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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K (Mark One) þ
    
    Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
for the fiscal year ended December 31, 2004 oro
    
    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 0-20488 Psychiatric Solutions, Inc.  DELAWARE
    
    23-2491707(State or Other Jurisdiction of Incorporation or
    
    (I.R.S. Employer Identification No.)Organization)
 840 Crescent Centre Drive, Suite 460
Franklin, TN 37067
(Address of Principal Executive Offices, Including Zip Code) (615) 312-5700
(Registrants Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Title Of Each Class
    
    Name of Each Exchange On Which RegisteredCommon Stock, $.01 par value
    
    NASDAQ National Market
 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2). Yes þ No o As of March 10, 2005, 20,496,730 shares of the registrants common stock were outstanding. As
of June 30, 2004, the aggregate market value of the shares of common stock of the registrant held
by non-affiliates of the registrant was approximately $357.7 million. For purposes of calculating
such aggregate market value, shares owned by directors, executive officers and 5% beneficial owners
of the registrant have been excluded.




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DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrants definitive proxy statement for its 2005 annual meeting of
stockholders to be held on May 17, 2005 are incorporated by reference into Part III of this Form
10-K.  
   INDEX PAGEPART IItem 1. Business
    
    
    1Item 2. Properties
    
    
    13Item 3. Legal Proceedings
    
    
    14Item 4. Submission of Matters To a Vote of Security Holders
    
    
    14PART IIItem 5. Market For Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities
    
    
    14Item 6. Selected Financial Data
    
    
    15Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 8. Financial Statements and Supplementary Data
    
    
    31Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
    
    
    31Item 9A. Controls and Procedures
    
    
    31PART IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    32Item 11. Executive Compensation
    
    
    33Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    33Item 13. Certain Relationships and Related Transactions
    
    
    33Item 14. Principal Accountant Fees and Services
    
    
    33Item 15. Exhibits and Financial Statement Schedules
    
    
    33Index to Financial Statements
    
    
    F-1Signatures
    
    II-1EX-10.4  INDEMNIFICATION AGREEMENTEX-12.1 COMPUTATION OF RATIO OF EARNINGSEX-21.1  LIST OF SUBSIDIARIESEX-23.1  CONSENT OF ERNST & YOUNG LLPEX-31.1  SECTION 302 CERTIFICATION OF THE CEOEX-31.2  SECTION 302 CERTIFICATION OF THE CAOEX-32.1  SECTION 906 CERTIFICATIONS OF THE CEO & CAO




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PART I All references in this Annual Report onForm 10-Kto Psychiatric Solutions, the Company,
we, us or our mean, unless the context otherwise requires, Psychiatric Solutions, Inc. and
its consolidated subsidiaries. 
 Item 1. Business Overview We are a leading provider of inpatient behavioral health care services in the United States.
Through our inpatient division, we operate 34 owned or leased inpatient behavioral health care
facilities with approximately 4,000 beds in 19 states. In addition, through our inpatient
management contract division, we manage 41 inpatient behavioral health care units for third
parties, including a contract to provide mental health case management services to approximately
4,600 children and adults with serious mental illness in the Nashville, Tennessee area, and 8
inpatient behavioral health care facilities for government agencies. We believe that our singular
focus on the provision of inpatient behavioral health care services allows us to operate more
efficiently and provide higher quality care than our competitors. We primarily operate in
underserved markets with limited competition and favorable demographic trends. We generated revenue
of $487.2 million and $284.9 million for the years ended December 31, 2004 and 2003, respectively. Our inpatient behavioral health care facilities accounted for approximately 86% of our revenue
for the year ended December 31, 2004 as compared to approximately 78% of our revenue for the year
ended December 31, 2003. These facilities offer a wide range of inpatient behavioral health care
services for children, adolescents and adults. We offer these services through a combination of
acute inpatient behavioral facilities and residential treatment centers. Our acute inpatient
behavioral facilities provide the most intensive level of care, including 24-hour skilled nursing
observation and care, daily interventions and oversight by a psychiatrist and intensive, highly
coordinated treatment by a physician-led team of mental health professionals. Our residential
treatment centers, or RTCs, offer longer term treatment programs primarily for children and
adolescents with long-standing acute behavioral health problems. Our RTCs provide physician-led,
multi-disciplinary treatments that address the overall medical, psychiatric, social and academic
needs of the patient. Our inpatient management contract division accounted for approximately 14% of our revenue for
the year ended December 31, 2004 as compared to approximately 22% of our revenue for the year ended
December 31, 2003. This portion of our business involves the development, organization and
management of behavioral health care programs within medical/surgical hospitals and the management
of inpatient behavioral health care facilities for government agencies. We provide our customers
with a variety of management options, including (1) clinical and management infrastructure, (2)
personnel recruitment, staff orientation and supervision, (3) corporate consultation and (4)
performance improvement plans. Our broad range of services can be customized into individual
programs that meet specific facility and community requirements. We are dedicated to providing
quality programs with integrity, innovation and flexibility. The Company was incorporated in the State of Delaware in 1988. Our principal executive offices
are located at 840 Crescent Centre Drive, Suite 460, Franklin, Tennessee 37067. Our telephone
number is (615) 312-5700. Our Internet address is
www.psysolutions.com. Significant Recent Transactions On March 10, 2005, we entered into a Stock Purchase Agreement with
Ardent Health Services LLC, a Delaware limited liability company (Seller), and Ardent Health
Services, Inc., a Delaware corporation and wholly-owned subsidiary of Seller (AHS), pursuant to
which we will acquire all of the outstanding capital stock of AHS for approximately $560 million.
The purchase price will be paid $500 million in cash and $60 million in shares of our common stock.
AHS owns and operates, through its subsidiaries, 20 inpatient
behavioral health care facilities, which include approximately 2,000 inpatient beds and
generated approximately $300 million in
revenues in 2004. We anticipate financing the cash portion of the purchase price through the
issuance of new debt. Closing of the transaction is conditioned upon satisfaction of customary
closing conditions, including the receipt of all necessary governmental permits and approvals and
the expiration or early termination of the Hart-Scott-Rodino Act waiting period. It is anticipated
that closing will occur during the second quarter of 2005. On January 14, 2005, we redeemed $50 million of our 10 5/8% senior subordinated notes, leaving
$100 million outstanding after the redemption. In connection with the redemption we paid
bondholders a 10 5/8% penalty and accrued interest. We expect to record a loss on refinancing
long-term debt of approximately $7 million during the first quarter of 2005. We paid the redemption
with borrowings under our revolving credit facility of $30 million and the remainder with cash on
hand. On December 21, 2004, we amended and restated our revolving credit facility with Bank of
America, N.A. (Bank of America) to increase the borrowings available to us to $150 million,
extend the term of the agreement until December 2009 and lower the applicable rate, as defined in
the credit agreement. We initially entered into a revolving credit facility with Bank of America of
up to $50 million on January 6, 2004. We subsequently amended and increased the revolving credit
facility to $125 million in June 2004. 1




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On December 20, 2004, we closed on the sale of 3,450,000 shares of our common stock at $33.70
per share. Of these shares, 450,000 were sold through the full exercise of the underwriters
over-allotment option. We sold 3,285,000 shares for approximately $105 million after underwriting
discounts and other issuance costs. Certain shareholders sold 165,000 shares in the offering. We
did not receive any proceeds from the sale of common stock by the selling shareholders.
Approximately $82 million of the net proceeds were used to pay down borrowings under our revolving
line of credit. On November 1, 2004, we purchased the real estate housing the operations of Summit Oaks
Hospital in Summit, New Jersey for approximately $15.9 million. Summit Oaks Hospital was one of
four inpatient psychiatric facilities acquired from Heartland Healthcare (Heartand) on June 1,
2004. Subsequent to the acquisition of this facility on June 1, 2004, we leased the real estate
from a third party. On
June 30, 2004, we completed the acquisition of substantially all
of the assets of Alliance
Behavioral Health Group (Alliance Behavioral), a system of inpatient behavioral health care
facilities with 144 beds located near El Paso, Texas, for approximately $12.5 million. On June 11, 2004, we completed the acquisition of substantially all of the assets of Piedmont
Behavioral Health Center LLC (Piedmont), a 77 bed inpatient behavioral health care facility
located in Leesburg, Virginia, for approximately $10.7 million. On June 1, 2004, we completed the acquisition of four inpatient behavioral health care
facilities from Heartland for approximately $49.9 million. The four inpatient facilities, located
in Summit, New Jersey, Ft. Lauderdale, Florida, Arlington, Texas and Eden Prairie, Minnesota, have
a total of 360 beds. On May 1, 2004, we completed the acquisition of all of the membership interests of Palmetto
Behavioral Health System, L.L.C. (Palmetto), an operator of two inpatient behavioral health care
facilities, for approximately $6.4 million. The two leased inpatient facilities, located in
Charleston and Florence, South Carolina, have 161 beds. On December 1, 2004, we purchased the real
estate of the Charleston facility for approximately $4.0 million. On March 1, 2004, we acquired two inpatient psychiatric facilities from Brentwood Behavioral
Health (Brentwood) for approximately $30.4 million cash with an earn-out of approximately $5
million expected to be paid in the second quarter of 2005. The inpatient facilities, which have an
aggregate of 311 licensed beds, are located in Shreveport, Louisiana and Jackson, Mississippi. On December 24, 2003, we closed on the sale of 6,900,000 shares of our common stock at $16.00
per share. Of these shares, 900,000 were sold through the full exercise of the underwriters
over-allotment option. We sold 3,271,538 shares for approximately $48.9 million after underwriting
discounts and other issuance costs. Certain existing stockholders sold 3,628,462 shares in the
offering. We did not receive any proceeds from the sale of common stock by the selling
stockholders. Our Industry An estimated 22% of the U.S. adult population and 10% of U.S. children and adolescents suffer
from a diagnosable mental disorder in a given year. Based on the 2002 U.S. census, these figures
translate to approximately 50 million Americans. In addition, four of the ten leading causes of
disability in the United States are mental disorders. The behavioral health care industry is extremely fragmented with only a few large national
providers. During the 1990s, the behavioral health care industry experienced a significant
contraction following a long period of growth. Between 1990 and 1999, nearly 300 inpatient
behavioral health care facilities, accounting for over 40% of available beds, were closed. The
reduction was largely driven by third party payors who decreased reimbursement, implemented more
stringent admission criteria and decreased the authorized length of stay. We believe this reduced
capacity has resulted in an underserved patient population. Reduced capacity, coupled with mental health parity legislation providing for greater access
to mental health services and increased demand for our behavioral health care services, has
resulted in favorable industry fundamentals. Behavioral health care providers have enjoyed
significant improvement in reimbursement rates, increased admissions and stabilized lengths of
stay. According to the National Association of Psychiatric Health Systems, payments for the
inpatient care of behavioral health and addictive disorders have increased nationwide. Inpatient
admissions increased from an average of approximately 2,350 in 2001 to an average of approximately
2,500 in 2002, while the average occupancy rates stabilized at approximately 74% for both 2001 and
2002 after being approximately 69% in 2000. Following a rapid decrease during the early 1990s,
inpatient average length of stay stabilized between 9 and 10 days from 1997 to 2002. In 2002, the
inpatient average length of stay was 10.3 days. The average RTC net revenue per day in 2002 was
$288 for hospital-based units and $273 for freestanding RTC facilities. The average number of
admissions for hospital-based RTC units was 171 for 2002. The average number of admissions for
freestanding RTC facilities was 213 for 2002. The average occupancy rate for hospital-based RTC
units increased from 73.0% in 2001 to 74.9% in 2002, with an average length of stay of 165.5 days
in 2002. The average occupancy rate for freestanding RTC facilities was 82.6% in 2002, with an
average length of stay 2




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of 187.3 days in 2002. These favorable trends have resulted in high demand for inpatient behavioral
health care services. Our Competitive Strengths We believe the following competitive strengths contribute to our strong market share in each
of our markets and will enable us to continue to successfully grow our business and increase our
profitability:  
    Singular focus on inpatient behavioral health care We focus
exclusively on the provision of inpatient behavioral health care
services. We believe this allows us to operate more efficiently and
provide higher quality care than our competitors. In addition, we
believe our focus and reputation have helped us to develop important
relationships and extensive referral networks within our markets and
to attract and retain qualified behavioral health care professionals.
    Strong and sustainable market position Our inpatient facilities have
an established presence in each of our markets, and we believe that
the majority of our owned and leased inpatient facilities have the
leading market share in their respective service areas. Our
relationships and referral networks would be difficult, time-consuming
and expensive for new competitors to replicate. In addition, many of
the states in which we operate require a certificate of need to open a
behavioral health care facility, which may be difficult to obtain and
may further preclude new market participants.
    Demonstrated ability to identify and integrate acquisitions We
attribute part of our success in integrating acquired inpatient
facilities to our rigorous due diligence review of these facilities
prior to completing the acquisitions as well as our ability to retain
key employees at the acquired facilities. We employ a disciplined
acquisition strategy that is based on defined criteria including
quality of service, return on invested capital and strategic benefits.
We also have a comprehensive post-acquisition strategic plan to
facilitate the integration of acquired facilities that includes
improving facility operations, retaining and recruiting psychiatrists
and expanding the breadth of services offered by the facilities.
    Diversified payor mix and revenue base As we have grown our
business, we have focused on diversifying our sources of revenue. For
the year ended December 31, 2004, we received 36.5% of our revenue
from Medicaid, 28.3% from multiple commercial and private payors,
14.7% from various state and local government payors, 8.3% from
various third parties and 12.3% from Medicare. As we receive Medicaid
payments from more than 35 states, we do not believe that we are
significantly affected by changes in reimbursement policies in any one
state. Substantially all of our Medicaid payments relate to the care
of children and adolescents. Management believes that children and
adolescents are a patient class that is less susceptible to reductions
in reimbursement rates. For the year ended December 31, 2004, no
single inpatient facility represented more than 7% of our revenue.
    Experienced management team Our senior management team has an
average of over 20 years of experience in the health care industry.
Joey A. Jacobs, our Chairman, President and Chief Executive Officer,
has over 29 years experience in various capacities in the health care
industry. Jack R. Salberg, our Chief Operating Officer, has more than
30 years of operational experience in both profit and non-profit
health care sectors. In addition, our senior management team includes
talented managers of our divisions, who have a wealth of experience in
all aspects of health care. Our senior management operates as a
cohesive, complementary group and has extensive operating knowledge of
our industry and understanding of the regulatory environment in which
we operate. Our senior managers employ conservative fiscal policies
and have a successful track record in both operating our core business
and integrating acquired assets.
    Consistent free cash flow and minimal capital requirements We
generate consistent free cash flow due to the profitable operation of
our business, our low capital expenditure requirements and through the
active management of our working capital. As the behavioral health
care business does not require the procurement and replacement of
expensive medical equipment, our capital expenditure requirements are
less than that of other facility-based health care providers.
Historically, our capital expenditures have amounted to less than 2%
of our revenue. Our accounts receivable management is less complex
than medical/surgical hospital providers because there are fewer
billing codes for inpatient behavioral health care facilities. Our Growth Strategy We have experienced significant growth in our operations as measured by the number of our
facilities, admissions, patient days, revenue and net income. We intend to continue to successfully
grow our business and increase our profitability by improving the performance of our inpatient
facilities and through strategic acquisitions. The principal elements of our growth strategy are
to: 3




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
    Continue to Drive Same-Facility Growth We increased our
same-facility revenue by approximately 9% for the year ended December
31, 2004 as compared to our revenue for the year ended December 31,
2003. Same-facility growth refers to the comparison of the 24
inpatient facilities owned during 2004 with the comparable period in
2003. We owned five inpatient facilities throughout 2003 and acquired
six inpatient facilities in April, 2003, 11 inpatient facilities in
June, 2003 and one each in November, 2003 and December, 2003. We
expect to continue to increase our same-facility growth by increasing
our admissions and patient days and obtaining annual reimbursement
rate increases. We plan to accomplish these goals by:  
    building relationships that enhance our presence in local and regional markets;
    developing formal marketing initiatives and expanding referral networks;
    continuing to provide high quality service; and
    expanding our services and developing new services to take advantage of
increased demand in select markets where we operate.  
    Grow Through Strategic Acquisitions Our industry is highly
fragmented and we plan to selectively pursue the acquisition of
additional inpatient behavioral health care facilities. There are
approximately 500 acute and residential treatment facilities in the
United States and the top three providers operate approximately 20% of
these facilities. We believe there are a number of acquisition
candidates available at attractive valuations, and we have a number of
potential acquisitions that are in various stages of development and
consideration. On March 10, 2005, we entered into a Stock
Purchase Agreement to acquire all of the capital stock of AHS. AHS
owns and operates, through its subsidiaries, 20 inpatient behavioral
health care facilities, which include approximately 2,000 inpatient
beds. We believe our focus on inpatient behavioral health
care provides us with a strategic advantage when assessing a potential
acquisition. We employ a disciplined acquisition strategy that is
based on defined criteria, including quality of service, return on
invested capital and strategic benefits.
    Enhance Operating Efficiencies Our management team has extensive
experience in the operation of multi-facility health care services
companies. We intend to focus on improving our profitability by
optimizing staffing ratios, controlling contract labor costs and
reducing supply costs through group purchasing. We believe that our
focus on efficient operations increases our profitability and will
attract qualified behavioral health care professionals and patients. Services by Segment We operate two reportable segments: (1) our owned and leased facilities segment operates
inpatient behavioral health care facilities and (2) our inpatient management contract segment
manages inpatient behavioral health care units and facilities for third parties and government
agencies. For financial information regarding our operating segments, see Note 14 to our
Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Inpatient Behavioral Health Care Facilities Division Our inpatient division operates 27 owned and 7 leased inpatient behavioral health care
facilities. These facilities offer a wide range of inpatient behavioral health care services for
children, adolescents and adults. Our inpatient facilities work closely with mental health
professionals, including licensed professional counselors, therapists and social workers;
psychiatrists; non-psychiatric physicians; emergency rooms; school systems; insurance and managed
care organizations; company-sponsored employee assistance programs; and law enforcement and
community agencies that interact with individuals who may need treatment for mental illness or
substance abuse. Many of our inpatient facilities have mobile assessment teams who travel to
prospective clients in order to assess their condition and determine if they meet established
criteria for inpatient care. Those clients not meeting the established criteria for inpatient care
may qualify for outpatient care or a less intensive level of care also provided by the facility.
During the year ended December 31, 2004, our inpatient behavioral health care facilities division
produced approximately 86% of our revenue. Through the diversity of programming and levels of care available, the patient can receive a
seamless treatment experience from acute care to residential long-term care to group home living to
outpatient treatment. This seamless care system provides the continuity of care needed to step the
patient down and allow the patient to develop and use successful coping skills and treatment
interventions to sustain long-term treatment success. Treatment modalities include comprehensive
assessment, multidisciplinary treatment planning including the patient and family, group,
individual and family therapy services, medical and dental services, educational services,
recreational services and discharge planning services. Specialized interventions such as skills
training include basic daily living skills, social skills, work/school adaptation skills and
symptom management skills. Collateral consultations are provided to significant others such as
family members, teachers, employers and other professionals when needed to help the patient
successfully reintegrate back into his/her world. Services offered at our inpatient facilities
include: 4




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
    acute psychiatric care;
    partial hospitalization;
    chemical dependency;
    intensive outpatient;
    acute eating disorders;
    reactive attachment disorder;
    dual diagnosis;
    rehabilitation care;
    day treatment;
    detoxification;
    developmentally delayed disorders ;
    therapeutic foster care;
    neurological disorders;
    rapid adoption services;
    day treatment;
    independent living skills;
    attention deficit/hyperactivity disorders; and
    vocational training. Acute inpatient hospitalization is the most intensive level of care offered and typically
involves 24-hour skilled nursing observation and care, daily interventions and oversight by a
psychiatrist, and intensive, highly coordinated treatment by a physician-led team of mental health
professionals. Every patient admitted to our acute inpatient facilities is assessed by a medical
doctor within 24 hours of admission. Patients with non-complex medical conditions are monitored
during their stay by the physician and nursing staff at the inpatient facility. Patients with more
complex medical needs are referred to more appropriate facilities for diagnosis and stabilization
prior to treatment. Patients admitted to our acute inpatient facilities also receive comprehensive
nursing and psychological assessments within 24 to 72 hours of admission. Oversight and management
of patients medication is performed by licensed psychiatrists on staff at the facility, and
individual, family, and group therapy is performed by licensed counselors as appropriate to the
patients assessed needs. Education regarding their illness is also provided by trained mental
health professionals. Detoxification for adult patients with a diagnosis of substance abuse is provided at some
inpatient facilities. Substance abuse therapy and education is provided to these patients during
their stay and referrals to appropriate aftercare services are made for the patient upon discharge,
usually to an intensive outpatient program provided by the inpatient facility. Our RTCs provide longer term treatment programs for children and adolescents with
long-standing behavioral health problems. Twenty-four hour observation and care is provided in our
RTCs, along with individualized therapy that usually consists of one-on-one sessions with a
licensed counselor, as well as process and rehabilitation group therapy. Another key component of
the treatment of children and adolescents in our inpatient facilities is family therapy.
Participation of the childs or adolescents immediate family is strongly encouraged in order to
heighten the chance of success once the resident is discharged. Medications for residents are
managed by licensed psychiatrists while they remain at the inpatient facility. Our RTCs also
provide academic programs by certified teachers to children and adolescent residents. These
programs are individualized for each resident based on analysis by the teacher upon admission. Upon
discharge, academic reports are forwarded to the residents school. Specialized programs for
children and adolescents in our RTCs include programs for sexually reactive children, sex
offenders, reactive attachment disorders, and children and adolescents who are developmentally
delayed with a behavioral component. Our RTCs often receive out-of-state referrals to their
programs due to the lack of specialized programs for these disorders within the patients own
state. Other major diagnoses treated at our inpatient behavioral health care facilities include
bipolar disorder, major depression, schizophrenia, attention deficit/hyperactivity disorder,
impulse disorder and oppositional and conduct disorders. Our inpatient facilities programs have been adapted to the requests of various sources to
provide services to patients with multiple issues and specialized needs. Our success rate with
these difficult to treat cases has expanded our network of referrals. The services provided at each
inpatient facility are continually assessed and monitored through an ongoing quality improvement
program. The purpose of this program is to strive for the highest quality of care possible to
individuals with behavioral health issues, and includes regular site visits to each inpatient
facility in order to assess their compliance with legal and regulatory standards, as well as
adherence to our compliance program. Standardized performance measures based on a national outcomes
measurement data base comparing our inpatient facilities performance with national norms are also
reported, reviewed and corrective steps are taken when necessary. Inpatient Management Contract Division Our inpatient management contract division develops, organizes and manages behavioral health
care programs within general third party medical/surgical hospitals and manages inpatient
behavioral health care facilities for government agencies. We manage 41 5




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inpatient behavioral health units for third parties in 13 states, including a contract to provide
mental health case management services to approximately 4,600 children and adults with serious
mental illness in the Nashville, Tennessee area, and 8 inpatient behavioral health care facilities
for government agencies. For the year ended December 31, 2004, our inpatient management contract
division produced approximately 14% of our revenue. Our broad range of services can be customized into individual programs that meet specific
inpatient facility and community requirements. Our inpatient management contract division is
dedicated to providing high quality programs with integrity, innovation and sufficient flexibility
to develop customized individual programs. We provide our customer with a variety of management
options, including clinical and management infrastructure, personnel recruitment, staff orientation
and supervision, corporate consultation and performance improvement plans. Under the management
contracts, the hospital is the actual provider of the mental health services and utilizes its own
facilities, support services, and generally its own nursing staff in connection with the operation
of its programs. Our management contracts generally have an initial term of two to five years and are extended
for successive one-year periods unless terminated by either party. The contracts also contain
termination provisions that allow either party to terminate upon certain material events, including
the failure to cure a breach or default under the contract, bankruptcy and the failure to maintain
required licensure. While turnover of contracts is expected, we expect the number of contracts to
remain relatively stable. Substantially all of our management contracts contain non-compete and
confidentiality provisions. In addition, our management contracts typically prohibit the client
hospital from soliciting our employees during the term of the contract and for a specified period
thereafter. In addition, we manage eight inpatient behavioral health care facilities for government
agencies located in Florida, Georgia and Puerto Rico. In general, our contracts to manage these
inpatient facilities have an initial term of one to five years. Most of these contracts may be
extended for up to three successive one-year periods at the discretion of the government agency.
Payment under the contracts is contingent on the annual appropriation of funds by the respective
state legislature. Most contracts allow us to terminate the agreement without cause upon 90 days
notice and the government agency may terminate without cause upon 30 days notice or upon the
occurrence of certain material events, including our failure to meet certain performance standards
for a specified period of time, bankruptcy or default under the contract. Our management contract revenue is sensitive to regulatory and economic changes in the States
of Tennessee and Florida. Our contract to provide case management services in and around Nashville,
Tennessee comprised approximately 4% of our consolidated revenue and approximately 27% of revenue
from our management contracts segment for the year ended December 31, 2004. Our contracts to manage
eight inpatient facilities for the Florida Department of Juvenile Justice comprised approximately
4% of our consolidated revenue and approximately 27% of revenue from our management contracts
segment for the year ended December 31, 2004. Seasonality of Services Our inpatient behavioral health care facilities division typically experiences lower patient
volumes and revenue during the beginning of the first quarter, the end of the second quarter, the
beginning of the third quarter, and the end of the fourth quarter. Because a high proportion of
patients served by our inpatient behavioral health care facilities division are children and
adolescents, this seasonality corresponds to periods that school is out of session. We believe
that, for a variety of reasons, children and adolescent patients are less likely to be admitted
during the summer months and the year-end holidays. Marketing Our local and regional marketing is led by clinical and business development representatives
at each of our inpatient facilities. These individuals manage relationships among a variety of
referral sources in their respective communities. Our national marketing efforts are focused on
increasing the census at our RTCs from various state referral sources by developing relationships
and identifying contracting opportunities in their respective territories. Our customer service is
managed through our call center. Both families and agencies seeking placement for children receive
quick, confidential service through the call center which further promotes our facilities. Competition The inpatient behavioral health care facility industry and the inpatient behavioral health
care unit management industry are highly fragmented. The industry is subject to continual changes
in the method in which services are provided and the types of companies providing such services. We
compete with several national competitors and many regional and local competitors, some of which
are owned by governmental agencies and supported by tax revenue, and others are owned by nonprofit
corporations and may be supported to a large extent by endowments and charitable contributions.
Such support is not available to our inpatient facilities. In addition, our owned and leased inpatient behavioral health care facilities and managed
inpatient behavioral health care units and inpatient facilities compete for patients with other
providers of mental health care services, including other inpatient behavioral health care
facilities, medical/surgical hospitals, independent psychiatrists and psychologists. We also
compete with hospitals, nursing 6




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homes, clinics, physicians offices and contract nursing companies for the services of registered
nurses. We believe we differentiate ourselves from our competition through our singular focus on
the provision of behavioral health care services, our reputation for the quality of our services,
recruitment of first rate medical staff and accessibility to our facilities. In addition, we
believe that the active development of our referral network and participation in selected managed
care provider panels enable us to successfully compete for patients in need of our services. Reimbursement Our inpatient owned and leased facilities receive payment for services from the federal
government primarily under the Medicare program, state governments under their respective Medicaid
programs, private insurers, including managed care plans, and directly from patients. Most of our
inpatient behavioral health facilities are certified as providers of Medicare and Medicaid services
by the appropriate governmental authorities. The requirements for certification are subject to
change, and, in order to remain qualified for such programs, it may be necessary for us to make
changes from time to time in our inpatient facilities, equipment, personnel and services. If an
inpatient facility loses certification, it will be unable to receive payment for patients under the
Medicare or Medicaid programs. Although we intend to continue participating in such programs, there
can be no assurance that we will continue to qualify for participation. Medicare Medicare provides hospital and medical insurance benefits to persons age 65 and over, some
disabled persons and persons with end-stage renal disease. Current freestanding psychiatric
hospitals and certified psychiatric units of acute care hospitals are transitioning to
reimbursement based on an inpatient services prospective payment system (PPS) from reimbursement
based on a reasonable cost basis. The Centers for Medicare and Medicaid Services (CMS) began implementing a three-year
transition period starting with the cost reporting periods beginning on or after January 2005. For
these three years, CMS is proposing a blended payment. The payment for the first year of the
transition period (cost reporting periods beginning after January 1, 2005 but on or before June 30,
2006) would consist of 75% based on the current cost-based reimbursement system and 25% on the
proposed prospective payment rate. In the second year, the split will be 50% each and in the third
year the split will be 25% based on the current cost-based system and 75% prospective payment
system. For cost reporting periods beginning on or after July 1, 2008, the prospective payment
rate percentage will be 100%. The first update to rates under this methodology is anticipated to
occur in July 2006, with annual updates anticipated thereafter. Once the transition to PPS is complete, the base per diem amount will cover nearly all labor
and non-labor costs of furnishing covered inpatient behavioral health care services  including
routine, ancillary and capital costs. The per diem will not, however, include the costs of bad
debts and certain other costs that are paid separately. Under CMS regulations the base per diem
will be adjusted for specific facility characteristics that increase the cost of patient care. It
is anticipated that payment rates for individual inpatient facilities will be adjusted to reflect
geographic differences in wages and that rural providers will receive an increased payment
adjustment, as would teaching facilities. Additionally, the base rate will be adjusted by factors
that influence the cost of an individual patients care, such as each patients diagnosis related
group, certain other medical and psychiatric comorbidities (i.e., other coexisting conditions that
may complicate treatment), and age. Because the cost of inpatient behavioral care tends to be
greatest at admission and a few days thereafter, it is anticipated that the per diem rate will be
adjusted for each day up to and including the eighth day to reflect the number of days the patient
has been in the facility. Medicare will pay this per diem amount, as adjusted, regardless of
whether it is more or less than a hospitals actual costs. Please see
http://www.cms.hhs.gov/providers/ipfpps for additional information. With respect to revenue derived from behavioral health care unit management services, we bill
our fees to the provider as a purchased management, administrative and consultative support
service. Substantially all of the patients admitted to these programs are eligible for Medicare
coverage. As a result, the providers rely upon payment from Medicare for the services. Many of the
patients are also eligible for Medicaid payments. To the extent that a hospital deems revenue for a
program we manage to be inadequate, it may seek to terminate its contract with us or not renew the
contract. Similarly, we may not add new unit management contracts if prospective customers do not
believe that such programs will generate sufficient revenue. Medicare generally deducts from the amount of its payments to hospitals an amount for patient
coinsurance, or the amount that the patient is expected to pay. Many patients are unable to pay
the coinsurance amount. Even if these patients are also covered by Medicaid, some states Medicaid
programs will not pay the Medicare coinsurance amount. As a result, the Medicare coinsurance amount
will go uncollected by the provider except to the extent that the provider is partially reimbursed
that amount as a Medicare bad debt. To the extent that neither a Medicare patient nor any
secondary payor for that patient pays the Medicare coinsurance amount after a reasonable collection
effort or the patients indigence is documented, the provider is entitled to be paid 70% of this
bad debt by Medicare. However, there are instances when Medicare denies reimbursement for all or
part of claimed bad debts for coinsurance on Medicare patients on grounds that the provider did not
engage in a reasonable collection effort or that the provider 7




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failed to maintain adequate documentation of its collection effort or of the patients indigence. Medicaid Medicaid, a joint federal-state program that is administered by the respective states,
provides hospital benefits to qualifying individuals who are unable to afford care. We cannot
predict the extent or scope of changes that may occur in the ways in which state Medicaid programs
contract for and deliver services to Medicaid recipients. All Medicaid funding is generally
conditioned upon financial appropriations to state Medicaid agencies by the state legislatures and
there are political pressures on such legislatures in terms of controlling and reducing such
appropriations. Some states may adopt substantial health care reform measures that could modify the manner in
which all health services are delivered and reimbursed, especially with respect to Medicaid
recipients and other individuals funded by public resources. Many states have enacted or are
considering enacting measures designed to reduce their Medicaid expenditures. As we receive
Medicaid payments from more than 35 states, we are not significantly affected by changes in
reimbursement policies in any one state. Most states have applied for and been granted federal
waivers from current Medicaid regulations to allow them to serve some or all of their Medicaid
participants through managed care providers. The majority of our Medicaid payments relate to the
care of children and adolescents. We believe that children and adolescents are a patient class that
is less susceptible to reductions in reimbursement rates. The reduction in other public resources
could have an impact on the delivery of services to Medicaid recipients. Any significant changes in
Medicaid funding, the structure of a particular states Medicaid program, the contracting process
or reimbursement levels could have a material adverse impact on our financial condition and results
of operations. Managed Care and Commercial Insurance Carriers In addition to government programs, our inpatient facilities are reimbursed for certain
behavioral health care services by private payors including health maintenance organizations
(HMOs), preferred provider organizations (PPOs), commercial insurance companies, employers and
individual private payors. To attract additional volume, our inpatient facilities offer discounts
from established charges to certain large group purchasers of health care services. Generally,
patients covered by HMOs, PPOs and other private insurers will be responsible for certain
co-payments and deductibles, which are paid by the patient. The Mental Health Parity Act of 1996 (MHPA) is a federal law that requires annual or
lifetime limits for mental health benefits be no lower than the dollar limits for medical/surgical
benefits offered by a group health plan. MHPA applies to group health plans or health insurance
coverage offered in connection with a group health plan that offers both mental health and
medical/surgical benefits. However it does not require plans to offer mental health benefits. MHPA
was scheduled to sunset on December 31, 2003, but the Mental Health Reauthorization Act of 2003
extended the sunset date of MHPA to December 31, 2004. However, no action has been taken by
Congress to further extend the sunset date. Bills have also been introduced in Congress from time
to time that could potentially apply this concept on a more far-reaching scale, but we cannot
predict whether any such legislation will be implemented in the future. Approximately 34 states
have also enacted some form of mental health parity laws. Some of these laws apply only to select
groups such as those with severe mental illness or specific diagnosis. Annual Cost Reports All facilities participating in the Medicare program and some Medicaid programs, whether paid
on a reasonable cost basis or under a PPS, are required to meet certain financial reporting
requirements. Federal regulations require submission of annual cost reports identifying medical
costs and expenses associated with the services provided by each facility to Medicare beneficiaries
and Medicaid recipients. Annual cost reports required under the Medicare and some Medicaid programs
are subject to routine governmental audits, which may result in adjustments to the amounts
ultimately determined to be due to us under these reimbursement programs. These audits often
require several years to reach the final determination of amounts earned under the programs.
Nonetheless, once the Medicare fiscal intermediaries have issued a final Notice of Program
Reimbursement (NPR) after audit, any disallowances of claimed costs are due and payable within 30
days of receipt of the NPR. Providers have rights to appeal, and it is common to contest issues
raised in audits of prior years cost reports. Regulation and Other Factors Licensure, Certification and Accreditation Health care facilities are required to comply with extensive regulation at the federal, state
and local levels. Under these laws and regulations, health care facilities must meet requirements
for licensure and qualify to participate in government programs, including the Medicare and
Medicaid programs. These requirements relate to the adequacy of medical care, equipment, personnel,
operating policies and procedures, fire prevention, maintenance of adequate records, hospital use,
rate-setting, and compliance with building codes and environmental protection laws. There are also
extensive regulations governing a facilitys participation in government programs. Facilities are
subject to periodic inspection by governmental and other authorities to assure continued compliance
with the various standards necessary for licensing and accreditation. 8




