<PAGE>   1
                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                FORM 10-Q/A NO. 1

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

                For the Quarterly Period Ended September 30, 1996

                                       OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

            For the Transition Period from ___________ to ___________


                         Commission File Number: 0-17969
                                                 _______

                                NEXTHEALTH, INC.
             ______________________________________________________
             (Exact Name of Registrant as Specified in its Charter)



           Delaware                                      86-0589712
           ________                                      __________
(State or Other Jurisdiction of             (I.R.S. Employer Identification No.)
Incorporation or Organization)



16600 N. Lago Del Oro Parkway, Tucson, Arizona                          85739
______________________________________________                        __________
   (Address of Principal Executive Offices)                           (Zip Code)


                                 (520) 792-5800
                  ____________________________________________
              (Registrant's Telephone Number, including Area Code)


                                       N/A
           ___________________________________________________________
             (Former name, former address and former fiscal year, if
                           changed since last report)


Indicate by check mark whether the registrant (1)has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2)has been subject to such filing
requirements for the past 90 days. [X] YES [ ] NO

On November 1, 1996, there were 8,554,938 shares of the registrant's Common
Stock outstanding.

Reference is made to the listing beginning on page 21 of all exhibits filed as a
part of this report.
<PAGE>   2
                                    FORM 10-Q

                                TABLE OF CONTENTS





<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION                                                                 PAGE
==============================                                                                 ====

<S>                                                                                            <C>
Item 1.  Financial Statements
         Consolidated Balance Sheets as of September 30, 1996 (unaudited) and
               December 31, 1995 .........................................................      3
         Unaudited Consolidated Statements of Operations for the three and nine month
                periods ended September 30, 1996 and 1995 ................................      4
         Unaudited Consolidated Statements of Cash Flows for the nine month periods
                     ended September 30, 1996 and 1995 ...................................      5
         Unaudited Consolidated Statement of Changes in Stockholders' Equity for the
              nine month period ended September 30, 1996 .................................      6
         Unaudited Notes to the Consolidated Financial Statements ........................      7
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of
              Operations .................................................................      9

PART II - OTHER INFORMATION

Item 1.  Legal Proceedings ...............................................................     16
Item 2.  Changes in Securities ...........................................................     16

Item 5.  Other Information ...............................................................     16

Item 6.  Exhibits and Reports on Form 8-K ................................................     21
Signatures ...............................................................................     22
</TABLE>



                                              2
<PAGE>   3
                         PART I - FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

                        NEXTHEALTH, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                   (000s, except share and per share amounts)



<TABLE>
<CAPTION>
                                                                  September 30,  December 31,
                                                                       1996          1995
                                                                     --------      --------
                                                                  (Unaudited)
<S>                                                                  <C>           <C>
ASSETS
  Current Assets:
    Cash and equivalents .......................................     $    430      $  2,864
    Short-term investments .....................................           --         1,635
    Accounts receivable, less allowance for doubtful accounts
       of $380 and $431, respectively ..........................          889         1,340
    Prepaid expenses ...........................................          672           476
    Other current assets .......................................          421           478
                                                                     --------      --------
       Total current assets ....................................        2,412         6,793
Property and equipment, net ....................................       39,554        40,158
Long-term receivables, less allowance for doubtful accounts
     of $62 and $70, respectively ..............................          185           211
Intangible assets, less amortization of $7 and $33, respectively          108           704
Other assets ...................................................          495            76
                                                                     --------      --------
       Total assets ............................................     $ 42,754      $ 47,942
                                                                     ========      ========
LIABILITIES AND STOCKHOLDERS' EQUITY
  Current Liabilities:
    Accounts payable, trade ....................................     $  2,730      $  2,410
    Accounts payable, construction .............................           --         4,517
    Current portion of long-term debt ..........................        3,052            --
    Accrued expenses and other liabilities .....................        4,333         3,451
                                                                     --------      --------
       Total current liabilities ...............................       10,115        10,378
  Long-term debt and financing obligation, less current 
    portion ....................................................        4,642           985
                                                                     --------      --------
       Total liabilities .......................................       14,757        11,363
                                                                     --------      --------
  Stockholders' Equity:
    Preferred stock, $.01 par value, 4,000,000 shares
      authorized; no shares issued and outstanding .............           --            --
    Common stock, $.01 par value, 16,000,000 shares
      authorized; 8,554,938 shares outstanding at September 30,
      1996 and December 31, 1995 ...............................           86            86
    Additional paid-in capital .................................       43,453        43,453
    Accumulated deficit ........................................      (15,542)       (6,960)
                                                                     --------      --------
       Total stockholders' equity ..............................       27,997        36,579
                                                                     --------      --------
       Total liabilities and stockholders' equity ..............     $ 42,754      $ 47,942
                                                                     ========      ========
</TABLE>


    The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                        3
<PAGE>   4
                        NEXTHEALTH, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                        (000s, except per share amounts)
                                   (Unaudited)



<TABLE>
<CAPTION>
                                       Three Months Ended          Nine months Ended
                                          September 30,              September 30,
                                     ----------------------      ----------------------
                                       1996          1995          1996          1995
                                     --------      --------      --------      --------
<S>                                  <C>           <C>           <C>           <C>
Revenue:
  Net operating revenue ............   $  4,255      $  3,005      $ 13,502      $  9,368
  Investment income ................         10           258            40         1,188
  Other revenue ....................         61            75           248           523
                                     --------      --------      --------      --------
        Total net revenue ..........      4,326         3,338        13,790        11,079

Operating expenses:
  Salaries and related benefits ....      3,695         1,953        11,225         5,784
  General and administrative .......      3,017         1,893         8,759         5,799
  Business expansion ...............         --         2,601            --         3,430
  Interest .........................        266            21           374            71
  Depreciation and amortization ....        681           402         2,014         1,184
                                     --------      --------      --------      --------

        Total operating expenses ...      7,659         6,870        22,372        16,268
                                     --------      --------      --------      --------


Loss before income tax benefit .....     (3,333)       (3,532)       (8,582)       (5,189)
Income tax benefit .................         --            --            --            --
                                     --------      --------      --------      --------
Net loss ...........................   $ (3,333)     $ (3,532)     $ (8,582)     $ (5,189)
                                     ========      ========      ========      ========

Weighted average shares of common
stock outstanding ..................      8,554         8,549         8,554         8,545
                                     ========      ========      ========      ========

Net loss per share of common stock..   $  (0.39)     $  (0.41)     $  (1.00)     $  (0.61)
                                     ========      ========      ========      ========
</TABLE>

   The accompanying notes are an integral part of the consolidated financial
                                  statements.


