAS 123(R) effective January 1, 2006 using the modified-prospective method.

Under the modified-prospective approach, SFAS 123(R) applies to new awards and to unvested awards that were outstanding on December 31, 2005, as well as those that are subsequently modified, repurchased or cancelled. Under the modified-prospective approach, compensation expense recognized in the three and nine months ended September 30, 2006 includes compensation expense for all share-based payments granted prior to, but not yet vested as of December 31, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and compensation expense for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). Prior periods were not restated to reflect the impact of adopting the new standard. Share-based compensation is reflected in corporate general and administrative expenses in the accompanying condensed consolidated statement of income.

Prior to the adoption of SFAS 123(R), we accounted for stock option grants in accordance with APB No. 25, and accordingly, recognized no compensation expense for stock option grants due to the grant price being equal to the market price at the date of grant. As a result of adopting SFAS 123(R), net income for the quarter and nine months ended September 30, 2006 was $0.5 million and $1.0 million, respectively (net of $0.2 million and $0.4 million tax benefit, respectively) lower, than if ResCare had continued to account for share-based compensation under APB No. 25.

The following table illustrates the effect on operating results and per share information had we accounted for share-based compensation in accordance with SFAS 123 for the three and nine months ended September 30, 2005 (in thousands, except per share data):


	Three Months Ended		Nine Months Ended
	September 30, 2005		September 30, 2005
Net income attributable to common shareholders, as reported	$	6,460	$	17,441
Deduct: Total share-based employee compensation expense determined under fair value method of all awards, net of related tax effects		213		639

Net income attributable to common shareholders, pro forma	$	6,247	$	16,802


Basic earnings per common share:
As reported	$	0.24	$	0.66

Pro forma	$	0.24	$	0.64


Diluted earnings per common share:
As reported	$	0.24	$	0.65

Pro forma	$	0.23	$	0.62

The adoption of SFAS 123(R) at January 1, 2006 resulted in prospective changes in our accounting for share-based compensation awards including recording share-based compensation expense and the related deferred income tax benefit on a prospective basis and reflecting the excess tax benefit from the exercise of share-based compensation awards in cash flows from financing activities.

In periods prior to January 1, 2006, the income tax benefits from the exercise of stock options were classified as cash provided by operating activities pursuant to Emerging Issues Task Force Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option. However, for periods ending after January 1, 2006, pursuant to SFAS 123(R), the income tax benefits exceeding the recorded deferred income tax benefit from share-based compensation awards (the excess tax benefits) are required to be reported in cash provided by financing activities.

As of September 30, 2006, we had outstanding awards under three share-based incentive plans. Under the plans, stock options are awarded at a price equal to the market price of our common stock on the date of grant, and an option’s maximum vesting term is normally five years. Generally, all options have varied vesting schedules, varying between 20% and 50% at date of grant with the remaining options vesting over one to five years. Restricted stock awards generally are comprised of service-based restricted shares and performance-based restricted shares. The service-based restricted shares generally vest in one-third increments over three years from the date of grant. The performance-based restricted shares vest in increments if and when certain performance criteria are met.

The fair value of each stock option is estimated on the date of grant using the Black-Scholes valuation model utilizing the assumptions noted below. The expected volatility of our stock price is based on historical volatility over the expected term. The expected term of the option is based on historical

employee stock option exercise behavior, the vesting term of the respective award and the contractual term. Our stock price volatility and expected option lives are based on management’s best estimates at the time of grant, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the vesting term of the option.

The following table sets forth the fair value of stock option grants using the Black-Scholes option-pricing model and the applicable weighted-average assumptions for the nine months ended September 30, 2005. We did not grant any stock options during the three months ended September 30, 2005 or the first nine months of 2006.


	Nine Months Ended
	September 30, 2005
Fair value per option	$	6.79
Risk-free interest rate		4.01	%
Dividend yield		—
Expected volatility		59	%
Expected option life (in years)		2-5

Total share-based compensation expense by type of award for the three and nine months ended September 30, 2006 was as follows (in thousands):


	Three Months Ended		Nine Months Ended
	September 30, 2006		September 30, 2006
Stock options	$	158	$	476
Restricted stock, service-based		155		435
Restricted stock, performance-based		368		459

Total share-based compensation expense		681		1,370
Tax effect		205		356

Share-based compensation expense, net of tax	$	476	$	1,014

Stock Options

As of September 30, 2006, a total of 894,940 stock options were outstanding under the plans. Share-based compensation expense recognized for the three and nine months ended September 30, 2006 included compensation expense for stock options granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with SFAS 123. Included in share-based compensation expense in the three and nine months ended September 30, 2006 was $0.2 million and $0.5 million, respectively, related to stock options which is net of the estimated forfeitures. The intrinsic value of the stock options exercised during the three and nine months ended September 30, 2006 was $1.5 million and $9.4 million, respectively. The fair value of the stock options which vested during the third quarter of 2006 and 2005 was approximately $0.1 million and $0.3 million, respectively. The fair value of the stock options which vested during the nine months ended September 30, 2006 and 2005 was approximately $1.7 million and $2.1 million, respectively.

As of September 30, 2006, there was $0.2 million of total share-based compensation related to nonvested stock options. That cost is expected to be recognized over an estimated amortization period of approximately fifteen months.

A summary of our stock option activity and related information for the nine months ended September 30, 2006 is as follows:


						Weighted
				Weighted		Average
				Average		Remaining
	Stock			Exercise		Contractual
	Options			Price		Life
Outstanding at December 31, 2005		1,750,497		$	9.22
Exercised		(832,777	)		8.03
Forfeited/canceled		(22,780	)		8.06

Outstanding at September 30, 2006		894,940			10.36		2.9


Exercisable at September 30, 2006		629,619		$	11.01

The aggregate intrinsic value of stock options outstanding and exercisable at September 30, 2006 was approximately $8.7 million and $5.7 million, respectively.

Restricted Stock, service-based

As of September 30, 2006, 168,781 shares of service-based restricted stock were outstanding which vest based on years of service. During the nine months ended September 30, 2006, we awarded 129,520 service-based restricted shares to key employees and directors. The fair value of the restricted stock awards was based on the closing market price of common stock on the date of award and is being amortized under the straight-line method over the service period. Share-based compensation expense recognized for the three and nine months ended September 30, 2006 is based on service-based restricted stock ultimately expected to vest, and therefore it has been reduced for estimated forfeitures.