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All of the inpatient
facilities owned and operated by us are properly licensed under
applicable state laws. Most of the inpatient facilities owned and operated by us are certified
under Medicare and Medicaid programs and most are accredited by the Joint Commission on
Accreditation or Healthcare Organizations (JCAHO), the effect of which is to permit the inpatient
facilities to participate in the Medicare and Medicaid programs. Should any of our inpatient
facilities lose its accreditation by JCAHO, or otherwise lose its certification under the Medicare
and/or Medicaid program, that inpatient facility would be unable to receive reimbursement from the
Medicare and Medicaid programs. If a provider contracting with us was excluded from any federal
health care programs, no services furnished by that provider would be covered by any federal health
care program. If we were excluded from federal health care programs, our owned and leased inpatient
facilities would not be eligible for reimbursement by any federal health care program. In addition,
providers would as a practical matter cease contracting for our inpatient behavioral health care
unit management services because they could not be reimbursed for any management fee amounts they
paid to us. We believe that the
inpatient facilities we own and operate are in substantial compliance with
current applicable federal, state, local and independent review body regulations and standards. The
requirements for licensure, certification and accreditation are subject to change and, in order to
remain qualified, it may be necessary for us to effect changes in our inpatient facilities,
equipment, personnel and services. Additionally, certain of the personnel working at inpatient
facilities owned and operated by us are subject to state laws and regulations governing their
particular area of professional practice. We assist our client hospitals in obtaining required
approvals for new programs. Some approval processes may lengthen the time required for programs to
begin operations. Fraud and Abuse Laws Participation in the Medicare and/or Medicaid programs is heavily regulated by federal law and
regulation. If a hospital fails to substantially comply with the numerous federal laws governing
that facilitys activities, the hospitals participation in the Medicare and/or Medicaid programs
may be terminated and/or civil or criminal penalties may be imposed. For example, a hospital may
lose its ability to participate in the Medicare and/or Medicaid program if it pays money to induce
the referral of patients or purchase of items or services where such items or services are
reimbursable under a federal or state health care program. The anti-kickback provision of the Social Security Act prohibits the payment, receipt, offer
or solicitation of money with the intent of generating referrals or orders for services or items
covered by a federal or state health care program (the Anti-kickback Statute). Violations of the
Anti-kickback Statute may be punished by criminal or civil penalties, exclusion from federal and
state health care programs, imprisonment and damages up to three times the total dollar amount
involved. The Anti-kickback Statute has been interpreted broadly by federal regulators and certain
courts to prohibit the intentional payment of anything of value if even one purpose of the payment
is to influence the referral of Medicare or Medicaid business. Therefore, many commonplace
commercial arrangements between hospitals and physicians could be considered by the government to
violate the Anti-kickback Statute. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) broadened the scope
of the fraud and abuse laws by adding several criminal statutes that are not related to receipt of
payments from a federal health care program. HIPAA created civil penalties for proscribed conduct,
including upcoding and billing for medically unnecessary goods or services. HIPAA established new
enforcement mechanisms to combat fraud and abuse. These new mechanisms include a bounty system,
where a portion of the payments recovered is returned to the government agencies, as well as a
whistleblower program. HIPAA also expanded the categories of persons that may be excluded from
participation in federal and state health care programs. The Office of Inspector General (the OIG) of the Department of Health and Human Services
(HHS) is responsible for identifying fraud and abuse activities in government programs. In order
to fulfill its duties, the OIG performs audits, investigations and inspections. In addition, it
provides guidance to health care providers by identifying types of activities that could violate
the Anti-kickback Statute. We have a variety of financial relationships with physicians who refer
patients to our owned and leased facilities, as well as at behavioral health programs and
facilities we manage. We also have contracts with physicians providing for a variety of financial
relationships including employment contracts, independent contractor agreements, professional
service agreements and medical director agreements. The OIG is authorized to publish regulations outlining activities and business relationships
that would be deemed not to violate the Anti-kickback Statute. These regulations are known as safe
harbor regulations. The safe harbor regulations do not make conduct illegal, but instead delineate
standards that, if complied with, protect conduct that might otherwise be deemed in violation of
the Anti-kickback Statute. We use our best efforts to structure each of our arrangements,
especially each of our business relationships with physicians, to fit as closely as possible within
an applicable safe harbor. However, not all of our business arrangements fit wholly within safe
harbors so we cannot guarantee that these arrangements will not be scrutinized by government
authorities or, if scrutinized, that they will be determined to be in compliance with the
Anti-kickback Statute or other applicable laws. The failure of a particular activity to comply with
the safe harbor regulations does not mean that the activity violates the Anti-kickback Statute. If
we do violate the Anti-kickback Statute, we would be subject to criminal and civil penalties and/or
possible exclusion from participating in Medicare, Medicaid or other governmental health care
programs. 9




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The OIG also issues advisory opinions to outside parties regarding the interpretation and
applicability of the Anti-kickback Statute and other OIG health care fraud and abuse sanctions. An
OIG advisory opinion only applies to the people or entities which requested it. However, advisory
opinions are published and made available to the public (see
http://oig.hhs.gov/fraud/advisoryopinions.html), and they provide guidance on those practices the
OIG believes may (or may not) violate federal law. On April 3, 2003, the OIG issued Advisory
opinion No. 03-8 regarding an arrangement whereby a company would develop and manage distinct part
inpatient rehabilitation units located within general acute care hospitals in exchange for a
management fee calculated on a per patient per day basis. The OIG found that the proposed
arrangement could potentially generate prohibited remuneration under the Anti-kickback Statute and
that the OIG could potentially impose administrative sanctions on the management company. The OIG
noted that any definitive conclusion regarding the existence of an anti-kickback violation would
require a determination of the parties intent, which is beyond the scope of the advisory opinion
process. The OIGs analysis noted that the proposed arrangement did not qualify for the safe harbor for
personal services and management contracts because the aggregate compensation paid by the hospital
to the management company was not set in advance. The OIG noted that per patient, per click,
per order, and similar payment arrangements with parties in a position, either directly or
indirectly, to refer or recommend an item or service payable by a federal health care program are
disfavored under the Anti-kickback Statute. The principal concern is that such arrangements promote
overutilization and unnecessarily lengthy stays. Other items of concern to the OIG included that
the unit was under the medical direction of a physician in a position to generate referrals to the
unit, the management company performed community outreach including marketing, and the fee
arrangement could be deemed a success fee. While the proposed arrangement had certain features that
would appear to reduce the risk, the OIG could not conclude that the residual risk was sufficiently
low to grant protection prospectively. We provide services to medical/surgical facilities through behavioral health care management
contracts and are compensated, in part, on a per discharge basis. We have not requested an advisory
opinion from the OIG with respect to our inpatient management contracts. We believe that we are in
compliance with the Anti-kickback Statute, despite the fact that our inpatient management contracts
do not qualify for the safe harbor for personal services and management contracts because the
aggregate compensation paid by our client hospitals is not set in advance. There can be no
assurances that our contracts will not be reviewed and challenged by the OIG or other regulatory
authorities empowered to do so. The Social Security Act also includes a provision commonly known as the Stark Law. This law
prohibits physicians from referring Medicare and Medicaid patients for the furnishing of any
designated health services to health care entities in which they or any of their immediate family
members have ownership or other financial interest. These types of referrals are commonly known as
self referrals. Sanctions for violating the Stark Law include civil monetary penalties,
assessments equal to twice the dollar value of each service rendered for an impermissible referral
and exclusion from the Medicare and Medicaid programs. There are ownership and compensation
arrangement exceptions for many customary financial arrangements between physicians and facilities,
including employment contracts, personal services agreements, leases and recruitment agreements. We
have structured our financial arrangements with physicians to comply with the statutory exceptions
included in the Stark Law and subsequent regulations. However, future Stark Law regulations may
interpret provisions of this law in a manner different from the manner in which we have interpreted
them. We cannot predict the effect such future regulations will have on us. Many states in which we operate also have adopted, or are considering adopting, laws similar
to the Anti-kickback Statute and/or the Stark Law. Some of these state laws apply even if the
government is not the payor. These statutes typically provide criminal and civil penalties as
remedies. While there is little precedent for the interpretation or enforcement of these state
laws, we have attempted to structure our financial relationships with physicians and others in
light of these laws. However, if a state determines that we have violated such a law, we would be
subject to criminal and civil penalties. Emergency Medical Treatment and Active Labor Act The Emergency Medical Treatment and Active Labor Act (EMTALA) is a federal law that requires
any health care facility that participates in the Medicare program to conduct an appropriate
medical screening examination of every person who presents to the hospitals emergency department
for treatment and, if the patient is suffering from an emergency medical condition, to either
stabilize that condition or make an appropriate transfer of the patient to a facility that can
handle the condition. The obligation to screen and stabilize emergency medical conditions exists
regardless of a patients ability to pay for treatment. There are severe penalties under EMTALA if
a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital
delays appropriate treatment in order to first inquire about the patients ability to pay.
Penalties for violations of EMTALA include civil monetary penalties and exclusion from
participation in the Medicare program. In addition, an injured patient, the patients family or a
medical facility that suffers a financial loss as a direct result of another hospitals violation
of the law can bring a civil suit against the hospital. CMS regulations describe when a patient is considered to be on a hospitals property for
purposes of screening and treating the person pursuant to EMTALA. CMS rules do not specify
particular on-call physician requirements for an emergency department, 10




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but provided a subjective standard stating that on-call hospital schedules should meet the
hospitals and communitys needs. Although we believe that our inpatient behavioral health care
facilities comply with EMTALA, we cannot predict if CMS will implement new requirements in the
future and whether we will comply with any new requirements. The Federal False Claims Act The federal False Claims Act prohibits providers from knowingly submitting false claims for
payment to the federal government. This law has been used not only by the federal government, but
also by individuals who bring an action on behalf of the government under the laws qui tam or
whistleblower provisions. When a private party brings a qui tam action under the federal False
Claims Act, the defendant will generally not be aware of the lawsuit until the government makes a
determination whether it will intervene and take a lead in the litigation. Civil liability under the federal False Claims Act can be up to three times the actual damages
sustained by the government plus civil penalties for each separate false claim. There are many
potential bases for liability under the federal False Claims Act, including claims submitted
pursuant to a referral found to violate the Anti-kickback Statute. Although liability under the
federal False Claims Act arises when an entity knowingly submits a false claim for reimbursement to
the federal government, the federal False Claims Act defines the term knowingly broadly. Although
simple negligence will not give rise to liability under the federal False Claims Act, submitting a
claim with reckless disregard to its truth or falsity can constitute knowingly submitting a false
claim. From time to time, companies in the health care industry, including us, may be subject to
actions under the federal False Claims Act. HIPAA Transaction, Privacy and Security Requirements There are currently numerous laws at the state and federal levels addressing patient privacy
concerns. Federal regulations issued pursuant to HIPAA contain, among other measures, provisions
that require many organizations, including our inpatient facilities, to implement very significant
and potentially expensive new computer systems, employee training programs and business procedures.
The federal regulations are intended to encourage electronic commerce in the health care industry. HHS issued regulations requiring our inpatient facilities to use standard data formats and
code sets established by the rule when electronically transmitting information in connection with
several transactions, including health claims and equivalent encounter information, health care
payment and remittance advice and health claim status with compliance required by October 16, 2003.
We have implemented or upgraded computer systems, as appropriate, at our inpatient facilities and
at our corporate headquarters to comply with the new transaction and code set regulations. HIPAA requires HHS to issue regulations establishing standard unique health identifiers for
individuals, employers, health plans and health care providers to be used in connection with
standard electronic transactions. All health care providers, including our facilities, will be
required to obtain a new National Provider Identifier (NPI) to be used in standard transactions
instead of other numerical identifiers beginning no later than May 23, 2007; health care providers
may begin applying for NPIs on May 23, 2005. We cannot predict whether our facilities may
experience payment delays during the transition to the new identifier. HHS has not yet issued
proposed rules that establish the standard for unique health identifiers for health plans or
individuals. Once these regulations are issued in final form, we expect to have approximately two
years to become fully compliant, but cannot predict the impact of such changes at this time. On February 20, 2003, HHS finalized a rule that establishes, in part, standards to protect the
confidentiality, availability and integrity of health information by health plans, health care
clearinghouses and health care providers that receive, store, maintain or transmit health and
related financial information in electronic form, regardless of format. These security standards
require our inpatient facilities to establish and maintain reasonable and appropriate
administrative, technical and physical safeguards to ensure the integrity, confidentiality and the
availability of electronic health and related financial information. The security standards were
designed to protect electronic information against reasonably anticipated threats or hazards to the
security or integrity of the information and to protect the information against unauthorized use or
disclosure. Although the security standards do not reference or advocate a specific technology, and
covered health care providers, plans and clearinghouses have the flexibility to choose their own
technical solutions, we expect that the security standards will require our inpatient facilities to
implement significant new systems, business procedures and training programs. Our inpatient
facilities must comply with these security regulations by April 21, 2005. We anticipate that our
inpatient facilities will comply this these security regulations by April 21, 2005. On December 28, 2000 (with revisions August 14, 2002), HHS published a final rule establishing
standards for the privacy of individually identifiable health information, with compliance required
by April 14, 2003. These privacy standards apply to all health plans, all health care
clearinghouses and health care providers that transmit health information in an electronic form in
connection with the standard transactions, including our inpatient facilities. The privacy
standards apply to individually identifiable information held or disclosed by a covered entity in
any form, whether communicated electronically, on paper or orally. These standards impose extensive
new administrative requirements on our inpatient facilities. They require our compliance with rules
governing the use and disclosure of this health information. They create new rights for patients in
their health information, such as the right to amend their health 11




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information, and they require our inpatient facilities to impose these rules, by contract, on any
business associate to whom they disclose such information in order to perform functions on their
behalf. In addition, our inpatient facilities will continue to remain subject to any state laws
that are more restrictive than the privacy regulations issued under HIPAA. These state laws vary by
state and could impose additional penalties. A violation of these regulations could result in civil money penalties of $100 per incident,
up to a maximum of $25,000 per person per year per standard. HIPAA also provides for criminal
penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or
disclosing protected health information, up to $100,000 and five years in prison for obtaining
protected health information under false pretenses, and up to $250,000 and ten years in prison for
obtaining or disclosing protected health information with the intent to sell, transfer or use such
information for commercial advantage, personal gain or malicious harm. Since there is no
significant history of enforcement efforts by the federal government at this time, it is not
possible to ascertain the likelihood of enforcement efforts in connection with the HIPAA
regulations or the potential for fines and penalties which may result from the violation of the
regulations. Compliance with these regulations has and will continue to require significant commitment and
action by us and our inpatient facilities. We have appointed members of our management team to
direct our compliance with these standards. Implementation of these regulations has and will
continue to require our inpatient facilities and us to engage in extensive preparation and make
significant expenditures. At this time we have appointed a privacy officer at each inpatient
facility, prepared privacy policies, trained our workforce on these policies and entered into
business associate agreements with the appropriate vendors. Because some of the regulations are
proposed regulations, we cannot predict the total financial impact of the regulations on our
operations. Certificates of Need (CON) The construction of new health care facilities, the acquisition or expansion of existing
facilities, the transfer or change of ownership and the addition of new beds, services or equipment
may be subject to state laws that require prior approval by state regulatory agencies. These CON
laws generally require that a state agency determine the public need for construction or
acquisition of facilities or the addition of new services. Failure to obtain necessary state
approval can result in the inability to expand facilities, add services, complete an acquisition or
change ownership. Violations of these state laws may result in the imposition of civil sanctions or
revocation of a facilitys license. Corporate Practice of Medicine and Fee Splitting Some states have laws that prohibit unlicensed persons or business entities, including
corporations or business organizations that own hospitals, from employing physicians. Some states
also have adopted laws that prohibit direct and indirect payments or fee-splitting arrangements
between physicians and unlicensed persons or business entities. Possible sanctions for violation of
these restrictions include loss of a physicians license, civil and criminal penalties and
rescission of business arrangements. These laws vary from state to state, are often vague and have
seldom been interpreted by the courts or regulatory agencies. Although we attempt to structure our
arrangements with health care providers to comply with the relevant state laws and the few
available regulatory interpretations, there can be no assurance that government officials charged
with responsibility for enforcing these laws will not assert that we, or certain transactions in
which we are involved, are in violation of such laws, or that such laws ultimately will be
interpreted by the courts in a manner consistent with our interpretation. Health Care Industry Investigations Significant media and public attention has focused in recent years on the hospital industry.
Because the law in this area is complex and constantly evolving, ongoing or future governmental
investigations or litigation may result in interpretations that are inconsistent with industry
practices, including our practices. It is possible that governmental entities could initiate
investigations of or litigation against inpatient facilities owned or managed by us in the future
and that such matters could result in significant penalties as well as adverse publicity. It is
also possible that our executives and other management personnel could be included in governmental
investigations or litigation or named as defendants in private litigation. Risk Management As is typical in the health care industry, we are subject to claims and legal actions by
patients in the ordinary course of business. To cover these claims, we maintain professional
malpractice liability insurance and general liability insurance in amounts we believe to be
sufficient for our operations, although it is possible that some claims may exceed the scope of the
coverage in effect. At various times in the past, the cost of malpractice insurance and other
liability insurance has risen significantly. Therefore, there can be no assurance that such
insurance will continue to be available at reasonable prices which would allow us to maintain
adequate levels of coverage. 12




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Conversion Legislation Many states have adopted legislation regarding the sale or other disposition of hospitals
operated by not-for-profit entities. In other states that do not have such legislation, the
attorneys general have demonstrated an interest in these transactions under their general
obligations to protect charitable assets. These legislative and administrative efforts primarily
focus on the appropriate valuation of the assets divested and the use of the proceeds of the sale
by the not-for-profit seller. These reviews and, in some instances, approval processes can add
additional time to the closing of a not-for-profit hospital acquisition. Future actions by state
legislators or attorneys general may seriously delay or even prevent our ability to acquire certain
hospitals. Regulatory Compliance Program We are committed to ethical business practices and to operating in accordance with all
applicable laws and regulations. Our Compliance Program was established to ensure that all
employees have a solid framework for business, legal, ethical, and employment practices. Our
Compliance Program establishes mechanisms to aid in the identification and correction of any actual
or perceived violations of any of our policies or procedures or any other applicable rules and
regulations. We have appointed a Chief Compliance Officer as well as compliance coordinators at
each inpatient facility. The Chief Compliance Officer heads our Compliance Committee which consists
of senior management personnel and a member of our board of directors. Employee training is a key
component of the Compliance Program. All employees receive training during orientation and annually
thereafter. Insurance We are subject to medical malpractice and other lawsuits due to the nature of the services we
provide. Due to our acquisition of Ramsay Youth Services, Inc. (Ramsay), we had two distinct
insurance programs that covered our inpatient facilities. Prior to January 1, 2005, all of our
inpatient facilities except those acquired from Ramsay had professional and general liability
insurance in umbrella form for claims in excess of $3.0 million with an insured limit of $20.0
million. For the inpatient facilities acquired from Ramsay, we had professional and general
liability insurance in umbrella form for claims in excess of $500,000 with an insured limit of
$26.0 million. These plans were combined in 2005 to cover all of our operations for professional
and general liability in umbrella form for claims in excess of $2.0 million with an insured limit
of $35.0 million. The self-insured reserves for professional and general liability risks are
calculated based on historical claims, demographic factors, industry trends, severity factors, and
other actuarial assumptions calculated by an independent third party. This self-insurance reserve
is discounted to its present value using a 5% discount rate. This estimated accrual for
professional and general liabilities could be significantly affected should current and future
occurrences differ from historical claim trends and expectations. We have utilized our captive
insurance company to manage this additional self-insured retention. While claims are monitored
closely when estimating professional and general liability accruals, the complexity of the claims
and wide range of potential outcomes often hampers timely adjustments to the assumptions used in
these estimates. We believe that our insurance coverage conforms to industry standards. There are no
assurances, however, that our insurance will cover all claims (e.g., claims for punitive damages)
or that claims in excess of our insurance coverage will not arise. A successful lawsuit against us
that is not covered by, or is in excess of, our insurance coverage may have a material adverse
effect on our business, financial condition and results of operations. Employees As of December 31, 2004, we employed approximately 9,100 employees, of whom approximately
6,100 are full-time employees. Approximately 7,900 employees staff our owned and leased inpatient
behavioral health care facilities, approximately 1,100 employees staff our inpatient management
contracts and approximately 70 are in corporate management including finance, accounting,
development, utilization review, training and education, information systems, member services, and
human resources. None of our employees is subject to a collective bargaining agreement and we
believe that our employee relations are good. Available Information We make available free of charge through our website, which you can find at
www.psysolutions.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a)
or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such
material with, or furnish it to, the Securities and Exchange Commission. 
 Item 2. Properties. At December 31, 2004, our inpatient behavioral health care facilities division operated 34
owned or leased inpatient behavioral health care facilities with 4,337 licensed beds in 19 states.
The following table sets forth the name, location, number of licensed beds and the acquisition date
for each of our owned and leased inpatient behavioral health care facilities as of December 31, 2004. 13




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##### Table of Contents



DateFacility
    
    Location
    
    Beds
    
    Own/Lease
    
    AcquiredCypress Creek Hospital
    
    Houston, TX
    
    
    96
    
    
    Own
    
    9/01West Oaks Hospital
    
    Houston, TX
    
    
    160
    
    
    Own
    
    9/01Texas NeuroRehab Center
    
    Austin, TX
    
    
    127
    
    
    Own
    
    11/01Holly Hill Hospital
    
    Raleigh, NC
    
    
    108
    
    
    Own
    
    12/01Riveredge Hospital
    
    Chicago, IL
    
    
    210
    
    
    Own
    
    7/02Whisper Ridge Behavioral Health System
    
    Charlottesville, VA
    
    
    60
    
    
    Lease
    
    4/03Cedar Springs Behavioral Health System
    
    Colorado Springs, CO
    
    
    110
    
    
    Own
    
    4/03Laurel Ridge Treatment Center
    
    San Antonio, TX
    
    
    196
    
    
    Own
    
    4/03San Marcos Treatment Center
    
    San Marcos, TX
    
    
    265
    
    
    Own
    
    4/03The Oaks Treatment Center
    
    Austin, TX
    
    
    118
    
    
    Own
    
    4/03Shadow Mountain Behavioral Health System
    
    Tulsa, OK
    
    
    156
    
    
    Own
    
    4/03Laurel Oaks Behavioral Health Center
    
    Dothan, AL
    
    
    111
    
    
    Own
    
    6/03Hill Crest Behavioral Health
    
    Birmingham, AL
    
    
    189
    
    
    Own
    
    6/03Gulf Coast Youth Academy
    
    Fort Walton Beach, FL
    
    
    168
    
    
    Own
    
    6/03Manatee Palms Youth Services
    
    Bradenton, FL
    
    
    60
    
    
    Own
    
    6/03Havenwyck Facility
    
    Auburn Hills, MI
    
    
    182
    
    
    Lease
    
    6/03Heartland Behavioral Health
    
    Nevada, MO
    
    
    169
    
    
    Own
    
    6/03Brynn Marr Behavioral Health
    
    Jacksonville, NC
    
    
    88
    
    
    Own
    
    6/03Mission Vista Hospital
    
    San Antonio, TX
    
    
    83
    
    
    Lease
    
    6/03Benchmark Behavioral Health
    
    Woods Cross, UT
    
    
    173
    
    
    Own
    
    6/03Macon Behavioral Health System
    
    Macon, GA
    
    
    155
    
    
    Own
    
    6/03Manatee Adolescent Treatment Services
    
    Bradenton, FL
    
    
    85
    
    
    Own
    
    6/03Alliance Health Center
    
    Meridian, MS
    
    
    169
    
    
    Own
    
    11/03Calvary Center
    
    Phoenix, AZ
    
    
    50
    
    
    Lease
    
    12/03Brentwood Acute Behavioral Health Center
    
    Shreveport, LA
    
    
    200
    
    
    Own
    
    3/04Brentwood Behavioral Health of Mississippi
    
    Flowood, MS
    
    
    107
    
    
    Own
    
    3/04Palmetto Lowcountry Behavioral Health System
    
    North Charleston, SC
    
    
    102
    
    
    Own
    
    5/04Palmetto Pee Dee Behavioral Health System
    
    Florence, SC
    
    
    59
    
    
    Lease
    
    5/04Fort Lauderdale Hospital
    
    Fort Lauderdale, FL
    
    
    100
    
    
    Lease
    
    6/04Millwood Hospital
    
    Arlington, TX
    
    
    98
    
    
    Lease
    
    6/04Pride Institute
    
    Eden Prairie, MN
    
    
    36
    
    
    Own
    
    6/04Summit Oaks Hospital
    
    Summit, NJ
    
    
    126
    
    
    Own
    
    6/04Whisper Ridge at Leesburg
    
    Leesburg, VA
    
    
    77
    
    
    Own
    
    6/04Peak Behavioral Health
    
    Santa Teresa, NM
    
    
    144
    
    
    Own
    
    6/04
 In addition, our principal executive offices are located in approximately 17,000 square feet
of leased space in Franklin, Tennessee. We do not anticipate that we will experience any difficulty
in renewing our lease upon its expiration in January 2010, or obtaining different space on
comparable terms if such lease is not renewed. We believe our executive offices and our hospital
property and equipment are generally well maintained, in good operating condition and adequate for
our present needs. 
 Item 3. Legal Proceedings. We are subject to various claims and legal actions that arise in the ordinary course of our
business. In the opinion of management, Psychiatric Solutions is not currently a party to any
proceeding that would have a material adverse effect on its financial condition or results of
operations. 
 Item 4. Submission of Matters to a Vote of Security Holders. None. 
 PART II 
 Item 5. Market For Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities. Our common stock has traded on the Nasdaq National Market under the symbol PSYS. The table
below sets forth, for the calendar quarters indicated, the high and low sales prices per share as
reported on the Nasdaq National Market for our common stock. 14




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##### Table of Contents



High
    
    
    Low2003First Quarter
    
    $
    8.50
    
    
    $
    4.47Second Quarter
    
    $
    10.17
    
    
    $
    7.95Third Quarter
    
    $
    14.51
    
    
    $
    9.53Fourth Quarter
    
    $
    20.95
    
    
    $
    12.262004First Quarter
    
    $
    23.10
    
    
    $
    17.64Second Quarter
    
    $
    27.95
    
    
    $
    17.97Third Quarter
    
    $
    29.04
    
    
    $
    21.24Fourth Quarter
    
    $
    37.34
    
    
    $
    22.33
 At the close of business on March 10, 2005, there were approximately 175 holders of record of
our common stock. We currently intend to retain future earnings for use in the expansion and operation of our
business. Our Credit Agreement with Bank of America prohibits us from paying dividends on our
common stock. Also, the Indenture governing our 10 5/8% senior subordinated notes provides certain
financial conditions that must be met in order for us to pay dividends. Subject to the terms of
applicable contracts, the payment of any future cash dividends will be determined by our Board of
Directors in light of conditions then existing, including our earnings, financial condition and
capital requirements, restrictions in financing agreements, business opportunities and conditions,
and other factors. During 2003, we sold 4,545,454 shares of series A convertible preferred stock for $25 million
to various investors. Holders of our series A convertible preferred stock received pay-in-kind
dividends, compounded quarterly, equal to 5% of the original share price. During 2004 the holders
of the series A convertible preferred stock converted all outstanding shares of series A
convertible preferred stock and related pay-in-kind dividends into 4,813,470 shares of our common
stock. Recent Sales of Unregistered Securities On January 8, 2004, we issued 6,080 shares of common stock to our former senior lender upon the
exercise of a warrant at a price of $0.08 per share. Also, on January 8, 2004, we issued 15,863
shares of common stock to our former senior lender upon the exercise of a warrant at a price of
$12.33 per share. On March 15, 2004, we issued 66,667 shares of common stock to one of our
directors and a former chief executive officer of PMR Corporation (PMR) upon the exercise of
stock options at a price of $14.25 per share. On November 21, 2004, we issued 1,564 shares of
common stock to a former stockholder of an affiliated entity upon the exercise of a warrant at a
price of $4.79 per share. On December 1, 2004, we issued 7,822 shares of common stock to a former
stockholder of an affiliated entity upon the exercise of a warrant at a price of $4.79 per share.
Finally, on December 29, 2004, we issued 4,167 shares of common stock upon the exercise of stock
options at $24.00 per share and issued an additional 4,167 shares of common stock upon the
exercise of stock options at $30.00 per share to a former executive officer of PMR. No underwriters were involved and no underwriters discounts or commissions were paid. Exemption
from registration is claimed under Section 4(2) of the Securities Act of 1933 as a transaction not
involving a public offering. We received cash and/or exchanged shares of our common stock as
consideration for the transactions. 
 Item 6. Selected Financial Data. The selected financial data presented below for the years ended December 31, 2004, 2003 and
2002, and at December 31, 2004 and December 31, 2003, are derived from our audited consolidated
financial statements included elsewhere in this Annual Report on Form 10-K. The selected financial
data for the years ended December 31, 2001 and 2000, and at December 31, 2002, 2001 and 2000, are
derived from our audited consolidated financial statements not included herein. The selected
financial data presented below should be read in conjunction with Managements Discussion and
Analysis of Financial Condition and Results of Operations and with our consolidated financial
statements and notes thereto included elsewhere in this Annual Report on Form 10-K. 15




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##### Table of Contents



Psychiatric Solutions, Inc.
Selected Financial Data
As of and for the Years Ended December 31, 2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(In thousands, except per share amounts)Income Statement Data:Revenue
    
    $
    487,190
    
    
    $
    284,946
    
    
    $
    113,912
    
    
    $
    43,999
    
    
    $
    23,502Costs and expenses:Salaries, wages and employee benefits
    
    
    265,678
    
    
    
    147,069
    
    
    
    62,326
    
    
    
    26,183
    
    
    
    15,257Other operating expenses
    
    
    147,947
    
    
    
    96,735
    
    
    
    35,716
    
    
    
    11,322
    
    
    
    5,826Provision for bad debts
    
    
    10,874
    
    
    
    6,315
    
    
    
    3,681
    
    
    
    662
    
    
    
    467Depreciation and amortization
    
    
    9,868
    
    
    
    5,734
    
    
    
    1,770
    
    
    
    945
    
    
    
    757Interest expense
    
    
    18,964
    
    
    
    14,781
    
    
    
    5,564
    
    
    
    2,660
    
    
    
    1,723Other expenses (1)
    
    
    6,407
    
    
    
    5,271
    
    
    
    178
    
    
    
    1,237
    
    
    
    Total costs and expenses
    
    
    459,738
    
    
    
    275,905
    
    
    
    109,235
    
    
    
    43,009
    
    
    
    24,030Income (loss) from continuing operations before income taxes
    
    
    27,452
    
    
    
    9,041
    
    
    
    4,677
    
    
    
    990
    
    
    
    (528
    )Provision for (benefit from) income taxes
    
    
    10,432
    
    
    
    3,800
    
    
    
    (1,007
    )
    
    
    
    
    
    
    Income (loss) from continuing operations
    
    $
    17,020
    
    
    $
    5,241
    
    
    $
    5,684
    
    
    $
    990
    
    
    $
    (528
    )Net income (loss) available to common stockholders
    
    $
    16,138
    
    
    $
    4,405
    
    
    $
    5,684
    
    
    $
    2,578
    
    
    $
    (1,916
    )Basic earnings (loss) per share from continuing operations
    
    $
    1.12
    
    
    $
    0.53
    
    
    $
    0.93
    
    
    $
    0.20
    
    
    $
    (0.11
    )Basic earnings (loss) per share
    
    $
    1.11
    
    
    $
    0.53
    
    
    $
    0.93
    
    
    $
    0.51
    
    
    $
    (0.40
    )Shares used in computing basic earnings (loss) per share
    
    
    14,570
    
    
    
    8,370
    
    
    
    6,111
    
    
    
    5,010
    
    
    