                                        4
<PAGE>   5
                        NEXTHEALTH, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                     (000s)
                                   (Unaudited)


<TABLE>
<CAPTION>
          `                                                                            Nine months Ended
                                                                                          September 30,
                                                                                     ----------------------
                                                                                       1996          1995
                                                                                     --------      --------

<S>                                                                                  <C>           <C>
Cash flows from operating activities:
   Net loss ....................................................................     $ (8,582)     $ (5,189)
Adjustments to reconcile net loss to cash (used in)
provided by operating activities:
   Depreciation and amortization ...............................................        2,014         1,184
   Provision (benefit) for bad debts ...........................................         (122)          155
Changes in operating assets and liabilities net of effects from acquisitions:
   Decrease (increase) in assets:
      Accounts receivable ......................................................          598         1,991
      Prepaid and other assets .................................................         (473)         (495)
   Increase in liabilities:
      Accounts payable and accrued liabilities .................................        2,225         5,156
      Income taxes receivable ..................................................           --         4,507
                                                                                     --------      --------
Net cash (used in) provided by operating activities ............................       (4,340)        7,309
                                                                                     --------      --------
Cash flows for investing activities:
   Purchase of property and equipment, net .....................................       (1,103)       (8,710)
   Business acquisitions, net of cash acquired .................................          (88)         (130)
   Sale of Hilton Head Health Institute ........................................          199            --
   Purchase of long-term investments ...........................................           --       (14,162)
   Sale of long-term investments ...............................................           --         9,325
                                                                                                   --------
Net cash used in investing activities ..........................................         (992)      (13,677)
                                                                                     --------      --------
Cash flows from financing activities:
   Exercise of Common Stock Options ............................................           --            22
   Proceeds from long-term debt ................................................        3,929            --
   Reduction of long-term debt .................................................       (2,666)         (119)
                                                                                     --------      --------
Net cash used in financing activities ..........................................        1,263           (97)
                                                                                     --------      --------
Net decrease in cash and cash equivalents ......................................       (4,069)       (6,465)
Cash and equivalents at beginning of period ....................................        4,499        11,741
                                                                                     --------      --------

Cash and equivalents at end of period ..........................................     $    430      $  5,276
                                                                                     ========      ========
</TABLE>


    The accompanying notes are an integral part of the consolidated financial
                                  statements.


                                        5
<PAGE>   6
                        NEXTHEALTH, INC. AND SUBSIDIARIES
            CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                          (000s, except share amounts)
                                   (Unaudited)





<TABLE>
<CAPTION>
                                                             Additional                       Total
                                       Common Stock            Paid-in     Accumulated    Stockholders'
                                    Cost         Shares        Capital       Deficit         Equity
                                  ---------     ---------     ---------     ---------      ---------

<S>                               <C>           <C>           <C>           <C>            <C>
Balance at December 31, 1995      $      86     8,554,938     $  43,453     $  (6,960)     $  36,579
Net loss for the nine months
     ended September 30, 1996            --            --            --        (8,582)        (8,582)
                                  ---------     ---------     ---------     ---------      ---------
Balance at September 30, 1996     $      86     8,554,938     $  43,453     $ (15,542)     $  27,997
                                  =========     =========     =========     =========      =========
</TABLE>








    The accompanying notes are an integral part of the consolidated financial
                                  statements.


                                        6
<PAGE>   7
                                NEXTHEALTH, INC.
                 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
                                     (000s)
                                   (Unaudited)


NOTE 1 - ORGANIZATION

NextHealth, Inc. is a leading provider of wellness and preventive health care
services in diverse retail markets. For over ten years, the Company has
developed effective treatment models which address individual wellness and
quality of life issues through a whole person, mind-body approach.

The Company operates in two distinct business segments. The Treatment segment
includes Sierra Tucson, Inc. ("STI"), a state licensed, special psychiatric
hospital and behavioral health care center for the treatment of substance abuse
and mental health disorders, including eating disorders and dual diagnosis and
Onsite Workshops, Inc. ("Onsite"), which offers short-term therapeutic
experiences and workshops. (See Note 3.) The Health and Leisure segment includes
Miraval(TM), a unique vacation experience blending stress management and
self-discovery programs in a luxury health resort environment, which opened in
late 1995 and Hilton Head Health Institute, Inc. ("HHHI"), a provider of weight
management programs for the development and maintenance of healthy lifestyles as
well as fitness, nutrition, stress management and other lifestyle change
programs, acquired in March 1996. (See Note 3.)

NOTE 2 - BASIS OF PRESENTATION

The unaudited consolidated financial statements presented herein should be read
in conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended December
31, 1995. The accompanying interim consolidated financial statements as of
September 30, 1996 and for the three and nine-month periods ended September 30,
1996 and 1995 included herein are unaudited, but reflect, in the opinion of
management, all adjustments (consisting of normal recurring adjustments)
considered necessary to fairly present the results for such periods. Operating
results for the three and nine-month periods ended September 30, 1996 are not
necessarily indicative of the results that may be expected for the year ended
December 31, 1996.

NOTE 3 - DIVESTITURES

On October 18, 1996, the Company announced the divestiture of Onsite Workshops,
Inc. and Hilton Head Health Institute in order to further reduce corporate
overhead, eliminate long-term debt obligations and focus on its two primary
lines of business, Miraval and Sierra Tucson, Inc. The Onsite sale, which was
completed on November 30, 1996, was made to the original owners in exchange for
the assumption of existing obligations. Goodwill of $281,000 recorded in
connection with the Onsite acquisition was written-off in anticipation of this
sale. The HHHI was purchased by NextHealth's President and Chief Executive
Officer, John Schmitz on October 1, 1996 for cash of $275,000 and assumption of
certain debt obligations, including the purchase of real property, such that no
gain or loss was realized by the Company on the sale. The Company guarantees up
to $130,000 of any loss related to the sale of the real property by John Schmitz
to an unaffiliated third party. The HHHI sales transaction was recorded in the
accompanying September 30, 1996 financial statements. This transaction was
reviewed and approved by an independent committee of the Company's Board of
Directors. In considering the divestiture of these two lines of business, the
Board concluded that neither offered a significant long-term profit potential
when compared to Miraval and Sierra Tucson, Inc. In addition, the divestitures
have a minimal impact on the Company's financial position, operations or cash
flow.




                                        7
<PAGE>   8
NOTE 4 - FINANCING TRANSACTIONS

On April 10, 1996, the Company obtained a $2,000 line of credit (the "LOC") from
the National Bank of Arizona for a term of six months. The LOC had a variable
interest rate based upon the prime rate as published in the Western Edition of
the Wall Street Journal plus 1 percent. The initial interest rate was 9.25%,
payable in monthly installments. The LOC was secured by certain real estate
owned by the Company. The LOC was paid off in full with the proceeds from the
$4,000 financing mentioned below.