As of September 30, 2006, there was $2.4 million of unrecognized share-based compensation related to nonvested service-based restricted stock. That cost is expected to be recognized over an estimated weighted-average amortization period of approximately four years. The intrinsic value of the service-based restricted stock outstanding at September 30, 2006 was $0.3 million.

A summary of our service-based restricted stock activity, and related information for the nine months ended September 30, 2006 is as follows:


			Weighted
	Service-Based		Average
	Restricted		Grant Date
	Stock		Fair Value
Outstanding at December 31, 2005		39,261	$	15.58
Granted		129,520		19.56

Outstanding at September 30, 2006		168,781	$	18.59

Restricted Stock, performance-based

As of September 30, 2006, a total of 449,162 shares of performance-based restricted shares were outstanding. The restricted stock primarily vests if ResCare meets certain operating targets set by our

Board of Directors. During the nine months ended September 30, 2006, we awarded 403,641 performance-based restricted shares to key employees. The fair value of the restricted stock awards was based on the closing market price of common stock on the date of award and is being amortized over the estimated service period to achieve the operating targets. Share-based compensation expense recognized for the three and nine months ended September 30, 2006 is based on performance-based restricted stock ultimately expected to vest, and therefore it has been reduced for estimated forfeitures.

As of September 30, 2006, there was $8.2 million of unrecognized share-based compensation related to nonvested performance-based restricted stock. The underlying performance criteria relate to meeting certain annual earnings targets. Based on current projections, all of this is considered probable.

A summary of performance-based restricted stock activity, and related information for the nine months ended September 30, 2006 is as follows:


	Performance-		Weighted
	Based		Average
	Restricted		Grant Date
	Stock		Fair Value

Outstanding at December 31, 2005		45,521	$	16.11
Granted		403,641		19.98

Outstanding at September 30, 2006		449,162	$	19.59

The aggregate intrinsic value of the performance-based restricted stock outstanding at September 30, 2006 was approximately $0.2 million.

Note 10. 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 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 supersedes bond has been filed with the Court of $6.0 million. Oral arguments were held on August 31, 2005. We have not made any provision in our condensed consolidated financial statements for the 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 condensed consolidated financial condition, results of operations or liquidity.

As a result of the death of one of the individuals we served, the Attorney General of Missouri brought criminal charges against one of our operating subsidiaries in 2003. This subsidiary served approximately 58 individuals. We voluntarily surrendered the license of the facility involved and settled the related civil litigation, which was covered by insurance. During the third quarter of 2006, a jury found the subsidiary guilty on one count of negligence in the criminal case. We believe that the evidence in the case was insufficient to warrant this decision and have appealed. The monetary fine associated with this matter was immaterial. Further, any adverse outcome would not affect the participation of our other subsidiaries in federal and state health programs. If similar allegations were to arise in the future in respect of a more significant subsidiary or in respect of ResCare, an adverse outcome could have a material adverse effect on our business, result 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 condensed consolidated financial condition, results of operations or liquidity.

Note 11. Impact of Recently Issued Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This interpretation requires that we recognize in our financial statements the impact of a tax position if that position is more likely than not to be sustained based on the technical merits of the position. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies when using other accounting pronouncements that require or permit fair value measurements, and does not require any new fair value measurements. SFAS 157 is effective for fiscal years beginning after December 15, 2007. We are currently evaluating the impact, if any, of adopting SFAS 157 on our financial statements.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108 (SAB 108) Considerating the Effects of Prior Year Misstatements in Current Year Financial Statements. SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires registrants to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB 108 is effective for periods ending after November 15, 2006. We are currently evaluating the impact, if any, of adopting SAB 108 on our consolidated financial statements.

Note 12. Income Taxes

A reconciliation of the U.S. Federal income tax rate of 35% to income tax expense expressed as a percent of pretax income follows:


	Three Months Ended						Nine Months Ended
	September 30						September 30
	2006			2005			2006			2005
Federal income tax at the statutory rate		35.0	%		35.0	%		35.0	%		35.0	%
Increase (decrease) in income taxes:
State taxes, net of federal benefit		3.9			4.5			3.9			4.5
Jobs tax credits, net		(0.6	)		(3.8	)		(1.0	)		(4.2	)
Other		(1.7	)		(1.7	)		0.6			(1.3	)

		36.6	%		34.0	%		38.5	%		34.0	%

Our effective income tax rates for the quarter and nine months ended September 30, 2006, are 36.6% and 38.5%, respectively, as compared to 34.0% in the comparable periods of 2005. The increase in the effective rate is primarily due to the expiration of the jobs tax credits in December 2005, which has not yet been reenacted by Congress, the impact of the non-deductibility of certain incentive stock options in accordance with SFAS 123(R) and less non-taxable investment income for 2006. In addition, our effective tax rate reflects the reversal of certain income tax reserves upon the expiration of the applicable statute of limitations for certain tax filing positions during the quarter.

Note 13. Related Party Transactions

We lease certain of our facilities under an operating lease with Ventas, Inc., a publicly traded healthcare real estate investment trust. Ronald Geary, who is our Chairman of the Board and former President and Chief Executive Officer, is a member of Ventas’ board of directors. Payments to the trust approximated $0.2 million for both the third quarter of 2006 and 2005 and $0.7 million and $0.6 million for the nine months ended September 30, 2006 and 2005, respectively.

ResCare used an airplane from an entity owned by Mr. Geary for certain corporate travel. Total costs incurred during the nine months ended September 30, 2006 were approximately $24,000. No costs were incurred during the first nine months of 2005.