    4,817Diluted earnings (loss) per share from continuing operations
    
    $
    0.97
    
    
    $
    0.44
    
    
    $
    0.86
    
    
    $
    0.19
    
    
    $
    (0.11
    )Diluted earnings (loss) per share
    
    $
    0.96
    
    
    $
    0.44
    
    
    $
    0.86
    
    
    $
    0.49
    
    
    $
    (0.40
    )Shares used in computing diluted earnings (loss) per share from
continuing operations
    
    
    17,573
    
    
    
    11,749
    
    
    
    6,986
    
    
    
    5,309
    
    
    
    4,817Balance Sheet Data:Cash and cash equivalents
    
    $
    33,255
    
    
    $
    44,954
    
    
    $
    2,392
    
    
    $
    1,262
    
    
    $
    336Working capital (deficit)
    
    
    39,890
    
    
    
    67,153
    
    
    
    2,369
    
    
    
    (3,624
    )
    
    
    (4,571
    )Property and equipment, net
    
    
    218,231
    
    
    
    149,589
    
    
    
    33,547
    
    
    
    17,980
    
    
    
    308Total assets
    
    
    497,846
    
    
    
    347,658
    
    
    
    90,138
    
    
    
    54,294
    
    
    
    26,356Total debt
    
    
    174,336
    
    
    
    175,003
    
    
    
    43,822
    
    
    
    36,338
    
    
    
    16,641Series A convertible preferred stock
    
    
    
    
    
    
    25,316
    
    
    
    
    
    
    
    
    
    
    
    Stockholders equity
    
    
    244,515
    
    
    
    91,328
    
    
    
    30,549
    
    
    
    9,238
    
    
    
    6,235Operating Data:Number of facilities
    
    
    34
    
    
    
    24
    
    
    
    5
    
    
    
    4
    
    
    
    Number of licensed beds
    
    
    4,337
    
    
    
    3,128
    
    
    
    699
    
    
    
    489
    
    
    
    Admissions
    
    
    49,484
    
    
    
    26,278
    
    
    
    14,737
    
    
    
    3,027
    
    
    
    Patient days
    
    
    996,840
    
    
    
    525,055
    
    
    
    145,575
    
    
    
    30,511
    
    
    
    Average length of stay
    
    
    20
    
    
    
    20
    
    
    
    10
    
    
    
    10
    
    
    
    
   (1)
    
    Refer to the notes to our consolidated financial statements regarding our adoption of
Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and
64, Amendment of FASB Statement No. 13, and Technical Corrections (SFAS 145). As a result of our
adoption of SFAS 145, we have reclassified certain losses on refinancing of long-term debt
previously reported as an extraordinary item to a component of income from continuing operations. 16




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Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read in conjunction with the selected
financial data and the accompanying consolidated financial statements and related notes thereto
included in this Annual Report on Form 10-K. Overview Psychiatric Solutions completed a number of significant transactions in 2004. Through
acquisitions, we increased our inpatient facility operations to 34 inpatient facilities and 4,337
licensed beds at December 31, 2004 from 24 inpatient facilities and 3,128 licensed beds at December
31, 2003. We also amended and restated our credit facility, in the process, lowering our effective
rate of borrowing by one percentage point. In addition, we raised nearly $105 million in a
secondary offering of our common stock. As a result, we ended 2004 with over $33 million in cash,
$218 million in fixed assets and a debt balance roughly equivalent to that at the end of 2003. We
believe these developments position us as a leading provider of inpatient behavioral health care
services in the United States. We also believe that our singular focus on the provision of
behavioral health care services allows us to operate more efficiently and provide higher quality
care than our competitors. Our business is characterized by diverse sources of revenue, stable cash
flows and low capital expenditure requirements. Our business strategy is
to acquire inpatient behavioral health care facilities and improve
operating results within new and existing inpatient facilities and our other inpatient behavioral
health care operations. We completed our first significant acquisition in 2000 when we acquired
Sunrise Behavioral Health, Ltd. and its inpatient behavioral health care management contracts. We
continued implementing our acquisition strategy in 2001 with the acquisition of four inpatient
behavioral health care facilities. In 2002, we acquired one inpatient behavioral health care
facility and merged with PMR, a public company and operator of inpatient
behavioral health care management contracts. 2003 marked our largest acquisitions to date with the
purchase of six inpatient behavioral health care facilities from The Brown Schools, Inc. (The
Brown Schools), the acquisition of Ramsay, an operator of 11 owned or leased inpatient
behavioral health care facilities and 10 contracts to manage inpatient behavioral health care
facilities for certain state governmental agencies, and the acquisitions of two other inpatient
behavioral health care facilities from other sellers. In 2004, we acquired 10 inpatient behavioral
health care facilities in five separate transactions, the most significant being the acquisition of
four inpatient behavioral health care facilities from Heartland. We strive to improve the operating results of new and existing inpatient behavioral health
care operations by providing the highest quality service, expanding referral networks and marketing
initiatives and meeting increased demand for our services by expanding our services and developing
new services. We also improve operating results by optimizing staffing ratios, controlling contract
labor costs and reducing supply costs through group purchasing. During 2004, we increased our
revenue from owned and leased inpatient facilities by 9.0% as compared to our 2003 revenue from
owned and leased inpatient facilities through same-facility growth. Same-facility growth also
produced gains in owned and leased inpatient facility admissions and patient days of 5.7% and 7.7%,
respectively, in 2004 as compared to 2003. Same-facility growth refers to the comparison of each
inpatient facility owned during 2003 with the comparable period in 2004. Acquisitions On March 10, 2004, we entered into a Stock
Purchase Agreement to acquire all of the outstanding capital stock of
AHS for approximately $560 million. The purchase price will be
paid $500 million in cash and $60 million in shares of our common stock. AHS owns and operates,
through its subsidiaries, 20 inpatient behavioral health care facilities, which include approximately
2,000 inpatient beds and generated approximately $300 million in revenues in 2004. On June 30, 2004, we completed the acquisition of substantially all the assets of Alliance
Behavioral, a system of inpatient behavioral health care facilities with 144 beds located near El
Paso, Texas, for approximately $12.5 million. On June 11, 2004, we completed the acquisition of substantially all of the assets of Piedmont,
a 77 bed inpatient behavioral health care facility located in Leesburg, Virginia, for approximately
$10.7 million. On June 1, 2004, we completed the acquisition of four inpatient behavioral health care
facilities from Heartland for approximately $49.9 million. The four inpatient facilities, located
in Summit, New Jersey, Ft. Lauderdale, Florida, Arlington, Texas and Eden Prairie, Minnesota, have
a total of 360 beds. On May 1, 2004, we completed the acquisition of all of the membership interests of Palmetto,
an operator of two inpatient behavioral health care facilities, for approximately $6.4 million. The
two inpatient facilities, located in Charleston and Florence, South Carolina, have 161 beds. On March 1, 2004, we acquired two inpatient psychiatric facilities from Brentwood Behavioral
Health for approximately $30.4 million cash with an earn-out of approximately $5 million payable in
the second quarter of 2005. The inpatient facilities, which have an aggregate of 311 licensed beds,
are located in Shreveport, Louisiana and Jackson, Mississippi. On December 16, 2003, we acquired the 50-bed Calvary Center located in Phoenix, Arizona for
approximately $4.0 million. We paid $650,000 of the purchase price on the acquisition date with the
balance paid in January 2004. 17




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##### Table of Contents



On November 1, 2003, we acquired the 109-bed Alliance Health Center located in Meridian,
Mississippi. Alliance Health Center is a licensed acute care hospital that provides psychiatric
care for children, adolescents and adults. In addition, we completed the construction of a 60-bed
residential treatment center in June 2004. On June 30, 2003, we
consummated the acquisition of Ramsay, a public company that traded on
the Nasdaq SmallCap Market under the symbol RYOU, for approximately $81.3 million, consisting of
$56.2 million in cash, or $5.00 per share, $22.3 million in net assumed debt that was repaid in
connection with the acquisition and $2.8 million in fees and expenses. The 11 owned or leased
inpatient behavioral health care facilities we acquired from Ramsay, which have an aggregate of
1,292 beds, are located primarily in the Southeastern region of the United States with locations
also in Michigan, Missouri and Utah. In the acquisition, we also assumed 10 contracts to manage
inpatient behavioral health care facilities for government agencies in Florida, Georgia and Puerto
Rico. In April 2003, we
consummated the acquisition of six inpatient behavioral health care
facilities from The Brown Schools for $63.0 million in
cash. The six
inpatient facilities, which have an aggregate of 895 licensed beds, are located in Austin, San
Antonio and San Marcos, Texas; Charlottesville, Virginia; Colorado Springs, Colorado; and Tulsa,
Oklahoma. These facilities offer a full continuum of care for troubled adolescents and adults. Acquiring inpatient behavioral health care facilities is a key part of our business strategy.
Because we have grown through acquisitions accounted for as purchases, it is difficult to make
meaningful comparisons between our financial statements for the fiscal periods presented. Sources of Revenue Patient Service Revenue Patient service revenue is generated by our inpatient facilities as a result of services
provided to patients within the inpatient behavioral health care facility setting. Patient service
revenue is reported on an accrual basis in the period in which services are rendered, at
established rates, regardless of whether collection in full is expected. Patient service revenue
includes amounts estimated by management to be reimbursable by Medicare and Medicaid under
provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally
less than the established billing rates of the inpatient facilities and the differences are
reported as deductions from patient service revenue at the time the service is rendered. For the
year ended December 31, 2004, patient service revenue comprised approximately 86% of our total
revenue. Management Contract Revenue Management contract revenue is earned by our inpatient management contract division. The
inpatient management contract division receives contractually determined management fees from
hospitals and clinics for providing psychiatric unit management and development services as well as
management fees for managing inpatient behavioral health care facilities for government agencies.
For the year ended December 31, 2004, management contract revenue comprised approximately 14% of
our total revenue. Results of Operations The following table illustrates our consolidated results of operations for the years ended
December 31, 2004, 2003 and 2002 (dollars in thousands). 18




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##### Table of Contents



Results of Operations, Consolidated Psychiatric SolutionsFor the Year Ended December 31,2004
    
    
    2003
    
    
    2002Amount
    
    
    %
    
    
    Amount
    
    
    %
    
    
    Amount
    
    
    %Revenue
    
    $
    487,190
    
    
    
    100.0
    %
    
    $
    284,946
    
    
    
    100.0
    %
    
    $
    113,912
    
    
    
    100.0
    %Salaries, wages, and employee benefits
    
    
    265,678
    
    
    
    54.6
    %
    
    
    147,069
    
    
    
    51.6
    %
    
    
    62,326
    
    
    
    54.7
    %Professional fees
    
    
    53,258
    
    
    
    10.9
    %
    
    
    32,466
    
    
    
    11.4
    %
    
    
    14,373
    
    
    
    12.6
    %Supplies
    
    
    31,139
    
    
    
    6.4
    %
    
    
    16,371
    
    
    
    5.8
    %
    
    
    5,325
    
    
    
    4.7
    %Provision for bad debts
    
    
    10,874
    
    
    
    2.2
    %
    
    
    6,315
    
    
    
    2.2
    %
    
    
    3,681
    
    
    
    3.2
    %Other operating expenses
    
    
    63,550
    
    
    
    13.1
    %
    
    
    47,898
    
    
    
    16.8
    %
    
    
    16,018
    
    
    
    14.1
    %Depreciation and amortization
    
    
    9,868
    
    
    
    2.0
    %
    
    
    5,734
    
    
    
    2.0
    %
    
    
    1,770
    
    
    
    1.5
    %Interest expense, net
    
    
    18,964
    
    
    
    3.9
    %
    
    
    14,781
    
    
    
    5.2
    %
    
    
    5,564
    
    
    
    4.9
    %Other expenses:Loss on refinancing long-term debt
    
    
    6,407
    
    
    
    1.3
    %

    
    
    4,856
    
    
    
    1.7
    %
    
    
    86
    
    
    
    0.1
    %Change in valuation of put warrants
    
    
    
    
    
    
    0.0
    %
    
    
    960
    
    
    
    0.3
    %
    
    
    
    
    
    
    0.0
    %Change in reserve on stockholder notes
    
    
    
    
    
    
    0.0
    %
    
    
    (545
    )
    
    
    -0.2
    %
    
    
    92
    
    
    
    0.1
    %Income from continuing operations before
income taxes
    
    
    27,452
    
    
    
    5.6
    %
    
    
    9,041
    
    
    
    3.2
    %
    
    
    4,677
    
    
    
    4.1
    %Provision for (benefit from) income taxes
    
    
    10,432
    
    
    
    2.1
    %
    
    
    3,800
    
    
    
    1.4
    %
    
    
    (1,007
    )
    
    
    -0.9
    %Income from continuing operations
    
    $
    17,020
    
    
    
    3.5
    %
    
    $
    5,241
    
    
    
    1.8
    %
    
    $
    5,684
    
    
    
    5.0
    %
 Year Ended December 31, 2004 Compared To Year Ended December 31, 2003 Revenue. Revenue from continuing operations was $487.2 million for the year ended December 31,
2004 compared to $284.9 million for the year ended December 31, 2003, an increase of $202.3 million
or 71.0%. Revenue from our owned and leased inpatient facilities segment accounted for $419.3
million of the 2004 results compared to $223.3 million of the 2003 results, an increase of $196.0
million or 87.8%. The increase in revenues from our owned and leased inpatient facilities segment
relates primarily to acquisitions. Acquisitions accounted for the following increases in revenue
during 2004 as compared to 2003: $20.7 million for the inpatient facilities acquired from The Brown
Schools, $61.8 million for the inpatient facilities acquired from Ramsay, $27.8 million for
Brentwood, $28.9 million for Heartland and $36.2 million for other acquisitions during 2004 and
2003. The remainder of the increase in revenues from owned and leased inpatient facilities is
primarily attributable to same-facility growth in admissions and patient days of 5.7% and 7.7%,
respectively. Revenue from our inpatient management contracts segment accounted for $67.9 million
of the 2004 results compared to $61.6 million of the 2003 results, an increase of $6.3 million or
10.2%. The increase in revenues from our inpatient management contracts segment relates primarily to revenues from
inpatient management contracts assumed in the Ramsay acquisition. Salaries, wage, and employee benefits. Salaries, wages and employee benefits (SWB) expense
was $265.7 million for the year ended December 31, 2004, or 54.6% of our total revenue, compared to
$147.1 million for the year ended December 31, 2003, or 51.6% of our total revenue. SWB expense for
our owned and leased inpatient facilities segment was $227.6 million in 2004, or 54.3% of segment
revenue. Same-facility SWB expense for our owned and leased inpatient facilities segment was $131.7
million in 2004, or 54.1% of segment revenue, compared to $122.5 million in 2003, or 54.9% of
segment revenue. SWB expense for our inpatient management contracts segment was $30.1 million in
2004. Same-facility SWB expense for our inpatient management contracts
segment was $20.3 million in 2004 compared to $21.1 million in 2003. SWB
expense for our corporate office was $8.0 million for 2004 compared to $3.5 million for 2003 as the
result of the hiring of additional staff necessary to manage the inpatient facilities and inpatient
management contracts acquired during 2003 and 2004. Professional fees. Professional fees were $53.3 million for the year ended December 31, 2004,
or 10.9% of our total revenue, compared to $32.5 million for the year ended December 31, 2003, or
11.4% of our total revenue. Professional fees for our owned and leased inpatient facilities segment
were $45.2 million in 2004, or 10.8% of segment revenue. Same-facility professional fees for our
owned and leased inpatient facilities segment were $26.9 million in 2004, or 11.0% of segment
revenue, compared to $26.3 million in 2003, or 11.8% of segment revenue. Professional fees for our
inpatient management contracts segment were $4.8 million in 2004. Same-facility professional fees for our inpatient management contracts segment were $4.1 million in
2004, compared to $4.3 million in 2003.
Professional fees for our corporate office were approximately $3.3 million in 2004 compared to
approximately $1.8 million in 2003. The increase in professional fees in our 19




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corporate office
relates to accounting, legal and other services required to meet the needs of a public company and
achieving our acquisition strategy. Supplies.Supplies expense was $31.1 million for the year ended December 31, 2004, or 6.4% of
our total revenue, compared to
$16.4 million for the year ended December 31, 2003, or 5.8% of our total revenue. Supplies expense
for our owned and leased inpatient facilities segment was $28.8 million in 2004, or 6.9% of segment
revenue. Same-facility supplies expense for our owned and leased inpatient facilities segment was
$16.9 million in 2004, or 6.9% of segment revenue, compared to $15.3 million in 2003, or 6.8% of
segment revenue. Supplies expense for our inpatient management contracts segment was $2.2 million
in 2004. Same-facility supplies expense for our inpatient management
contracts segment were $1.1 million in 2004 compared to $1.0 million
in 2003. Supplies expense at our owned and leased inpatient facilities
segment has historically comprised the majority of our supplies expense as a whole; however, our
inpatient management contracts segment began to utilize supplies to a larger extent due to the
assumption of inpatient management contracts from Ramsay. Supplies expense for our corporate office
consists of office supplies and are negligible to supplies expense overall. Provision for bad debts. The provision for bad debts was $10.9 million for the year ended
December 31, 2004, or 2.2% of our total revenue, compared to $6.3 million for the year ended
December 31, 2003, or 2.2% of our total revenue. The provision for bad debts at our owned and
leased inpatient facilities segment comprises the majority of our provision for bad debts as a
whole. Other operating expenses. Other operating expenses were approximately $63.6 million for the
year ended December 31, 2004, or 13.1% of our total revenue, compared to $47.9 million for the year
ended December 31, 2003, or 16.8% of our total revenue. Other operating expenses for our owned and
leased inpatient facilities segment were $40.3 million in 2004, or 9.6% of segment revenue.
Same-facility other operating expenses for our owned and leased inpatient facilities segment were
$21.4 million in 2004, or 8.8% of segment revenue, compared to $21.7 million in 2003, or 9.7% of
segment revenue. Other operating expenses for our inpatient management contracts segment were $20.0
million in 2004. Same-facility other operating expenses for our
inpatient management contracts segment were $18.3 million in 2004 compared to $24.2 million in 2003. This decrease in other operating
expenses for our inpatient management contracts segment on a same-facility basis, as compared to 2003, is primarily attributable to the net
presentation of pharmacy receipts  related to our Tennessee case management contract as an offset to other operating expenses. Other operating expenses at
our corporate office increased to $3.3 million in 2004 from approximately $2.0 million in 2003. Depreciation and amortization. Depreciation and amortization expense was $9.9 million for the
year ended December 31, 2004 compared to $5.7 million for the year ended December 31, 2003, an
increase of approximately $4.2 million. This increase in depreciation and amortization expense is
primarily the result of the numerous acquisitions of inpatient facilities during 2003 and 2004. Interest expense. Interest expense was $19.0 million for the year ended December 31, 2004
compared to $14.8 million for the year ended December 31, 2003, an increase of $4.2 million or
28.4%. The increase in interest expense is primarily attributable to the increase in our long-term
debt during 2004. We began 2004 with $175.0 million in long-term debt, increasing to $191.9
million, $249.6 million and $244.4 million for the quarters ended March 31, 2004, June 30, 2004 and
September 30, 2004, respectively, due to borrowings under our revolving line of credit to finance
the acquisition of inpatient behavioral health care facilities. On December 31, 2004, we had $174.3
million in long-term debt as the result of repaying borrowings under our revolving line of credit
with proceeds from our secondary offering of common stock that closed on December 20, 2004. Other expenses.Other expenses totaled $6.4 million for the year ended December 31, 2004
compared to approximately $5.3 million for the year ended December 31, 2003. Other expenses in 2004
consisted of $6.4 million in loss on the refinancing of our long-term debt. Other expenses in 2003
consisted of $4.9 million in loss on the refinancing of our long-term debt, $960,000 in expense
recorded to recognize the change in fair value of stock purchase put warrants (for additional
information on these warrants, see Liquidity and Capital Resources below) and the release of
$545,000 in reserves related to our stockholder notes. Loss from discontinued operations, net of taxes. The loss from discontinued operations (net of
income tax effect) of approximately $219,000 and $25,000 for the years ended December 31, 2004 and
2003, respectively, is from the operations of three contracts to manage inpatient facilities for
the Florida Department of Juvenile Justice. These contracts were assumed in the Ramsay acquisition
in 2003 and exited in 2004. Year Ended December 31, 2003 Compared To Year Ended December 31, 2002 Revenue. Revenue from continuing operations was $284.9 million for the year ended December 31,
2003 compared to $113.9 million for the year ended December 31, 2002, an increase of $171.0 million
or 150.1%. Revenue from our owned and leased inpatient facilities segment accounted for $223.3
million of the 2003 results compared to $81.9 million of the 2002 results, an increase of $141.4
million or 172.5%. The increase in revenues from our owned and leased inpatient facilities segment
relates primarily to revenues of $14.9 million during the first six months of 2003 for Riveredge
Hospital, $57.3 million during 2003 for the inpatient facilities acquired from The Brown Schools
and $59.6 million for the owned and leased inpatient facilities acquired from Ramsay. The 20




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remainder
of the increase in revenues from inpatient facilities is primarily attributable to growth in
admissions and patient days of 4.1% and 7.0%, respectively, on a same-facility basis. Revenue from
our inpatient management contracts segment accounted for $61.6 million of the 2003 results compared
to $32.0 million of the 2002 results, an increase of $29.6 million or 92.5%. The increase in
revenues from our inpatient management contracts segment relates primarily to revenues of $13.6
million from inpatient management contracts acquired from PMR in August 2002, $13.8 million for
Ramsays inpatient management contracts and growth of approximately $3.4 million in our contract to
provide case management services in and around Nashville, Tennessee. This growth was offset by a
reduction in the number of inpatient unit management contracts from 48 at December 31, 2002 to 42
at December 31, 2003, impacting revenues by approximately $1.2 million. Salaries, wage, and employee benefits. SWB expense was $147.1 million for the year ended
December 31, 2003, or 51.6% of our total revenue, compared to $62.3 million for the year ended
December 31, 2002, or 54.7% of our total revenue. SWB expense for our owned and leased inpatient
facilities segment was $122.5 million in 2003, or 54.9% of our total revenue. Same-facility SWB
expense for our owned and leased inpatient facilities segment was $48.2 million in 2003, or 53.9%
of segment revenue, compared to $47.0 million in 2002, or 57.4% of segment revenue. This decrease
in SWB expense as a percentage of revenue from our owned and leased inpatient facilities segment on
a same-facility basis, as compared to 2002, primarily relates to efforts to maintain staffing
levels on higher volumes. SWB expense for our inpatient management contracts segment was $21.1
million in 2003, or 34.2% of segment revenue. Same-facility SWB expense for our inpatient
management contracts segment was $12.0 million in 2003, or 35.2% of segment revenue, compared to
$13.2 million in 2002, or 41.2% of segment revenue. This decrease in SWB expense as a percentage of
revenue from our inpatient management contracts segment on a same-facility basis, as compared to
2002, primarily relates to our acquisition from PMR of a contract to provide case management
services in and around Nashville, Tennessee. We incur little SWB expense to provide these services
because primarily all the costs to provide these services are recorded in other operating expenses
because the actual services provided are subcontracted. SWB expense for our corporate office was
$3.5 million for 2003 compared to $2.1 million for 2002 as the result of the hiring of additional
staff necessary to manage the inpatient facilities and inpatient management contracts acquired
during 2002 and 2003. Professional fees. Professional fees were $32.5 million for the year ended December 31, 2003,
or 11.4% of our total revenue, compared to $14.4 million for the year ended December 31, 2002, or
12.6% of our total revenue. Professional fees for our owned and leased inpatient facilities segment
were $26.3 million in 2003, or 11.8% of segment revenue. Same-facility professional fees for our
owned and leased inpatient facilities segment were $10.8 million in 2003, or 12.1% of segment
revenue, compared to $10.3 million in 2002, or 12.6% of segment revenue. This decrease in
professional fees for our owned and leased inpatient facilities segment as a percentage of revenue
on a same-facility basis, as compared to 2002, was primarily the result of efforts within our owned
and leased inpatient facilities segment to reduce our reliance on contract labor. Professional fees
for our inpatient management contracts segment were $4.3 million in 2003, or 7.0% of segment
revenue. Same-facility professional fees for our inpatient management contracts segment were $3.6
million in 2003, or 10.6% of segment revenue, compared to $3.5 million in 2002, or 11.1% of segment
revenue. Professional fees for our corporate office were approximately $1.8 million in 2003
compared to approximately $500,000 in 2002. The increase in professional fees in our corporate
office relates to accounting, legal and other services required to meet the needs of a public
company and achieving our acquisition strategy. Supplies.Supplies expense was $16.4 million for the year ended December 31, 2003, or 5.8% of
our total revenue, compared to $5.3 million for the year ended December 31, 2002, or 4.7% of our
total revenue. Supplies expense for our owned and leased inpatient facilities segment was $15.3
million in 2003, or 6.8% of segment revenue. Same-facility supplies expense for our owned and
leased inpatient facilities segment was $5.9 million in 2003, or 6.6% of segment revenue, compared
to $5.3 million in 2002, or 6.4% of segment revenue. Supplies expense for our inpatient management
contracts segment was $1.0 million in 2003, or 1.7% of segment revenue, compared to $40,000 in
2002, or less than 1% of segment revenue. Supplies expense at our owned and leased inpatient
facilities segment has historically comprised the majority of our supplies expense as a whole;
however, our inpatient management contracts segment began to utilize supplies to a larger extent
due to the assumption of inpatient management contracts from Ramsay. Supplies expense for our
corporate office consists of office supplies and are negligible to supplies expense overall. Provision for bad debts. The provision for bad debts was $6.3 million for the year ended
December 31, 2003, or 2.2% of our total revenue, compared to $3.7 million for the year ended
December 31, 2002, or 3.2% of our total revenue. The provision for bad debts at our owned and
leased inpatient facilities segment comprises the majority of our provision for bad debts as a
whole. The reduction in provision for bad debts as a percentage of revenue was driven by the
acquisition of inpatient facilities from The Brown Schools and Ramsay, which have fewer self-pay
accounts. Other operating expenses. Other operating expenses were approximately $47.9 million for the
year ended December 31, 2003, or 16.8% of our total revenue, compared to $16.0 million for the year
ended December 31, 2002, or 14.1% of our total revenue. Other operating expenses for our owned and
leased inpatient facilities segment were $21.7 million in 2003, or 9.7% of segment revenue.
Same-facility other operating expenses for our owned and leased inpatient facilities segment were
$7.9 million in 2003, or 8.8% of segment revenue, compared to $6.6 million in 2002, or 8.0% of
segment revenue. This increase in other operating expenses for our owned and leased inpatient
facilities segment as a percentage of revenue on a same-facility basis, as compared to 2002,
relates primarily to increased insurance costs in 2003. Other operating expenses for our inpatient
management contracts segment were $24.2 21




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million in 2003, or 39.3% of segment revenue. Same-facility
other operating expenses for our inpatient management contracts segment was $11.1 million in 2003,
or 32.6% of segment revenue, compared to $7.9 million in 2002, or 24.8% of segment revenue. This
increase in other operating expenses for our inpatient management contracts segment as a percentage
of revenue from this segment on a same-facility basis, as compared to 2002, is primarily
attributable to growth in the contract to provide case management services in and around Nashville,
Tennessee where actual services provided are subcontracted. Other operating expenses at our
corporate office increased to $2.0 million in 2003 from approximately $1.4 million in 2002. Depreciation and amortization. Depreciation and amortization expense was $5.7 million for the
year ended December 31, 2003 compared to $1.8 million for the year ended December 31, 2002, an
increase of approximately $4.0 million. This increase in depreciation and amortization expense is
the result of the acquisitions of Riveredge Hospital, PMR, The Brown Schools and Ramsay. Interest expense. Interest expense was $14.8 million for the year ended December 31, 2003
compared to $5.6 million for the year ended December 31, 2002, an increase of $9.2 million or
164.3%. The increase in interest expense is primarily attributable to the increase in our long-term
debt from approximately $43.8 million at December 31, 2002 to approximately $175.0 million at
December 31, 2003 due to our 10 5/8% senior subordinated note offering, the expansion of our senior credit
facility and the refinancing of our term loans from CapitalSource Finance LLC with mortgage loans
insured by the U.S. Department of Housing and Urban Development (HUD). The proceeds from the 10
5/8% senior subordinated notes and the expanded credit facility were used to finance acquisitions
in 2003. Other expenses.Other expenses totaled $5.3 million for the year ended December 31, 2003
compared to approximately $180,000 for the year ended December 31, 2002. Other expenses in 2003
consisted of $4.9 million in loss on the refinancing of our long-term debt, $960,000 in expense
recorded to recognize the change in fair value of stock purchase put warrants (for additional
information on these warrants, see Liquidity and Capital Resources below) and the release of
$545,000 in reserves related to our stockholder notes. Other expenses in 2002 consisted of
approximately $90,000 in loss on the refinancing of our long-term debt and approximately $90,000 to
increase the reserve related to our stockholder notes. Loss from discontinued operations, net of taxes. The loss from discontinued operations of
approximately $25,000 for the year ended December 31, 2003 is from the operations of three
contracts to manage inpatient facilities for the Florida Department of Juvenile Justice. These
contracts were assumed from Ramsay in 2003 and exited in 2004. Liquidity and Capital Resources As of December 31, 2004, we had working capital of $39.9 million, including cash and cash
equivalents of $33.3 million, compared to working capital of $67.2 million, including cash and cash
equivalents of $45.0 million, at December 31, 2003. At December 31, 2004, our current liabilities
include $20 million of our 10 5/8% senior subordinated bonds, which were repaid on January 14,
2005. The decrease in working capital is primarily due to the classification of $20 million of our
10 5/8% senior subordinated bonds as current at December 31, 2004 versus long-term at December 31,
2003. Cash provided by operating activities was $39.9 million for the year ended December 31, 2004
compared to $18.3 million for the year ended December 31, 2003. The increase in cash flows from
operating activities was primarily due to the cash generated from the inpatient facilities we
acquired in 2004 and the full year operations of the inpatient facilities acquired from Ramsay and
The Brown Schools, which we acquired in 2003. Cash used in investing activities was $154.1 million for the year ended December 31, 2004
compared to $108.1 million for the year ended December 31,
2003. Cash used in investing activities for the year ended December 31, 2004 was primarily the
result of $136.5 million paid for acquisitions and $17.2 million paid for the purchases of fixed
assets. Cash used in the acquisition of Brentwood was approximately $31 million, of which $17
million came from our revolving credit facility. Cash used in the acquisition of Palmetto was
approximately $11 million, including the purchase of real estate in Charleston, South Carolina of
approximately $4 million. Cash used in the acquisition of Heartland was approximately $67 million,
including the purchase of real estate in Summit, New Jersey of approximately $15.9 million. We
borrowed $35 million under our revolving credit facility for the purchase of Heartland. Cash used
in the acquisition of Piedmont was approximately $11 million, of which $10 million came from our
revolving credit facility. Cash used in the acquisition of Alliance Behavioral was approximately
$13 million, all of which came from our revolving credit facility. Cash used for routine capital
expenditures were approximately $7 million for the year ended December 31, 2004. Cash used for
non-routine capital expenditures during 2004 included the construction of a 60-bed RTC in Meridian,
Mississippi and other expansion of beds. Cash used for non-routine capital expenditures during 2004
also included conversions and upgrades of computer systems at some of our newly acquired
facilities. Cash used in investing activities for the year ended December 31, 2003 was primarily
the result of $100.4 million paid for acquisitions and capital expenditures of approximately $5.8
million. Capital expenditures are generally not for the expansion of capacity within our inpatient
facilities and historically approximate 2% of our net revenues. During 2003, our capital
expenditures included typical non-expansion capital expenditures, as well as expenditures to
upgrade computer systems at some of our newly acquired facilities and certain expansion projects. 22