On April 3, 1996, the Company negotiated an agreement with Sundt Corporation
("Sundt"), the general contractor of the Miraval project, for the payment of
approximately $3,700, which represented the remaining balance due Sundt at that
date for the construction of Miraval. This agreement has a term of eighteen
months and bears interest at an annual rate equal to the prime rate as
established by Bank One, N.A. plus 4 percent. Sundt received a $300 payment at
the closing of the LOC and will receive payments of $125 per month for a period
of eleven months commencing in May 1996. The balance remaining after the
aforementioned payments will be paid evenly in six monthly installments. Sundt
has agreed to subordinate the master Mechanics' Lien recorded against Miraval's
real property on March 28, 1996 to the LOC and additional borrowings up to
$5,000. Additionally, as part of this agreement, if the Company were to obtain
secured borrowings in excess of $5,000 or unsecured borrowings in excess of
$3,000, the unpaid balance due Sundt would immediately become due. At December
31, 1995, the amount due Sundt was classified as accounts payable, construction.
At June 30, 1996, as a result of the agreement negotiated with Sundt, the
long-term portion of this obligation has been classified as long-term debt.

On June 28, 1996, the Company amended its agreement with Sundt to facilitate the
closing of the $4,000 financing noted below. Sundt received an additional $100
payment in connection with this amendment.

On June 28, 1996, the Company secured financing in the amount of $4,000 with
Mortgages Ltd. Principal and interest at 13.75% is payable in monthly
installments of $53 through March, 1998 at which time all unpaid principal is
due and payable. The financing is collateralized by certain real estate and
property, plant and equipment owned by the Company. Proceeds were used to repay
the existing balance on the LOC and to assist with meeting short-term working
capital requirements.

On November 15, 1996, the Company completed separate equity and debt
transactions with affiliates of Apollo Real Estate Advisors, L.P. (See Part II,
Item 5). Both Sundt and Mortgages Limited were paid in full. See discussion in
the "Liquidity and Capital Resources" section.

NOTE 5 - SUBSEQUENT EVENTS

See Part II - Other Information, Item 5, Other Information.

NOTE 6 - RECLASSIFICATIONS

Certain prior period amounts in the unaudited consolidated financial statements
have been reclassified to conform to the presentation used in 1996.



                                        8
<PAGE>   9
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

The following discussion and analysis relates to factors which have affected the
consolidated financial condition and results of operations of the Company for
the three and nine-month periods ended September 30, 1996 and 1995. Certain
prior year amounts have been reclassified to conform to the presentation used in
1996. Reference should also be made to the Company's unaudited consolidated
financial statements and related notes thereto included elsewhere in this
document.

GENERAL

NextHealth, Inc. is a leading provider of wellness and preventive health care
services in diverse retail markets. For over ten years, the Company has
developed effective treatment models which address individual wellness and
quality of life issues through a whole person, mind-body approach.

The Company operates in two distinct business segments. The Treatment segment
includes Sierra Tucson, Inc., a state licensed, special psychiatric hospital and
behavioral health care center for the treatment of substance abuse and mental
health disorders, including eating disorders and dual diagnosis and Onsite,
which offers short-term therapeutic experiences and workshops. The Health and
Leisure segment includes Miraval, a unique vacation experience blending stress
management and self-discovery programs in a 106 room luxury health resort
environment, which opened in late 1995 and HHHI, a provider of weight management
programs for the development and maintenance of healthy lifestyles as well as
fitness, nutrition, stress management and other lifestyle change programs which
was acquired in March 1996. Agreements to sell both Onsite and HHHI were
executed after September 30, 1996.

The Company, as part of its long range plan, believes that it has positioned
itself to capitalize on the newly emerging health and leisure segment of the
health care services industry by developing Miraval, a luxury health resort
providing a full range of self-discovery, stress management and recreational
activities. For the nine-month period ended September 30, 1996, the Treatment
segment accounted for approximately 62% of all the Company's operating revenues
and approximately 37% of operating expenses while the Health and Leisure segment
accounted for approximately 37% of the Company's operating revenue and
approximately 46% of operating expenses. However, the Company believes that the
Health and Leisure segment will make significant contributions to the Company's
operating results in the future.




                                        9
<PAGE>   10
RESULTS OF OPERATIONS

THREE-MONTH PERIOD ENDED SEPTEMBER 30, 1996 COMPARED TO THREE-MONTH PERIOD ENDED
SEPTEMBER 30, 1995

The significant changes in results of operations and net cash provided by (used
in) operating activities for the three-month period ended September 30, 1996,
compared to the same period in 1995 are discussed below.


<TABLE>
<CAPTION>
                                                                          Three Months Ended
                                                                              September 30
                                                               ------------------------------------------
                                                                1996              1995           % Change
                                                               -------           -------         --------

<S>                                                            <C>               <C>              <C>
FINANCIAL RESULTS: (000s, except per share amounts)
  Total net revenue .................................          $ 4,326           $ 3,338            29.6 %
  Total operating expenses, less business expansion
      costs .........................................            7,659             4,269            79.4 %
  Business expansion costs ..........................               --             2,601          (100.0)%
  Net loss ..........................................           (3,333)           (3,532)            5.6 %
  Net loss per share of common stock ................             (.39)             (.41)            4.9 %
  Net cash provided by (used in) operating activities             (902)              334          (370.1)%
OPERATING DATA:
  Patient days - STI ................................            3,470             4,266           (18.7)%
  Average daily census - STI ........................               38                46           (17.4)%
  Participant days - Onsite .........................            1,927             2,137            (9.8)%
  Average daily census - Onsite .....................               21                23            (8.7)%
  Participant days - HHHI (1) .......................            2,569                --              --
  Average daily census - HHHI (1) ...................               28                --              --
  Guest days - Miraval (2) ..........................            4,893                --              --
  Average daily guest count - Miraval (2) ...........               53                --              --
</TABLE>

(1) HHHI was acquired effective March 1, 1996.

(2) Miraval commenced operations in December 1995. Complimentary guest days of
    334 are included in the stated figures.

For the three-month period ended September 30, 1996, the loss before income tax
benefit and net loss decreased from $3.5 million in 1995 to $3.3 million in
1996. Net cash provided by operating activities was $334,000 in 1995 compared to
net cash used in operating activities of $902,000 in 1996.

Total net revenue increased $1.0 million to $4.3 million, an increase of 30%
when compared to the same period in 1995. Results reflect commencement of
operations at Miraval and the acquisition of HHHI. This increase was offset by a
decrease in investment income attributable to the use of cash and investments
for the development of Miraval.

Salaries and related benefits increased $1.7 million to $3.7 million, an
increase of 89% when compared to the same period in 1995. The increase was
primarily due to staffing requirements related to the operations at Miraval.

General and administrative expense increased $1.1 million to $3.0 million, an
increase of 59% when compared to the same period in 1995. The increase was due
primarily to operational costs related to Miraval. This increase was partially
offset by a decrease in general and administrative expense of $356,000 at Sierra
Tucson, Inc.

The Company recognized a pre-tax loss of $3.3 million for the three-month period
ended September 30, 1996.


                                       10
<PAGE>   11
No provision or benefit for income taxes was recorded during this period. The
Company will be able to carry forward the current period loss to offset future
tax liabilities.