Note 14. Minority Interests

The accompanying condensed consolidated financial statements include the financial information of ResCare and that of several subsidiaries in which we hold a majority interest. For consolidated

majority-owned subsidiaries in which we own less than 100%, we recognize a minority interest for the ownership interest of the minority owners. ResCare currently holds a 67.5% interest in Pharmacy Alternatives, LLC, a closed-door pharmacy providing products and services to both ResCare operations and other providers of services to persons with developmental disabilities. We also hold a 66.7% interest in Rest Assured LLC, a limited liability company comprised of public and private organizations providing remote monitoring services for persons with disabilities. The minority interest represents the share of the equity that is attributable to the minority owner and is disclosed separately in the condensed consolidated balance sheet. The associated minority interest impact for the quarter and nine months ended September 30, 2006 is not material to our results of operations, and therefore has been classified as general and administrative expense in the condensed consolidated statements of income.

Note 15. Subsequent Event

Effective October 31, 2006, pursuant to the contract terms, the State of New Mexico cancelled our contract without cause. We have ceased providing services to people with developmental disabilities in the state of New Mexico and are in the process of exiting the state. The New Mexico operations generated revenues of approximately $19 million for the first nine months of 2006. We anticipate that the results of operations for New Mexico will be reported as discontinued operations in the fourth quarter of 2006 and any exit charges will be recorded at this time.

Note 16. Subsidiary Guarantors

On October 3, 2005, we issued $150 million of 7.75% Senior Notes due October 15, 2013 (the Senior Notes) in a private placement under Rule 144A of the Securities Act of 1933. The Senior Notes are jointly, severally, fully and unconditionally guaranteed by our 100% and majority owned U.S. subsidiaries. There are no restrictions on our ability to obtain funds from our U.S. subsidiaries by dividends or other means. The following are condensed consolidating financial statements of our company, including the guarantors. This information is provided pursuant to Rule 3 – 10 of Regulation S-X in lieu of separate financial statements of each subsidiary guaranteeing the Senior Notes. The following condensed consolidating financial statements present the balance sheet, statement of income and cash flows of (i) Res-Care, Inc. (in each case, reflecting investments in its consolidated subsidiaries under the equity method of accounting), (ii) the guarantor subsidiaries, (iii) the nonguarantor subsidiaries, and (iv) the eliminations necessary to arrive at the information for our company on a consolidated basis. The condensed consolidating financial statements should be read in conjunction with the accompanying condensed consolidated financial statements.

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEET
September 30, 2006
(In thousands)


				Guarantor		Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries		Subsidiaries			Eliminations			Total
ASSETS
Current assets:
Cash and cash equivalents	$	1,513		$	1,493	$	3,646		$	—		$	6,652
Accounts receivable, net		33,527			161,926		636			—			196,089
Deferred income taxes		11,403			—		—			—			11,403
Prepaid expenses and other current assets		7,366			12,411		50			—			19,827

Total current assets		53,809			175,830		4,332			—			233,971

Property and equipment, net		29,967			44,665		69			—			74,701
Goodwill		75,953			289,561		4,818			—			370,332
Investment in subsidiaries		380,972			—		—			(380,972	)		—
Other assets		9,169			32,495		—			—			41,664

	$	549,870		$	542,551	$	9,219		$	(380,972	)	$	720,668


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable	$	27,199		$	13,567	$	169		$	—		$	40,935
Accrued expenses		37,775			42,030		170			—			79,975
Current portion of long-term debt and obligations under capital leases		745			4,102		—			—			4,847
Accrued income taxes		4,183			—		(162	)		—			4,021

Total current liabilities		69,902			59,699		177			—			129,778

Intercompany		(105,885	)		105,249		636			—			—
Long-term liabilities		27,698			388		—			—			28,086
Long-term debt and obligations under capital leases		208,801			1,713		—			—			210,514
Deferred gains		1,773			2,710		—			—			4,483
Deferred income taxes		6,789			—		(4	)		—			6,785

Total liabilities		209,078			169,759		809			—			379,646

Minority interests		—			230		—			—			230

Total shareholders’ equity		340,792			372,562		8,410			(380,972	)		340,792

	$	549,870		$	542,551	$	9,219		$	(380,972	)	$	720,668

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEET
December 31, 2005
(In thousands)


				Guarantor		Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries		Subsidiaries			Eliminations			Total
ASSETS
Current assets:
Cash and cash equivalents	$	5,192		$	1,927	$	2,775		$	—		$	9,894
Short-term investments		27,650			—		—			—			27,650
Accounts receivable, net		37,512			122,673		636			—			160,821
Refundable income taxes		416			—		(73	)		—			343
Deferred income taxes		12,353			—		—			—			12,353
Prepaid expenses and other current assets		7,591			3,001		74			—			10,666

Total current assets		90,714			127,601		3,412			—			221,727

Property and equipment, net		28,430			45,288		457			—			74,175
Goodwill		66,405			210,002		4,609			—			281,016
Investment in subsidiaries		300,809			—		—			(300,809	)		—
Other assets		9,866			14,245		—			—			24,111

	$	496,224		$	397,136	$	8,478		$	(300,809	)	$	601,029


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable	$	29,360		$	11,127	$	105		$	—		$	40,592
Accrued expenses		29,058			33,954		256			—			63,268
Current portion of long-term debt and obligations under capital leases		1,046			3,340		168			—			4,554

Total current liabilities		59,464			48,421		529			—			108,414

Intercompany		(49,227	)		48,728		499			—			—
Long-term liabilities		27,628			265		—			—			27,893
Long-term debt and obligations under capital leases		149,078			3,281		225			—			152,584
Deferred gains		1,004			2,861		—			—			3,865
Deferred income taxes		6,279			—		(4	)		—			6,275

Total liabilities		194,226			103,556		1,249			—			299,031

Total shareholders’ equity		301,998			293,580		7,229			(300,809	)		301,998

	$	496,224		$	397,136	$	8,478		$	(300,809	)	$	601,029

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF INCOME
Three Months Ended September 30, 2006
(In thousands)


				Guarantor		Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries		Subsidiaries			Eliminations			Total
Revenues	$	61,143		$	277,538	$	(2,420	)	$	—		$	336,261

Operating expenses		55,714			262,384		(2,991	)		—			315,107


Operating income		5,429			15,154		571			—			21,154

Other (income) expenses:
Interest, net		2,205			2,304		(4	)		—			4,505
Equity in earnings of subsidiaries		(8,639	)		—		—			8,639			—