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Cash provided by financing activities was $102.5 million for the year ended December 31, 2004
compared to $132.3 million for the year ended December 31, 2003. During 2004, we raised
approximately $109 million from the proceeds of the offering of our common stock and stock option
exercises. Also during 2004, we spent approximately $7 million to refinance our long-term debt, pay
loan and issuance costs and make principal payments on our long-term debt. During 2003, we received
cash from borrowings of approximately $62.0 million, net of refinancings and not including proceeds
from borrowings that were paid directly to the sellers of our acquisitions. Also during 2003, we
received $48.9 million and $24.5 million, net of issuance costs, from the secondary offering of our
common stock and from our issuance of series A convertible preferred stock, respectively. These
sources of cash from financing activities were offset by cash payments during 2003 of $2.0 million
and $1.4 million for capitalized loan costs on new debt and early termination fees on debt that we
refinanced, respectively. On January 14, 2005, we redeemed $50 million of our 10 5/8% senior subordinated notes, leaving
$100 million outstanding after the redemption. In connection with the redemption we paid
bondholders a 10 5/8% penalty and accrued interest. We expect to record a loss on refinancing
long-term debt of approximately $7 million during the first quarter of 2005. We paid the redemption
with borrowings under our revolving credit facility of $30 million and the remainder with cash on
hand. We issued $150 million in 10 5/8% senior subordinated notes, which are fully
and unconditionally guaranteed on a senior subordinated basis by substantially all of our existing
operating subsidiaries, on June 30, 2003. Proceeds from the issuance of the senior subordinated notes and the private
placement of $12.5 million in series A convertible preferred stock were used to finance the
acquisition of Ramsay and pay down the majority of our long-term debt. Interest on the senior
subordinated notes accrues at the rate of 10.625% per annum and is payable semi-annually in arrears
on June 15 and December 15, commencing on December 15, 2003. The senior subordinated notes will
mature on June 15, 2013. On December 21, 2004, we amended and restated our revolving credit facility with Bank of
America to increase the borrowings available to us to $150 million, extend the term of the
agreement until December 2009 and lower the applicable interest rate, as defined in the credit
agreement. We initially entered into a revolving credit facility with Bank of America of up to $50
million on January 6, 2004. We subsequently amended and increased the revolving credit facility to
$125 million in June 2004. On December 20, 2004, we closed on the sale of 3,450,000 shares of our common stock at $33.70
per share. Of these shares, 450,000 were sold through the full exercise of the underwriters
over-allotment option. We sold 3,285,000 shares for approximately $105 million after underwriting
discounts and other issuance costs. Certain shareholders sold 165,000 shares in the offering. We
did not receive any proceeds from the sale of common stock by the selling shareholders.
Approximately $82 million of the net proceeds were used to pay down borrowings under our revolving
line of credit. On January 26, 2004, we entered into an interest rate swap agreement to manage our exposure to
fluctuations in interest rates. The swap agreement effectively converts $20 million of fixed-rate
long-term debt to a LIBOR indexed variable rate instrument plus an agreed upon interest rate spread
of 5.86%. On April 23, 2004, we entered into another interest rate swap agreement. This swap
agreement effectively converts $30.0 million of fixed rate debt to a LIBOR indexed variable rate
instrument plus an agreed upon interest rate spread of 5.51%. On November 5, 2003, we borrowed approximately $12.1 million under a mortgage loan agreement
insured by the U.S. Department of Housing and Urban Development (HUD), secured by real estate
located at Riveredge Hospital near Chicago, Illinois. Interest accrues on the HUD loan at 5.65% and
principal and interest are payable in 420 monthly installments through December 2038. We used the
proceeds from the loan to repay approximately $11.2 million of our term debt under our former
senior secured credit facility, pay certain financing costs, and fund required escrow amounts for
future improvements to the property. On August 28, 2003, we borrowed approximately $6.8 million under a mortgage loan agreement
insured by HUD, secured by real estate located at West Oaks Hospital in Houston, Texas. Interest
accrues on the HUD loan at 5.85% and principal and interest are payable in 420 monthly installments
through September 2038. We used the proceeds from the loan to repay approximately $5.8 million of
our term debt under our former senior secured credit facility, pay certain financing costs, and
fund required escrow amounts for future improvements to the property. We believe that our working capital on hand, cash flows from operations and funds available
under our revolving line of credit will be sufficient to fund our operating needs, planned capital
expenditures and debt service requirements for the next 12 months. 23




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In connection with our proposed
acquisition of the capital stock of AHS, we anticipate financing the $500 million cash
portion of the purchase price with new debt. We have entered into a commitment letter with Citigroup
Global Markets, Inc. to provide such financing subject to the terms and conditions of such letter.
In addition, we are actively seeking other acquisitions that fit our corporate growth strategy and
may acquire additional inpatient psychiatric facilities. Management continually assesses our
capital needs and, should the need arise, we will seek additional financing, including debt or
equity, to fund potential acquisitions or for other corporate purposes. In negotiating such
financing, there can be no assurance that we will be able to raise additional capital on terms
satisfactory to us. Failure to obtain additional financing on reasonable terms could have a
negative effect on our plans to acquire additional inpatient psychiatric facilities Obligations and Commitments Payments Due by Period (in thousands)Less than
    
    
    
    
    
    
    
    
    
    
    AfterTotal
    
    
    1 year
    
    
    1-3 years
    
    
    4-5 years
    
    
    5 yearsLong-term debt (1)
    
    $
    173,980
    
    
    $
    20,603
    
    
    $
    512
    
    
    $
    574
    
    
    $
    152,291Lease obligations
    
    
    37,529
    
    
    
    5,670
    
    
    
    8,932
    
    
    
    6,401
    
    
    
    16,526$
    211,509
    
    
    $
    26,273
    
    
    $
    9,444
    
    
    $
    6,975
    
    
    $
    168,817
   (1)
    
    Excludes capital lease obligations, which are included in lease obligations. The fair value of our $150 million 10 5/8% senior subordinated notes was approximately $173
million as of December 31, 2004.
The carrying value of our other long-term debt, including current maturities, of $24.3 million and
$25.0 million at December 31, 2004 and December 31, 2003, respectively, approximated fair value. As
a result of entering into two interest rate swap agreements during 2004, we effectively had $50
million in variable rate debt outstanding at December 31, 2004. At the December 31, 2004 borrowing
level, a hypothetical 10% increase in interest rates would decrease net income and cash flows by
approximately $250,000. Impact of Inflation and Economic Trends Although inflation has not had a material impact on our results of operations, the health care
industry is very labor intensive and salaries and benefits are subject to inflationary pressures as
are rising supply costs which tend to escalate as vendors pass on the rising costs through price
increases. Some of our freestanding owned, leased and managed inpatient behavioral health care
facilities we operate are experiencing the effects of the tight labor market, including a shortage
of nurses, which has caused and may continue to cause an increase in our salaries, wages and
benefits expense in excess of the inflation rate. Although we cannot predict our ability to cover
future cost increases, management believes that through adherence to cost containment policies,
labor management and reasonable price increases, the effects of inflation on future operating
margins should be manageable. Our ability to pass on increased costs associated with providing
health care to Medicare and Medicaid patients is limited due to various federal, state and local
laws which have been enacted that, in certain cases, limit our ability to increase prices. In
addition, as a result of increasing regulatory and competitive pressures and a continuing industry
wide shift of patients into managed care plans, our ability to maintain margins through price
increases to non-Medicare patients is limited. The behavioral health care industry is typically not directly impacted by periods of
recession, erosions of consumer confidence or other general economic trends as most health care
services are not considered a component of discretionary spending. However, our inpatient
facilities may be indirectly negatively impacted to the extent such economic conditions result in
decreased reimbursements by federal or state governments or managed care payers. We are not aware
of any economic trends that would prevent us from being able to remain in compliance with all of
our debt covenants and to meet all required obligations and commitments in the near future. Critical Accounting Policies Our consolidated financial statements have been prepared in accordance with accounting
principles generally accepted in the United States. In preparing our financial statements, we are
required to make estimates and assumptions that affect the reported amounts of assets, liabilities,
revenues, and expenses included in the financial statements. Estimates are based on historical
experience and other information currently available, the results of which form the basis of such
estimates. While we believe our estimation processes are reasonable, actual results could differ
from our estimates. The following represent the estimates considered most critical to our operating
performance and involve the most subjective and complex assumptions and assessments. Allowance for Doubtful Accounts Our ability to collect outstanding patient receivables from third party payors and receivables
due under our inpatient management contracts is critical to our operating performance and cash
flows. The primary collection risk with regard to patient receivables lies with uninsured patient
accounts or patient accounts for which primary insurance has paid, but the portion owed by the
patient remains outstanding. We estimate the allowance for doubtful accounts primarily based upon
the age of the accounts since the patient discharge date. We continually monitor our accounts
receivable 24




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balances and utilize cash collection data to support our estimates of the provision for
doubtful accounts. Significant changes in payor mix or business office operations could have a
significant impact on our results of operations and cash flows. The primary collection risk with regard to receivables due under our inpatient management
contracts is attributable to contractual disputes. We estimate the allowance for doubtful accounts
for these receivables based primarily upon the specific identification of potential collection
issues. As with our patient receivables, we continually monitor our accounts receivable balances
and utilize cash collection data to support our estimates of the provision for doubtful accounts. Allowances for Contractual Discounts The Medicare and Medicaid regulations are complex and various managed care contracts may
include multiple reimbursement mechanisms for different types of services provided in our inpatient
facilities and cost settlement provisions requiring complex calculations and assumptions subject to
interpretation. We estimate the allowance for contractual discounts on a payor-specific basis given
our interpretation of the applicable regulations or contract terms. The services authorized and
provided and related reimbursement are often subject to interpretation that could result in
payments that differ from our estimates. Additionally, updated regulations and contract
renegotiations occur frequently necessitating continual review and assessment of the estimation
process by our management. Professional and General Liability We are subject to medical malpractice and other lawsuits due to the nature of the services we
provide. Due to our acquisition of Ramsay, we had two distinct insurance programs that covered our
inpatient facilities. Prior to December 31, 2004, all of our inpatient facilities except those
acquired from Ramsay had professional and general liability insurance in umbrella form for claims
in excess of $3.0 million with an insured limit of $20.0 million. For the inpatient facilities
acquired from Ramsay, we had professional and general liability insurance in umbrella form for
claims in excess of $500,000 with an insured limit of $26.0 million. These plans were combined in
2005 to cover all of our operations for professional and general liability in umbrella form for
claims in excess of $2.0
million with an insured limit of $35.0 million. The self-insured reserves for professional and
general liability risks are calculated based on historical claims, demographic factors, industry
trends, severity factors, and other actuarial assumptions calculated by an independent third party.
This self-insurance reserve is discounted to its present value using a 5% discount rate. This
estimated accrual for professional and general liabilities could be significantly affected should
current and future occurrences differ from historical claim trends and expectations. We have
utilized our captive insurance company to manage this additional self-insured retention. While
claims are monitored closely when estimating professional and general liability accruals, the
complexity of the claims and wide range of potential outcomes often hampers timely adjustments to
the assumptions used in these estimates. Income Taxes As part of our process for preparing our consolidated financial statements, our management is
required to compute income taxes in each of the jurisdictions in which we operate. This process
involves estimating the current tax benefit or expense of future deductible and taxable temporary
differences. The future deductible and taxable temporary differences are recorded as deferred tax
assets and liabilities which are components of our balance sheet. Management then assesses our
ability to realize the deferred tax assets based on reversals of deferred tax liabilities and, if
necessary, estimates of future taxable income. A valuation allowance for deferred tax assets is
established when we believe that it is more likely than not that the deferred tax asset will not be
realized. Management must also assess the impact of our acquisitions on the realization of deferred
tax assets subject to a valuation allowance to determine if all or a portion of the valuation
allowance will be offset by reversing taxable differences or future taxable income of the acquired
entity. To the extent the valuation allowance can be reversed due to the estimated future taxable
income of an acquired entity, then our valuation allowance is reduced accordingly as an adjustment
to purchase price. Forward-Looking Statements This Annual Report on Form 10-K and other materials we have filed or may file with the
Securities and Exchange Commission, as well as information included in oral statements or other
written statements made, or to be made, by our senior management, contain, or will contain,
disclosures that are forward-looking statements within the meaning of the safe harbor provisions
of The Private Securities Litigation Reform Act of 1995. Forward-looking statements include all
statements that do not relate solely to historical or current facts and can be identified by the
use of words such as may, will, expect, believe, intend, plan, estimate, project,
continue, should and other comparable terms. These forward-looking statements are based on the
current plans and expectations of management and are subject to a number of risks and
uncertainties, including those set forth below, which could significantly affect our current plans
and expectations and future financial condition and results. We undertake no obligation to publicly update or revise any forward-looking statements,
whether as a result of new information, future events or otherwise. Stockholders and investors are
cautioned not to unduly rely on such forward-looking statements when evaluating the information
presented in our filings and reports. 25




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While it is not possible to identify all these factors, we continue to face many risks and
uncertainties that could cause actual results to differ from those forward-looking statements,
including:  
    potential competition that alters or impedes our acquisition strategy by decreasing our ability to acquire
additional inpatient facilities on favorable terms;
    our ability to improve the operations of acquired inpatient facilities;
    our ability to maintain favorable and continuing relationships with physicians who use our inpatient facilities;
    our limited operating history as a public company;
    our ability to receive timely additional financing on terms acceptable to us to fund our acquisition strategy
and capital expenditure needs, including the financing required to complete our acquisition of the capital
stock of AHS;
    risks inherent to the health care industry, including the impact of unforeseen changes in regulation,
reimbursement rates from federal and state health care programs or managed care companies and exposure to
claims and legal actions by patients and others;
    our ability to retain key employees who are instrumental to our successful operations;
    our ability to ensure confidential information is not inappropriately disclosed and that we are in compliance
with federal and state health information privacy standards; and
    our ability to comply with federal and state governmental
regulation covering health care-related products and
services on-line, including the regulation of medical
devices and the practice of medicine and pharmacology. In addition, future trends for pricing, margins, revenues and profitability remain difficult
to predict in the industries that we serve. Risk Factors If we fail to comply with extensive laws and government regulations, we could
suffer penalties or be required to make significant changes to our operations. The health care industry is required to comply with extensive and complex laws and regulations
at the federal, state and local government levels relating to, among other things:  
    billing for services;
    relationships with physicians and other referral sources;
    adequacy of medical care;
    quality of medical equipment and services;
    qualifications of medical and support personnel;
    confidentiality, maintenance and security issues associated with health-related information and medical records;
    licensure;
    hospital rate or budget review;
    operating policies and procedures; and
    addition of facilities and services. Among these laws are the Anti-kickback Statute and the Stark Law. These laws impact the
relationships that we may have with physicians and other referral sources. The OIG of the HHS has
enacted safe harbor regulations that outline practices that are deemed 26




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protected from prosecution
under the Anti-kickback Statute. Our current financial relationships with physicians and other
referral sources may not qualify for safe harbor protection under the Anti-kickback Statute.
Failure to meet a safe harbor does not mean that the arrangement automatically violates the
Anti-kickback Statute, but may subject the arrangement to greater scrutiny. Further, we cannot
guarantee that practices that are outside of a safe harbor will not be found to violate the
Anti-kickback Statute. In order to comply with the Stark Law, our financial relationships with physicians and their
immediate family members must meet an exception. We have structured our financial arrangements
with physicians to comply with the statutory exceptions included in the Stark Law and subsequent
regulations. However, future Stark Law regulations may interpret provisions of this law in a manner
different from the manner in which we have interpreted them. We cannot predict the effect such
future regulations will have on us. If we fail to comply with the Anti-kickback Statute, the Stark Law or other applicable laws
and regulations, we could be subjected to penalties, including criminal penalties, civil penalties
(including the loss of our licenses to operate one or more inpatient facilities), and exclusion of
one or more of our inpatient facilities from participation in the Medicare, Medicaid and other
federal and state health care programs. In addition, if we do not operate our inpatient facilities
in accordance with applicable law, our inpatient facilities may lose their licenses or the ability
to participate in third party reimbursement programs. Because many of these laws and regulations are relatively new, we do not always have the
benefit of significant regulatory or judicial interpretation of these laws and regulations. In the
future, different interpretations or enforcement of these laws and regulations could subject our
current or past practices to allegations of impropriety or illegality or could require us to make
changes in our inpatient facilities, equipment, personnel, services, capital expenditure programs
and operating expenses. A determination that we have violated these laws, or the public
announcement that we are being investigated for possible violations of these laws, could have a
material adverse effect on our business, financial condition, results of operations or prospects
and our business reputation could suffer significantly. In addition, we are unable to predict
whether other legislation or regulations at the federal or state level will be adopted. We may be required to spend substantial amounts to comply with legislative and
regulatory initiatives relating to privacy and security of patient health
information and standards for electronic transactions. There are currently numerous legislative and regulatory initiatives at the federal and state
levels addressing patient privacy and security concerns. In particular, federal regulations issued
under the Health Insurance Portability Accountability Act of 1996 contain provisions that have
required, and in the future may require, our facilities to implement costly new computer systems
and to adopt business procedures designed to protect the privacy and security of each of their
patients individually identifiable health and related financial information. Compliance with the
privacy regulations was required on April 14, 2003 for most health care organizations, including
our inpatient facilities. The privacy regulations have had a financial impact on the health care
industry because they impose extensive new administrative requirements, restrictions on the use and
disclosure of individually identifiable patient health and related financial information, provide
patients with new rights with respect to their health information and require our inpatient
facilities to
enter into contracts extending many of the privacy regulation requirements to third parties who
perform functions on our behalf involving health information. On February 20, 2003, HHS issued final security regulations. Compliance with these security
regulations is required by April 21, 2005 for most health care organizations, including our
inpatient facilities. These security regulations require our inpatient facilities to implement
administrative, physical and technical safeguards to protect the integrity, confidentiality and
availability of electronically received, maintained or transmitted patient individually
identifiable health and related financial information. We cannot predict the total financial or
other impact of these regulations on our business. Compliance with these regulations requires
substantial expenditures, which could negatively impact our financial results. In addition, our
management has spent, and may spend in the future, substantial time and effort on compliance
measures. On August 17, 2000, HHS issued regulations requiring most health care organizations, including
our inpatient facilities, to use standard data formats and code sets by October 16, 2003 when
electronically transmitting information in connection with several types of transactions, including
health claims, health care payment and remittance advice and health claim status transactions. We
have implemented or upgraded computer systems, as appropriate, at our inpatient facilities and at
our corporate headquarters to comply with the new transaction and code set regulations. Violations of the privacy, security and transaction regulations could subject our inpatient
facilities to civil penalties of up to $25,000 per calendar year for each provision contained in
the privacy, security and transaction regulations that is violated and criminal penalties of up to
$250,000 per violation for certain other violations. Since there is no significant history of
enforcement efforts by the federal government at this time, it is not possible to ascertain the
likelihood of enforcement efforts in connection with these regulations or the potential for fines
and penalties which may result from the violation of the regulations. 27




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Other companies within the health care industry continue to be the subject of
federal and state investigations, which increases the risk that we may become
subject to investigations in the future. Both federal and state government agencies as well as private payors have heightened and
coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of
health care organizations. These investigations relate to a wide variety of topics, including:  
    cost reporting and billing practices;
    quality of care;
    financial relationships with referral sources;
    medical necessity of services provided; and
    treatment of indigent patients. The OIG and the U.S. Department of Justice have, from time to time, undertaken national
enforcement initiatives that focus on specific billing practices or other suspected areas of abuse.
Moreover, health care providers are subject to civil and criminal false claims laws, including the
federal False Claims Act, which allows private parties to bring whistleblower lawsuits against
private companies doing business with or receiving reimbursement under federal health care
programs. Some states have adopted similar state whistleblower and false claims provisions.
Publicity associated with the substantial amounts paid by other health care providers to settle
these lawsuits may encourage our current and former employees and other health care providers to
bring whistleblower lawsuits. Any investigations of us or our executives or managers could result
in significant liabilities or penalties as well as adverse publicity. As a provider of health care services, we are subject to claims and legal actions by patients and others. We
are subject to medical malpractice and other lawsuits due to the
nature of the services we provide. Facilities acquired by us may have unknown or contingent liabilities, including liabilities
related to patient care and liabilities for failure to comply with health care laws and
regulations, which could result in large claims and significant defense costs. Although we
generally seek indemnification covering these matters from prior owners of facilities we acquire,
material liabilities for past activities of acquired facilities may exist and such prior owners may
not be able to satisfy their indemnification obligations. We are also susceptible to being named in
claims brought related to patient care and other matters at inpatient facilities owned by third
parties and operated by us. To protect ourselves from the cost of these claims, professional malpractice liability
insurance and general liability insurance coverage is maintained in amounts and with deductibles
common in the industry. We have professional and general liability insurance in umbrella form for
claims in excess of $2 million with an insured limit of $35 million for all of our inpatient
facilities. The self-insured reserves for professional and general liability risks are calculated
based on historical claims, demographic factors, industry trends, severity factors, and other
actuarial assumptions calculated by an independent third party. The self-insured reserve is
discounted to its present value using a 5% discount rate. This estimated accrual for professional
and general liabilities could be significantly affected should current and future occurrences
differ from historical claim trends and expectations. We have established a captive insurance
company to manage this additional self-insured retention. There are no assurances that our
insurance will cover all claims (e.g., claims for punitive damages) or that claims in excess of our
insurance coverage will not arise. A successful lawsuit against us that is not covered by, or is in
excess of, our insurance coverage may have a material adverse effect on our business, financial
condition and results of operations. This insurance coverage may not continue to be available at a
reasonable cost, especially given the significant increase in insurance premiums generally
experienced in the health care industry. If federal or state health care programs or managed care companies reduce
reimbursement rates for services provided, revenues may decline. A large portion of our revenue comes from the Medicare and Medicaid programs. In recent years,
federal and state governments have made significant changes in these programs. On November 3, 2004, CMS announced final regulations adopting a prospective payment system for
services provided by inpatient behavioral health care hospitals. Inpatient behavioral health care
facilities historically have been reimbursed based on reasonable cost, subject to a discharge
ceiling. For cost reporting periods after January 1, 2005, CMS will begin to phase in over a
three-year period a prospective payment system which will pay inpatient behavioral health care
facilities a per diem base rate. During the three-year phase-in period, CMS has agreed to a stop
loss provision which will guarantee that a provider will receive at least 70% of the amount it
would have been paid under the cost-based reimbursement system. 28




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The per diem base rate will be adjusted by factors that influence the cost of an individual
patients care, such as each patients diagnosis related group, certain other medical and
psychiatric comorbidities (i.e., other coexisting conditions that may complicate treatment), and
age. The per diem amounts are calculated in part based on national averages, but will be adjusted
for specific facility characteristics that increase the cost of patient care. The base rate per
diem is intended to compensate a facility for costs incurred to
treat a patient with a particular diagnosis, including nearly all labor and non-labor costs of
furnishing covered inpatient behavioral health care services as well as routine, ancillary and
capital costs. Payment rates for individual inpatient facilities will be adjusted to reflect
geographic differences in wages and will allow additional outlier payments for expenses associated
with extraordinary cases. Additionally, rural providers will receive an increased payment
adjustment. Medicare will pay this per diem amount, as adjusted, regardless of whether it is more
or less than a hospitals actual costs. The per diem will not, however, include the costs of bad
debt and certain other costs that are paid separately. Please see
http://www.cms.hhs.gov/providers/ipfppsfor additional information. Future federal and state legislation may reduce the payments we receive for our services. Insurance and managed care companies and other third parties from whom we receive payment are
increasingly attempting to control health care costs by requiring that facilities discount their
fees in exchange for exclusive or preferred participation in their benefit plans. This trend may
continue and may reduce the payments received by us for our services. If competition decreases the ability to acquire additional inpatient facilities
on favorable terms, we may be unable to execute our acquisition strategy. Competition among hospitals and other health care providers in the United States has
intensified in recent years due to cost containment pressures, changing technology, changes in
government regulation and reimbursement, changes in practice patterns (such as shifting from
inpatient to outpatient treatments), the impact of managed care organizations and other factors. An
important part of our business strategy is to acquire inpatient facilities in growing markets. Some
inpatient facilities and health care providers that compete with us have greater financial
resources and a larger, more experienced development staff focused on identifying and completing
acquisitions. In addition, some competitors are owned by governmental agencies or not-for-profit
corporations supported by endowments and charitable contributions, and can finance capital
expenditures on a tax-exempt basis. Any or all of these factors may impede our business strategy. Our substantial indebtedness could adversely affect our financial condition. As of December 31, 2004, our total consolidated indebtedness was approximately $174.3 million. Our indebtedness could have important consequences including:  
    increasing our vulnerability to general adverse economic and industry conditions;
    requiring that a portion of our cash flow from operations be used for the payment of interest on our debt,
thereby reducing our ability to use our cash flow to fund working capital, capital expenditures, acquisitions and
general corporate requirements;
    restricting our ability to sell assets, including capital stock of our restricted subsidiaries, merge or
consolidate with other entities, and engage in transactions with our affiliates;
    limiting our ability to obtain additional financing to fund future working capital, capital expenditures,
acquisitions and general corporate requirements;
    limiting our flexibility in planning for, or reacting to, changes in our business and the health care industry;
    restricting our ability or the ability of our restricted subsidiaries to pay dividends or make other payments; and
    placing us at a competitive disadvantage to our competitors that have less indebtedness. In connection with our
proposed acquisition of the capital stock of AHS, we expect to incur
significant additional indebtedness to finance the $500 million
cash portion of the purchase price. If new indebtedness is added to our and our subsidiaries current
indebtedness levels, the related risks that we and they now face could intensify. In addition, our
amended and restated credit facility requires us to maintain specified financial ratios and tests
which may require that we take action to reduce our debt or to act in a manner contrary to our
business objectives. Events beyond our control, 29




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including changes in general business and economic
conditions, may affect our ability to meet those financial ratios and tests. We cannot assure you
that we will meet those ratios and tests or that the lenders will waive any failure to meet those
ratios and tests. A breach of any of these covenants would result in a default under the amended
and restated credit facility and any resulting acceleration thereunder may result in a default
under the indenture governing our 10 5/8% senior subordinated notes. If an event of default under
our amended and restated credit facility occurs, the lenders could elect to declare all amounts
outstanding thereunder, together with accrued interest, to be immediately due and payable. Additional financing may be necessary to fund our acquisition program and
capital expenditures, and additional financing may not be available when
needed. Our acquisition program requires substantial capital resources. Likewise, the operation of
existing inpatient facilities requires ongoing capital expenditures for renovation, expansion and
the upgrade of equipment and technology. In connection with our
proposed acquisition of the capital stock of AHS, we expect to incur
significant additional indebtedness to finance the $500 million
cash portion of the purchase price. We may not receive additional financing on satisfactory terms. In addition, our level of
indebtedness at any time may restrict our ability to borrow additional funds. If we are not able to
obtain financing, then we may not be in a position to consummate acquisitions or undertake capital
expenditures. Recently acquired businesses and businesses acquired in the future will expose us to increased operating risks. We
acquired 19 inpatient facilities in 2003 and acquired 10 inpatient
facilities in 2004. In addition, we have entered into a Stock
Purchase Agreement to acquire all of the capital stock of AHS. AHS
owns and operates, through its subsidiaries, 20 inpatient behavioral
health care facilities. This expansion exposes us to additional business and operating risk and uncertainties,
including:  
    our ability to effectively manage the expanded activities;
    our ability to realize our investment in the increased number of inpatient facilities;
    our exposure to unknown liabilities; and
    our ability to meet contractual obligations. If we are unable to manage this expansion efficiently or effectively, or are unable to attract
and retain additional qualified management personnel to run the expanded operations, it could have
a material adverse effect on our business, financial condition and results of operations. If we fail to improve the operations of acquired inpatient facilities, we may be unable to achieve our growth strategy. We may be unable to maintain or increase the profitability of, or operating cash flows at, any
existing hospital or other acquired inpatient facility, effectively integrate the operations of any
acquisitions or otherwise achieve the intended benefit of our growth strategy. To the extent that
we are unable to enroll in third party payor plans in a timely manner following an acquisition, we
may experience a decrease in cash flow or profitability. Hospital acquisitions generally require a longer period to complete than acquisitions in many
other industries and are subject to additional regulatory uncertainty. Many states have adopted
legislation regarding the sale or other disposition of facilities operated by not-for-profit
entities. In other states that do not have specific legislation, the attorneys general have
demonstrated an interest in these transactions under their general obligations to protect
charitable assets from waste. These legislative and administrative efforts focus primarily on the
appropriate valuation of the assets divested and the use of the proceeds of the sale by the
non-profit seller. In addition, the acquisition of facilities in certain states requires advance
regulatory approval under certificate of need or state licensure regulatory regimes. These
state-level procedures could seriously delay or even prevent us from acquiring inpatient
facilities, even after significant transaction costs have been incurred. We depend on our relationships with physicians who use our inpatient facilities. Our business depends upon the efforts and success of the physicians who provide health care
services at our inpatient facilities and the strength of the relationships with these physicians. Our business could be adversely affected if a significant number of physicians or a group of
physicians: 30




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
    terminate their relationship with, or reduce their use of, our inpatient facilities;
    fail to maintain acceptable quality of care or to otherwise adhere to professional standards;
    suffer damage to their reputation; or
    exit the market entirely. We depend on our key management personnel. We are highly dependent on our senior management team, which has many years of experience
addressing the broad range of concerns and issues relevant to our business. Our senior management
team includes talented managers of our divisions, who have a wealth of experience in all aspects of
health care. We have entered into employment agreements with Joey A. Jacobs, Chief Executive
Officer, and Jack Salberg, Chief Operating Officer, which include non-competition and
non-solicitation provisions. Key man life insurance policies are not maintained on any member of
senior management other than Mr. Jacobs. The loss of key
management or the inability to attract, retain and motivate sufficient numbers of qualified management personnel
could have a material adverse effect on us. Failure to achieve and maintain effective internal controls in accordance with
Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on
our business and stock price. Each year we are required to document and test our internal control procedures in order to
satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management
assessments of the effectiveness of our internal controls over financial reporting and a report by
our independent registered public accounting firm addressing these assessments. During the course
of our testing we may identify deficiencies that we may not be able to remediate in time to meet
the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404.
In addition, if we fail to maintain the adequacy of our internal controls, as such standards are
modified, supplemented or amended from time to time, we may not be able to ensure that we can
conclude on an ongoing basis that we have effective internal controls over financial reporting in
accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective
internal control environment could have a material adverse effect on our stock price. Our stock price could be volatile. The market price of our common stock could fluctuate significantly in response to various factors,
including:  
    the proposed acquisition of the capital stock of AHS;
    problems achieving revenue enhancements and operating efficiencies;
    actual and estimated earnings and cash flows;
    quarter-to-quarter variations in operating results;
    changes in market conditions in the mental health or behavioral health care industries;
    changes in general economic conditions;
    fluctuations in the securities markets in general;
    operating results differing from analysts estimates; and
    changes in analysts earnings estimates. 
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Our interest expense
is sensitive to changes in the general level of interest rates. With
respect to our interest-bearing liabilities, all of our long-term debt outstanding at December 31,
2004 was subject to a weighted average fixed interest rate of 10%, not including our interest rate
swaps. At December 31, 2004, we had $50 million in interest rate swaps that effectively changed $50
million of our 10 5/8% fixed rate senior subordinated bonds to a variable rate. A hypothetical 10%
increase in interest rates would decrease our net income and cash flows by approximately
$250,000 on an annual basis based upon the borrowing level at December 31, 2004. As discussed above, we do have a $150 million
revolving credit facility that is subject to variable interest rates; however, at December 31,
2004, no balance was outstanding under the revolving line of credit. In the event we draw on our
revolving credit facility and interest rates change significantly, we expect management would take
actions intended to further mitigate our exposure to such change. Information on quantitative and
qualitative disclosure about market risk is included in Part II, Item 7 of this Annual Report on
Form 10-K under the caption Managements Discussion and Analysis of Financial Condition and
Results of Operations  Liquidity and Capital Resources and Managements Discussion and Analysis
of Financial Condition and Results of Operations  Liquidity and Capital Resources  Contractual
Obligations. 
 Item 8. Financial Statements and Supplementary Data. Information with respect to this Item is contained in our consolidated financial statements
indicated in the Index on Page F-1 of this Annual Report on Form 10-K. 
 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None. 
 Item 9A. Controls and Procedures. Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures We carried out an evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures as of the end of the period covered
by this report pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief
Executive 31




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Officer and Chief Accounting Officer concluded that our disclosure controls and
procedures were effective in ensuring that information required to be disclosed by us (including
our consolidated subsidiaries) in reports that we file or submit under the Securities Exchange Act
of 1934, as amended, is recorded, processed, summarized and reported on a timely basis. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we have included a report of
managements assessment of the design and operating effectiveness of our internal controls as part
of this Annual Report on Form 10-K for the year ended December 31, 2004. Our independent registered
public accounting firm also attested to, and reported on, managements assessment of the
effectiveness of internal control over financial reporting. Managements report and the independent
registered public accounting firms attestation report are included in our 2004 consolidated
financial statements beginning with the index on page F-1 of this report under the captions
entitled Managements Report on Internal Control Over Financial Reporting and Report of
Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting. Changes in Internal Control Over Financial Reporting There has been no change in our internal control over financial reporting during the fourth
quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. Item 9B. Other Information. None. 
 PART III 
 Item 10. Directors And Executive Officers of the Registrant. Directors The information relating to our directors set forth in the Companys Proxy Statement relating
to the 2005 Annual Meeting of Stockholders under the caption Election of Directors and Corporate
Governance  Audit Committee is incorporated herein by reference. Executive Officers of the Registrant The executive officers of the Company are: Name
    
    Age
    
    Officer Since
    
    PositionsJoey A. Jacobs
    
    
    51
    
    
    April 1997
    
    President and Chief Executive OfficerSteven T. Davidson
    
    
    47
    
    
    August 1997
    
    Chief Development Officer and SecretaryJack R. Salberg
    
    
    56
    
    
    May 2000
    
    Chief Operating OfficerJack E. Polson
    
    
    38
    
    
    August 2002
    
    Chief Accounting OfficerBrent Turner
    
    
    39
    
    
    February 2003
    
    Vice President, Treasurer and Investor Relations
 Joey A. Jacobs, President and Chief Executive Officer. Mr. Jacobs serves as President and
Chief Executive Officer and was one of our co-founders in April 1997. Prior to our founding, Mr.
Jacobs served for 21 years in various capacities with Hospital Corporation of America (HCA, also
formerly known as Columbia and Columbia/HCA), most recently as President of the Tennessee Division.
Mr. Jacobs background at HCA also includes serving as President of HCAs Central Group, Vice
President of the Western Group, Assistant Vice President of the Central Group and Assistant Vice
President of the Salt Lake City Division. Steven T. Davidson, Chief Development Officer. Mr. Davidson has served as Chief Development
Officer since August 1997 and has over 21 years of health care experience. Prior to joining us, Mr.
Davidson served as the Director of Development at HCA from 1991 until 1997. Mr. Davidson also
served as a Senior Audit Supervisor and Hospital Controller during his term at HCA, which began in
1983, where he supervised audits of hospitals and other corporate functions. Prior to joining HCA,
Mr. Davidson was employed by Ernst & Young LLP as a Senior Auditor. Mr. Davidson is a Certified
Public Accountant and a member of the American Institute of Certified Public Accountants. Jack Salberg, Chief Operating Officer. Mr. Salberg has served as Chief Operating Officer since
May 2000 and has more than 32 years of operational experience in both for-profit and non-profit
health care sectors. Prior to joining us, Mr. Salberg served as President and Chief Executive
Officer of Sunrise Behavioral Health, Ltd. from 1996 to 2000. In addition, Mr. Salberg served for
ten years in various capacities with American Healthcorp, most recently as Senior Vice President
with specific responsibilities for multi-facility contract management. Mr. Salberg also spent three
years as head of Health Group, Inc.s psychiatric division. In addition, Mr. Salberg was employed
for four years with Humana Corporation as the Executive Director of a hospital and seven years with 32