NINE-MONTH PERIOD ENDED SEPTEMBER 30, 1996 COMPARED TO NINE-MONTH PERIOD ENDED
SEPTEMBER 30, 1995

The significant changes in results of operations and net cash provided by (used
in) operating activities for the nine-month period ended September 30, 1996,
compared to the same period in 1995 are discussed below.

<TABLE>
<CAPTION>
                                                                               Nine months Ended
                                                                                  September 30,
                                                                ---------------------------------------------
                                                                  1996               1995            % Change
                                                                --------           --------          --------

<S>                                                             <C>                <C>               <C>
FINANCIAL RESULTS: (000s, except per share amounts)
   Total net revenue .................................          $ 13,790           $ 11,079            24.5 %
   Total operating expenses, less business expansion
      costs ..........................................            22,372             12,838            74.3 %
   Business expansion cost ...........................                --              3,430          (100.0)%
   Net loss ..........................................            (8,582)            (5,189)          (65.4)%
   Net loss per share of common stock ................             (1.00)             (0.61)          (63.9)%
   Net cash provided by (used in) operating activities            (4,340)             7,309          (159.4)%

OPERATING DATA:
   Patient days - STI ................................            11,682             13,182           (11.4)%
   Average daily census - STI ........................                43                 48           (10.4)%
   Participant days - Onsite .........................             5,800              5,862            (1.1)%
   Average daily census - Onsite .....................                21                 22            (4.5)%
   Participant days - HHHI (1) .......................             7,077                 --              --
   Average daily census - HHHI (1) ...................                26                 --              --
   Guest days - Miraval (2) ..........................            12,617                 --              --
   Average daily guest count - Miraval (2) ...........                46                 --
</TABLE>


(1) HHHI was acquired effective March 1, 1996 and was sold on October 1, 1996.

(2) Miraval commenced operations in December 1995. Complimentary guest days of
    1,895 are included in the stated figures.

For the nine-month period ended September 30, 1996, net loss increased $3.4
million to $8.6 million and net cash provided by operating activities decreased
$14.0 million resulting in net cash used in operating activities of $6.7 million
compared to the same period in 1995.

Total net revenue increased $2.7 million to $13.8 million, an increase of 24%
when compared to the same period in 1995. Results reflect commencement of
operations at Miraval and the acquisition of HHHI. This increase was offset by a
decrease in investment income attributable to the use of cash and investments
for the development of Miraval.

Salaries and related benefits increased $5.4 million to $11.2 million, an
increase of 94% when compared to the same period in 1995. The increase was
primarily due to staffing requirements related to the operations at Miraval.


                                       11
<PAGE>   12
General and administrative expense increased $3.0 million to $8.8 million, an
increase of 51% when compared to the same period in 1995. The increase was
primarily due to operational costs related to Miraval. The Company recognized a
pre-tax loss of $8.6 million for the nine-month period ended September 30, 1996.
No provision or benefit for income taxes was recorded during this period. The
Company will be able to carry forward the current period loss to offset future
tax liabilities.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary sources of liquidity and capital resources have typically
been cash provided by the Treatment segment's operating activities and funds
generated from the sale of investments and proceeds from public equity
offerings. Historically, these sources have been sufficient to meet the needs
and finance the operations and growth of the Company's business. Net cash
provided by the Treatment segment's operating activities has been primarily
affected by census levels and net revenue per patient day. This segment
contributed positive cash flow to the Company's operations during the three and
nine-month periods ended September 30, 1996.

Primarily as a result of operating expenditures required to support the Health
and Leisure segment until it is self sufficient, the Company's cash from
operations has decreased significantly. For the three-month period ended
September 30, 1996, the Company's net cash used in operating activities was
$902,000.

For the nine-month period ended September 30, 1996 the Company had net capital
expenditures of approximately $1.1 million. Primarily as a result of operating
expenditures required to support the Health and Leisure segment until it is
self-sufficient and the aforementioned capital expenditures, the Company's cash
reserves have decreased significantly. For the nine-month period ended September
30, 1996 the Company's net cash used in operating activities was $4.3 million.

The Treatment segment's operational results for the three-month period ended
September 30, 1996 reflect the segment's focus on attracting a high percentage
of retail patients. During this period, 74% of patient revenue was derived from
retail payments and the remaining 26% from third party payors. STI continues to
experience pressure from third party payors and managed care organizations to
restrict patient access to and payment for treatment services. Based on current
census levels and operating expenses, STI believes that it will generate
adequate cash flows to sustain the Treatment segment's ongoing operational
requirements.

Miraval, the Company's Health and Leisure segment's primary line of business,
commenced operations in December 1995. This segment's results are primarily
affected by occupancy, average annual room rates and the segment's ability to
manage costs. Miraval believes that it operates in a unique niche in an emerging
health and leisure market. Marketing and advertising initiatives for creating
marketplace awareness and demand for Miraval's services resulted in a room
occupancy rate of approximately 31% through September 30, 1996 of which 83% were
paying guests and 17% non-paying guests. As part of the segment's marketing
strategy, media, travel and trade representatives as well as other key
influencers have been invited to experience Miraval with the anticipation that
Miraval will be promoted in the marketplace. Management believes the Health and
Leisure segment will, in time, make a significant contribution to the Company's
financial condition. However, until such time that it generates positive cash
flow, short and long-term financing and the implementation of cost containment
measures will be necessary to sustain its operations.

To meet its current liquidity requirements, the Company entered into debt and
equity financing transactions. (See Item 5.) The financing transactions closed
on November 15, 1996. The proceeds from the transactions were approximately
$12,340,000. The source and use of funds are as follows:


<TABLE>
<CAPTION>
Source of Funds
---------------
<S>                                                        <C>
-   Preferred Stock - Series A                             $ 1,578,000
-   Preferred Stock - Series B                               2,672,000
-   Debt                                                     8,090,000
                                                           -----------
        Total Source of Funds                               12,340,000
</TABLE>



                                       12
<PAGE>   13
<TABLE>
<CAPTION>
Use of Funds
------------
<S>                                                                                          <C>
-   Payoff of contractor obligations to Sundt Corporation                                      2,680,000
-   Funds placed into escrow  to pay off the first mortgage with Mortgages Ltd. (1)            4,235,000
-   Payoff short term working capital loans                                                      800,000
                                                                                             -----------
        Total Debt Repayments                                                                  7,715,000
-   Funds available to meet operating cash requirements and alleviate net
    working capital deficit (2)                                                                4,625,000
                                                                                             -----------
        Total Use of Funds                                                                   $12,340,000
                                                                                             ===========
</TABLE>

(1)     Funds were placed in escrow to avoid a prepayment penalty of
        approximately $158,000. The funds placed in escrow will be used to pay
        off the principal balance on January 4, 1997. The Company expects to
        receive approximately $260,000 from the escrow monies after paying off
        the balance on January 4, 1997.