Total other expenses		(6,434	)		2,304		(4	)		8,639			4,505

Income from continuing operations, before income taxes		11,863			12,850		575			(8,639	)		16,649
Income tax expense		1,244			4,624		221			—			6,089

Income from continuing operations		10,619			8,226		354			(8,639	)		10,560
Loss from discontinued operations, net of tax		—			59		—			—			59


Net income	$	10,619		$	8,285	$	354		$	(8,639	)	$	10,619

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF INCOME
Nine Months Ended September 30, 2006
(In thousands)


				Guarantor			Non-Guarantor					Consolidated
	ResCare, Inc.			Subsidiaries			Subsidiaries		Eliminations			Total

Revenues	$	195,154		$	784,237		$	4,383	$	—		$	983,774

Operating expenses		185,700			732,531			3,664		—			921,895


Operating income		9,454			51,706			719		—			61,879

Other (income) expenses:
Interest, net		6,438			6,635			95		—			13,168
Equity in earnings of subsidiaries		(25,852	)		—			—		25,852			—

Total other expenses		(19,414	)		6,635			95		25,852			13,168

Income from continuing operations, before income taxes		28,868			45,071			624		(25,852	)		48,711
Income tax expense		1,162			17,352			240		—			18,754

Income from continuing operations		27,706			27,719			384		(25,852	)		29,957
Loss from discontinued operations, net of tax		—			(2,251	)		—		—			(2,251	)


Net income	$	27,706		$	25,468		$	384	$	(25,852	)	$	27,706

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF INCOME
Three Months Ended September 30, 2005
(In thousands)


				Guarantor			Non-Guarantor					Consolidated
	ResCare, Inc.			Subsidiaries			Subsidiaries		Eliminations			Total

Revenues	$	62,528		$	211,430		$	1,822	$	—		$	275,780

Operating expenses		63,107			193,703			1,638		—			258,448


Operating income		(579	)		17,727			184		—			17,332

Other (income) expenses:
Interest, net		2,641			1,989			3		—			4,633
Equity in earnings of subsidiaries		(9,754	)		—			—		9,754			—

Total other expenses		(7,113	)		1,989			3		9,754			4,633

Income from continuing operations, before income taxes		6,534			15,738			181		(9,754	)		12,699
Income tax (benefit) expense		(1,095	)		5,350			62		—			4,317

Income from continuing operations		7,629			10,388			119		(9,754	)		8,382
Loss from discontinued operations, net of tax		—			(753	)		—		—			(753	)


Net income	$	7,629		$	9,635		$	119	$	(9,754	)	$	7,629

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF INCOME
Nine Months Ended September 30, 2005
(In thousands)


				Guarantor			Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries			Subsidiaries			Eliminations			Total
Revenues	$	183,040		$	608,169		$	4,796		$	—		$	796,005

Operating expenses		179,371			563,724			4,223			—			747,318


Operating income		3,669			44,445			573			—			48,687

Other (income) expenses:
Interest, net		7,062			6,634			(6	)		—			13,690
Equity in earnings of subsidiaries		(22,866	)		—			—			22,866			—

Total other expenses		(15,804	)		6,634			(6	)		22,866			13,690

Income from continuing operations, before income taxes		19,473			37,811			579			(22,866	)		34,997
Income tax (benefit) expense		(1,153	)		12,855			197			—			11,899

Income from continuing operations		20,626			24,956			382			(22,866	)		23,098
Loss from discontinued operations, net of tax		—			(2,472	)		—			—			(2,472	)


Net income	$	20,626		$	22,484		$	382		$	(22,866	)	$	20,626

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Nine Months Ended September 30, 2006
(In thousands)


				Guarantor			Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries			Subsidiaries			Eliminations			Total
Operating activities:
Net income	$	27,706		$	25,468		$	392		$	(25,860	)	$	27,706
Adjustments to reconcile net income to cash (used in) provided by operating activities:
Depreciation and amortization		5,352			7,269			22			—			12,643
Impairment charges		—			1,110			—			—			1,110
Amortization of discount and deferred debt issuance costs on notes		736			—			—			—			736
Share-based compensation		1,371			—			—			—			1,371
Deferred income taxes		1,460			—			—			—			1,460
Excess tax benefits from share-based compensation		(2,627	)		—			—			—			(2,627	)
Provision for losses on accounts receivable		—			4,319			—			—			4,319
Equity in earnings of subsidiaries		(25,860	)		—			—			25,860			—
Changes in operating assets and liabilities		(46,895	)		23,150			(305	)		—			(24,050	)

Cash (used in) provided by operating activities		(38,757	)		61,316			109			—			22,668

Investing activities:
Purchases of property and equipment		(6,584	)		(5,528	)		366			—			(11,746	)
Acquisitions of businesses		—			(108,430	)		—			—			(108,430	)
Proceeds from sale of assets		—			13			—			—			13
Proceeds from sales and maturities of short-term investments		66,850			—			—			—			66,850
Purchases of short-term investments		(39,200	)		—			—			—			(39,200	)

Cash provided by (used in) investing activities		21,066			(113,945	)		366			—			(92,513	)

Financing activities:
Repayments of long-term debt and capital leases		(78	)		(3,970	)		(393	)		—			(4,441	)
Borrowings of long-term debt		40,000			—			—			—			40,000
Short-term borrowings — three months or less, net		19,500			—			—			—			19,500
Proceeds from sale and leaseback transactions		—			2,651			—			—			2,651
Debt issuance costs		(468	)		—			—			—			(468	)
Excess tax benefit from share-based compensation		2,627			—			—			—			2,627
Net payments relating to intercompany financing		(54,303	)		53,514			789			—			—
Proceeds received from exercise of stock options		6,734			—			—			—			6,734

Cash provided by financing activities		14,012			52,195			396			—			66,603

(Decrease) increase in cash and cash equivalents		(3,679	)		(434	)		871			—			(3,242	)
Cash and cash equivalents at beginning of period		5,192			1,927			2,775			—			9,894

Cash and cash equivalents at end of period	$	1,513		$	1,493		$	3,646		$	—		$	6,652

RES-CARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Nine Months Ended September 30, 2005
(In thousands)