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Arden Hill Hospital, an independent hospital, as its Associate Executive Director. Jack E. Polson, Chief Accounting Officer. Mr. Polson has served as Chief Accounting Officer
since August 2002. Prior to being appointed Chief Accounting Officer, Mr. Polson had served as
Controller since June 1997. From June 1995 until joining us, Mr. Polson served as Controller for
Columbia Healthcare Network, a risk-bearing physician health organization. From May 1992 until June
1995, Mr. Polson served as an Internal Audit Supervisor for HCA. Brent Turner, Vice President, Treasurer and Investor Relations. Mr. Turner has served as the
Vice President, Treasurer and Investor Relations since February 2003. From April 2002 until joining
us, Mr. Turner served as Executive Vice President and Chief Financial Officer of Educational
Services of America, a privately-held owner and operator of schools for children with learning
disabilities. From November 2001 until March 2002, Mr. Turner served as Senior Vice President of
Business Development for The Brown Schools, a provider of educational and therapeutic services for
at-risk youth. From 1996 until January 2001, Mr. Turner was employed by Corrections Corporation of
America, a private prison operator, serving as Treasurer from 1998 to 2001. Code of Ethics We adopted a Code of Ethics that applies to all of our directors, officers and employees. The
Code of Ethics is available on our website at www.psysolutions.com. We will disclose any amendment
to, other than technical, administrative or non-substantive amendments, or waiver of our code of
ethics granted to a director or executive officer by filing a Form 8-K disclosing the amendment or
waiver within four business days. Section 16(a) Compliance The information relating to Section 16(a) beneficial ownership reporting compliance set forth
in our Proxy Statement relating to the 2005 Annual Meeting of Stockholders under the caption
Security Ownership of Certain Beneficial Owners and Management is incorporated herein by
reference. 
 Item 11. Executive Compensation. The information set forth in our Proxy Statement relating to the 2005 Annual Meeting of
Stockholders under the caption Executive Compensation is incorporated herein by reference. The
Comparative Performance Graph and the Compensation Committee Report on Executive Compensation also
included in the Proxy Statement are expressly not incorporated herein by reference. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management. The information set forth in our Proxy Statement relating to the 2005 Annual Meeting of
Stockholders under the caption Security Ownership of Certain Beneficial Owners and Management and
Equity Compensation Plan Information is incorporated herein by reference. 
 Item 13. Certain Relationships and Related Transactions. The information set forth in our Proxy Statement relating to the 2005 Annual Meeting of
Stockholders under the caption Certain Relationships and Related Transactions is incorporated
herein by reference. 
 Item 14. Principal Accountant Fees and Services. The information set forth in our Proxy Statement relating to the 2005 Annual Meeting of
Stockholders under the caption Independent Auditors  Audit and Non-Audit Fees is incorporated
herein by reference. 
 Item 15. Exhibits and Financial Statement Schedules. (a) The following documents are filed as part of this Annual Report onForm 10-K: 1. Consolidated Financial Statements: The consolidated financial
statements of Psychiatric Solutions are included as follows: PageReport of Independent Registered Public Accounting Firm
    
    F-2Managements Report on Internal Control Over Financial Reporting
    
    F-3Report of Independent Registered Public Accounting Firm on
Internal Control Over Financial Reporting
    
    F-4Consolidated Balance Sheets
    
    F-5
 33




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PageConsolidated Statements of Income
    
    F-6Consolidated Statements of Stockholders Equity
    
    F-7Consolidated Statements of Cash Flows
    
    F-8Notes to Consolidated Financial Statements
    
    F-10
 2. Financial Statement Schedules. All schedules are omitted because they are not applicable or are not required,
or because the required information is included in the consolidated financial
statements or notes in this report. 3. The exhibits which are filed with this report or which are
incorporated herein by reference are set forth in the Exhibit Index on
pages 34 through 36. (b) Exhibits. ExhibitNumber
    
    Description2.1
    
    Agreement and Plan of Merger by and among PMR Corporation, PMR Acquisition
Corporation and Psychiatric Solutions, Inc., dated May 6, 2002, as amended
by Amendment No. 1, dated as of June 10, 2002, and Amendment No. 2, dated
as of July 9, 2002 (included as Annex A to Amendment No. 1 to the Companys
Registration Statement on Form S-4, filed on July 11, 2002 (Reg. No.
333-90372) (the 2002 S-4 Amendment)).2.2
    
    Asset Purchase Agreement, dated February 13, 2003, by and between The Brown
Schools, Inc. and Psychiatric Solutions, Inc., as amended by Amendment No.
1 to Asset Purchase Agreement, dated March 31, 2003, by and between The
Brown Schools, Inc. and Psychiatric Solutions, Inc. (incorporated by
reference to Exhibit 2.1 of the Companys Current Report on Form 8-K, filed
on April 9, 2003).2.3
    
    Agreement and Plan of Merger, dated April 8, 2003, by and among Psychiatric
Solutions, Inc., PSI Acquisition Sub, Inc. and Ramsay Youth Services, Inc.
(incorporated by reference to Exhibit 2.1 of the Companys Current Report
on Form 8-K, filed on April 10, 2003).2.4
    
    Asset Purchase Agreement, dated February 23, 2004, by and among Psychiatric
Solutions, Inc., Brentwood Health Management, L.L.C., Brentwood, A
Behavioral Health Company, L.L.C. and River Rouge, Inc. (incorporated by
reference to Exhibit 2.1 of the Companys Current Report on Form 8-K, filed
on March 3, 2004).2.5
    
    Asset Purchase Agreement, dated February 23, 2004, by and among Psychiatric
Solutions, Inc., Brentwood Health Management of MS, LLC, and Turner-Windham
of Mississippi, LLC (incorporated by reference to Exhibit 2.2 of the
Companys Current Report on Form 8-K, filed on March 3, 2004).2.6
    
    Asset Purchase Agreement, dated April 23, 2004, by and among Psychiatric
Solutions, Inc., Fort Lauderdale Hospital, Inc., Millwood Hospital, L.P.,
PSI Pride Institute, Inc., PSI Summit Hospital, Inc., Fort Lauderdale
Hospital Management, LLC, Millwood Health, LLC, Pride Institute, LLC and
Summit Health, LLC (incorporated by reference to Exhibit 2.1 of the
Companys Current Report on Form 8-K, filed on June 2, 2004).3.1
    
    Amended and Restated Certificate of Incorporation of PMR Corporation, filed
with the Delaware Secretary of State on March 9, 1998 (incorporated by
reference to Exhibit 3.1 to the Companys Annual Report on Form 10-K for
the fiscal year ended April 30, 1998).3.2
    
    Certificate of Amendment to Amended and Restated Certificate of
Incorporation of PMR Corporation, filed with the Delaware Secretary of
State on August 5, 2002 (incorporated by reference to Exhibit 3.2 to the
Companys Quarterly Report on Form 10-Q for the quarter ended July 31,
2002).3.3
    
    Certificate of Amendment to Amended and Restated Certificate of
Incorporation of Psychiatric Solutions, Inc., filed with the Delaware
Secretary of State on March 21, 2003 (incorporated by reference to Appendix
A of the Companys Definitive Proxy Statement, filed on January 22, 2003).3.4
    
    Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to
the Companys Annual Report on Form 10-K for the fiscal year ended April
30, 1997) (the 1997 10-K)).
 34




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##### Table of Contents



ExhibitNumber
    
    Description4.1
    
    Reference is made to Exhibits 3.1 through 3.4.4.2
    
    Common Stock Specimen Certificate (incorporated by reference to Exhibit 4.2
to the Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 2002) (the 2002 10-K)).4.3
    
    Certificate of Designations, Preferences and Rights of Series A Convertible
Preferred Stock, filed with the Delaware Secretary of State on March 24,
2003 (incorporated by reference to Appendix D of the Companys Definitive
Proxy Statement, filed January 22, 2003).4.4
    
    Indenture, dated as of June 30, 2003, among Psychiatric Solutions, Inc.,
the Guarantors named therein and Wachovia Bank, National Association, as
Trustee (incorporated by reference to the Companys Registration Statement
on Form S-4, filed on July 30, 2003 (Registration No. 333-107453) (the
2003 S-4)).4.5
    
    Form of Notes (included in Exhibit 4.4).4.6
    
    Purchase Agreement, dated as of June 19, 2003, among Psychiatric Solutions,
Inc., the Guarantors named therein, Lehman Brothers Inc., Merrill Lynch,
Pierce, Fenner & Smith Incorporated and Jefferies & Company, Inc.
(incorporated by reference to Exhibit 4.12 to the 2003 S-4).10.1
    
    Employment Agreement between Jack R. Salberg and Psychiatric Solutions,
Inc., dated as of October 1, 2002 (incorporated by reference to Exhibit
10.14 to the 2002 10-K).10.2
    
    Second Amended and Restated Employment Agreement between Joey A. Jacobs and
Psychiatric Solutions, Inc., dated as of August 6, 2002 (incorporated by
reference to Exhibit 10.16 to the 2002 10-K).10.3
    
    Amendment to Second Amended and Restated Employment Agreement between Joey
A. Jacobs and Psychiatric Solutions, Inc., dated as of November 26, 2003
(incorporated by reference to Exhibit 10.14 to Amendment No. 2 to the
Companys Registration Statement on Form S-2, filed on December 18, 2003
(Registration No. 333-110206)).10.4*
    
    Form of Indemnification Agreement
executed by each director of Psychiatric Solutions, Inc. and
Psychiatric Solutions, Inc.
 35




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##### Table of Contents



ExhibitNumber
    
    Description10.5
    
    Amended and Restated Credit Agreement, dated as of December 21, 2004, among
Psychiatric Solutions, Inc., the Guarantors named therein, Bank of America,
N.A., as administrative agent, swing line lender and l/c issuer, Banc of
America Securities LLC, as sole lead arranger and sole book manager,
Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated,
and Citicorp USA, Inc., as co-syndication agents, JPMorgan Chase Bank,
N.A., as documentation agent, and the Lenders named a party thereto
(incorporated by reference to Exhibit 2.2 of the Companys Current Report
on Form 8-K, filed on December 28, 2004).10.6
    
    Interest Rate Swap Agreement, dated January 28, 2004, between Bank of
America, N.A. and Psychiatric Solutions, Inc. (incorporated by reference to
Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the quarter
ended March 31, 2004).10.7
    
    Confirmation of Interest Rate Swap Agreement, dated April 26, 2004, between
Bank of America, N.A. and Psychiatric Solutions, Inc. (incorporated by
reference to Exhibit 10.5 to the Companys Quarterly Report on Form 10-Q
for the quarter ended June 30, 2004).10.8
    
    Amended and Restated Psychiatric Solutions, Inc. 2003 Long-Term Equity
Compensation Plan (incorporated by reference to Exhibit 10.21 to the 2003
10-K).10.9
    
    Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan, as
amended by an Amendment adopted on May 4, 2004 (incorporated by reference
to Appendix A to the Companys Definitive Proxy Statement, filed on April
9, 2004).10.10
    
    Form of Incentive Stock Option Agreement under the 1997 Plan (incorporated
by reference to Exhibit 10.2 to the 1997 10-K).10.11
    
    Form of Nonstatutory Stock Option Agreement under the 1997 Plan
(incorporated by reference to Exhibit 10 to the 1997 10-K).10.12
    
    Amended and Restated Psychiatric Solutions, Inc. Outside Directors
Non-Qualified Stock Option Plan (incorporated by reference to Appendix C to
the Companys Definitive Proxy Statement, filed on April 14, 2003).10.13
    
    Form of Outside Directors Non-Qualified Stock Option Agreement
(incorporated by reference to Exhibit 10.5 to the 1997 10-K).12.1*
    
    Computation of Ratio of Earnings to Fixed Charges.21.1*
    
    List of Subsidiaries.23.1*
    
    Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.31.1*
    
    Certification of the Chief Executive Officer of Psychiatric Solutions, Inc.
Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.31.2*
    
    Certification of the Chief Accounting Officer of Psychiatric Solutions,
Inc. Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.32.1*
    
    Certifications of the Chief Executive Officer and Chief Accounting Officer
of Psychiatric Solutions, Inc. Pursuant to Rule 13a-14(b) of the Securities
Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Filed herewith
    
    Management contract or compensatory plan or arrangement 36




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PSYCHIATRIC SOLUTIONS, INC. 
 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGEReport of Independent Registered Public Accounting Firm
    
    F-2Managements Report on Internal Control over Financial Reporting
    
    F-3Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
    
    F-4Consolidated Financial Statements:Consolidated Balance Sheets, December 31, 2004 and 2003
    
    F-5Consolidated Statements of Income for the years ended December 31, 2004, 2003 and 2002
    
    F-6Consolidated Statements of Stockholders Equity for the years ended December 31, 2004, 2003 and 2002
    
    F-7Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002
    
    F-8Notes to Consolidated Financial Statements
    
    F-10
 F-1




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Psychiatric Solutions, Inc. We have audited the accompanying consolidated balance sheets of Psychiatric Solutions, Inc. as of
December 31, 2004 and 2003, and the related consolidated statements of income, stockholders
equity, and cash flows for each of the three years in the period ended December 31, 2004. These
financial statements are the responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of Psychiatric Solutions, Inc. at December 31, 2004
and 2003, and the consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting
principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of Psychiatric Solutions, Inc.s internal control over
financial reporting as of December 31, 2004, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated March 10, 2005, expressed an unqualified opinion thereon. /s/ ERNST & YOUNG LLP Nashville, Tennessee
March 10, 2005 F-2




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MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over
financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under
the supervision and with the participation of our management, including our Chief Executive Officer
and Chief Accounting Officer, we conducted an evaluation of the effectiveness of our internal
control over financial reporting as of December 31, 2004 based on the framework in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on that evaluation, our management concluded that our internal control
over financial reporting was effective as of December 31, 2004. Managements assessment of the effectiveness of our internal control over financial reporting as of
December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public
accounting firm, as stated in their report which is included elsewhere herein. F-3




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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Psychiatric Solutions, Inc. We have audited managements assessment, included in the accompanying Managements Report on
Internal Control Over Financial Reporting, that Psychiatric Solutions, Inc. maintained effective
internal control over financial reporting as of December 31, 2004, based on criteria established in
Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). Psychiatric Solutions, Inc.s management is responsible
for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of the companys internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion. A companys internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the
financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that Psychiatric Solutions, Inc. maintained effective
internal control over financial reporting as of December 31, 2004 is fairly stated, in all material
respects, based on the COSO criteria. Also, in our opinion, Psychiatric Solutions, Inc.
maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2004, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the consolidated balance sheets of Psychiatric Solutions, Inc. as of
December 31, 2004 and 2003 and the related consolidated statements of income, stockholders equity
and cash flows for each of the three years in the period ended December 31, 2004 and our report
dated March 10, 2005 expressed an unqualified opinion thereon. /s/ERNST & YOUNG LLP Nashville, Tennessee
March 10, 2005 F-4




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC. 
 CONSOLIDATED BALANCE SHEETS
 (in thousands)
 December 31,2004
    
    
    2003ASSETSCurrent assets:Cash and
cash equivalents
    
    $
    33,255
    
    
    $
    44,954Accounts receivable, less allowance for doubtful accounts of
$10,639 and $7,491, respectively
    
    
    77,539
    
    
    
    56,617Prepaids and other
    
    
    16,412
    
    
    
    11,075Total current assets
    
    
    127,206
    
    
    
    112,646Property and equipment:Land
    
    
    30,461
    
    
    
    23,088Buildings
    
    
    182,864
    
    
    
    123,005Equipment
    
    
    20,200
    
    
    
    10,023Less accumulated depreciation
    
    
    (15,294
    )
    
    
    (6,527
    )218,231
    
    
    
    149,589Cost in excess of net assets acquired
    
    
    130,079
    
    
    
    68,970Other assets
    
    
    22,330
    
    
    
    16,453Total assets
    
    $
    497,846
    
    
    $
    347,658LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    10,529
    
    
    $
    11,417Salaries and benefits payable
    
    
    27,355
    
    
    
    13,074Other accrued liabilities
    
    
    28,668
    
    
    
    19,979Current portion of long-term debt
    
    
    20,764
    
    
    
    1,023Total current liabilities
    
    
    87,316
    
    
    
    45,493Long-term debt, less current portion
    
    
    153,572
    
    
    
    173,980Deferred tax liability
    
    
    8,020
    
    
    
    6,762Other liabilities
    
    
    4,423
    
    
    
    4,779Total liabilities
    
    
    253,331
    
    
    
    231,014Series A convertible preferred stock, $0.01 par value, 6,000 shares
authorized; 4,545 shares issued and outstanding at
December 31, 2003
    
    
    
    
    
    
    25,316Stockholders equity:Common stock, $0.01 par value, 48,000 shares authorized;
20,468 and 11,937 issued and outstanding, respectively
    
    
    205
    
    
    
    119Additional paid-in capital
    
    
    228,044
    
    
    
    91,423Notes receivable from stockholders
    
    
    
    
    
    
    (338
    )Accumulated unrealized losses
    
    
    
    
    
    
    (4
    )Accumulated earnings
    
    
    16,266
    
    
    
    128Total stockholders equity
    
    
    244,515
    
    
    
    91,328Total liabilities and stockholders equity
    
    $
    497,846
    
    
    $
    347,658
 See accompanying notes. F-5




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC. 
 CONSOLIDATED STATEMENTS OF INCOME
 (In thousands except for per share amounts)
 Year Ended December 31,2004
    
    
    2003
    
    
    2002Revenue
    
    $
    487,190
    
    
    $
    284,946
    
    
    $
    113,912Salaries, wages and employee benefits
    
    
    265,678
    
    
    
    147,069
    
    
    
    62,326Professional fees
    
    
    53,258
    
    
    
    32,466
    
    
    
    14,373Supplies
    
    
    31,139
    
    
    
    16,371
    
    
    
    5,325Rentals and leases
    
    
    9,019
    
    
    
    4,043
    
    
    
    870Other operating expenses
    
    
    54,531
    
    
    
    43,855
    
    
    
    15,148Provision for bad debts
    
    
    10,874
    
    
    
    6,315
    
    
    
    3,681Depreciation and amortization
    
    
    9,868
    
    
    
    5,734
    
    
    
    1,770Interest expense
    
    
    18,964
    
    
    
    14,781
    
    
    
    5,564Loss on refinancing long-term debt
    
    
    6,407
    
    
    
    4,856
    
    
    
    86Change in valuation of put warrants
    
    
    
    
    
    
    960
    
    
    
    Change in reserve of stockholder notes
    
    
    
    
    
    
    (545
    )
    
    
    92459,738
    
    
    
    275,905
    
    
    
    109,235Income from continuing operationsbefore income taxes
    
    
    27,452
    
    
    
    9,041
    
    
    
    4,677Provision for (benefit from) income taxes
    
    
    10,432
    
    
    
    3,800
    
    
    
    (1,007
    )Income from continuing operations
    
    
    17,020
    
    
    
    5,241
    
    
    
    5,684Loss from discontinued operations, net of
income tax benefit of $134 and $15 for
2004 and 2003, respectively
    
    
    (219
    )
    
    
    (25
    )
    
    
    Net income
    
    
    16,801
    
    
    
    5,216
    
    
    
    5,684Accrued preferred stock dividends
    
    
    663
    
    
    
    811
    
    
    
    Net income available to common stockholders
    
    $
    16,138
    
    
    $
    4,405
    
    
    $
    5,684Basic
earnings (loss) per share:Income from continuing operations
    
    $
    1.12
    
    
    $
    0.53
    
    
    $
    0.93Loss from discontinued operations
    
    
    (0.01
    )
    
    
    
    
    
    
    Net income
    
    $
    1.11
    
    
    $
    0.53
    
    
    $
    0.93Diluted
earnings (loss) per share:Income from continuing operations
    
    $
    0.97
    
    
    $
    0.44
    
    
    $
    0.86Loss from discontinued operations
    
    
    (0.01
    )
    
    
    
    
    
    
    Net income
    
    $
    0.96
    
    
    $
    0.44
    
    
    $
    0.86Shares used in computing per share amounts:Basic
    
    
    14,570
    
    
    
    8,370
    
    
    
    6,111Diluted
    
    
    17,573
    
    
    
    11,749
    
    
    
    6,986
 See accompanying notes. F-6




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC. 
 CONSOLIDATED STATEMENTS STOCKHOLDERS EQUITY
 (in thousands)
 Additional
    
    
    Notes
    
    
    Accumulated
    
    
    AccumulatedCommon Stock
    
    
    Paid-In
    
    
    Receivable from
    
    
    Unrealized
    
    
    EarningsShares
    
    
    Amount
    
    
    Capital
    
    
    Stockholders
    
    
    Losses
    
    
    (Deficit)
    
    
    TotalBalance at December 31, 2001
    
    
    4,990
    
    
    $
    50
    
    
    $
    19,149
    
    
    $
    
    
    
    $
    
    
    
    $
    (9,961
    )
    
    $
    9,238Common stock and options issued
with PMR merger
    
    
    2,421
    
    
    
    24
    
    
    
    15,361
    
    
    
    (259
    )
    
    
    
    
    
    
    
    
    
    
    15,126Value of warrants issued
    
    
    
    
    
    
    
    
    
    
    330
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    330Exercise of stock options and
warrants
    
    
    328
    
    
    
    3
    
    
    
    50
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    53Issuance of stock options
    
    
    
    
    
    
    
    
    
    
    118
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    118Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,684
    
    
    
    5,684Balance at December 31, 2002
    
    
    7,739
    
    
    
    77
    
    
    
    35,008
    
    
    
    (259
    )
    
    
    
    
    
    
    (4,277
    )
    
    
    30,549Issuance of common stock
    
    
    3,272
    
    
    
    33
    
    
    
    48,864
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    48,897Conversion of convertible debt
    
    
    538
    
    
    
    5
    
    
    
    4,580
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,585Payment of notes receivable from
stockholders with stock
    
    
    (48
    )
    
    
    
    
    
    
    (483
    )
    
    
    466
    
    
    
    
    
    
    
    
    
    
    
    (17
    )Change in reserve on stockholder
notes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (545
    )
    
    
    
    
    
    
    
    
    
    
    (545
    )Exercise of stock options and
warrants
    
    
    436
    
    
    
    4
    
    
    
    3,454
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,458Unrealized loss on investments
available for sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    (4
    )Net income available to
common stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,405
    
    
    
    4,405Balance at December 31, 2003
    
    
    11,937
    
    
    
    119
    
    
    
    91,423
    
    
    
    (338
    )
    
    
    (4
    )
    
    
    128
    
    
    
    91,328Issuance of common stock
    
    
    3,285
    
    
    
    33
    
    
    
    104,658
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    104,691Conversion of series A
convertible preferred stock
    
    
    4,814
    
    
    
    48
    
    
    
    25,867
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25,915Payment on notes receivable
from stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    338
    
    
    
    
    
    
    
    
    
    
    
    338Exercise of stock options and
warrants
    
    
    432
    
    
    
    5
    
    
    
    6,096
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,101Unrealized gain on investments
available for sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    4Net income available to
common stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,138
    
    
    
    16,138Balance at December 31, 2004
    
    
    20,468
    
    
    $
    205
    
    
    $
    228,044
    
    
    $
    
    
    
    $
    
    
    
    $
    16,266
    
    
    $
    244,515
 See accompanying notes. F-7




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 Year Ended December 31,2004
    
    
    2003
    
    
    2002Operating
Activities:Net income
    
    $
    16,801
    
    
    $
    5,216
    
    
    $
    5,684Adjustments to reconcile net income to
net cash provided by continuing
operating activities:Depreciation and amortization
    
    
    9,868
    
    
    
    5,734
    
    
    
    1,770Provision for doubtful accounts
    
    
    10,874
    
    
    
    6,315
    
    
    
    3,681Amortization of loan costs
    
    
    691
    
    
    
    1,478
    
    
    
    419Loss on refinancing long-term debt

    
    
    6,407
    
    
    
    4,856
    
    
    
    Change in income tax assets and liabilities
    
    
    6,920
    
    
    
    2,809
    
    
    
    (1,007
    )Change in valuation of put warrants
    
    
    
    
    
    
    960
    
    
    
    (Release of) additional reserve on stockholder notes
    
    
    
    
    
    
    (545
    )
    
    
    92Loss from discontinued operations, net of taxes
    
    
    219
    
    
    
    25
    
    
    
    Changes in operating assets and liabilities,
net of effect of acquisitions:Accounts receivable
    
    
    (14,075
    )
    
    
    (11,709
    )
    
    
    (1,348
    )Prepaids and other current assets
    
    
    2,200
    
    
    
    2,213
    
    
    
    (399
    )Accounts payable
    
    
    (5,176
    )
    
    
    (1,979
    )
    
    
    (2,523
    )Salaries and benefits payable
    
    
    5,756
    
    
    
    1,365
    
    
    
    1,504Accrued liabilities and other liabilities
    
    
    (628
    )
    
    
    1,304
    
    
    
    (70
    )Other
    
    
    
    
    
    
    286
    
    
    
    1,119Net cash provided by continuing operating activities
    
    
    39,857
    
    
    
    18,328
    
    
    
    8,922Investing activities:Cash (paid for) acquired in acquisitions, net of cash
acquired or paid
    
    
    (136,495
    )
    
    
    (100,424
    )
    
    
    6,243Capital purchases of leasehold improvements,
equipment and software
    
    
    (17,216
    )
    
    
    (5,755
    )
    
    
    (1,470
    )Sale (purchase) of long-term securities
    
    
    953
    
    
    
    (971
    )
    
    
    Other assets
    
    
    (1,301
    )
    
    
    (908
    )
    
    
    (612
    )Net cash (used in) provided by investing activities
    
    
    (154,059
    )
    
    
    (108,058
    )
    
    
    4,161
 (Continued) F-8




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Year Ended December 31,2004
    
    
    2003
    
    
    2002Financing activities:Net principal (payments) borrowings on long-term debt
    
    $
    (810
    )
    
    $
    61,980
    
    
    $
    (11,772
    )Payment of loan and issuance costs
    
    
    (2,300
    )
    
    
    (1,998
    )
    
    
    (234
    )Refinancing of long-term debt
    
    
    (3,844
    )
    
    
    (1,410
    )
    
    
    Proceeds from issuance of series A convertible
preferred stock, net of issuance costs
    
    
    
    
    
    
    24,505
    
    
    
    Proceeds from secondary offering of common stock,
net of issuance costs
    
    
    104,691
    
    
    
    48,897
    
    
    
    Proceeds from exercises of common stock options
    
    
    4,428
    
    
    
    318
    
    
    
    53Proceeds from repayment of stockholder notes
    
    
    338
    
    
    
    
    
    
    
    Net cash provided by (used in) financing activities
    
    
    102,503
    
    
    
    132,292
    
    
    
    (11,953
    )Net (decrease) increase in cash
    
    
    (11,699
    )
    
    
    42,562
    
    
    
    1,130Cash and
cash equivalents at beginning of the year
    
    
    44,954
    
    
    
    2,392
    
    
    
    1,262Cash and
cash equivalents at end of the year
    
    $
    33,255
    
    
    $
    44,954
    
    
    $
    2,392Supplemental Cash Flow Information:Interest paid
    
    $
    18,821
    
    
    $
    13,017
    
    
    $
    3,905Income taxes paid
    
    $
    3,354
    
    
    $
    318
    
    
    $
    Effect of Acquisitions:Assets acquired, net of cash acquired
    
    $
    148,345
    
    
    $
    201,525
    
    
    $
    34,868Liabilities assumed
    
    
    (11,850
    )
    
    
    (37,336
    )
    
    
    (8,862
    )Common stock and stock options issued
    
    
    
    
    
    
    
    
    
    
    (15,385
    )Long-term debt issued
    
    
    
    
    
    
    (63,765
    )
    
    
    (16,864
    )Cash paid for (acquired in) acquisitions, net of
cash acquired or paid
    
    $
    136,495
    
    
    $
    100,424
    
    
    $
    (6,243
    )Significant Non-cash Transactions:Issuance of common stock upon conversion of series A
convertible preferred stock
    
    $
    25,915
    
    
    $
    
    
    
    $
    Refinancing of long-term debt
    
    $
    2,563
    
    
    $
    3,446
    
    
    $
    Deferred tax asset recorded to recognize income tax effect
of stock option exercises
    
    $
    2,483
    
    
    $
    186
    
    
    $
    Financing of loan costs
    
    $
    
    
    
    $
    9,172
    
    
    $
    2,004Issuance of common stock upon conversion
of convertible debt
    
    $
    
    
    
    $
    4,588
    
    
    $
    Issuance of common stock upon exercise of warrants
    
    $
    
    
    
    $
    2,979
    
    
    $
    Issuance of detachable stock warrants as
consideration for subordinated debt financing
    
    $
    
    
    
    $
    
    
    
    $
    2,018
 See accompanying notes. F-9




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC. 
 NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
 December 31, 2004
 1. Summary of Significant Accounting Policies Description of Business Psychiatric Solutions, Inc. was incorporated in 1988 as a Delaware corporation with its corporate
office in Franklin, Tennessee. Psychiatric Solutions, Inc. and its subsidiaries (we, us or
our) are a leading provider of inpatient behavioral health care services in the United States.
Through our owned and leased facilities segment, we operate 34 owned or leased inpatient behavioral
health care facilities with approximately 4,000 beds in 19 states. In addition, through our
management contract segment, we manage 41 inpatient behavioral health care units for third parties
and 8 inpatient behavioral health care facilities for government agencies. Basis of Presentation The accompanying consolidated financial statements have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of financial statements in
conformity with accounting principles generally accepted in the United States requires management
to make estimates and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those estimates. The majority
of our expenses are cost of revenue items. Costs that could be classified as general and
administrative expenses at our corporate office were approximately 3% of net revenue for the year
ended December 31, 2004. The consolidated financial statements include the accounts of Psychiatric Solutions, Inc. and its
subsidiaries. All significant intercompany balances and transactions are eliminated in
consolidation. Cash and Cash Equivalents Cash consists of demand deposits held at financial institutions. We place our cash in financial
institutions that are federally insured. At December 31, 2004, the majority of our cash is
deposited with one financial institution. Cash equivalents are short-term investments with original
maturities of three months or less. Accounts Receivable Accounts receivable vary according to the type of service being provided. Accounts receivable for
our management contract segment is comprised of contractually determined fees for services
rendered. Such amounts are recorded net of estimated bad debts. Concentration of credit risk is
reduced by the large number of customers. Accounts receivable for our owned and leased facilities segment is comprised of patient service
revenue and is recorded net of contractual adjustments and estimated bad debts. Such amounts are
owed by various governmental agencies, insurance companies and private patients. Medicare comprised
approximately 11% and 13% of net patient receivables for our owned and leased inpatient facilities
at December 31, 2004 and 2003, respectively. Medicaid comprised approximately 31% and 40% of net
patient receivables for our owned and leased inpatient facilities at December 31, 2004 and 2003,
respectively. Concentration of credit risk from other payers is reduced by the large number of
patients and payers. Allowance for Doubtful Accounts Our ability to collect outstanding patient receivables from third party payors and receivables due
under our inpatient management contracts is critical to our operating performance and cash flows. The primary collection risk with regard to patient receivables lies with uninsured patient accounts
or patient accounts for which primary insurance has paid, but the portion owed by the patient
remains outstanding. We estimate the allowance for doubtful accounts primarily based upon the age
of the accounts since the patient discharge date. We continually monitor our accounts receivable
balances and utilize cash collection data to support our estimates of the provision for doubtful
accounts. Significant changes in payor mix or business office operations could have a significant
impact on our results of operations and cash flows. The primary collection risk with regard to receivables due under our inpatient management contracts
is attributable to contractual disputes. We estimate the allowance for doubtful accounts for these
receivables based primarily upon the specific identification of potential collection issues. As
with our patient receivables, we continually monitor our accounts receivable balances and utilize
cash collection data to support our estimates of the provision for doubtful accounts. Allowances for Contractual Discounts The Medicare and Medicaid regulations are complex and various managed care contracts may include
multiple reimbursement F-10




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 mechanisms for different types of services provided in our inpatient
facilities and cost settlement provisions requiring complex calculations and assumptions subject to
interpretation. We estimate the allowance for contractual discounts on a payor-specific basis given
our interpretation of the applicable regulations or contract terms. The services authorized and
provided and related reimbursement are often subject to interpretation that could result in payments that differ from
our estimates. Additionally, updated regulations and contract renegotiations occur frequently
necessitating continual review and assessment of the estimation process by our management. Income Taxes We account for income taxes under the asset and liability method. Under this method, deferred tax
assets and liabilities are determined based upon differences between the financial statement
carrying amounts and tax bases of assets and liabilities and are measured using the enacted tax
laws that will be in effect when the differences are expected to reverse. A valuation allowance for
deferred tax assets is established when we believe that it is more likely than not that the
deferred tax asset will not be realized. At December 31, 2004, we had a deferred tax asset of
approximately $8.7 million in prepaids and other on our consolidated balance sheet. Long-Lived Assets  Property
and Equipment Property and equipment are stated at cost and depreciated using the straight-line method over the
useful lives of the assets, which range from 25 to 35 years for buildings and improvements and 2 to
7 years for equipment. Leasehold improvements are amortized on a straight-line basis over the
shorter of the lease term or estimated useful lives of the assets. Depreciation expense was $8.8
million and $4.7 million for the years ended December 31, 2004 and 2003, respectively. Cost in Excess of Net Assets Acquired (Goodwill) We account for acquisitions using the purchase method of accounting. Goodwill is reviewed at least
annually for impairment. Potential impairment is noted for a reporting unit if its carrying value
exceeds the fair value of the reporting unit. For those reporting units that we have identified
with potential impairment of goodwill, we determine the implied fair value of goodwill. If the
carrying value of goodwill exceeds its implied fair value, an impairment loss is recorded. Our
annual impairment test of goodwill in 2004 resulted in no goodwill impairment. The following table presents the changes in the carrying amount of goodwill for the years ended
December 31, 2004 and 2003 (in thousands): Balance at December 31, 2002
    