(2)     The funds available to meet operating cash requirements and alleviate
        net working capital deficit will be utilized to bring trade accounts
        payable and other current liabilities up to a current status. After
        disbursing the funds necessary to bring trade payables and other current
        liabilities to a current status, the Company expects to have
        approximately $1,500,000 in cash (cash on hand) available to meet future
        operating cash requirements.

The debt financing transaction (see Item 5) contains certain provisions related
to a stand by commitment for an additional $5,000,000. To the extent that cash
on hand is not enough to meet future operating cash requirements, the stand by
funds will be utilized to provide the cash necessary to fund future operating
cash requirements.

The Company must receive shareholder approval for certain items related to the
equity financing transaction (see Item 5). If shareholder approval of these
items is not obtained prior to March 15, 1997, the debt of $8,090,000 becomes
immediately due and payable as well as any accrued interest thereon and the
$4,250,000 of Preferred Stock is redeemable at the option of the holders, out of
funds legally available therefor. To the extent that shareholder approval is not
obtained related to those items required in the equity financing transaction,
this would create an immediate and significant liquidity crisis for the Company.
The effect of this potential liquidity crisis would have a major impact on the
Company's ability to continue operations.

Also, in order to alleviate current liquidity requirements, it is necessary for
the Company to increase occupancy levels and to implement additional cost
controls. Insufficient occupancy levels at Miraval or any significant decrease
in STI's patient levels would adversely affect the Company's financial position,
results of operations and cash flows. Management does not anticipate any
significant impact upon operations as a result of inflation, nor has the Company
historically experienced any such impact.

BUSINESS OUTLOOK

In 1997, the Company expects to realize a contribution to net income and cash
flow from its primary lines of business -- Treatment and Health & Leisure.

Performance in the Treatment segment (Sierra Tucson, Inc.) will be driven by
continued aggressive implementation of cost controls and new marketing
initiatives. Particular emphasis will be placed on increasing the number of
self-pay patients through a combination of innovative treatment programs and
focused advertising, direct mail, field sales and outbound telemarketing
campaigns.

Recently introduced programs such as Recovery Plus(TM) and Sierra Care(TM) will
continue to be promoted to major referent and retail market sectors, and will
likewise be introduced to the corporate marketplace. Recovery Plus(TM) is a
unique product which ensures that a chemically-dependent patient who relapses
during the first six months following discharge will be readmitted for an
additional 10-14 days at a very modest per diem rate. This program is the first
of its kind in the treatment field, and visible evidence of STI's commitment to
the long-term recovery of each patient, and the proven effectiveness of the
Sierra Model(TM).

Sierra Care(TM) is an all-inclusive addictions package which provides the
patient with the tools necessary to


                                       13
<PAGE>   14
meet their recovery goals within a 24 day time frame -- and at a substantially
reduced cost. Sierra Care(TM) is designed for addiction patients with a lower
acuity on the mental health diagnosis, and those who fall more into a straight
chemical dependency diagnosis.

STI will continue its traditional marketing efforts to the referent therapist
community, and look for the continued double-digit growth of prospective
patients which has characterized the third quarter of 1996.

Miraval, the Company's initial entry in the Health & Leisure category, has now
been in operation for nine months, and appears poised for steadily improving
performance in 1997. The resort has received extensive press coverage in such
diverse media as CNN, InStyle, Gourmet, and Vogue magazine (to name a few), and
has likewise gained a high level of awareness among consumers and travel
professionals.

Management's primary objective for Miraval in 1997 is to build short and
long-term occupancy levels while maintaining our unique program structure and
operational excellence. Marketing initiatives will be aimed primarily at upscale
consumers and top-echelon travel agents as well as corporate and incentive
groups. The Miraval message will be delivered through a blend of direct sales
and advertising -- including print, data base-driven direct mail, and public
relation activities.

Cost containment measures will continue to be a critical management objective in
1997. Variable staffing relative to seasonal occupancy fluctuations, a more
structured program format, and self-directed internal work teams focusing on all
aspects of operational quality should further improve efficiencies and cash
flow.

FACTORS THAT MAY AFFECT FUTURE RESULTS

Management's Discussion and Analysis of Results of Operations and Financial
Condition contains forward looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995 that involve a number of risks and
uncertainties. While management believes that such forward looking statements
are accurate as of the date hereof, the actual results and conditions could
differ materially from the statements contained herein. The information below
should be read in conjunction with the Company's unaudited consolidated
financial statements and related notes thereto included elsewhere and in other
portions of this document.

In addition, the following other factors could cause actual results and
conditions relating to liquidity and capital resources to differ materially.

Miraval represents a new and significant line of business for the Company.
Miraval is the Company's initial entry into a unique niche in the emerging
health and leisure market for which there is little, if any, industry market
data available. Its products and services are different than those of
traditional destination resorts or destination "spa" facilities. The Company has
little experience in the marketing, management or operation of a facility of
this nature, although it has hired qualified and experienced personnel from
related operations.

The Company is unable to project with any degree of accuracy the future
occupancy levels or revenues of Miraval because the facility is in its first
year of operation. The Company has no historical operating data for projecting
occupancy levels during peak and non-peak periods, marketing, operating or
maintenance costs and expenses. Although the Company believes that there is
strong consumer demand for Miraval's products and services because it represents
a unique vacation alternative, the Company cannot be certain that its current
marketing strategy will successfully attract the targeted clientele.

The Company cannot be certain that Miraval will generate sufficient revenues to
cover its operating expenses. Management believes that the existing capital
resources of the Company are insufficient to meet its short-term capital needs.
Additional capital may be available through short and long-term financing;
however, the Company cannot predict the terms or availability of such financing.

Miraval competes in the competitive resort hotel/spa industry. In many
instances, its competitors have greater name recognition and financial resources
as well as long-standing relationships with travel agents and tour and trip
planners. Management cannot anticipate what impact this will have on future
occupancy levels.


                                       14
<PAGE>   15
The entities comprising the Company's Treatment segment participate in the
highly competitive mental and behavioral health industry characterized by
intense competition for market share resulting from aggressive pricing practices
and increasing competition from companies with greater resources, including tax
exempt, non-profit status, government subsidized or endowment-related financial
support which may provide lower costs of capital.

While the Company anticipates continued growth in revenues and is committed to a
return to profitability, operating results could be adversely impacted if the
businesses are unable to anticipate customer demand accurately, are unable to
differentiate their products from those of their competitors, are unable to
offer services expeditiously in response to customer demand, or are negatively
impacted by managed care restrictions on payor reimbursement.