				Guarantor			Non-Guarantor						Consolidated
	ResCare, Inc.			Subsidiaries			Subsidiaries			Eliminations			Total
Operating activities:
Net income	$	20,626		$	22,484		$	382		$	(22,866	)	$	20,626
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization		4,744			5,549			25			—			10,318
Amortization of discount and deferred debt issuance costs on notes		652			—			—			—			652
Deferred income taxes, net		(1,139	)		2,190			1			—			1,052
Tax benefit from exercise of stock options		1,368			—			—			—			1,368
Provision for losses on accounts receivable		—			3,548			—			—			3,548
Equity in earnings of subsidiaries		(22,866	)		—			—			22,866			—
Changes in operating assets and liabilities		40,251			(50,441	)		(569	)		—			(10,759	)

Cash provided by (used in) operating activities		43,636			(16,670	)		(161	)		—			26,805

Investing activities:
Purchases of property and equipment		(2,560	)		(5,891	)		(51	)		—			(8,502	)
Acquisitions of businesses		—			(31,975	)		—			—			(31,975	)
Proceeds from sales of assets		—			64			—			—			64
Proceeds from sales and maturities of short-term investments		353,660			—			—			—			353,660
Purchases of short-term investments		(320,425	)		—			—			—			(320,425	)

Cash provided by (used in) investing activities		30,675			(37,802	)		(51	)		—			(7,178	)

Financing activities:
Repayments of long-term debt and capital leases		(41,345	)		(1,085	)		—			—			(42,430	)
Borrowings of long-term debt		13,000			—			—			—			13,000
Net payments relating to intercompany financing		(52,943	)		52,608			335			—			—
Proceeds received from exercise of stock options		4,491			—			—			—			4,491

Cash (used in) provided by financing activities		(76,797	)		51,523			335			—			(24,939	)

(Decrease) increase in cash and cash equivalents		(2,486	)		(2,949	)		123			—			(5,312	)
Cash and cash equivalents at beginning of period		22,080			3,590			2,734			—			28,404

Cash and cash equivalents at end of period	$	19,594		$	641		$	2,857		$	—		$	23,092

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

Preliminary Note Regarding 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 that may cause actual results to differ materially from those in such statements. We discuss events or circumstances that could cause actual results to differ in the “Risk Factors” section in Part II, Item 1A of this Report and in our 2005 Annual Report on Form 10-K. Our 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.

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 — significant developments during 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.

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, 2006, we have three reportable operating segments: (i) Community 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 8 of the Notes to Condensed Consolidated Financial Statements.

Revenues for our Community Services operations 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 government agencies and are also reimbursed under the Medicaid program. Our services include social, functional and vocational skills training, supported employment and emotional and psychological counseling for individuals with mental retardation or other disabilities. We also provide respite, therapeutic and other services to individuals with special needs and to older people in their homes. These services are provided 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 with local and state governments funded by federal agencies, including the DOL and the Department of Health and Human Services.

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 have been no material changes in our method of providing for reserves for doubtful accounts during 2006.

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 and include an amount determined from reported claims and an amount based on past experiences for losses incurred but not reported. 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. There have been no material changes to our method of providing reserves for insurance risks during 2006.

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 10 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 have been no material changes to our method of providing reserves for legal contingencies during 2006.

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. During the first quarter of 2006, we recorded a charge totaling $2.2 million in connection with our withdrawal from the District of Columbia (District). Included in this charge was $0.6 million related to asset impairment, principally leaseholds and furniture. Unrelated to our withdrawal from the District, in the second quarter of 2006 we recorded a charge of $0.4 million related to asset impairment of certain land and buildings. There have been no other material asset valuation losses during 2006.

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 implied fair value. Fair values are established using a weighted average of comparative market multiples in the current market conditions and discounted cash flows. No valuation losses have been recorded during 2006.

Revenue Recognition

Community 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 have been no material changes in the application of our revenue recognition policies during 2006.

Quarter in Review

Revenues for the quarter were $336.3 million, net income was $10.6 million, and cash provided from operations was $18.2 million. These items are discussed in more detail in the following sections of the MD&A.

	•		During the third quarter, we completed the tuck-in acquisition of the operations of TLC Supported Living Services, which is expected to generate annual revenues of approximately $20 million. TLC provides in-home care services in the state of Indiana and Louisville, Kentucky. Also, during the third quarter, we completed the acquisitions of Magnolia Home Care (Georgia), Quality Healthcare Services (Georgia) and All Ways Caring Services (Illinois). These three acquisitions are expected to generate annual revenues of approximately $11 million.

	•		In the third quarter, revenues for the Employment Training Services segment were $48.3 million, down from $55.3 million in the second quarter of 2006. This decrease was primarily the result of contract non-renewals and revisions to certain contracts, on less favorable terms.

	•		On September 6, 2006, we announced that we are leading a coalition of public and private organizations to introduce a telecare system aimed at improving services to people with disabilities. Through a 66.7% interest in Rest Assured, LLC, we are providing remote monitoring services to both ResCare operations and other disabilities services providers, resulting in improvements to the lives of people served, as well as cost savings. The Rest Assured ^TMsystem incorporates traditional Web cam technology with interactive Web-based devises. The technology allows one staff person to monitor multiple individuals at a number of different sites. Rest Assured ^TM was recently approved by the state of Indiana to support people with cognitive, intellectual and related disabilities who receive services paid for by state government. The impact of Rest Assured on the quarter and nine months ended September 30, 2006 was not material.

	•		In August 2006, Standard & Poor’s Rating Services (S&P) raised our corporate credit rating to “BB-” from “B+”, the senior secured debt rating to “BB” from “BB-”, and the senior unsecured debt rating to “B+” from “B.”