    $
    28,822Acquisition of The Brown Schools
    
    
    17,377Acquisition of Ramsay Youth Services
    
    
    19,161Acquisition of Alliance Health Center
    
    
    1,755Acquisition of Calvary Center
    
    
    4,114Valuation of contracts acquired from PMR
    
    
    (3,187
    )Other
    
    
    928Balance at December 31, 2003
    
    $
    68,970Acquisition of Brentwood
    
    
    3,956Acquisition of Palmetto
    
    
    5,349Acquisition of Heartland
    
    
    44,714Acquisition of Piedmont
    
    
    5,703Acquisition of Alliance Behavioral
    
    
    7,552Release of deferred tax asset valuation allowance
    
    
    (6,684
    )Other
    
    
    519Balance at December 31, 2004
    
    $
    130,079
 Other Assets Other assets include contracts that represent the fair value of inpatient management contracts and
service contracts purchased and are being amortized using the straight-line method over five years.
At December 31, 2004 and 2003, contracts totaled $2.1 million and $2.9 million and are net of
accumulated amortization of $1.3 million and $1.9 million, respectively. Amortization expense
related to contracts was $987,000 and $944,000 for the years ended December 31, 2004 and 2003,
respectively. Estimated amortization expense for the years ended December 31, 2005, 2006, 2007 and
2008 of contracts is $704,000, $704,000, $704,000 and $17,000, respectively. F-11




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 When events, circumstances and operating results indicate that the carrying values of certain
long-lived assets and the related identifiable intangible assets might be impaired, we prepare
projections of the undiscounted future cash flows expected to result from the use of the assets and
their eventual disposition. If the projections indicate that the recorded amounts are not expected
to be recoverable, such amounts are reduced to estimated fair value. Fair value is estimated based upon
projections of discounted cash flows. Other assets also include loan costs that are deferred and amortized over the term of the related
debt. Loan costs reported at December 31, 2004 and 2003 are net of accumulated amortization of
$966,000 and $1.6 million, respectively. During January 2004, we terminated our revolving line of
credit with CapSource and associated loan costs and accumulated amortization of $3.8 million and
$1.3 million, respectively, were written-off. Stock-Based Compensation In December 2002, the Financial Accounting Standards Board (FASB) issued Statement on Financial
Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an
Amendment of FASB Statement No. 123(SFAS 148). SFAS 148 amends Statement on Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation(SFAS 123), to provide alternative
methods of transition for a voluntary change to the fair-value based method of accounting for
stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS
123 to require prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the method used on
reported results. SFAS 148 had no material impact on our results of operations or financial
position. We have included the required disclosures below and in Note 10. We account for our stock option plans in accordance with the provisions of Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations as more fully described in Note 10. As such, compensation expense would be recorded
on the date of grant only if the current market price of the underlying stock exceeded the exercise
price. We will begin expensing stock options in the third quarter of 2005 in accordance with
Statement of Financial Accounting Standards No. 123 (Revised 2004), Share Based Payment (SFAS
123R). See Recent Accounting Pronouncements for a discussion of SFAS 123R. Pro forma information regarding net income and earnings per share is required by SFAS 123, and has
been determined as if we had accounted for our employee stock options under the fair value method
of that Statement. During 2004, 2003 and 2002, we granted 710,000, 713,000 and 515,000 stock
options, respectively. The fair value of these options was estimated using the Black-Scholes option
pricing model. The following weighted-average assumptions were used in the respective pricing models: 2004
    
    
    2003
    
    
    2002Risk-free interest rate
    
    
    3.17
    %
    
    
    2.79
    %
    
    
    3.11
    %Volatility
    
    
    31.87
    %
    
    
    51.99
    %
    
    
    111.70
    %Expected life
    
    
    5.2
    
    
    
    5.6
    
    
    
    4.9Dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 The weighted-average fair value of options granted is presented in the following table: 2004
    
    
    2003
    
    
    2002Exercise Price equal to Market Price
    
    $
    7.33
    
    
    $
    5.05
    
    
    $
    4.41Exercise Price less than Market Price
    
    $
    
    
    
    $
    
    
    
    $
    3.74Exercise Price greater than Market Price
    
    $
    
    
    
    $
    5.04
    
    
    $
    2.56
 Option valuation models require the input of highly subjective assumptions. Because our employee
stock options have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the fair value estimate,
in our opinion, the existing models do not necessarily provide a reliable single measure of the
fair value of our employee stock options. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to
expense over the options vesting period. Our pro forma information follows (in thousands, except
per share amounts): F-12




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 2004
    
    
    2003
    
    
    2002Net income available to common stockholders (1)
    
    $
    16,138
    
    
    $
    4,405
    
    
    $
    5,684Pro forma compensation expense from stock options
    
    
    1,467
    
    
    
    605
    
    
    
    127Pro forma net income
    
    $
    14,671
    
    
    $
    3,800
    
    
    $
    5,557Basic earnings per share:As reported
    
    $
    1.11
    
    
    $
    0.53
    
    
    $
    0.93Pro forma
    
    $
    1.01
    
    
    $
    0.45
    
    
    $
    0.91Diluted earnings per share:As reported
    
    $
    0.96
    
    
    $
    0.44
    
    
    $
    0.86Pro forma
    
    $
    0.87
    
    
    $
    0.39
    
    
    $
    0.84
   (1)
    
    Net income available to common stockholders reflects stock
compensation expense of $118,000 for the year ended December 31, 2002,
for stock options granted with exercise prices below market price
during 2002. Derivatives During 2004 we entered into two interest rate swap agreements to manage our exposure to
fluctuations in interest rates that effectively convert $50 million of fixed-rate long-term debt to
a LIBOR indexed variable rate instrument plus an agreed upon interest rate spread. Under Statement
of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities, as amended (SFAS 133), we have designated our interest rate swap agreements as fair
value hedges. Accordingly, the changes in the fair value of the interest rate swaps are recorded in
interest expense. If our derivatives were deemed to be cash flow hedges under SFAS 133, changes in
the fair value of the derivatives would be recognized as other comprehensive income and recorded to
the income statement in the period when the hedged item affects earnings. We believe our interest
rate swap agreements to be highly effective in offsetting fair value changes in our hedged
fixed-rate long-term debt. Risk Management We are subject to medical malpractice and other lawsuits due to the nature of the services we
provide. Due to our acquisition of Ramsay Youth Services, Inc. (Ramsay), we had two distinct
insurance programs that covered our inpatient facilities. Prior to December 31, 2004, all of our
inpatient facilities except those acquired from Ramsay, had professional and general liability
insurance in umbrella form for claims in excess of $3.0 million with an insured limit of $20.0
million. For the inpatient facilities acquired from Ramsay, we had professional and general
liability insurance in umbrella form for claims in excess of $500,000 with an insured limit of
$26.0 million. These plans were combined, effective December 31, 2004, to cover all of our
operations for professional and general liability in umbrella form for claims in excess of $2.0
million with an insured limit of $35.0 million. The self-insured reserves for professional and
general liability claims are calculated based on historical claims, demographic factors, industry
trends, severity factors, and other actuarial assumptions calculated by an independent third party.
This self-insurance reserve is discounted to its present value using a 5% discount rate. This
estimated accrual for professional and general liabilities could be significantly affected should
current and future occurrences differ from historical claim trends and expectations. We have
utilized our captive insurance company to manage this additional self-insured retention. While
claims are monitored closely when estimating professional and general liability accruals, the
complexity of the claims and wide range of potential outcomes often hampers timely adjustments to
the assumptions used in these estimates. We believe that our insurance coverage conforms to
industry standards. There are no assurances, however, that our insurance will cover all claims
(e.g., claims for punitive damages) or that claims in excess of our insurance coverage will not
arise. The reserve for professional and general liability was approximately $4.9 million and $4.2
million as of December 31, 2004 and 2003, respectively. We carry statutory workers compensation insurance from an unrelated commercial insurance carrier.
Our statutory workers compensation program is fully insured with a $350,000 deductible per
incident, which is funded and managed through a rent-a-captive arrangement. We
believe that adequate provision has been made for workers compensation and professional and general
liability risk exposures. The reserve for workers compensation liability was approximately $5.4
million and $3.3 million as of December 31, 2004 and 2003, respectively. Fair Value of Financial Instruments The carrying amounts reported in the accompanying Consolidated Balance Sheets for cash, accounts
receivable, and accounts payable approximate their fair value given the short-term maturity of
these instruments. At December 31, 2004, the carrying value and fair F-13




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 value of our 10 5/8% senior
subordinated notes was approximately $150 million and $173 million, respectively. Based upon the
borrowing rates currently available to us, the carrying amounts reported in the accompanying
Consolidated Balance Sheets for other long-term debt approximate fair value. Merger with PMR Corporation On August 5, 2002, pursuant to a definitive Merger Agreement, dated May 6, 2002, and with
respective stockholder and regulatory approvals, PMR Acquisition Corporation, a newly formed,
wholly-owned subsidiary of PMR Corporation, merged with and into Psychiatric Solutions, Inc., a
Delaware corporation whose name, subsequent to the merger, was changed to Psychiatric Solutions
Hospitals, Inc. (PSH). The surviving corporation in the merger was PSH, which became a
wholly-owned subsidiary of PMR Corporation (PMR). In connection with the merger, PMR changed its
name to Psychiatric Solutions, Inc. (PSI). In exchange for their outstanding shares of common
stock or preferred stock in PSH, stockholders of PSH received newly-issued shares of PSI common
stock. Options to acquire PSH common stock were converted into options to purchase shares of PSI
common stock based on the common stock exchange ratio used in the merger. Warrants to purchase
shares of PSH common stock were converted into warrants to purchase shares of PSI common stock.
After giving effect to the exercise of all outstanding options and warrants of PSH following the
merger, the former PSH stockholders and PSIs pre-merger stockholders received approximately 72%
and 28% of our common stock, respectively. In addition, effective August 6, 2002, our common stock
was approved for listing on the Nasdaq National Market under the ticker symbol PSYS. The Merger
Agreement is on file with the Securities and Exchange Commission (SEC) as an exhibit to Amendment
No. 1 to our Registration Statement on Form S-4 filed on June 12, 2002, as amended July 11, 2002. Since the former PSH stockholders had ownership of more than half of our outstanding common stock
pursuant to the merger, PSH has been treated as the acquiring company for accounting purposes. The
condensed consolidated financial statements located herein relate to PSH only prior to August 5,
2002, and to the merged company on and subsequent to August 5, 2002. Historical financial
information relating to PMR just prior to the merger can be found in PMRs quarterly report on Form
10-Q for the quarter ended July 31, 2002, as filed with the Securities and Exchange Commission on
September 16, 2002. Reclassifications Certain reclassifications have been made to the prior year to conform with current year
presentation. Recent Pronouncements In December 2004, the FASB issued SFAS 123R, which requires companies to measure and recognize the
cost of employee services received in exchange for an award of equity instruments based on the
grant-date fair value. SFAS 123R eliminates the ability to account for the award of these
instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under
the original provisions of SFAS No. 123. The effective date is the first interim reporting period
beginning after June 15, 2005. We are currently evaluating pricing models and the transition
provisions of this standard and will begin expensing stock options in accordance with SFAS 123R in
the third quarter of 2005. Exclusive of future grants of equity instruments to employees, we do not
expect the impact of adopting SFAS 123R to be materially different than the amount disclosed in the
stock-based compensation section of this Note. 2. Revenue Revenue consists of the following amounts (in thousands): December 31,2004
    
    
    2003
    
    
    2002Patient service revenue
    
    $
    419,299
    
    
    $
    223,340
    
    
    $
    81,929Management fee revenue
    
    
    67,891
    
    
    
    61,606
    
    
    
    31,983Total revenue
    
    $
    487,190
    
    
    $
    284,946
    
    
    $
    113,912
 Net Patient Service Revenue Patient service revenue is reported on the accrual basis in the period in which services are
provided, at established rates, regardless of whether collection in full is expected. Net patient
service revenue includes amounts we estimate to be reimbursable by Medicare and Medicaid under
provisions of cost or prospective reimbursement formulas in effect. Amounts received are generally
less than the established billing rates of the facilities and the differences (contractual
allowances) are reported as deductions from patient service revenue at the time the service is
rendered. The effect of other arrangements for providing services at less than established rates is
also reported as deductions from patient service revenue. During the years ended December 31, 2004
and 2003, approximately 37% and F-14




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 32% of our revenues related to patients participating in the
Medicaid program. During the years ended December 31, 2004 and 2003, approximately 12% of our
revenues related to patients participating in the Medicare program. We provide care without charge to patients who are financially unable to pay for the health care
services they receive. Because we do not pursue collection of amounts determined to qualify as
charity care, they are not reported in revenues. Settlements under cost reimbursement agreements
with third party payers are estimated and recorded in the period in which the related services are
rendered and are adjusted in future periods as final settlements are determined. Final
determination of amounts earned under the Medicare and Medicaid programs often occur in subsequent
years because of audits by the programs, rights of appeal and the application of numerous technical
provisions. Our revenue is particularly sensitive to regulatory and economic changes in the State of Texas. As
of December 31, 2004, 2003 and 2002, we operated eight, seven and three inpatient facilities in
Texas, respectively. We generated approximately 27%, 34% and 50% of our revenue from our Texas
operations for the years ended December 31, 2004, 2003 and 2002, respectively. Management Contract Revenue Revenue is recorded as management contract revenue for our inpatient management contract segment.
Our inpatient management contract segment receives contractually determined management fees from
hospitals and clinics for providing inpatient psychiatric management and development services. Our management contract revenue is sensitive to regulatory and economic changes in the State of
Florida because, as of December 31, 2004 and 2003, we managed six inpatient facilities for the
Florida Department of Juvenile Justice. We generated approximately 4% and 3% of our revenue for the
years ended December 31, 2004 and 2003 from our management contracts for the Florida Department of
Juvenile Justice. Our management contract revenue is also sensitive to regulatory and economic
changes in the State of Tennessee because of the contract to provide case management services in
and around Nashville, Tennessee. This contract generated approximately 4% and 8% of our revenue for
the years ended December 31, 2004 and 2003, respectively. There were no individual or groups of
affiliated contracts in 2002 that provided a significant concentration of our management contract
revenue. 3. Earnings Per Share Statement of Financial Accounting Standards No. 128, Earnings per Share(SFAS 128), requires dual
presentation of basic and diluted earnings per share by entities with complex capital structures.
Basic earnings per share includes no dilution and is computed by dividing net income available to
common stockholders by the weighted average number of common shares outstanding for the period.
Diluted earnings per share reflects the potential dilution of securities that could share in the
earnings of the entity. We have calculated earnings per share in accordance with SFAS 128 for all
periods presented. The following table sets forth the computation of basic and diluted earnings per share (in
thousands, except per share amounts): F-15




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Year ended December 31,2004
    
    
    2003
    
    
    2002Numerator:Basic earnings per share:Income from continuing operations
    
    $
    17,020
    
    
    $
    5,241
    
    
    $
    5,684Accrued dividends on series A convertible preferred stock
    
    
    663
    
    
    
    811
    
    
    
    Income from continuing operations used in computing basic
earnings per share
    
    
    16,357
    
    
    
    4,430
    
    
    
    5,684Loss from discontinued operations, net of taxes
    
    
    (219
    )
    
    
    (25
    )
    
    
    Net income available to common stockholders
    
    $
    16,138
    
    
    $
    4,405
    
    
    $
    5,684Diluted earnings per share:Income from continuing operations
    
    $
    17,020
    
    
    $
    5,241
    
    
    $
    5,684Add: Interest expense on convertible notes
    
    
    
    
    
    
    
    
    
    
    324Income from continuing operations used in computing diluted
earnings per share
    
    
    17,020
    
    
    
    5,241
    
    
    
    6,008Loss from discontinued operations, net of taxes
    
    
    (219
    )
    
    
    (25
    )
    
    
    Net income used in computing diluted earnings per share
    
    $
    16,801
    
    
    $
    5,216
    
    
    $
    6,008Denominator:Weighted average shares outstanding for basic earnings per share
    
    
    14,570
    
    
    
    8,370
    
    
    
    6,111Effects of dilutive stock options and warrants outstanding
    
    
    569
    
    
    
    431
    
    
    
    453Effect of dilutive convertible debt outstanding
    
    
    
    
    
    
    
    
    
    
    422Effect of dilutive series A convertible preferred stock outstanding
    
    
    2,434
    
    
    
    2,948
    
    
    
    Shares used in computing diluted earnings per common share
    
    
    17,573
    
    
    
    11,749
    
    
    
    6,986Basic
earnings (loss) per share:Income from continuing operations
    
    $
    1.12
    
    
    $
    0.53
    
    
    $
    0.93(Loss) income from discontinued operations, net of taxes
    
    
    (0.01
    )
    
    
    
    
    
    
    $
    1.11
    
    
    $
    0.53
    
    
    $
    0.93Diluted earnings (loss) per share:Income from continuing operations
    
    $
    0.97
    
    
    $
    0.44
    
    
    $
    0.86(Loss) income from discontinued operations, net of taxes
    
    
    (0.01
    )
    
    
    
    
    
    
    $
    0.96
    
    
    $
    0.44
    
    
    $
    0.86
 Diluted earnings per share for the year ended December 31, 2003 does not include the potential
dilutive effect of debt outstanding which was convertible into 106,000 shares of our common stock,
respectively, as the effect would be anti-dilutive. Interest expense related to this convertible
debt was approximately $124,000 for the year ended December 31, 2003. 4. Discontinued Operations Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, requires that all components of an entity that have been disposed of (by sale,
by abandonment or in a distribution to owners) or are held for sale and whose cash flows can be
clearly distinguished from the rest of the entity be presented as discontinued operations. During
2004, we exited three of our contracts to manage state-owned facilities in Florida. Accordingly,
the operations of these contracts, net of applicable income taxes, have been presented as
discontinued operations and prior period consolidated financial statements have been reclassified. The components of loss from discontinued operations, net of taxes, are as follows (in thousands): F-16




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Year Ended December 31,2004
    
    
    2003Revenue
    
    $
    10,683
    
    
    $
    8,720Salaries, wages and employee benefits
    
    
    7,865
    
    
    
    6,430Professional fees
    
    
    982
    
    
    
    827Supplies
    
    
    907
    
    
    
    703Rentals and leases
    
    
    151
    
    
    
    66Other operating expenses
    
    
    1,113
    
    
    
    715Depreciation and amortization
    
    
    18
    
    
    
    1911,036
    
    
    
    8,760Loss from discontinued operations before income taxes
    
    
    (353
    )
    
    
    (40
    )Benefit from income taxes
    
    
    (134
    )
    
    
    (15
    )Loss from discontinued operations, net of income taxes
    
    $
    (219
    )
    
    $
    (25
    )
 5. Acquisitions 2004 ACQUISITIONS During 2004, we acquired two inpatient psychiatric facilities from Brentwood Behavioral Health
(Brentwood), all of the membership interests of Palmetto Behavioral Health System, L.L.C.
(Palmetto), an operator of two inpatient behavioral health care facilities, four inpatient
behavioral health care facilities from Heartland Healthcare (Heartland), an inpatient behavioral
health care facility from Piedmont Behavioral Health Center LLC
(Piedmont) and a system of inpatient behavioral health
care facilities from Alliance
Behavioral Health Group (Alliance Behavioral). These acquisitions were accounted for by the purchase method. The aggregate purchase
price of these transactions was allocated to the assets acquired and liabilities assumed based upon
their respective fair values. The consolidated financial statements include the accounts and
operations of the acquired entities for periods subsequent to the respective acquisition dates. As
the acquisition of Palmetto involved the acquisition of membership interests, the goodwill
associated with this acquisition is not deductible for federal income tax purposes. The goodwill
associated with the other acquisitions during 2004 is deductible for federal income tax purposes. The following table summarizes the allocation of the aggregate purchase price of the aforementioned
acquisitions (in thousands): Alliance2004
    
    Brentwood
    
    
    Palmetto
    
    
    Heartland
    
    
    Piedmont
    
    
    Behavioral
    
    
    TotalAssets acquired:Accounts receivable
    
    $
    4,086
    
    
    $
    1,703
    
    
    $
    8,637
    
    
    $
    748
    
    
    $
    2,548
    
    
    $
    17,722Other current assets
    
    
    214
    
    
    
    593
    
    
    
    166
    
    
    
    65
    
    
    
    34
    
    
    
    1,072Fixed assets
    
    
    27,868
    
    
    
    4,877
    
    
    
    17,563
    
    
    
    4,970
    
    
    
    4,328
    
    
    
    59,606Costs in excess of net assets acquired
    
    
    3,956
    
    
    
    5,349
    
    
    
    44,714
    
    
    
    5,703
    
    
    
    7,552
    
    
    
    67,274Other assets
    
    
    1,899
    
    
    
    4
    
    
    
    30
    
    
    
    
    
    
    
    111
    
    
    
    2,04438,023
    
    
    
    12,526
    
    
    
    71,110
    
    
    
    11,486
    
    
    
    14,573
    
    
    
    147,718Liabilities assumed
    
    
    7,087
    
    
    
    1,774
    
    
    
    4,481
    
    
    
    505
    
    
    
    1,353
    
    
    
    15,200Cash paid, net of cash acquired
    
    $
    30,936
    
    
    $
    10,752
    
    
    $
    66,629
    
    
    $
    10,981
    
    
    $
    13,220
    
    
    $
    132,518
 At December 31, 2004, we have accrued approximately $5 million for an earn-out related to the
acquisition of Brentwood. We expect to pay this amount in the second quarter of 2005. The purchase
price allocations for Brentwood and Heartland are preliminary pending final measurement of certain
assets and liabilities related to these acquisitions. 2003 ACQUISITIONS During 2003, we acquired Ramsay, an operator of 11 owned or leased inpatient behavioral health care
facilities and 10 contracts to manage inpatient behavioral health care facilities for state
government agencies. Also during 2003, we acquired six inpatient behavioral health care facilities
from The Brown Schools, Inc. (The Brown Schools). In addition, we purchased Alliance Health F-17




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Center (Alliance) and the Calvary Center (Cavalry) during 2003. These acquisitions were
accounted for by the purchase method. The aggregate purchase price of these transactions was
allocated to the assets acquired and liabilities assumed based upon their respective fair values.
The consolidated financial statements include the accounts and operations of the acquired entities
for periods subsequent to the respective acquisition dates. Our liabilities assumed included
approximately $3.3 million payable to the seller of Calvary upon the completion of certain
licensing issues. This amount was paid to the seller in January 2004. As the acquisitions of Ramsay
and Alliance involved the acquisition of stock, the goodwill associated with these acquisitions is
not deductible for federal income tax purposes. The goodwill associated with the acquisitions of
The Brown Schools and Calvary is deductible for federal income tax purposes. The following table summarizes the allocation of the aggregate purchase price of the aforementioned
acquisitions (in thousands): The Brown2003
    
    Ramsay
    
    
    Schools
    
    
    Alliance
    
    
    Calvary
    
    
    TotalAssets acquired:Accounts receivable
    
    $
    18,396
    
    
    $
    11,367
    
    
    $
    1,901
    
    
    $
    70
    
    
    $
    31,734Other current assets
    
    
    7,228
    
    
    
    1,046
    
    
    
    139
    
    
    
    20
    
    
    
    8,433Fixed assets
    
    
    53,050
    
    
    
    43,756
    
    
    
    14,460
    
    
    
    36
    
    
    
    111,302Costs in excess of net assets acquired
    
    
    19,161
    
    
    
    17,377
    
    
    
    1,755
    
    
    
    4,114
    
    
    
    42,407Other assets
    
    
    1,496
    
    
    
    591
    
    
    
    
    
    
    
    9
    
    
    
    2,09699,331
    
    
    
    74,137
    
    
    
    18,255
    
    
    
    4,249
    
    
    
    195,972Liabilities assumed
    
    
    18,536
    
    
    
    9,601
    
    
    
    4,229
    
    
    
    3,591
    
    
    
    35,957Long-term debt issued
    
    
    
    
    
    
    51,171
    
    
    
    12,594
    
    
    
    
    
    
    
    63,765Cash paid, net of cash acquired
    
    $
    80,795
    
    
    $
    13,365
    
    
    $
    1,432
    
    
    $
    658
    
    
    $
    96,250
 2002 ACQUISITIONS During 2002, we acquired one free-standing inpatient psychiatric hospital in Illinois (Riveredge
Hospital). Also during 2002, we merged with PMR, a developer and manager of specialized mental
health programs and disease management services designed to treat individuals diagnosed with a
serious mental illness. The acquisition of Riveredge Hospital and merger with PMR were accounted
for by the purchase method. The aggregate purchase price of these transactions was allocated to the
assets acquired and liabilities assumed based upon their respective fair values. The consolidated
financial statements include the accounts and operations of the acquired entities for periods
subsequent to the respective acquisition dates. As these transactions involved the acquisition of
stock, the goodwill associated with these acquisitions is not deductible for federal income tax
purposes. The purchase of Riveredge Hospital included an escrow arrangement whereby we deposited
$4.5 million of the purchase price with an escrow agent. The escrowed funds will be released to the
seller upon satisfaction of certain earnings targets and indemnification by the seller of certain
claims and cost report settlements. Any claims by us on these escrowed funds would affect the
purchase price. Approximately $1.5 million of these funds were released during 2002. The following table summarizes the allocation of the aggregate purchase price of the aforementioned
acquisitions (in thousands): 2002
    
    Riveredge
    
    
    PMR
    
    
    TotalAssets acquired:Accounts receivable
    
    $
    4,208
    
    
    $
    121
    
    
    $
    4,329Other current assets
    
    
    833
    
    
    
    168
    
    
    
    1,001Fixed assets
    
    
    15,350
    
    
    
    155
    
    
    
    15,505Costs in excess of net assets acquired
    
    
    662
    
    
    
    10,938
    
    
    
    11,600Other assets
    
    
    100
    
    
    
    3,544
    
    
    
    3,64421,153
    
    
    
    14,926
    
    
    
    36,079Liabilities assumed
    
    
    4,289
    
    
    
    5,784
    
    
    
    10,073Subordinated notes issued
    
    
    10,000
    
    
    
    
    
    
    
    10,000Long-term debt issued
    
    
    6,864
    
    
    
    
    
    
    
    6,864Common stock issued
    
    
    
    
    
    
    15,385
    
    
    
    15,385Cash acquired, net of cash paid
    
    $
    
    
    
    $
    (6,243
    )
    
    $
    (6,243
    )
 The purchase price allocation for PMR was completed during the quarter ended March 31, 2003, with
the valuation of identifiable F-18




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 intangible assets acquired in the merger and related deferred tax
liability. Other Information The following represents the unaudited pro forma results of consolidated operations as if the
aforementioned acquisitions had occurred at the beginning of the immediate preceding period, after
giving effect to certain adjustments, including the depreciation and amortization of the assets
acquired based upon their fair values and changes in interest expense resulting from changes in
consolidated debt: 2004
    
    
    2003
    
    
    2002Revenues
    
    $
    532,826
    
    
    $
    508,425
    
    
    $
    362,283Net income available to common stockholders
    
    
    18,896
    
    
    
    11,688
    
    
    
    6,912Earnings per common share, basic
    
    $
    1.30
    
    
    $
    1.40
    
    
    $
    1.13
 The pro forma information for the years ended December 31, 2004 and 2003 includes losses from
refinancing long-term debt of approximately $6.4 million and $4.9 million, respectively. The pro
forma information given does not purport to be indicative of what our results of operations would
have been if the acquisitions had in fact occurred at the beginning of the periods presented, and
is not intended to be a projection of the impact on future results or trends. 6. Long-term debt Long-term debt consists of the following (in thousands): December 31,2004
    
    
    200310 5/8% senior subordinated notes
    
    $
    150,000
    
    
    $
    150,000Mortgage loans on facilities, maturing in 2037 and 2038
bearing fixed interest rates of 5.65% to 5.95%
    
    
    23,611
    
    
    
    23,833Subordinated seller notes with varying maturities
    
    
    369
    
    
    
    1,170Other
    
    
    356
    
    
    
    174,336
    
    
    
    175,003Less current portion
    
    
    20,764
    
    
    
    1,023Long-term debt
    
    $
    153,572
    
    
    $
    173,980
 Senior Credit Facility On January 6, 2004, we terminated our senior credit facility with CapitalSource Finance LLC
(CapSource) and entered into a new credit agreement (the Credit Agreement) with Bank of
America, N.A. (Bank of America) that provided for a revolving credit facility of up to $50
million. As a result of the termination of our senior credit facility with CapSource, we recorded a
loss on refinancing long-term debt of $6.4 million for the quarter ended March 31, 2004, including
approximately $3.8 million paid as a termination fee to CapSource. On December 21, 2004, our credit
agreement with Bank of America was amended and restated to provide for a revolving credit facility
of up to $150 million. Our credit facility with Bank of America is secured by substantially all of
the personal property owned by us or our subsidiaries, substantially all real property owned by us
or our subsidiaries that has a value in excess of $2.5 million and the stock of our operating
subsidiaries. In addition, the credit facility is fully and unconditionally guaranteed by
substantially all of our operating subsidiaries. The revolving line of credit accrues interest at
our choice of the Base Rate or the Eurodollar Rate (as defined in the Credit Agreement) and is
due December 21, 2009. The Base Rate and Eurodollar Rate fluctuate based upon market rates and
certain leverage ratios, as defined in the Credit Agreement. At December 31, 2004, we had no
borrowings outstanding under the revolving credit facility. Until the maturity date, we may borrow,
repay and re-borrow an amount not to exceed $150 million. We pay a quarterly commitment fee of 0.5%
per annum on the unused portion of our revolving credit facility. Prior to the amended and restated
agreement on December 21, 2004 we were required to pay a utilization fee of 0.25% per annum on the
unused portion of the revolving credit facility when the balance of outstanding borrowings under
the revolving credit facility were less than one-third of the borrowings allowed under the
agreement. Commitment and utilization fees were approximately $260,000 for the year ended December
31, 2004. Our revolving credit facility contains customary covenants that include: (1) a limitation on
capital expenditures and investments, sales of assets, mergers, changes of ownership, new principal
lines of business, indebtedness, dividends and redemptions; (2) various financial covenants; and
(3) cross-default covenants triggered by a default of any other indebtedness of at least $3.0
million. As of December 31, 2004, we were in compliance with all debt covenant requirements. If we
violate one or more of these covenants, F-19




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 amounts outstanding under the revolving credit facility
could become immediately payable and additional borrowings could be restricted. 10 5/8% Senior Subordinated Notes On June 30, 2003, we issued $150 million in 10 5/8% senior subordinated notes, which are fully and
unconditionally guaranteed on a senior subordinated basis by substantially all of our existing
operating subsidiaries. Proceeds from the issuance of the senior subordinated notes and the
issuance of $12.5 million in series A convertible preferred stock were used to finance the
acquisition of Ramsay and pay down substantially all of our previously existing long-term debt.
Interest on the senior subordinated notes accrues at the rate of 10.625% per annum and is payable
semi-annually in arrears on June 15 and December 15, commencing on December 15,
2003. The senior subordinated notes will mature on June 15, 2013. On December 15, 2004, we provided the required binding notice to holders of our 10 5/8% senior
subordinated notes that we would repay $50 million of the notes and, on January 14, 2005, we paid
the holders $50 million plus a 10 5/8% penalty and accrued interest. We borrowed $30 million under
our revolving line of credit and used cash on hand for the remainder of the redemption. As a result
of this notice of redemption and subsequent payment, we have classified $20 million of the 10 5/8%
senior subordinated notes as current portion of long-term debt. Mortgage Loans During 2002 and 2003 we borrowed approximately $23.8 million under mortgage loan agreements insured
by the U.S. Department of Housing and Urban Development (HUD). The mortgage loans insured by HUD
are secured by real estate located at Holly Hill Hospital in Raleigh, North Carolina, West Oaks
Hospital in Houston, Texas and Riveredge Hospital near Chicago, Illinois. Interest accrues on the
Holly Hill, West Oaks and Riveredge HUD loans at 5.95%, 5.85% and 5.65% and principal and interest
are payable in 420 monthly installments through December 2037, September 2038 and December 2038,
respectively. We used the proceeds from the mortgage loans to repay approximately $4.4 million in
2002 and $17.0 million in 2003 of our term debt under our former senior credit facility, pay
certain financing costs, and fund required escrow amounts for future improvements to the property.
The carrying amount of assets held as collateral approximated $22 million at December 31, 2004. Senior Subordinated Notes On June 28, 2002, we entered into a securities purchase agreement with The 1818 Mezzanine Fund II,
L.P. (the 1818 Fund) where the 1818 Fund agreed to purchase up to $20 million of senior
subordinated notes with detachable nominal warrants. At the closing on June 28, 2002, a total of
$10 million of the senior subordinated notes were issued. On June 30, 2003, we repaid principal of
$10 million, accrued interest and a prepayment penalty of 3% to the 1818 Fund with proceeds from
our issuance of 10 5/8% senior subordinated notes, and we no longer have the ability to borrow
under the securities purchase agreement with the 1818 Fund. In connection with the issuance of the senior subordinated notes to the 1818 Fund, we issued
detachable stock purchase warrants for the purchase of 372,412 shares of our common stock at an
exercise price of $.01 per share. Also, we provided the 1818 Fund with the ability to require us to
repurchase their warrants or common stock acquired upon exercise of the warrants at fair market
value for cash. The 1818 Fund exercised its stock purchase warrant and received 372,039 shares of
our common stock on May 16, 2003. Because the 1818 Fund had the ability to require us to repurchase
the warrants for cash, the warrants constituted a derivative that required changes in value of the
warrants to be recorded as an increase or decrease to our earnings. In connection with the exercise
of the warrants, the 1818 Fund provided us with a written consent to waive its ability to require
that we repurchase the warrants for cash effective April 1, 2003. As such, we are no longer
required to record non-cash expense for changes in the fair market value of our common stock. In
addition, the 1818 Fund sold its shares of our common stock on December 24, 2003 so it no longer
has the right to require us to repurchase the shares of our common stock it received upon the
exercise of its warrant. Subordinated Seller Notes In connection with an acquisition in 2000, we issued a promissory note payable in the amount of
$400,000 bearing interest at 9% for the year ended December 31, 2000. Principal on this note is
payable in five equal annual installments beginning April 1, 2001. Accrued interest is due and
payable on the first day of each calendar quarter beginning July 1, 2000. The principal amount we
owe on this note is $80,000 at December 31, 2004. In connection with two acquisitions in 2001, we issued two promissory notes totaling $4.5 million.
A $2.5 million note bore interest at 9% per annum and matured June 30, 2002. A $2.0 million note
bears interest at 9% per annum and matures June 30, 2005, with periodic principal and interest
payments due beginning September 30, 2002. The principal amount we owe on this note is
approximately $290,000 at December 31, 2004. F-20