The Company must receive shareholder approval for certain items related to the
equity financing transaction (see Item 5). If shareholder approval of these
items is not obtained prior to March 15, 1997, the debt of $8,090,000 becomes
immediately due and payable as well as any accrued interest thereon and the
$4,250,000 of Preferred Stock is redeemable at the option of the holders, out of
funds legally available therefor. To the extent that shareholder approval is not
obtained related to those items required in the equity financing transaction,
this would create an immediate and significant liquidity crisis for the Company.
The effect of this potential liquidity crisis would have a major impact on the
Company's ability to continue operations.



                                       15
<PAGE>   16
                           PART II - OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

The Company is involved in various litigation and administrative proceedings
arising in the normal course of business. In the opinion of management, any
liabilities that may result from these claims will not, individually or in the
aggregate, have a material adverse effect on the Company's financial position,
results of operations or cash flows.

ITEM 2.  CHANGES IN SECURITIES

See Item 5 - Other Information - "Financing Transaction".

ITEM 5.  OTHER INFORMATION

                             Financing Transactions

As discussed in previous public filings, the costs of construction of Miraval,
the introduction of a significant new business line and ongoing operating losses
during the continuing period of strategic transition substantially reduced the
Company's capital resources and severely affected its liquidity. After exploring
alternative mechanisms to finance its capital needs, on November 15, 1996
("Transaction Date"), the Company completed separate equity and debt
transactions with affiliates of Apollo Real Estate Advisors, L.P. ("Apollo")
that resulted in the Company's receipt of approximately $12,340,000 in cash and,
subject to compliance with certain conditions, a $5,000,000 loan commitment (the
"Apollo Transactions"). The Apollo Transactions consisted of: (a) the sale to AP
NH LLC, a Delaware limited liability company ("APNH") pursuant to a Preferred
Stock and Warrant Purchase Agreement (the "Purchase Agreement") of (I) shares of
two series of Preferred Stock for an aggregate purchase price of $4,250,000 (the
"Preferred Stock Transaction") and (ii) a warrant (the "Warrant") to purchase
500,000 shares of the Company's Common Stock, $0.01 par value ("Common Stock")
and (b) a secured loan in the amount of $13,090,000 (the "Debt Transaction")
with AP LOM LLC, a Delaware limited liability company ("APLOM"). The Debt
Transaction includes a $5,000,000 stand-by loan commitment, subject to
compliance with certain conditions, (the "Stand-by Commitment").

On October 11, 1996 the Company signed a Letter of Interest ("Letter of
Interest") with Apollo which outlined the terms of the debt and equity
financings represented by the Apollo Transactions. Because of the Company's
financial condition at the time, an affiliate of Apollo provided a short-term
working capital line of credit of $750,000; of which, $500,000 had been borrowed
and was repaid at the Transaction Date with the proceeds from the Apollo
Transactions. In addition, the Apollo affiliate received a warrant to purchase
100,000 shares of Common Stock at an exercise price of $1.50 per share. The
average closing price of the common stock during the 20 trading days prior to
October 11, 1996 was $1.266. The closing prices of the Common Stock on October
11, 1996 and on the Transaction Date were $1.75 and $2.06 per share,
respectively.

The net proceeds from the funded portion of the Apollo Transactions were used to
retire certain short-term and working capital obligations (approximately
$5,000,000), pay-off the balance due to the general contractor for Miraval
(approximately $2,680,00) and the balance to fund immediate cash flow
requirements and provide working capital for the continued operations of Miraval
until it can be operated at a profit. The Stand-by Commitment, if available
pursuant to its terms, will be used to support the Company's operations and the
long-term expansion of Miraval.

The Preferred Stock Transaction consisted of the sale of 17,109 shares of
Preferred Stock, Series A ("Series A Preferred Stock") at a price of $92.26 per
share ($1,578,476, in the aggregate) and 28,956 shares of Cumulative Preferred
Stock, Series B ("Series B Preferred Stock") at a price of $92.26 per share
($2,671,480, in the aggregate). At the time of their issuance, the shares of the
Series A Preferred Stock represented approximately 19.9% of outstanding voting
power of the Company. Although APNH desired to purchase Series



                                       16
<PAGE>   17
A Preferred Stock having voting rights of up to 35% of the shares of outstanding
Common Stock, because of the provisions of Rule 4460(I) of the NASDAQ Stock
Market ("NASDAQ"), the Company does not intend to issue additional shares of
Series A Preferred Stock until stockholder approval is obtained. NASD Rule
4460(I) provides that sales of securities by a company listed on NASDAQ/NMS
having or representing 20% or more of the outstanding voting power on the date
of issuance for less than current market price or book value must be first
approved by the stockholders.

The Company's stockholders are being asked to approve the issuance to APNH of an
additional 28,956 shares of Series A Preferred Stock ("Proposed Issuance"). If
the Company's stockholders approve such issuance, the 28,956 outstanding shares
of Series B Preferred Stock will be automatically converted into a like number
of shares of Series A Preferred Stock.

The Company retained the services of Victor Capital to review the terms of the
Apollo Transactions and advise the Board of Directors on the fairness of such
terms. After considering and based upon the Company's financial condition, the
alternative sources of capital available at the time, and other conditions
affecting the Company, Victor Capital advised the Board that the financial terms
of the Apollo Transactions are commercially reasonable and therefore fair to the
Company and its stockholders from a financial point of view.

Description of Preferred Stock Transaction

Immediately prior to the Transaction Date, the Company's Board of Directors
created two series of Preferred Stock consisting of 46,065 shares of Series A
Preferred Stock and 28,956 shares of Series B Preferred Stock. The following is
a summary of the respective designations, preferences and rights of the Series A
and Series B Preferred Stock as set forth in the Certificate of Designation,
Preference and Rights filed with the State of Delaware, Office of the Secretary
of State ("Series Designation"). Reference herein to "Preferred Stock" shall
include Series A Preferred Stock and Series B Preferred Stock.

1. Dividends. The holders of Series A Preferred Stock are not entitled to
receive dividends except upon an event of default as defined in the Series
Designation in which event, the dividend rate on the Series A Preferred Stock
will be 18% per annum. The holders of Series B Preferred Stock are entitled to
receive cumulative, preferred dividends at the rate of 12% per annum from
January 1, 1997 to January 31, 1997 and at the rate of 18% per annum from
February 1, 1997 and thereafter and upon a Default of the provisions of the
Series Designation.

So long as any shares of Preferred Stock remain outstanding, the Company may not
declare or pay any cash dividend or make any other distributions with respect to
the Common Stock.

2. Liquidation Preference. In the event of any liquidation, dissolution or
winding-up of the Company, the holders of Preferred Stock shall be entitled to a
liquidation preference over the holders of Common Stock in the amount of any
accrued but unpaid dividends. There are no other liquidation preferences.