	•		On September 27, 2006, ResCare entered into a new employment agreement with Ralph G. Gronefeld, Jr., ResCare’s President and Chief Executive Officer. The term is effective as of July 1, 2006 to December 31, 2011. Under this agreement, Mr. Gronefeld is eligible for restricted stock awards for a total of 400,000 shares of ResCare common stock comprised of (a) 300,000 “annual restricted shares” and (b) 100,000 “financial performance restricted shares.” The annual restricted shares will be awarded only if ResCare attains a net income threshold of $19.5 million for the twelve month period ending June 30, 2007. If the shares are awarded, 60,000 shares will vest immediately on the date of the award, which will be upon the public release of earnings for the quarter ending June 30, 2007. Thereafter, provided that Mr. Gronefeld continues to be employed by ResCare, 60,000 shares will vest annually on January 1 of each calendar year through January 1, 2011. Mr. Gronefeld was awarded the financial performance restricted shares on September 27, 2006, upon the execution of his employment agreement. The financial performance restricted shares will vest at one time if ResCare attains a net income target amount for any calendar year during the initial five-year term of the agreement, provided that Mr. Gronefeld continues to be employed by ResCare as of the last day of such calendar year. Pretax compensation expense attributable to these restricted stock awards for the third quarter of 2006 was approximately $0.3 million. For the fourth quarter of 2006 and the calendar year ending December 31, 2007, pretax compensation expense attributable to these awards is estimated to be approximately $1.0 million and $3.1 million, respectively, assuming we are on target to achieve the financial performance thresholds.

			In addition, we anticipate renewing employment contracts for other members of management effective in the first quarter of 2007. Those renewals are expected to contain share-based awards.

In addition, after the quarter the following events occurred:

•

Effective October 31, 2006, pursuant to the contract terms, the State of New Mexico cancelled our contract without cause. We ceased providing services to people with developmental disabilities in the state of New Mexico and are in the process of exiting the state. The New Mexico operations generated revenues of approximately $19 million for the first nine months of 2006 and have operated on an approximately break-even basis. We anticipate that the results of operations for New Mexico will be reported as discontinued operations in the fourth quarter and any exit charges will be recorded at that time.

•

ResCare announced on November 6, 2006, that Ralph G. Gronefeld, Jr., ResCare president and chief executive officer, has been elected to ResCare's Board of Directors, effective immediately. Mr. Gronefeld replaced Nigel S. Wright, a director since 2004, who resigned because of his other business obligations and commitments.

Results of Operations


	Three Months Ended						Nine Months Ended
	September 30						September 30
	2006			2005			2006			2005
	(Dollars in thousands)
Revenues:
Community Services	$	244,496		$	218,457		$	691,130		$	630,977
Job Corps Training Services		39,404			39,240			118,733			114,212
Employment Training Services		48,344			16,440			158,848			45,154
Other		4,017			1,643			15,063			5,662

Consolidated	$	336,261		$	275,780		$	983,774		$	796,005


Operating income:
Community Services	$	27,878		$	23,770		$	77,336		$	66,479
Job Corps Training Services		4,350			4,318			12,732			12,274
Employment Training Services		3,393			1,460			12,254			4,164
Corporate and Other		(14,467	)		(12,216	)		(40,443	)		(34,230	)

Consolidated	$	21,154		$	17,332		$	61,879		$	48,687


Operating margin:
Community Services		11.4	%		10.9	%		11.2	%		10.5	%
Job Corps Training Services		11.0	%		11.0	%		10.7	%		10.8	%
Employment Training Services		7.0	%		8.9	%		7.7	%		9.2	%
Consolidated		6.3	%		6.3	%		6.3	%		6.1	%

Consolidated

Consolidated revenues for both the quarter and nine months ended September 30, 2006, increased 22% and 24%, respectively, over the same periods in 2005, as more fully described in the segment discussions.

Operating income for the quarter and the nine months ended September 30, 2006 increased 22% and 27%, respectively, over the same periods in 2005. Operating margin was 6.3% for both the quarters ended September 30, 2006 and 2005, and increased from 6.1% to 6.3% for the nine months ended September 30, 2006, compared to the same period in 2005. These results are attributed to the revenue growth and operating margin improvement in the Community Services segment, offset by decreases primarily in the Employment Training Services segment, both of which are discussed below.

As a percentage of total revenues, corporate general and administrative expenses were 4.1% and 4.2% for the quarter and nine months ended September 30, 2006, respectively, and 4.3% for both of the same periods of 2005. These reductions were primarily the result of revenue growth through tuck-in acquisitions with minimal additional administrative expenses, partially offset by the effect of share-based compensation expense included in 2006.

Net interest expense decreased $0.1 million for the third quarter of 2006 and $0.5 million for the nine months ended September 30, 2006, compared to the same periods in 2005. These decreases were attributable to lower interest expense due to the refinancing in October 2005, offset by additional

borrowings in 2006 to fund the Workforce Services and other acquisitions and increases in the prime rate and London Interbank Offered Rate (LIBOR) in 2006.

Our effective income tax rates for the quarter and nine months ended September 30, 2006, are 36.6% and 38.5%, respectively, as compared to 34.0% in the comparable periods of 2005. The increase in the effective rate is primarily due to the expiration of the jobs tax credits in December 2005, which has not yet been reenacted by Congress, the impact of the non-deductibility of certain incentive stock options in accordance with SFAS 123(R) and less non-taxable investment income for 2006. In addition, our effective tax rate reflects the reversal of certain income tax reserves due to the expiration of the applicable statute of limitations for certain tax filing positions during the quarter.

Community Services

Community Services revenues for the quarter and nine months ended September 30, 2006 increased by 12% and 10%, respectively, over the same periods in 2005. This increase was due primarily to acquisitions in the second half of 2005 and during 2006 and increases in periodic in-home services. Periodic in-home services revenues increased $14.5 million from the year earlier quarter and $30.8 million from the year earlier nine months. Also contributing to the increase were revenues of approximately $4.5 million from our majority interest in Pharmacy Alternatives, LLC, a closed-door pharmacy providing products and services to both ResCare operations and other providers. Operating margin increased from 10.9% in the third quarter of 2005 to 11.4% in the same period in 2006 and from 10.5% to 11.2% for the nine months ended September 30, 2006, over the comparable period in 2005, due primarily to continued growth in the higher margin periodic in-home services unit, acquisitions and improved staff utilization.

Job Corps Training Services

Job Corps Training Services revenues remained flat in the third quarter 2006 compared to the same period in 2005 and increased 4% for the nine months ended September 30, 2006 over the same period in 2005, due principally to the addition of Northlands Job Corps center in July 2005 and contractual increases. Operating margins were similar to the comparable periods in 2005.