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 These subordinated seller notes contain customary covenants which include a cross-default covenant
with the occurrence of a default of any indebtedness of at least $1,000,000 held by any creditor.
As of December 31, 2004, we were in compliance with these covenants. Subordinated Convertible Notes In connection with an acquisition during May 2000, we issued subordinated convertible notes in the
amount of $3.6 million. The principal amount of these convertible notes and the interest thereon
was converted into 537,908 shares of our common stock in April and May 2003, based on a conversion
price of $8.53 per share. Other The aggregate maturities of long-term debt are as follows (in thousands): 2005
    
    $
    20,7642006
    
    
    4442007
    
    
    2632008
    
    
    2792009
    
    
    295Thereafter
    
    
    152,291Total
    
    $
    174,336
 7. Series A Convertible Preferred Stock In conjunction with our acquisitions of The Brown Schools and Ramsay, we issued 4,545,454 shares of
our series A convertible preferred stock for $25.0 million in equal installments in April and June
of 2003. Each share of series A convertible preferred stock was convertible into one share of our
common stock. Holders of our series A convertible preferred stock were entitled to receive
pay-in-kind dividends, compounded quarterly, equal to 5% per share of the original share price
through March 31, 2005 and 7% per share of the original share price thereafter. Because we may have
been required to redeem the series A convertible preferred stock upon certain change of control
events that may not have been within our control, the series A convertible preferred stock were
classified outside of our permanent stockholders equity. During the year ended December 31, 2004,
the holders of our series A convertible preferred stock converted all shares of series A
convertible preferred stock and related accrued dividends into 4,813,470 shares of our common
stock. 8. Leases At December 31, 2004, future minimum lease payments under leases having an initial or remaining
non-cancelable lease term in excess of one year are as follows (in thousands): 2005
    
    $
    5,6702006
    
    
    5,0852007
    
    
    3,8472008
    
    
    3,2752009
    
    
    3,126Thereafter
    
    
    16,526Total
    
    $
    37,529
 9. Income Taxes Total income tax for the years ended December 31, 2004 and 2003 was allocated as follows (in
thousands): F-21




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 2004
    
    
    2003
    
    
    2002Provision for (benefit from) income taxes attributable
to income from continuing operations
    
    $
    10,432
    
    
    $
    3,800
    
    
    $
    (1,007
    )Benefit from income taxes attributable to
loss from discontinued operations
    
    
    (134
    )
    
    
    (15
    )
    
    
    Total provision for (benefit from) income taxes
    
    $
    10,298
    
    
    $
    3,785
    
    
    $
    (1,007
    )
 The provision for (benefit from) income taxes attributable to income from continuing operations
consists of the following (in
thousands): 2004
    
    
    2003
    
    
    2002Current:Federal
    
    $
    10,117
    
    
    $
    
    
    
    $
    State
    
    
    1,659
    
    
    
    421
    
    
    
    32311,776
    
    
    
    421
    
    
    
    323Deferred:Federal
    
    
    (1,279
    )
    
    
    3,372
    
    
    
    (1,192
    )State
    
    
    (244
    )
    
    
    7
    
    
    
    (138
    )Foreign
    
    
    179
    
    
    
    
    
    
    
    (1,344
    )
    
    
    3,379
    
    
    
    (1,330
    )Provision for income taxes
    
    $
    10,432
    
    
    $
    3,800
    
    
    $
    (1,007
    )
 The reconciliation of income tax computed by applying the U.S. federal statutory rate to the actual
income tax (benefit) expense attributable to income from continuing operations is as follows (in
thousands): 2004
    
    
    2003
    
    
    2002Federal tax
    
    $
    9,609
    
    
    $
    3,074
    
    
    $
    1,590State income taxes (net of federal)
    
    
    919
    
    
    
    282
    
    
    
    179Change in valuation allowance
    
    
    
    
    
    
    
    
    
    
    (2,809
    )Other
    
    
    (96
    )
    
    
    444
    
    
    
    33Provision for (benefit from) income taxes
    
    $
    10,432
    
    
    $
    3,800
    
    
    $
    (1,007
    )
 Deferred income taxes reflect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the amounts used for income
tax purposes. The tax effects of significant items comprising temporary differences at December 31,
2004 and 2003 are as follows (in thousands): 2004
    
    
    2003Deferred tax assets:Net operating loss carryforwards
    
    $
    15,491
    
    
    $
    17,711Allowance for doubtful accounts
    
    
    2,550
    
    
    
    1,955Capital loss carryforwards
    
    
    
    
    
    
    445Alternative minimum tax credit carryovers
    
    
    1,244
    
    
    
    1,150Accrued Liabilities
    
    
    8,270
    
    
    
    3,498Other
    
    
    18
    
    
    
    Total gross deferred tax assets
    
    
    27,573
    
    
    
    24,759Less: Valuation allowance
    
    
    (3,435
    )
    
    
    (11,283
    )Total deferred tax assets
    
    
    24,138
    
    
    
    13,476Deferred tax liabilities:Intangible assets
    
    
    (8,048
    )
    
    
    (6,867
    )Property and equipment
    
    
    (15,002
    )
    
    
    (13,201
    )Other
    
    
    (453
    )
    
    
    (170
    )Net deferred tax asset (liability)
    
    $
    635
    
    
    $
    (6,762
    )
 F-22




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Current accounting standards generally accepted in the United States (GAAP) require that deferred
income taxes reflect the tax consequences of differences between the tax bases of assets and
liabilities and their carrying values for GAAP. Future tax benefits are recognized to the extent
that realization of such benefits is more likely than not. A valuation allowance is established for
those benefits that do not meet the more likely than not criteria. We have evaluated the need for a
valuation allowance against deferred tax assets and have established a valuation allowance of $3.4
million and $11.3 million at December 31, 2004 and 2003, respectively. The valuation allowances at
December 31, 2004 and 2003 relate primarily to deferred tax assets acquired in the Ramsay and PMR
acquisitions. The 2004 reduction in valuation allowance for deferred tax assets was primarily the
release to goodwill of valuation allowances on net operating loss carryforwards established at the
acquisition of Ramsay and the expiration of capital loss carryforwards which had been reserved. As of December 31, 2004, we had federal net operating loss carryforwards of $34.6 million expiring
in the years 2012 through 2023, state net operating loss carryforwards of $47.1 million expiring in
various years through 2024, foreign net operating loss carryforwards of $4.9 million expiring
through 2023 and an alternative minimum tax credit carryover of approximately $1.2 million
available to reduce future federal income taxes. As of December 31, 2004 and 2003, we also had
approximately $5.6 million and $400,000, respectively, in income tax payable, which is included in
other accrued current liabilities in the accompanying consolidated balance sheets. 10. Stock Option Plans Upon the merger with PMR on August 5, 2002, we acquired PMRs 1997 Equity Incentive Plan, which was
subsequently renamed the Psychiatric Solutions, Inc. Equity Incentive Plan (the Equity Incentive
Plan). The Equity Incentive Plan was amended and restated at our 2004 Annual Meeting of
Stockholders to increase the number of shares of our common stock subject to grant under the Equity
Incentive Plan to 2,933,333 from 2,233,333. Under the Equity Incentive Plan, options may be granted
for terms of up to ten years and are generally exercisable in cumulative annual increments of 25%
each year, commencing one year after the date of grant. The exercise prices of incentive stock
options and nonqualified options shall not be less than 100% and 85%, respectively, of the fair
market value of the common shares on the trading day immediately preceding the date of grant. Also upon the merger with PMR, we acquired PMRs Outside Directors Non-qualified Stock Option Plan
of 1992, which was subsequently renamed the Psychiatric Solutions, Inc. Outside Directors Stock
Option Plan (the Directors Plan). The Directors Plan provides for a grant of 4,000 stock
options at each annual meeting of stockholders to each outside director at the fair market value of
our common shares on the trading day immediately preceding the date of grant. The options vest 25%
on the grant date and 25% on the succeeding three anniversaries of the grant date. Options for a
maximum of 341,667 shares may be granted under the Directors Plan. During 2002, we recognized $118,000 compensation expense related to stock options issued to certain
officers and employees with exercise prices below fair market value. No options with exercise
prices below fair market value were granted during 2004 or 2003. Stock option activity, including options granted for acquisitions, is as follows (number of options
in thousands): F-23




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 WeightedNumber
    
    
    
    
    
    
    Averageof
    
    
    Option
    
    
    ExerciseOptions
    
    
    Exercise Price
    
    
    PriceBalance at December 31, 2001
    
    
    214
    
    
    $
    0.87 to $3.04
    
    
    $
    2.08Granted
    
    
    515
    
    
    $
    0.87 to $5.50
    
    
    $
    5.07Stock options acquired
    
    
    408
    
    
    $
    4.50 to $30.00
    
    
    $
    17.10Canceled
    
    
    (26
    )
    
    $
    0.87 to $29.25
    
    
    $
    4.28Exercised
    
    
    (38
    )
    
    $
    0.87 to $3.04
    
    
    $
    1.14Balance at December 31, 2002
    
    
    1,073
    
    
    $
    0.87 to $30.00
    
    
    $
    9.21Granted
    
    
    713
    
    
    $
    5.05 to $13.75
    
    
    $
    10.77Canceled
    
    
    (83
    )
    
    $
    0.87 to $30.00
    
    
    $
    11.38Exercised
    
    
    (64
    )
    
    $
    0.87 to $9.56
    
    
    $
    4.92Balance at December 31, 2003
    
    
    1,639
    
    
    $
    0.87 to $30.00
    
    
    $
    9.94Granted
    
    
    710
    
    
    $
    19.95 to $26.19
    
    
    $
    21.29Canceled
    
    
    (124
    )
    
    $
    3.04 to $30.00
    
    
    $
    13.61Exercised
    
    
    (459
    )
    
    $
    0.87 to $30.00
    
    
    $
    11.72Balance at December 31, 2004
    
    
    1,766
    
    
    $
    0.87 to $30.00
    
    
    $
    13.78
 The following table summarizes information concerning outstanding and exercisable options at
December 31, 2004 (number of options in thousands). Options Outstanding
    
    
    Options ExercisableWeighted Avg.
    
    
    WeightedRemaining
    
    
    AverageNumber
    
    
    Contractual
    
    
    Exercise
    
    
    NumberExercise Prices
    
    Outstanding
    
    
    Life (in years)
    
    
    Price
    
    
    Exercisable$0.87 to $4.99
    
    
    78
    
    
    
    4.9
    
    
    $
    1.61
    
    
    
    76$5.00 to $9.99
    
    
    576
    
    
    
    7.6
    
    
    $
    5.90
    
    
    
    239$10.00 to $14.99
    
    
    377
    
    
    
    8.7
    
    
    $
    13.28
    
    
    
    95$15.00 to $19.99
    
    
    157
    
    
    
    8.8
    
    
    $
    19.88
    
    
    
    8$20.00 to $24.99
    
    
    502
    
    
    
    8.4
    
    
    $
    21.15
    
    
    
    128$25.00 to $30.00
    
    
    76
    
    
    
    7.5
    
    
    $
    30.00
    
    
    
    17$0.87 to $30.00
    
    
    1,766
    
    
    
    8.0
    
    
    $
    10.98
    
    
    
    563
 11. Employee Benefit Plan We sponsor the Psychiatric Solutions, Inc. Retirement Savings Plan (the Plan). The Plan is a
tax-qualified profit sharing plan with a cash or deferred arrangement whereby employees who have
completed three months of service and are age 21 or older are eligible to participate. The Plan
allows eligible employees to make contributions of 1% to 85% of their annual compensation, subject
to annual limitations. The Plan enables us to make discretionary contributions into each
participants account that fully vest over a four year period based upon years of service. 12. Contingencies and Health Care Regulation Contingencies We are subject to various claims and legal actions which arise in the ordinary course of
business. We have professional liability insurance to protect against such claims or legal actions.
We believe the ultimate resolution of such matters will be adequately covered by insurance and will
not have a material adverse effect on our financial position or results of operations. Employment Agreements Effective August 6, 2002, we entered into an Amended and Restated Employment Agreement with Joey A.
Jacobs, our Chairman, Chief Executive Officer and President. Mr. Jacobs Amended and Restated
Employment Agreement was amended on November 26, 2003. Mr. Jacobs agreement provides for an annual
base salary and an annual cash incentive compensation award tied to objective criteria as
established by the board of directors. The employment agreement has an initial term of one year and
is subject to automatic F-24




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 annual renewals absent prior notice from either party. Mr. Jacobs employment agreement provides for various payments to Mr. Jacobs upon cessation of
employment, depending on the circumstances. If we terminate Mr. Jacobss employment without cause
or if he resigns pursuant to a constructive discharge, then (i) all options scheduled to vest
during the succeeding 24 month period will immediately vest and will remain exercisable for 12
months from the date of termination, (ii) certain restricted stock will immediately vest, (iii) Mr.
Jacobs will receive a cash payment equal to 200% of his base salary and bonus earned during the
twelve months prior to termination, and (iv) all benefits and perquisites will continue for 18
months. In the event of a change in control, his employment agreement requires that we pay him 200%
of his base salary and bonus earned in the twelve months prior to termination, paid out over a
period of 24 months, and to continue all benefits and perquisites for 18 months. Effective October 1, 2002, we entered into an employment agreement with Jack Salberg, our Chief
Operating Officer. Mr. Salbergs agreement provides for an annual base salary and an annual cash
incentive compensation award tied to objective criteria established by the board of directors. The
employment agreement had an initial term of 15 months, subject to automatic annual renewals absent
prior notice from either party. Mr. Salbergs employment agreement provides for various payments to Mr. Salberg upon cessation of
employment, depending upon the circumstances. If we terminate Mr. Salbergs employment without
cause or if he resigns pursuant to a constructive discharge, then (i) all options scheduled to vest
during the succeeding 18 months will immediately vest, (ii) any restricted stock will immediately
vest, (iii) Mr. Salberg will receive a cash payment equal to 150% of his base salary and bonus
earned in 12 months prior to termination, and (iv) all benefits and perquisites will continue for
18 months. If Mr. Salberg is terminated after a change in control, his employment agreement
requires we pay him a cash amount equal to 150% of his base salary and bonus earned during the 12
months prior to termination, paid out over a period of 18 months, and to continue all benefits and
perquisites for 18 months. Current Operations Final determination of amounts earned under prospective payment and cost-reimbursement activities
is subject to review by appropriate governmental authorities or their agents. We believe adequate
provision has been made for any adjustments that may result from such reviews. Laws and regulations governing the Medicare and Medicaid programs are complex and subject to
interpretation. We believe that we are in compliance with all applicable laws and regulations and
are not aware of any pending or threatened investigations involving allegations of potential
wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and
regulations can be subject to future government review and interpretation as well as significant
regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid
programs. We have acquired and may continue to acquire professional corporations with prior operating
histories. Acquired corporations may have unknown or contingent liabilities for failure to comply
with health care laws and regulations, such as billing and reimbursement, fraud and abuse and
similar anti-referral laws. Although we attempt to assure ourselves that no such liabilities exist
and obtain indemnification from prospective sellers covering such matters, there can be no
assurance that any such matter will be covered by indemnification or, if covered, that the
liability sustained will not exceed contractual limits or the financial capacity of the
indemnifying party. 13. Related Party Transactions Joey Jacobs, our Chief Executive Officer, served as a member of the board of directors of Stones
River Hospital until the first quarter of 2003, a hospital in which we manage a psychiatric unit
pursuant to a management agreement. The term of the third amendment to the management agreement is
two years, and automatically renews for one year terms unless terminated by either party. Total
revenue from this management agreement was $783,000 for the year ended December 31, 2003. We
believe the terms of the management agreement are consistent with management agreements negotiated
at arms-length. Jack Salberg, our Chief Operating Officer, served as a minority owner and member of the board of
directors of the entity which owned Riveredge Hospital prior to our acquisition of it in July 2002.
Mr. Salberg disclosed his interest to the board of directors and was not directly involved in the
negotiations to acquire the hospital. We believe that the purchase price paid for the Riveredge
acquisition constituted our best estimate of fair value. All terms were negotiated on an
arms-length basis. Edward Wissing, one of our outside directors, occasionally provided advisory and consulting
services during 2002 to Brentwood Capital Advisors, our financial advisor. Mr. Wissing also was a
party to a consulting arrangement with Brentwood Capital pursuant to which he provided certain
consulting services. According to the terms of this consulting arrangement, Mr. Wissing received a
fixed F-25




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 consulting fee of $5,000 per month beginning in August 2002 and ending in May 2003. In January 2000, PMR loaned Mark. P. Clein, PMRs chief executive officer at the time and currently
one of our directors, $467,500 pursuant to promissory notes for the purchase of stock in connection
with the exercise of stock options (the Stock Notes). The Stock Notes, due December 31, 2004,
bear interest at the rate of 6.21% per annum and are with recourse in addition to being secured by
stock under pledge agreements. PMR also received promissory notes from Mr. Clein for up to $257,208
for tax liabilities related to the purchase of such stock (the Tax Notes). The Tax Notes, due
December 31, 2004, bear interest at the rate of 6.21% and are secured by stock pledges, but are
otherwise without recourse. During the third quarter of 2004, Mr. Clien repaid the remaining
principal balance of $338,000 on the Stock Notes and Tax Notes. Joseph P. Donlan, a former director of the Company, is the co-manager of the 1818 Fund. On June 28,
2002, we entered into a securities purchase agreement with the 1818 Fund where the 1818 Fund agreed
to purchase up to $20 million of senior subordinated notes with detachable warrants. At the closing
on June 28, 2002, a total of $10 million of the senior subordinated notes were issued. On June 30,
2003, we repaid principal of $10 million, accrued interest and a prepayment penalty of 3% to the
1818 Fund with proceeds from our issuance of 10 5/8% senior subordinated notes, and we no longer
have the ability to borrow under the Securities Purchase Agreement with the 1818 Fund. On February 4, 2003, our stockholders approved the private placement of $25 million of series A
convertible preferred stock with affiliates of Oak Investment Partners and Salix Ventures and the
1818 Fund. The 1818 Fund invested an aggregate of $1 million and received an aggregate of 181,818
shares of series A convertible preferred stock. Oak Investment Partners invested an aggregate of
$20 million and received an aggregate of 3,636,364 shares of series A convertible preferred stock.
Salix Ventures invested an aggregate of $4 million and received an aggregate of 727,272 shares of
series A convertible preferred stock. One half of the series A convertible preferred stock was
issued on April 1, 2003. The other half was issued on June 19, 2003. The 1818 Fund, Oak Investment
Partners and Salix Ventures each had a representative who was a member of our board of directors
when we sold the series A convertible preferred stock. The proceeds of the sale of the series A
convertible preferred stock were used to acquire Ramsay, six facilities from The Brown Schools, and
to pay down a portion of our long-term debt. During 2004, the holders of series A convertible
preferred stock converted all outstanding shares of series A convertible preferred stock and
related pay-in-kind dividends into 4,813,470 shares of our common stock. Currently we lease 7,745 square feet of office space from a company in which Dr. Richard Treadway,
the former chairman of our board of directors, is a minority investor. The lease was entered into
in October 2001 and has a term of approximately six years. The annual rent under this lease is
approximately $158,000. We believe the terms of this lease are at fair market value. We currently
sublease this space to a third party. 14. Disclosures About Reportable Segments In accordance with the criteria of Statement of Financial Accounting Standards No. 131, Disclosures
About Segments of an Enterprise and Related Information, (SFAS 131) we operate two reportable
segments: (1) owned and leased facilities and (2) management contracts. Each of our inpatient
facilities and inpatient management contracts qualifies as an operating segment under SFAS 131;
however, none is individually material. We have aggregated our operations into two reportable
segments based on the characteristics of the services provided. As of December 31, 2004, the owned
and leased facilities segment provides mental health and behavioral heath services to patients in
its 27 owned and 7 leased inpatient facilities in 19 states. The management contracts segment
provides inpatient psychiatric management and development services to 41 inpatient behavioral
health units in hospitals and clinics in 15 states and provides mental health and behavioral health
services to 8 inpatient facilities for state government agencies. Activities classified as
Corporate and Other in the following schedule relate primarily to unallocated home office items. Adjusted EBITDA is a non-GAAP financial measure and is defined as net income (loss) before
discontinued operations, interest expense (net of interest income), income taxes, depreciation,
amortization, stock compensation and other items included in the caption labeled Other expenses.
These other expenses may occur in future periods, but the amounts recognized can vary significantly
from period to period and do not directly relate to ongoing operations of our health care
facilities. Our management relies on adjusted EBITDA as the primary measure to review and assess
the operating performance of our inpatient facilities and their management teams. We believe it is
useful to investors to provide disclosures of our operating results on the same basis as that used
by management. Management and investors also review adjusted EBITDA to evaluate our overall
performance and to compare our current operating results with corresponding periods and with other
companies in the health care industry. You should not consider adjusted EBITDA in isolation or as a
substitute for net income, operating cash flows or other cash flow statement data determined in
accordance with accounting principles generally accepted in the United States. Because adjusted
EBITDA is not a measure of financial performance under accounting principles generally accepted in
the United States and is susceptible to varying calculations, it may not be comparable to similarly
titled measures of other companies. The following is a financial
summary by reportable segment for F-26




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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 the periods indicated (dollars in thousands): Year ended
December 31, 2004 Owned andLeased
    
    
    Management
    
    
    CorporateFacilities
    
    
    Contracts
    
    
    and Other
    
    
    ConsolidatedRevenue
    
    $
    419,299
    
    
    $
    67,891
    
    
    $
    
    
    
    $
    487,190Adjusted EBITDA
    
    $
    66,309
    
    
    $
    11,021
    
    
    $
    (14,639
    )
    
    $
    62,691Interest expense, net
    
    
    19,645
    
    
    
    (15
    )
    
    
    (666
    )
    
    
    18,964Provision for income taxes
    
    
    2,737
    
    
    
    
    
    
    
    7,695
    
    
    
    10,432Depreciation and amortization
    
    
    8,353
    
    
    
    1,155
    
    
    
    360
    
    
    
    9,868Inter-segment expenses
    
    
    11,471
    
    
    
    3,330
    
    
    
    (14,801
    )
    
    
    Other expenses:Loss on refinancing long-term debt
    
    
    
    
    
    
    
    
    
    
    6,407
    
    
    
    6,407Total other expenses
    
    
    
    
    
    
    
    
    
    
    6,407
    
    
    
    6,407Income (loss) from continuing operations
    
    $
    24,103
    
    
    $
    6,551
    
    
    $
    (13,634
    )
    
    $
    17,020Total assets
    
    $
    402,953
    
    
    $
    33,917
    
    
    $
    60,976
    
    
    $
    497,846Capital expenditures
    
    $
    15,632
    
    
    $
    
    
    
    $
    1,584
    
    
    $
    17,216Cost in excess of net assets acquired
    
    $
    106,313
    
    
    $
    23,766
    
    
    $
    
    
    
    $
    130,079
 Year ended December 31, 2003 Owned andLeased
    
    
    Management
    
    
    CorporateFacilities
    
    
    Contracts
    
    
    and Other
    
    
    ConsolidatedRevenue
    
    $
    223,340
    
    
    $
    61,606
    
    
    $
    
    
    
    $
    284,946Adjusted EBITDA
    
    $
    30,801
    
    
    $
    11,365
    
    
    $
    (7,339
    )
    
    $
    34,827Interest expense, net
    
    
    6,996
    
    
    
    92
    
    
    
    7,693
    
    
    
    14,781Provision for income taxes
    
    
    2,165
    
    
    
    73
    
    
    
    1,562
    
    
    
    3,800Depreciation and amortization
    
    
    4,410
    
    
    
    1,135
    
    
    
    189
    
    
    
    5,734Inter-segment expenses
    
    
    5,639
    
    
    
    1,432
    
    
    
    (7,071
    )
    
    
    Other expenses:Loss on refinancing long-term debt
    
    
    
    
    
    
    
    
    
    
    4,856
    
    
    
    4,856Change in valuation of put warrants
    
    
    
    
    
    
    
    
    
    
    960
    
    
    
    960Change in reserve of stockholder notes
    
    
    
    
    
    
    (545
    )
    
    
    
    
    
    
    (545
    )Total other expenses
    
    
    
    
    
    
    (545
    )
    
    
    5,816
    
    
    
    5,271Income (loss) from continuing operations
    
    $
    11,591
    
    
    $
    9,178
    
    
    $
    (15,528
    )
    
    $
    5,241Total assets
    
    $
    246,526
    
    
    $
    35,599
    
    
    $
    65,533
    
    
    $
    347,658Capital expenditures
    
    $
    5,516
    
    
    $
    
    
    
    $
    239
    
    
    $
    5,755Cost in excess of net assets acquired
    
    $
    45,093
    
    
    $
    23,877
    
    
    $
    
    
    
    $
    68,970
 F-27




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Year ended December 31, 2002 Owned andLeased
    
    
    Management
    
    
    CorporateFacilities
    
    
    Contracts
    
    
    and Other
    
    
    ConsolidatedRevenue
    
    $
    81,929
    
    
    $
    31,983
    
    
    $
    
    
    
    $
    113,912Adjusted EBITDA
    
    $
    9,343
    
    
    $
    7,082
    
    
    $
    (4,118
    )
    
    $
    12,307Interest expense
    
    
    3,375
    
    
    
    325
    
    
    
    1,864
    
    
    
    5,564Provision for (benefit from) income taxes
    
    
    
    
    
    
    324
    
    
    
    (1,331
    )
    
    
    (1,007
    )Depreciation and amortization
    
    
    1,286
    
    
    
    379
    
    
    
    105
    
    
    
    1,770Inter-segment expenses
    
    
    3,149
    
    
    
    902
    
    
    
    (4,051
    )
    
    
    Other expenses:Stock compensation expense
    
    
    
    
    
    
    
    
    
    
    118
    
    
    
    118Loss on refinancing long-term debt
    
    
    
    
    
    
    
    
    
    
    86
    
    
    
    86Change in reserve of stockholder notes
    
    
    
    
    
    
    92
    
    
    
    
    
    
    
    92Total other expenses
    
    
    
    
    
    
    92
    
    
    
    204
    
    
    
    296Income (loss) from continuing operations
    
    $
    1,533
    
    
    $
    5,060
    
    
    $
    (909
    )
    
    $
    5,684Total assets
    
    $
    51,004
    
    
    $
    33,012
    
    
    $
    6,122
    
    
    $
    90,138Capital expenditures
    
    $
    677
    
    
    $
    171
    
    
    $
    622
    
    
    $
    1,470Cost in excess of net assets acquired
    
    $
    1,238
    
    
    $
    27,580
    
    
    $
    4
    
    
    $
    28,822
 15. Other Information A summary of activity in allowance for doubtful accounts follows (in thousands): Balances
    
    
    Additions
    
    
    Additions
    
    
    Accounts written
    
    
    Balancesat beginning
    
    
    charged to costs
    
    
    charged to
    
    
    off, net of
    
    
    at endof period
    
    
    and expenses
    
    
    other accounts (1)
    
    
    recoveries
    
    
    of periodAllowance for doubtful accounts:Year ended December 31, 2002
    
    $
    3,940
    
    
    
    3,681
    
    
    
    461
    
    
    
    2,798
    
    
    $
    5,284Year ended December 31, 2003
    
    $
    5,284
    
    
    
    6,315
    
    
    
    4,338
    
    
    
    8,446
    
    
    $
    7,491Year ended December 31, 2004
    
    $
    7,491
    
    
    
    10,874
    
    
    
    3,253
    
    
    
    10,979
    
    
    $
    10,639
  (1)
    Allowances as a result of acquisition. 16. Quarterly Information (Unaudited) As discussed in Note 4, we exited three of our contracts to manage state-owned facilities in
Florida during 2004 which have been accounted for as discontinued operations in accordance with
SFAS 144. Accordingly, the operations of these contracts, net of income tax, have been presented as
discontinued operations and all prior quarterly data has been reclassified. Summarized results for
each quarter in the years ended December 31, 2004 and 2003 are as follows (in thousands, except per
share data): F-28




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 1stQuarter
    
    
    2nd Quarter
    
    
    3rd Quarter
    
    
    4th Quarter2004Revenue
    
    $
    103,430
    
    
    $
    116,936
    
    
    $
    131,591
    
    
    $
    135,233Income from continuing operations
    
    $
    107
    
    
    $
    5,277
    
    
    $
    5,346
    
    
    $
    6,290Net (loss) income available to common stockholders
    
    $
    (360
    )
    
    $
    4,923
    
    
    $
    5,215
    
    
    $
    6,360Earnings per share:Basic
    
    $
    (0.03
    )
    
    $
    0.35
    
    
    $
    0.35
    
    
    $
    0.37Diluted
    
    $
    (0.03
    )
    
    $
    0.29
    
    
    $
    0.31
    
    
    $
    0.352003Revenue
    
    $
    37,104
    
    
    $
    57,438
    
    
    $
    93,923
    
    
    $
    96,481Income (loss) from continuing operations
    
    $
    789
    
    
    $
    (594
    )
    
    $
    2,307
    
    
    $
    2,739Net income (loss) available to common stockholders
    
    $
    789
    
    
    $
    (771
    )
    
    $
    2,103
    
    
    $
    2,284Earnings per share:Basic
    
    $
    0.10
    
    
    $
    (0.09
    )
    
    $
    0.24
    
    
    $
    0.26Diluted
    
    $
    0.10
    
    
    $
    (0.09
    )
    
    $
    0.18
    
    
    $
    0.19
 In the first quarter of 2004, we incurred a loss on refinancing long-term debt of approximately
$6.4 million in conjunction with the termination of our credit agreement with CapSource. In the
second quarter of 2003, we incurred a loss on refinancing long-term debt of approximately $4.6
million in conjunction with early repayments of portions of our long-term debt with proceeds from
our issuance of $150 million in 10 5/8% senior subordinated notes. 17. Financial Information for the Company and Its Subsidiaries We conduct substantially all of our business through our subsidiaries. Presented below is
consolidated financial information for us and our subsidiaries as of December 31, 2004 and 2003,
and for the years ended December 31, 2004, 2003 and 2002. The information segregates the parent
company (Psychiatric Solutions, Inc.), the combined wholly-owned subsidiary guarantors, the
combined non-guarantors, and eliminations. All of the subsidiary guarantees are both full and
unconditional and joint and several. F-29




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Balance Sheet
As of December 31, 2004
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmountsCurrent Assets:Cash and
cash equivalents
    
    $
    
    
    
    $
    30,792
    
    
    $
    2,463
    
    
    $
    
    
    
    $
    33,255Accounts receivable, net
    
    
    
    
    
    
    77,539
    
    
    
    
    
    
    
    
    
    
    
    77,539Prepaids and other
    
    
    
    
    
    
    15,437
    
    
    
    975
    
    
    
    
    
    
    
    16,412Total current assets
    
    
    
    
    
    
    123,768
    
    
    
    3,438
    
    
    
    
    
    
    
    127,206Property and equipment, net of accumulated depreciation
    
    
    
    
    
    
    196,152
    
    
    
    30,155
    
    
    
    (8,076
    )
    
    
    218,231Cost in excess of net assets acquired
    
    
    
    
    
    
    130,079
    
    
    
    
    
    
    
    
    
    
    
    130,079Investment in subsidiaries
    
    
    160,065
    
    
    
    
    
    
    
    
    
    
    
    (160,065
    )
    
    
    Other assets
    
    
    6,791
    
    
    
    11,974
    
    
    
    3,565
    
    
    
    
    
    
    
    22,330Total assets
    
    $
    166,856
    
    
    $
    461,973
    
    
    $
    37,158
    
    
    $
    (168,141
    )
    
    $
    497,846Current Liabilities:Accounts payable
    
    $
    
    
    
    $
    10,529
    
    
    $
    
    
    
    $
    
    
    
    $
    10,529Salaries and benefits payable
    
    
    
    
    
    
    27,355
    
    
    
    
    
    
    
    
    
    
    
    27,355Other accrued liabilities
    
    
    1,162
    
    
    
    27,383
    
    
    
    1,682
    
    
    
    (1,559
    )
    