3. Voting Rights. The holders of Series B Preferred Stock do not possess any
voting rights. The holders of Series A Preferred Stock are entitled to vote on
all matters presented to the Company's stockholders for a vote and, except with
respect to the election of Directors, each share of Series A Preferred Stock
shall entitle the holder thereof to such number of votes per share as shall
equal the number of shares of the Common Stock into which such share of Series A
Preferred Stock is then convertible. Initially, each share of Series A Preferred
Stock is convertible into 100 shares of Common Stock. In addition, the holders
of Series A Preferred Stock are entitled to vote separately as a separate class
on all matters other than the election of directors. This means that matters
submitted for a vote of the stockholders of the Company must receive the
approval of the requisite percentage of the holders of Common Stock (with the
holders of Series A Preferred Stock being entitled to vote on an "as converted"
basis) as well as of the holders of the Series A Preferred Stock.

In addition, the holders of Series A Preferred Stock, as a class, are entitled
to elect four directors to the Company's Board of Directors ("Preferred
Directors").


                                       17
<PAGE>   18
Upon the occurrence of an event of default as defined in the Series Designation,
the holders of Series A Preferred Stock will become entitled to elect a majority
of the Company's Board of Directors.

A majority vote of the holders of the outstanding Series A Preferred Stock
voting as a separate class is required in order to approve certain transactions
including: (I) the amendment of the Company's Certificate of Incorporation so as
to adversely affect the rights of the holders of Series A Preferred Stock or any
of the provisions of the Certificate of Designation; (ii) authorize, create or
issue any class of capital stock that is senior to or pari passu with the Series
A Preferred Stock or (iii) enter into a transaction having a total value in
excess of $250,000 per transaction except under certain conditions.

As part of the Apollo Transactions, effective on the Transaction Date, the
Company's Board of Directors was expanded from five to nine persons and the
following Preferred Directors were elected to represent the holder of Series A
Preferred Stock: Lee S. Neibart, W. Edward Scheetz, Bruce Spector and Alfred C.
Trivilino.

4. Conversion of Series B Preferred Stock into Series A Preferred Stock. Each
share of Series B Preferred Stock is automatically converted into Series A
Preferred Stock, on a one for one basis, upon the approval by a majority of the
total votes cast by the stockholders of the Company of the issuance of
additional shares of Series A Preferred Stock in excess of 17,109 shares
("Stockholder Approval").

Each share of Series B Preferred Stock will be convertible, at the option of the
holder, into one share of Series A Preferred Stock after March 15, 1997, unless
Stockholder Approval has been obtained. The Series Designation also provides
that the Series B Preferred Stock is convertible, at the option of the holders
thereof, into Series A Preferred Stock if the stockholders of the Company have
not approved an amendment to the Company's Certificate of Incorporation deleting
Article 9 thereof on or before June 15, 1997. Article 9 imposes a 66 2/3%
affirmative stockholder voting requirement in connection with certain change of
control transactions such as a merger, consolidation, sale of all or
substantially all of the assets of the Company, etc. APNH, as the holder of the
Series B Preferred Stock has waived the operation of this provision until such
time as it gives not less than 90 days written request to the Company to present
a proposal to the stockholders to delete Article 9. The stockholders of the
Company must approve the deletion of Article 9 (and other related provisions)
within 90 days of such notice.

5. Conversion of Series A Preferred Stock into Common Stock. As of the date
hereof, each share of Series A Preferred Stock is convertible into 100 shares of
Common Stock or 1,710,900 shares in the aggregate. Shares of Series B Preferred
Stock are not convertible into Common Stock. The number of shares of Common
Stock issuable upon conversion of the Series A Preferred Stock is subject to
adjustment to reflect certain transactions affecting the Common Stock such as
the issuances of Common Stock at less than $0.9226 per share, stock dividends,
splits, reverse splits, etc. Upon Stockholder Approval, each of the 28,956
shares of Series B Preferred Stock will be automatically converted into one
share of Series A Preferred Stock. Such additional shares of Series A Preferred
Stock will be convertible into 2,895,600 shares of Common Stock.

6. Redemption. Commencing on January 1, 2001, the Company may, at its option,
redeem shares of Preferred Stock at a price per share equal to the redemption
price of $92.26 per share ("Redemption Price") plus all accrued but unpaid
dividends.

If Stockholder Approval has not been obtained on or before March 15, 1997, the
holders of Preferred Stock have the option to require the Company to redeem all
or any portion of their Preferred Stock at a price equal to the Redemption Price
plus all accrued and unpaid dividends.

Unless and until Stockholder Approval is obtained, upon a "change in control" as
defined in the Series Designation, the holders of Preferred Stock shall have the
option to require the Company to redeem all but not less than all of their
shares of Preferred Stock at a price equal to the greater of 200% of the
Redemption Price or the fair market value of the aggregate number of shares of
Common Stock into which such shares of Preferred Stock are convertible on the
effective date of such change in control. A change of control includes the
acquisition of 20% or more of the outstanding voting stock of the Company, the
merger or consolidation or sale of substantially all of the assets of the
Company or if the Preferred Directors cease to


                                       18
<PAGE>   19
constitute at least forty percent (40%) of the Board of Directors.

Unless and until Stockholder Approval is obtained, upon the occurrence of any
default as described below ("Default"), the holders of Series A and Series B
Preferred Stock shall have the option to require the Company to redeem all but
not less than all of the shares of Preferred Stock held by such person at a
price equal to the Redemption Price plus all accrued but unpaid dividends.
Events of default include the failure to pay dividends for any two quarterly
periods, a default of the Purchase Agreement and the passage of fifteen days
thereafter, or a default under the Credit Agreement relating to the Debt
Transaction.

The Company anticipates that a meeting of the stockholders will be held prior to
March 15, 1997 in order to consider the issuance of 28,956 shares of Series A
Preferred Stock to APNH. The Company has been advised that the shares of Common
Stock beneficially owned by Messrs. William T. O'Donnell, Jr. (2,240,078 shares)
and John H. Schmitz (296,684 shares) will be voted to approve such issuance. In
additional, APNH is required to vote its shares of Series A Preferred Stock
(representing 1,710,900 votes) to approve such issuance.

Other Provisions

The Purchase Agreement requires the approval of a majority of the Preferred
Directors in connection with certain matters presented to the Board of Directors
including annual budgets and operating forecasts of the Company; and
transactions with affiliates. In addition, APNH has the right to approve all
future nominations to the Board of Directors other than those individuals
serving as directors on the Transaction Date.

Warrant

The Warrant entitles APNH to purchase 500,000 shares of Common Stock at an
exercise price of $1.50 per share. The Warrant is exercisable only on or after
March 15, 1997 and before November 14, 2006. The exercise price of and number of
shares purchasable under the Warrant are subject to adjustment to reflect
certain transactions affecting the Common Stock such as issuances of Common
Stock at less than $1.50 per share, stock dividends, splits, reverse splits,
etc.