Employment Training Services

Employment Training Services revenues increased $31.9 million and $113.7 million, respectively, in the quarter and nine months ended September 30, 2006, over the same periods in 2005, due primarily to the Workforce Services acquisition, which accounted for approximately $30 million and $102 million of the increases, and increases of nearly $3 million and $13 million related to the New York City WeCare contract. Operating income for this segment increased $1.9 million for the quarter and $8.1 million for the nine months ended September 30, 2006, over the year earlier periods. Operating margin decreased from 8.9% in the third quarter of 2005 to 7.0% in the same period of 2006 and from 9.2% for the nine months ended September 30, 2005, to 7.7% in the comparable period of 2006. The third quarter results represent a 13% decline in revenues and a 100 basis point decline in operating margin from the second quarter of 2006. The decrease in the third quarter of 2006 is primarily attributable to contract non-renewals and fewer contract awards in addition to unfavorable modifications to existing contracts, generally effective July 1, 2006. The decrease for the nine months ended September 30, 2006 also included higher amortization expense due to the Workforce Services acquisition which was completed in the first quarter of 2006.

Other

A small portion of our business is dedicated to operating charter schools and international job training and placement agencies. Revenues from this segment more than doubled over the prior year periods. The primary reason for the increase is the new education contracts that were acquired with the Workforce Services acquisition in January 2006.

Discontinued Operations

Net income from discontinued operations was $0.1 million for the third quarter of 2006 and net loss from discontinued operations was $2.3 million for the nine months ended September 30, 2006, compared to net losses of $0.8 million and $2.5 million for the same periods a year ago. Included in net loss from discontinued operations for the nine months ended September 30, 2006, is a charge of $2.2 million for impaired assets and abandoned leased facilities and pretax operational losses of $1.4 million, offset by a tax benefit of $1.4 million.

Financial Condition, Liquidity and Capital Resources

Total assets increased 20% in 2006 over 2005. As described below, the increase in accounts receivable is primarily due to the Workforce Services acquisition and other growth. Workforce Services revenues for 2006 are estimated to be $145 million, down from previous estimates of $165 million, due in large part to contract non-renewals and delayed implementation of new and anticipated contracts. Primarily as a result of Workforce Services acquisition, and acquisitions during the second and third quarters of 2006, goodwill increased $89.3 million from December 31, 2005.

During the nine months ended September 30, 2006, cash, cash equivalents and short-term investments decreased by $30.9 million. During the three months and nine months ended September 30, 2006, cash provided from operations was $18.2 million and $22.7 million, respectively, compared to $1.8 million and $26.8 million provided from operations for the comparable periods in 2005. The decrease in 2006 from 2005 was the result of funding working capital requirements for the Workforce Services acquisition and other acquisitions primarily in the first quarter of 2006, offset by an increase in net income.

Days revenue in net accounts receivable were 51 days at September 30, 2006 and December 31, 2005. Net accounts receivable at September 30, 2006 increased to $196.1 million, compared to $160.8 million at December 31, 2005. The increase in net accounts receivable is primarily due to receivables related to the Workforce Services and other acquisitions and some collection timing differences. Of the total net accounts receivable balance at September 30, 2006 and December 31, 2005, approximately 3% were greater than 540 days.

Capital expenditures were consistent with our historical experience, comprised principally of maintenance capital expenditures, with a less significant amount expended for strategic systems. We spent $108.4 million on acquisitions during the first nine months of 2006, of which the acquisition of Workforce Services was $69.8 million and acquisitions in the second and third quarters of 2006 were $38.6 million.

Our financing activities during the first nine months included net borrowings of $59.5 million on the revolver and $2.7 million in proceeds from sale and leaseback transactions. These inflows were offset

by payments of debt of $4.4 million and $0.5 million in debt issuance costs associated with amending our credit facility. Option exercise activity resulted in $6.7 million in proceeds and $2.6 million in tax benefits.

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.

As of September 30, 2006, we had irrevocable standby letters of credit in the principal amount of $49.2 million issued primarily in connection with our insurance programs.

On June 7, 2006, we amended our existing senior secured credit facility. The amendment reduced certain borrowing cost margins and increased the revolving credit facility by $25 million to a total of $200 million. Additional capacity of $50 million remains in place, which allows us to expand our total borrowing capacity to $250 million. The credit facility expires on October 3, 2010 and will be used primarily for working capital purposes, letters of credit required under our insurance programs and for acquisitions.

As of September 30, 2006, we had $91.3 million available under the revolver with an outstanding balance of $59.5 million. Outstanding balances bear interest at 1.625% over the LIBOR or other bank developed rates at our option. As of September 30, 2006, the weighted average interest rate was 7.26%. Letters of credit had a borrowing rate of 1.625% as of September 30, 2006. The commitment fee on the unused balance is .35%. The margin over LIBOR and the commitment fee are determined quarterly based on our leverage ratio, as defined by the revolving credit facility.

The amended and restated credit facility contains various financial covenants relating to net worth, capital expenditures and rentals and requires us to maintain specified ratios with respect to our interest and leverage. We are in compliance with our debt covenants as of September 30, 2006. 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.

Operating funding sources are approximately 68% through Medicaid reimbursement, 12% from the DOL and 20% from other 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
	Twelve Months Ending September 30
									2012 and
Contractual Obligations	Total		2007		2008-2009		2010-2011		Thereafter
Long-term Debt	$	215,775	$	4,406	$	1,705	$	59,515	$	150,149
Capital Lease Obligations		695		441		56		52		146
Operating Leases		175,975		41,222		60,596		36,176		37,981
Purchase Contracts		—		—		—		—		—

Total Contractual Obligations	$	392,445	$	46,069	$	62,357	$	95,743	$	188,276

Amount of Commitments Expiring per Period

Total

Twelve Months Ending September 30

Other Commercial

Amounts

2012 and

Commitments

Committed

2007

2008-2009

2010-2011

Thereafter

Standby Letters-of-Credit

49,175

—

Impact of Recently Issued Accounting Pronouncements

See Note 11 of the Notes to Condensed Consolidated Financial Statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

While we are exposed to changes in interest rates as a result of any outstanding variable rate debt, we do not currently utilize any derivative financial instruments related to our interest rate exposure. At September 30, 2006, we had $59.5 million variable rate debt outstanding as compared to no variable rate debt outstanding at December 31, 2005. This variable rate debt was comprised of our senior secured credit facility, which has an interest rate based on margins over LIBOR or prime, tiered based upon leverage calculations. A 100 basis point movement in the interest rate would result in an approximate $0.6 million annualized effect on interest expense and cash flows.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

ResCare’s management, under the supervision and with the participation of the Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”), evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2006. 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 first nine months of 2006 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 described in Note 10 to the condensed consolidated financial statements set forth in Part I of this report and incorporated by reference into this Part II, Item 1.