    
    28,668Current portion of long-term debt
    
    
    20,529
    
    
    
    
    
    
    
    235
    
    
    
    
    
    
    
    20,764Total current liabilities
    
    
    21,691
    
    
    
    65,267
    
    
    
    1,917
    
    
    
    (1,559
    )
    
    
    87,316Long-term debt, less current portion
    
    
    130,195
    
    
    
    
    
    
    
    23,377
    
    
    
    
    
    
    
    153,572Deferred tax liability
    
    
    
    
    
    
    8,020
    
    
    
    
    
    
    
    
    
    
    
    8,020Other liabilities
    
    
    3,325
    
    
    
    (461
    )
    
    
    
    
    
    
    1,559
    
    
    
    4,423Total liabilities
    
    
    155,211
    
    
    
    72,826
    
    
    
    25,294
    
    
    
    
    
    
    
    253,331Stockholders equity:Total stockholders equity
    
    
    11,645
    
    
    
    389,147
    
    
    
    11,864
    
    
    
    (168,141
    )
    
    
    244,515Total liabilities and stockholders equity
    
    $
    166,856
    
    
    $
    461,973
    
    
    $
    37,158
    
    
    $
    (168,141
    )
    
    $
    497,846
 F-30




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Balance Sheet
As of December 31, 2003
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmounCurrent Assets:Cash and
cash equivalents
    
    $
    
    
    
    $
    43,456
    
    
    $
    1,498
    
    
    
    
    
    
    $
    44,954Accounts receivable, net
    
    
    
    
    
    
    56,617
    
    
    
    
    
    
    
    
    
    
    
    56,617Prepaids and other
    
    
    
    
    
    
    11,056
    
    
    
    19
    
    
    
    
    
    
    
    11,075Total current assets
    
    
    
    
    
    
    111,129
    
    
    
    1,517
    
    
    
    
    
    
    
    112,646Property and equipment, net of accumulated depreciation
    
    
    
    
    
    
    126,879
    
    
    
    31,029
    
    
    
    (8,319
    )
    
    
    149,589Cost in excess of net assets acquired
    
    
    
    
    
    
    68,970
    
    
    
    
    
    
    
    
    
    
    
    68,970Investment in subsidiaries
    
    
    199,154
    
    
    
    
    
    
    
    
    
    
    
    (199,154
    )
    
    
    Other assets
    
    
    7,731
    
    
    
    4,769
    
    
    
    3,953
    
    
    
    
    
    
    
    16,453Total assets
    
    $
    206,885
    
    
    $
    311,747
    
    
    $
    36,499
    
    
    $
    (207,473
    )
    
    $
    347,658Current Liabilities:Accounts payable
    
    $
    
    
    
    $
    11,417
    
    
    $
    
    
    
    $
    
    
    
    $
    11,417Salaries and benefits payable
    
    
    
    
    
    
    13,074
    
    
    
    
    
    
    
    
    
    
    
    13,074Other accrued liabilities
    
    
    871
    
    
    
    18,987
    
    
    
    1,090
    
    
    
    (969
    )
    
    
    19,979Current portion of long-term debt
    
    
    
    
    
    
    801
    
    
    
    222
    
    
    
    
    
    
    
    1,023Total current liabilities
    
    
    871
    
    
    
    44,279
    
    
    
    1,312
    
    
    
    (969
    )
    
    
    45,493Long-term debt, less current portion
    
    
    150,369
    
    
    
    
    
    
    
    23,611
    
    
    
    
    
    
    
    173,980Deferred tax liability
    
    
    
    
    
    
    6,762
    
    
    
    
    
    
    
    
    
    
    
    6,762Other liabilities
    
    
    3,218
    
    
    
    592
    
    
    
    
    
    
    
    969
    
    
    
    4,779Total liabilities
    
    
    154,458
    
    
    
    51,633
    
    
    
    24,923
    
    
    
    
    
    
    
    231,014Series A convertible preferred stock
    
    
    25,316
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25,316Stockholders equity:Total stockholders equity
    
    
    27,111
    
    
    
    260,114
    
    
    
    11,576
    
    
    
    (207,473
    )
    
    
    91,328Total liabilities and stockholders equity
    
    $
    206,885
    
    
    $
    311,747
    
    
    $
    36,499
    
    $
    $
    (207,473
    )
    
    $
    347,658
 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Income
For the Year Ended December 31, 2004
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmounRevenue
    
    $
    
    
    
    $
    487,190
    
    
    $
    3,702
    
    
    $
    (3,702
    )
    
    $
    487,190Salaries, wages and employee benefits
    
    
    
    
    
    
    265,678
    
    
    
    
    
    
    
    
    
    
    
    265,678Professional fees
    
    
    
    
    
    
    53,200
    
    
    
    58
    
    
    
    
    
    
    
    53,258Supplies
    
    
    
    
    
    
    31,139
    
    
    
    
    
    
    
    
    
    
    
    31,139Rentals and leases
    
    
    
    
    
    
    9,019
    
    
    
    
    
    
    
    
    
    
    
    9,019Other operating expenses
    
    
    
    
    
    
    54,521
    
    
    
    618
    
    
    
    (608
    )
    
    
    54,531Provision for bad debts
    
    
    
    
    
    
    10,874
    
    
    
    
    
    
    
    
    
    
    
    10,874Depreciation and amortization
    
    
    
    
    
    
    9,136
    
    
    
    975
    
    
    
    (243
    )
    
    
    9,868Interest expense
    
    
    17,469
    
    
    
    
    
    
    
    1,495
    
    
    
    
    
    
    
    18,964Loss on refinancing of long-term debt
    
    
    6,407
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,40723,876
    
    
    
    433,567
    
    
    
    3,146
    
    
    
    (851
    )
    
    
    459,738(Loss) income from continuing operations before
income taxes
    
    
    (23,876
    )
    
    
    53,623
    
    
    
    556
    
    
    
    (2,851
    )
    
    
    27,452(Benefit from) provision for income taxes
    
    
    (9,073
    )
    
    
    19,505
    
    
    
    
    
    
    
    
    
    
    
    10,432(Loss) income from continuing operations
    
    
    (14,803
    )
    
    
    34,118
    
    
    
    556
    
    
    
    (2,851
    )
    
    
    17,020Loss from
discontinued operations
    
    
    
    
    
    
    (219
    )
    
    
    
    
    
    
    
    
    
    
    (219
    )Net (loss) income
    
    
    (14,803
    )
    
    
    33,899
    
    
    
    556
    
    
    
    (2,851
    )
    
    
    16,801Accrued preferred stock dividends
    
    
    663
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    663Net (loss) income available to common shareholders
    
    $
    (15,466
    )
    
    $
    33,899
    
    
    $
    556
    
    
    $
    (2,851
    )
    
    $
    16,138
 F-31




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Income
For the Year Ended December 31, 2003
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmounRevenue
    
    $
    
    
    
    $
    284,946
    
    
    $
    1,802
    
    
    $
    (1,802
    )
    
    $
    284,946Salaries, wages and employee benefits
    
    
    
    
    
    
    147,069
    
    
    
    
    
    
    
    
    
    
    
    147,069Professional fees
    
    
    
    
    
    
    32,372
    
    
    
    94
    
    
    
    
    
    
    
    32,466Supplies
    
    
    
    
    
    
    16,371
    
    
    
    
    
    
    
    
    
    
    
    16,371Rentals and leases
    
    
    
    
    
    
    4,043
    
    
    
    
    
    
    
    
    
    
    
    4,043Other operating expenses
    
    
    545
    
    
    
    45,109
    
    
    
    903
    
    
    
    (2,702
    )
    
    
    43,855Provision for bad debts
    
    
    
    
    
    
    6,315
    
    
    
    
    
    
    
    
    
    
    
    6,315Depreciation and amortization
    
    
    
    
    
    
    5,287
    
    
    
    447
    
    
    
    
    
    
    
    5,734Interest expense
    
    
    14,089
    
    
    
    124
    
    
    
    568
    
    
    
    
    
    
    
    14,781Loss on refinancing of long-term debt
    
    
    4,856
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,856Change in valuation of put warrants
    
    
    960
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    960Change in reserve of stockholder notes
    
    
    (545
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (545
    )19,905
    
    
    
    256,690
    
    
    
    2,012
    
    
    
    (2,702
    )
    
    
    275,905(Loss) income from continuing operations before
income taxes
    
    
    (19,905
    )
    
    
    28,256
    
    
    
    (210
    )
    
    
    900
    
    
    
    9,041(Benefit from) provision for income taxes
    
    
    (7,357
    )
    
    
    11,156
    
    
    
    1
    
    
    
    
    
    
    
    3,800(Loss) income from continuing operations
    
    
    (12,548
    )
    
    
    17,100
    
    
    
    (211
    )
    
    
    900
    
    
    
    5,241Loss from
discontinued operations
    
    
    
    
    
    
    (25
    )
    
    
    
    
    
    
    
    
    
    
    (25
    )Net (loss) income
    
    
    (12,548
    )
    
    
    17,075
    
    
    
    (211
    )
    
    
    900
    
    
    
    5,216Accrued preferred stock dividends
    
    
    811
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    811Net (loss) income available to common shareholders
    
    $
    (13,359
    )
    
    $
    17,075
    
    
    $
    (211
    )
    
    $
    900
    
    
    $
    4,405
 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Income
For the Year Ended December 31, 2002
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmounRevenue
    
    $
    
    
    
    $
    113,794
    
    
    $
    118
    
    
    $
    
    
    
    $
    113,912Salaries, wages and employee benefits
    
    
    
    
    
    
    62,326
    
    
    
    
    
    
    
    
    
    
    
    62,326Professional fees
    
    
    
    
    
    
    14,327
    
    
    
    46
    
    
    
    
    
    
    
    14,373Supplies
    
    
    
    
    
    
    5,325
    
    
    
    
    
    
    
    
    
    
    
    5,325Rentals and leases
    
    
    
    
    
    
    870
    
    
    
    
    
    
    
    
    
    
    
    870Other operating expenses
    
    
    769
    
    
    
    14,489
    
    
    
    68
    
    
    
    
    
    
    
    15,326Provision for bad debts
    
    
    
    
    
    
    3,681
    
    
    
    
    
    
    
    
    
    
    
    3,681Equity in earnings of subsidiaries
    
    
    (11,669
    )
    
    
    
    
    
    
    
    
    
    
    11,669
    
    
    
    Depreciation and amortization
    
    
    
    
    
    
    1,750
    
    
    
    20
    
    
    
    
    
    
    
    1,770Interest expense
    
    
    5,216
    
    
    
    324
    
    
    
    24
    
    
    
    
    
    
    
    5,564(5,684
    )
    
    
    103,092
    
    
    
    158
    
    
    
    11,669
    
    
    
    109,235Income (loss) from continuing operations before
income taxes
    
    
    5,684
    
    
    
    10,702
    
    
    
    (40
    )
    
    
    (11,669
    )
    
    
    4,677Benefit from income taxes
    
    
    
    
    
    
    (1,007
    )
    
    
    
    
    
    
    
    
    
    
    (1,007
    )Net (loss) income
    
    $
    5,684
    
    
    $
    11,709
    
    
    $
    (40
    )
    
    $
    (11,669
    )
    
    $
    5,684
 F-32




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Cash Flows
For the Year Ended December 31, 2004
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmountsOperating
Activities:Net (loss) income
    
    $
    (14,803
    )
    
    $
    33,899
    
    
    $
    556
    
    
    $
    (2,851
    )
    
    $
    16,801Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    
    
    
    
    9,136
    
    
    
    975
    
    
    
    (243
    )
    
    
    9,868Provision for doubtful accounts
    
    
    
    
    
    
    10,874
    
    
    
    
    
    
    
    
    
    
    
    10,874Amortization of loan costs
    
    
    691
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    691Loss on refinancing long-term debt
    
    
    6,407
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,407Change in income tax assets and liabilities
    
    
    
    
    
    
    6,920
    
    
    
    
    
    
    
    
    
    
    
    6,920Loss from discontinued operations
    
    
    
    
    
    
    219
    
    
    
    
    
    
    
    
    
    
    
    219Changes in operating assets and liabilities, net of
effect of acquisitions:Accounts receivable
    
    
    
    
    
    
    (13,119
    )
    
    
    (956
    )
    
    
    
    
    
    
    (14,075
    )Prepaids and other current assets
    
    
    
    
    
    
    2,200
    
    
    
    
    
    
    
    
    
    
    
    2,200Accounts payable
    
    
    
    
    
    
    (5,176
    )
    
    
    
    
    
    
    
    
    
    
    (5,176
    )Accrued liabilities and other liabilities
    
    
    (363
    )
    
    
    4,886
    
    
    
    605
    
    
    
    
    
    
    
    5,128Net cash (used in) provided by continuing operating
activities
    
    
    (8,068
    )
    
    
    49,839
    
    
    
    1,180
    
    
    
    (3,094
    )
    
    
    39,857Investing Activities:Cash paid for acquisitions, net of cash acquired
    
    
    (136,495
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (136,495
    )Capital purchases of property and equipment
    
    
    
    
    
    
    (17,115
    )
    
    
    (101
    )
    
    
    
    
    
    
    (17,216
    )Sale of long-term securities
    
    
    
    
    
    
    
    
    
    
    953
    
    
    
    
    
    
    
    953Other assets
    
    
    
    
    
    
    (2,642
    )
    
    
    1,341
    
    
    
    
    
    
    
    (1,301
    )Net used in investing activities
    
    
    (136,495
    )
    
    
    (19,757
    )
    
    
    2,193
    
    
    
    
    
    
    
    (154,059
    )Financing Activities:Net principal borrowings on long-term debt
    
    
    (810
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (810
    )Net transfers to and from members
    
    
    42,060
    
    
    
    (42,746
    )
    
    
    (2,408
    )
    
    
    3,094
    
    
    
    Payment of loan and issuance costs
    
    
    (2,300
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,300
    )Refinancing of long-term debt
    
    
    (3,844
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,844
    )Proceeds from secondary offering of common stock,
net of issuance costs
    
    
    104,691
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    104,691Proceeds from issuance of common stock
    
    
    4,428
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,428Proceeds from repayment of stockholder notes
    
    
    338
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    338Net cash provided by (used in) financing activities
    
    
    144,563
    
    
    
    (42,746
    )
    
    
    (2,408
    )
    
    
    3,094
    
    
    
    102,503Net increase in cash
    
    
    
    
    
    
    (12,664
    )
    
    
    965
    
    
    
    
    
    
    
    (11,699
    )Cash and
cash equivalents at beginning of year
    
    
    
    
    
    
    43,456
    
    
    
    1,498
    
    
    
    
    
    
    
    44,954Cash and
cash equivalents at end of year
    
    $
    
    
    
    $
    30,792
    
    
    $
    2,463
    
    
    $
    
    
    
    $
    33,255
 F-33




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Cash Flows
For the Twelve Months Ended December 31, 2003
(Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmountsOperating
Activities:Net (loss) income
    
    $
    (12,548
    )
    
    $
    17,075
    
    
    $
    (211
    )
    
    $
    900
    
    
    $
    5,216Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    
    
    
    
    5,287
    
    
    
    447
    
    
    
    
    
    
    
    5,734Provision for doubtful accounts
    
    
    
    
    
    
    6,315
    
    
    
    
    
    
    
    
    
    
    
    6,315Amortization of loan costs
    
    
    1,454
    
    
    
    
    
    
    
    24
    
    
    
    
    
    
    
    1,478Loss on refinancing long-term debt
    
    
    4,856
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,856Change in valuation of put warrants
    
    
    960
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    960Change in income tax assets and liabilities
    
    
    
    
    
    
    2,809
    
    
    
    
    
    
    
    
    
    
    
    2,809Release of reserve on stockholder notes
    
    
    (545
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (545
    )Loss from discontinued operations, net of taxes
    
    
    
    
    
    
    25
    
    
    
    
    
    
    
    
    
    
    
    25Changes in operating assets and liabilities, net of
effect of acquisitions:Accounts receivable
    
    
    
    
    
    
    (11,709
    )
    
    
    
    
    
    
    
    
    
    
    (11,709
    )Prepaids and other current assets
    
    
    (7,731
    )
    
    
    9,948
    
    
    
    (4
    )
    
    
    
    
    
    
    2,213Accounts payable
    
    
    
    
    
    
    (1,979
    )
    
    
    

    
    
    
    
    
    
    
    (1,979
    )Accrued liabilities and other liabilities
    
    
    (58
    )
    
    
    1,730
    
    
    
    997
    
    
    
    
    
    
    
    2,669Other
    
    
    162
    
    
    
    124
    
    
    
    
    
    
    
    
    
    
    
    286Net cash (used in) provided by continuing operating
activities
    
    
    (13,450
    )
    
    
    29,625
    
    
    
    1,253
    
    
    
    900
    
    
    
    18,328Investing Activities:Cash paid for acquisitions, net of cash acquired
    
    
    (100,424
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (100,424
    )Capital purchases of property and equipment
    
    
    
    
    
    
    (5,755
    )
    
    
    (25,487
    )
    
    
    25,487
    
    
    
    (5,755
    )Purchase of long-term securities
    
    
    
    
    
    
    
    
    
    
    (971
    )
    
    
    

    
    
    
    (971
    )Other assets
    
    
    
    
    
    
    (904
    )
    
    
    (4
    )
    
    
    
    
    
    
    (908
    )Net used in investing activities
    
    
    (100,424
    )
    
    
    (6,659
    )
    
    
    (26,462
    )
    
    
    25,487
    
    
    
    (108,058
    )Financing Activities:Net principal borrowings on long-term debt
    
    
    61,980
    
    
    
    
    
    
    
    18,962
    
    
    
    (18,962
    )
    
    
    61,980Net transfers to and from members
    
    
    (18,418
    )
    
    
    19,315
    
    
    
    6,528
    
    
    
    (7,425
    )
    
    
    Payment of loan and issuance costs
    
    
    (1,998
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,998
    )Refinancing of long-term debt
    
    
    (1,410
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,410
    )Proceeds from issuance of series A convertible preferred
stock,
net of issuance costs
    
    
    24,505
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    24,505Proceeds from secondary offering of common stock,
net of issuance costs
    
    
    48,897
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    48,897Proceeds from issuance of common stock
    
    
    318
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    318Net cash provided by (used in) financing activities
    
    
    113,874
    
    
    
    19,315
    
    
    
    25,490
    
    
    
    (26,387
    )
    
    
    132,292Net increase in cash
    
    
    
    
    
    
    42,281
    
    
    
    281
    
    
    
    
    
    
    
    42,562Cash and
cash equivalents at beginning of year
    
    
    
    
    
    
    1,175
    
    
    
    1,217
    
    
    
    
    
    
    
    2,392Cash and
cash equivalents at end of year
    
    $
    
    
    
    $
    43,456
    
    
    $
    1,498
    
    
    $
    
    
    
    $
    44,954
 F-34




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##### Table of Contents



PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 Psychiatric Solutions, Inc.
Condensed Consolidating Statement of Cash Flows
For the Twelve Months Ended December 31, 2002 (Dollars in thousands) Combined
    
    
    
    
    
    
    
    
    
    
    TotalSubsidiary
    
    
    Combined Non-
    
    
    Consolidating
    
    
    ConsolidatedParent
    
    
    Guarantors
    
    
    Guarantors
    
    
    Adjustments
    
    
    AmountsOperating
Activities:Net income (loss)
    
    $
    5,684
    
    
    $
    11,709
    
    
    $
    (40
    )
    
    $
    (11,669
    )
    
    $
    5,684Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    
    
    
    
    1,750
    
    
    
    20
    
    
    
    
    
    
    
    1,770Provision for doubtful accounts
    
    
    
    
    
    
    3,681
    
    
    
    
    
    
    
    
    
    
    
    3,681Amortization of loan costs
    
    
    
    
    
    
    419
    
    
    
    
    
    
    
    
    
    
    
    419Change in income tax assets and liabilities
    
    
    
    
    
    
    (1,007
    )
    
    
    
    
    
    
    
    
    
    
    (1,007
    )Additional reserve on stockholder notes
    
    
    
    
    
    
    92
    
    
    
    
    
    
    
    
    
    
    
    92(Loss) equity in earnings of subsidiaries
    
    
    (11,669
    )
    
    
    
    
    
    
    
    
    
    
    11,669
    
    
    
    Changes in operating assets and liabilities, net of
effect of acquisitions:Accounts receivable
    
    
    
    
    
    
    (1,348
    )
    
    
    
    
    
    
    
    
    
    
    (1,348
    )Prepaids and other current assets
    
    
    
    
    
    
    (353
    )
    
    
    (46
    )
    
    
    
    
    
    
    (399
    )Accounts payable
    
    
    
    
    
    
    (2,523
    )
    
    
    
    
    
    
    
    
    
    
    (2,523
    )Accrued liabilities and other liabilities
    
    
    929
    
    
    
    439
    
    
    
    66
    
    
    
    
    
    
    
    1,434Other
    
    
    
    
    
    
    1,119
    
    
    
    
    
    
    
    
    
    
    
    1,119Net cash (used in) provided by continuing operating
activities
    
    
    (5,056
    )
    
    
    13,978
    
    
    
    
    

    
    
    
    
    
    
    8,922Investing Activities:Cash acquired for acquisitions, net of cash paid
    
    
    
    
    
    
    6,243
    
    
    
    
    
    
    
    
    
    
    
    6,243Capital purchases of property and equipment
    
    
    
    
    
    
    (1,470
    )
    
    
    
    
    
    
    
    
    
    
    (1,470
    )Other assets
    
    
    
    
    
    
    (612
    )
    
    
    
    
    
    
    
    
    
    
    (612
    )Net used in investing activities
    
    
    
    
    
    
    4,161
    
    
    
    
    
    
    
    
    
    
    
    4,161Financing Activities:Net principal borrowings (payments) on long-term debt
    
    
    7,484
    
    
    
    (19,256
    )
    
    
    
    
    
    
    
    
    
    
    (11,772
    )Payment of loan costs
    
    
    
    
    
    
    (234
    )
    
    
    
    
    
    
    
    
    
    
    (234
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    53
    
    
    
    
    
    
    
    
    
    
    
    53Change in intercompany
    
    
    (2,428
    )
    
    
    2,428
    
    
    
    
    
    
    
    
    
    
    
    Net cash provided by (used in) financing activities
    
    
    5,056
    
    
    
    (17,009
    )
    
    
    
    
    
    
    
    
    
    
    (11,953
    )Net increase in cash
    
    
    
    
    
    
    1,130
    
    
    
    
    
    
    
    
    
    
    
    1,130Cash and
cash equivalents at beginning of year
    
    
    
    
    
    
    45
    
    
    
    1,217
    
    
    
    
    
    
    
    1,262Cash and
cash equivalents at end of year
    
    $
    
    
    
    $
    1,175
    
    
    $
    1,217
    
    
    $
    
    
    
    $
    2,392
 18. Subsequent Events On March 10, 2005, we entered into a Stock Purchase Agreement with Ardent Health Services LLC, a
Delaware limited liability company (Seller), and Ardent Health Services, Inc., a Delaware
corporation and wholly-owned subsidiary of Seller (AHS), pursuant to which we will acquire all of
the outstanding capital stock of AHS for approximately $560 million. The purchase price will be
paid $500 million in cash and $60 million in shares of our common stock. AHS owns and operates
through its subsidiaries 20 inpatient behavioral health care
facilities, which include approximately
2,000 inpatient beds and generated approximately $300 million in revenues in 2004. We anticipate
financing the cash portion of the purchase price through the issuance of new debt. Closing of the
transaction is conditioned upon satisfaction of customary closing conditions, including the receipt
of all necessary governmental permits and approvals and the expiration or early termination of the
Hart-Scott-Rodino Act waiting period. It is anticipated that closing will occur during the second
quarter of 2005. On January 14, 2005, we redeemed $50 million of our 10 5/8% senior subordinated notes. As part of the
redemption we paid a 10 5/8% penalty and accrued interest. We borrowed $30 million under our
revolving line of credit and used cash on hand for the remainder of the redemption. We expect to
record a loss on refinancing of long-term debt of approximately $7 million during the first quarter
of 2005. F-35




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##### Table of Contents



Pursuant to the requirements of Section 13 or 15(d) 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. Psychiatric Solutions, Inc.By:
    
    /s/ Joey A. JacobsJoey A. JacobsChief Executive Officer
 Dated: March 14, 2005 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated. Signature
    
    Title
    
    Date/s/ Joey A. Jacobs
    
    Chairman of the Board, President
and Chief Executive Officer
    
    March 14, 2005Joey A. Jacobs
    
    (Principal Executive Officer)/s/ Jack E. Polson
    
    Chief Accounting Officer
(Principal Accounting Officer)
    
    March 14, 2005Jack E. Polson/s/ William F. Carpenter
    
    Director
    
    March 14, 2005William F. Carpenter/s/ Mark P. Clein
    
    Director
    
    March 14, 2005Mark P. Clein/s/ Richard D. Gore
    
    Director
    
    March 14, 2005Richard D. Gore/s/ Christopher Grant, Jr.
    
    Director
    
    March 14, 2005Christopher Grant, Jr./s/ Ann H. Lamont
    
    Director
    
    March 14, 2005Ann H. Lamont/s/ William M. Petrie, MD
    
    Director
    
    March 14, 2005William M. Petrie, MD/s/ Edward K. Wissing
    
    Director
    
    March 14, 2005Edward K. Wissing




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##### Table of Contents



Exhibit Index ExhibitNumber
    
    Description2.1
    
    Agreement and Plan of Merger by and among PMR Corporation, PMR Acquisition
Corporation and Psychiatric Solutions, Inc., dated May 6, 2002, as amended
by Amendment No. 1, dated as of June 10, 2002, and Amendment No. 2, dated
as of July 9, 2002 (included as Annex A to Amendment No. 1 to the Companys
Registration Statement on Form S-4, filed on July 11, 2002 (Reg. No.
333-90372) (the 2002 S-4 Amendment)).2.2
    
    Asset Purchase Agreement, dated February 13, 2003, by and between The Brown
Schools, Inc. and Psychiatric Solutions, Inc., as amended by Amendment No.
1 to Asset Purchase Agreement, dated March 31, 2003, by and between The
Brown Schools, Inc. and Psychiatric Solutions, Inc. (incorporated by
reference to Exhibit 2.1 of the Companys Current Report on Form 8-K, filed
on April 9, 2003).2.3
    
    Agreement and Plan of Merger, dated April 8, 2003, by and among Psychiatric
Solutions, Inc., PSI Acquisition Sub, Inc. and Ramsay Youth Services, Inc.
(incorporated by reference to Exhibit 2.1 of the Companys Current Report
on Form 8-K, filed on April 10, 2003).2.4
    
    Asset Purchase Agreement, dated February 23, 2004, by and among Psychiatric
Solutions, Inc., Brentwood Health Management, L.L.C., Brentwood, A
Behavioral Health Company, L.L.C. and River Rouge, Inc. (incorporated by
reference to Exhibit 2.1 of the Companys Current Report on Form 8-K, filed
on March 3, 2004).2.5
    
    Asset Purchase Agreement, dated February 23, 2004, by and among Psychiatric
Solutions, Inc., Brentwood Health Management of MS, LLC, and Turner-Windham
of Mississippi, LLC (incorporated by reference to Exhibit 2.2 of the
Companys Current Report on Form 8-K, filed on March 3, 2004).2.6
    
    Asset Purchase Agreement, dated April 23, 2004, by and among Psychiatric
Solutions, Inc., Fort Lauderdale Hospital, Inc., Millwood Hospital, L.P.,
PSI Pride Institute, Inc., PSI Summit Hospital, Inc., Fort Lauderdale
Hospital Management, LLC, Millwood Health, LLC, Pride Institute, LLC and
Summit Health, LLC (incorporated by reference to Exhibit 2.1 of the
Companys Current Report on Form 8-K, filed on June 2, 2004).3.1
    
    Amended and Restated Certificate of Incorporation of PMR Corporation, filed
with the Delaware Secretary of State on March 9, 1998 (incorporated by
reference to Exhibit 3.1 to the Companys Annual Report on Form 10-K for
the fiscal year ended April 30, 1998).3.2
    
    Certificate of Amendment to Amended and Restated Certificate of
Incorporation of PMR Corporation, filed with the Delaware Secretary of
State on August 5, 2002 (incorporated by reference to Exhibit 3.2 to the
Companys Quarterly Report on Form 10-Q for the quarter ended July 31,
2002).3.3
    
    Certificate of Amendment to Amended and Restated Certificate of
Incorporation of Psychiatric Solutions, Inc., filed with the Delaware
Secretary of State on March 21, 2003 (incorporated by reference to Appendix
A of the Companys Definitive Proxy Statement, filed on January 22, 2003).3.4
    
    Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to
the Companys Annual Report on Form 10-K for the fiscal year ended April
30, 1997) (the 1997 10-K)).




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##### Table of Contents



ExhibitNumber
    
    Description4.1
    
    Reference is made to Exhibits 3.1 through 3.4.4.2
    
    Common Stock Specimen Certificate (incorporated by reference to Exhibit 4.2
to the Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 2002) (the 2002 10-K)).4.3
    
    Certificate of Designations, Preferences and Rights of Series A Convertible
Preferred Stock, filed with the Delaware Secretary of State on March 24,
2003 (incorporated by reference to Appendix D of the Companys Definitive
Proxy Statement, filed January 22, 2003).4.4
    
    Indenture, dated as of June 30, 2003, among Psychiatric Solutions, Inc.,
the Guarantors named therein and Wachovia Bank, National Association, as
Trustee (incorporated by reference to the Companys Registration Statement
on Form S-4, filed on July 30, 2003 (Registration No. 333-107453) (the
2003 S-4)).4.5
    
    Form of Notes (included in Exhibit 4.4).4.6
    
    Purchase Agreement, dated as of June 19, 2003, among Psychiatric Solutions,
Inc., the Guarantors named therein, Lehman Brothers Inc., Merrill Lynch,
Pierce, Fenner & Smith Incorporated and Jefferies & Company, Inc.
(incorporated by reference to Exhibit 4.12 to the 2003 S-4).10.1
    
    Employment Agreement between Jack R. Salberg and Psychiatric Solutions,
Inc., dated as of October 1, 2002 (incorporated by reference to Exhibit
10.14 to the 2002 10-K).10.2
    
    Second Amended and Restated Employment Agreement between Joey A. Jacobs and
Psychiatric Solutions, Inc., dated as of August 6, 2002 (incorporated by
reference to Exhibit 10.16 to the 2002 10-K).10.3
    
    Amendment to Second Amended and Restated Employment Agreement between Joey
A. Jacobs and Psychiatric Solutions, Inc., dated as of November 26, 2003
(incorporated by reference to Exhibit 10.14 to Amendment No. 2 to the
Companys Registration Statement on Form S-2, filed on December 18, 2003
(Registration No. 333-110206)).10.4*
    
    Form of Indemnification Agreement
executed by each director of Psychiatric Solutions, Inc. and
Psychiatric Solutions, Inc.




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##### Table of Contents



ExhibitNumber
    
    Description10.5
    
    Amended and Restated Credit Agreement, dated as of December 21, 2004, among
Psychiatric Solutions, Inc., the Guarantors named therein, Bank of America,
N.A., as administrative agent, swing line lender and l/c issuer, Banc of
America Securities LLC, as sole lead arranger and sole book manager,
Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated,
and Citicorp USA, Inc., as co-syndication agents, JPMorgan Chase Bank,
N.A., as documentation agent, and the Lenders named a party thereto
(incorporated by reference to Exhibit 2.2 of the Companys Current Report
on Form 8-K, filed on December 28, 2004).10.6
    
    Interest Rate Swap Agreement, dated January 28, 2004, between Bank of
America, N.A. and Psychiatric Solutions, Inc. (incorporated by reference to
Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the quarter
ended March 31, 2004).10.7
    
    Confirmation of Interest Rate Swap Agreement, dated April 26, 2004, between
Bank of America, N.A. and Psychiatric Solutions, Inc. (incorporated by
reference to Exhibit 10.5 to the Companys Quarterly Report on Form 10-Q
for the quarter ended June 30, 2004).10.8
    
    Amended and Restated Psychiatric Solutions, Inc. 2003 Long-Term Equity
Compensation Plan (incorporated by reference to Exhibit 10.21 to the 2003
10-K).10.9
    
    Amended and Restated Psychiatric Solutions, Inc. Equity Incentive Plan, as
amended by an Amendment adopted on May 4, 2004 (incorporated by reference
to Appendix A to the Companys Definitive Proxy Statement, filed on April
9, 2004).10.10
    
    Form of Incentive Stock Option Agreement under the 1997 Plan (incorporated
by reference to Exhibit 10.2 to the 1997 10-K).10.11
    
    Form of Nonstatutory Stock Option Agreement under the 1997 Plan
(incorporated by reference to Exhibit 10 to the 1997 10-K).10.12
    
    Amended and Restated Psychiatric Solutions, Inc. Outside Directors
Non-Qualified Stock Option Plan (incorporated by reference to Appendix C to
the Companys Definitive Proxy Statement, filed on April 14, 2003).10.13
    
    Form of Outside Directors Non-Qualified Stock Option Agreement
(incorporated by reference to Exhibit 10.5 to the 1997 10-K).12.1*
    
    Computation of Ratio of Earnings to Fixed Charges.21.1*
    
    List of Subsidiaries.23.1*
    
    Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.31.1*
    
    Certification of the Chief Executive Officer of Psychiatric Solutions, Inc.
Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.31.2*
    
    Certification of the Chief Accounting Officer of Psychiatric Solutions,
Inc. Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.32.1*
    
    Certifications of the Chief Executive Officer and Chief Accounting Officer
of Psychiatric Solutions, Inc. Pursuant to Rule 13a-14(b) of the Securities
Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Filed herewith
    
    Management contract or compensatory plan or arrangement