Debt Transaction

The Debt Transaction was made pursuant to a Credit Agreement ("Credit
Agreement") between the Company and APLOM and consisted of a loan funded on the
Transaction Date in the principal amount of $8,090,000 together with a
$5,000,000 standby commitment subject to compliance with certain conditions. The
promissory notes evidencing the Debt Transaction ("Promissory Notes") bear
interest at the rate of 10% per annum during the first year; 11% during the
second year and 12% during the third year. The interest rate increases to 18%
per annum upon the occurrence of an event of default (as defined in the Credit
Agreement) or on February 1, 1997 (retroactive to November 15, 1996) if
Stockholder Approval has not been obtained by that date. The Promissory Notes
mature on the third anniversary of the Transaction Date but, the Promissory
Notes become immediately due and payable if Stockholder Approval has not been
obtained on or before March 15, 1997.

The obligations and indebtedness under the Credit Agreement and Promissory Notes
("Credit Documents") are secured by a deed of trust to essentially, all of the
land and buildings of the Company, a security interest in all of the Company's
and its subsidiaries (including Soften) ("Subsidiaries") personal property and
by the collateral pledge of the Company's stock or other interest in the
Subsidiaries. In addition, each of the Subsidiaries guaranteed performance of
the Credit Documents.

GENERAL EFFECTS OF PREFERRED TRANSACTION ON COMMON STOCKHOLDERS

The Preferred Stock Transaction significantly impacts the rights of existing
stockholders. Since the Series A Preferred Stock is convertible into Common
Stock and currently has voting rights and because the Preferred Directors
effectively have a veto right with respect to certain matters presented to the
Board of Directors for a vote, the voting rights of the current stockholders are
diluted.



                                       19
<PAGE>   20
All matters presented to the Company's stockholders for a vote, other than the
election of directors, must receive the requisite percentage approval of the
holders of Series A Preferred Stock as well as of the holders of Common Stock
(with the holders of Series A Preferred Stock voting with the Common
stockholders on an "as converted" basis).

In addition, the Series A Preferred Stock is convertible into Common Stock at
the current conversion rate of 100 shares of Common Stock for each share of
Series A Voting Preferred Stock. Upon conversion of the Series B Preferred Stock
into Series A Voting Preferred Stock (if stockholders approve the Proposed
Issuance), there will be 46,065 shares of Series A Voting Preferred Stock
outstanding which will be convertible into 4,606,500 shares of Common Stock
representing approximately 35% of the outstanding Common Stock on the date
hereof. As indicated above, if Stockholder Approval has not been obtained on or
before March 15, 1997, each share of Series B Preferred Stock is convertible
into one share of Series A Preferred Stock at the option of the holder thereof.

The issuance of Series A Preferred Stock will also have a dilutive effect on the
holders of Common Stock because it was sold at an equivalent price per share of
Common Stock less than the then current market price and book value of the
Common Stock. Series A Preferred Stock is convertible into Common Stock at an
equivalent conversion price of $0.9226 per share of Common Stock. The average
closing price of the Common Stock during the 20 trading days prior to October
11, 1996 was $1.266. The closing prices of the Common Stock on October 11, 1996
and on the Transaction Date were $1.756 and $2.06 per share, respectively.
Although the shares of Common Stock issuable on conversion of the Series A
Preferred Stock or on exercise of the Warrant are subject to a Registration and
Pre-Emptive Rights Agreement granting APNH certain piggy-back and demand
registration rights (the "Registration Rights Agreement"), such shares are
restricted and may not be publicly traded at this time without registration
pursuant to the Securities Act of 1933.

The Registration Rights Agreement grants APNH the right to purchase additional
shares of capital stock as necessary to allow it to maintain its proportionate
interest in the Company.

                    Transfer of Assets of Sierra Tucson, Inc.

Based on its analysis of the Company's business structure, Apollo recommended
that the assets of Sierra Tucson, the Company's treatment center for substance
abuse, addictions and other behavioral health disorders, be sold to a newly
formed entity, partially owned by APNH. Consequently, on November 13, 1996, the
assets of Sierra Tucson were sold to Soften Realty, L.L.C., a Delaware limited
liability company ("Soften") for $8,000,000. The purchase price is evidenced by
Soften's non-negotiable promissory note which is secured by a security interest
in the assets of Sierra Tucson. Such assets consist of the business of Sierra
Tucson, the tangible and intangible assets used in connection with the business
and a possessory right to use certain land and buildings owned by the Company.
The Company is the manager of and owns a 98% interest in Soften; the remaining
2% is owned by APNH.

The Board of Directors recognized that the transfer of Sierra Tucson's assets to
Soften would facilitate the operations and utilization of the business and
strengthen its identity as a separate and distinct business operation. In
addition, it will provide greater flexibility to the Company in the development
of strategic alternatives for Sierra Tucson.

                               Management Changes

On November 14, 1996, John H. Schmitz resigned as the Company's President, Chief
Executive Officer and Chief Financial Officer and as a director. The Company's
Chairman of the Board and founder, Mr. William T. O'Donnell, Jr., was appointed
acting Chief Executive Officer and President and Ms. Loree Thompson was
appointed as acting Chief Financial Officer. Mr. Stephen Berger was elected to
fill the vacancy created by the resignation and to serve the remaining term of
Mr. Schmitz. Mr. Berger is a partner in the Chicago law firm of Neal, Gerber and
Eisenberg.


                                       20
<PAGE>   21
Immediately following the closing of the Preferred Stock Transaction, the Board
of Directors of the Company increased the size of the Board to nine persons and
elected the following persons as directors of the Company: Lee S. Neibart, W.
Edward Scheetz, Bruce Spector and Alfred C. Trivilino. Each of the Preferred
Directors is affiliated with Apollo.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

    (a)  Exhibits

              10.70  Asset Purchase agreement between Sierra Tucson, Inc. and
                     Soften Realty, LLC

              10.71  Operating Agreement of Soften Realty, Inc. between
                     NextHealth, Inc. and AP NH, LLC

              10.72  Security Agreement between Sierra Tucson, Inc. and Soften
                     Realty, LLC

              10.73  Non-negotiable Secured Promissory Note

              10.74  Assumption agreement

              10.75  Bill of Sale and Assignment between Sierra Tucson, Inc. and
                     Soften Realty, LLC

              10.76  Preferred Stock and Warrant Purchase agreement between
                     NextHealth, Inc. and AP LOM LLC

              10.77  Registration and Pre-emptive Rights agreement between
                     NextHealth, Inc. and AP LOM LLC

              10.78  Credit agreement between NextHealth, Inc. and AP LOM LLC

              10.79  Pledge agreement between NextHealth, Inc. and AP LOM LLC

    (b) Reports on Form 8-K

              NONE


                                   SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                                    NextHealth, Inc.

                                    Registrant

DATE:  December 19, 1996            BY:/s/ William T. O'Donnell, Jr.
                                       _____________________________
                                    WILLIAM T. O'DONNELL, JR.
                                    President and Chief Executive Officer



DATE:   December 19, 1996           BY:/s/ Loree Thompson
                                       _____________________________
                                    LOREE THOMPSON
                                    Principal Financial and Accounting Officer


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