Item 1A. Risk Factors

The following sets forth changes from risk factors previously disclosed in our 2005 Annual Report on Form 10-K and our 2006 Quarterly Reports on Form 10-Q.

We receive a substantial amount of jobs tax credits that Congress must renew.

Over the years, we have employed numerous individuals qualifying us to receive a substantial amount of jobs tax credits. If Congress does not pass legislation to renew the jobs tax credit, our income tax expense will increase. These credits have existed for over 30 years and have always been renewed, in more than one instance by retroactively effective legislation. Certain jobs tax credits expired on December 31, 2005, and while we gauge legislative intent to indicate that the credits will be renewed retroactively to January 1, 2006 (a seamless extension), there can be no assurance that this will happen.

Our inability to renew our existing contracts with governmental agencies and to obtain additional contracts can adversely affect our revenues.

Each of our operating segments derives a substantial amount of revenue from contracts with government agencies. These contracts are generally in effect for a specific term, and our ability to renew or retain them depends on our operating performance and reputation, as well as other factors over which we have less or no control. We may not be successful in bidding for contracts to operate, or to continue operating, Job Corps or Employment Training centers. Our Job Corps contracts are re-bid regardless of operating performance, at least every five years and our Employment Training Services contracts are typically re-bid every one or two years. Government contracts of the operations we acquire may be subject to termination upon such an event, and our ability to retain them may be affected by the performance of prior operators. 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 our 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.

Item 5. Other Information

From time to time executive officers and directors of ResCare may adopt non-discretionary, written trading plans that comply with SEC Rule 10b5-1, or otherwise monetize their equity-based compensation. Rule 10b5-1 provides executives with a method to monetize their equity-based compensation in an automatic and non-discretionary manner over time. All such activities will be subject to compliance with our compensation and trading policies, and applicable laws and regulations. Reporting the adoption of 10b5-1 plans by executive officers and directors, and posting information

about such plans on our website, is consistent with ResCare’s philosophy of open communication with our shareholders.

On December 24, 2005, Ronald G. Geary, Chairman of ResCare, adopted a written trading plan that complies with Rule 10b5-1 for financial planning purposes and to diversify his financial holdings. The plan covers 97,686 shares of ResCare common stock that Mr. Geary will obtain through the exercise of stock options granted to him under his employment contract with ResCare. The plan extends for one year and sales are expected to be weekly. On June 27, 2006, the plan was amended to suspend sales under it until September 5, 2006, at which time sales resumed covering 74,500 shares to be sold between September 5 and 22, 2006. At the time of the plan’s adoption, Mr. Geary beneficially owned 1,142,988 shares or 4.3% of the ResCare common shares outstanding. As of September 30, 2006, he beneficially owned 673,573 shares or 2.4% of common shares outstanding.

E. Halsey Sandford, a director of ResCare, and an affiliate of Mr. Sandford have adopted non-discretionary written trading plans that comply with Rule 10b5-1. The plans were also adopted for financial planning purposes. Mr. Sandford’s plan covers approximately 40,850 shares which Mr. Sandford obtained through exercise of stock options granted to him under his employment agreement with ResCare prior to his retirement in 2001. The affiliate’s plan covers approximately 52,800 shares that were obtained by gift from Mr. Sandford from shares he obtained through option exercises as described above. After the affiliate’s plan was terminated, the affiliate subsequently sold the balance of its shares. Mr. Sandford’s plan extends for one year and the sales are expected to be monthly. At the time his plan was adopted, Mr. Sandford owned 115,689 shares, or 0.4% of ResCare’s common shares outstanding. At the time the affiliate’s plan was adopted, Mr. Sandford owned 97,700 shares, or 0.3% of ResCare’s common shares outstanding.

Item 6. Exhibits

(a) Exhibits

	10		Employment Agreement between Res-Care, Inc. and Ralph G. Gronefeld, Jr. is incorporated by reference to Exhibit 99.1 of Form 8-K filed on October 3, 2006.

	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		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.


	September 30		December 31
	2006		2005
	(In thousands)
7.75% senior notes due 2013, net of discount of $1.0 million in 2006 and $1.1 million in 2005	$	149,030	$	148,926
Senior secured credit facility		59,500		—
Obligations under capital leases		695		1,586
Notes payable and other		6,136		6,626

		215,361		157,138
Less current portion		4,847		4,554

	$	210,514	$	152,584


	RES-CARE, INC. Registrant
Date: November 7, 2006	By:	/s/ Ralph G. Gronefeld, Jr.
		Ralph G. Gronefeld, Jr.
		President and Chief Executive Officer


Date: November 7, 2006	By:	/s/ David W. Miles
		David W. Miles
		Executive Vice President and Chief Financial Officer


	PAGE
	NUMBER
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – September 30, 2006 and December 31, 2005		2

Condensed Consolidated Statements of Income – Three Months Ended September 30, 2006 and 2005; Nine Months Ended September 30, 2006 and 2005		3

Condensed Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2006 and 2005		4

Notes to Condensed Consolidated Financial Statements – September 30, 2006		5

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		28

Item 3. Quantitative and Qualitative Disclosures about Market Risk		38

Item 4. Controls and Procedures		38

PART II. OTHER INFORMATION

Item 1. Legal Proceedings		40

Item 1A. Risk Factors		40

Item 5. Other Information		40

Item 6. Exhibits		41

SIGNATURES

EXHIBITS
EX-31.1
EX-31.2
EX-32