**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

_______________**FORM 10-Q**_______________

| **(Mark One)** |       |                                                            |
|----------------|------------|-----------------------------------------------------------------|
| ** **     | ** ** | ** **                                                      |
| **x**          |       | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**         |
|           | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                         |
|           |       |                                                            |
|           | ** ** | **For the quarterly period ended December 31, 2005**            |
|           |       |                                                            |
|           |       | **OR**                                                          |
| ** **     | ** ** | ** **                                                      |
| o              | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF**        |
|           | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                         |
|           |       |                                                            |
|           | ** ** | **For the transition period from ____________ to ____________** |

**Commission File Number: 333-71934**_______________
**VANGUARD HEALTH SYSTEMS, INC.******(Exact name of registrant as specified in its charter)

**Delaware**

**62-1698183**

*(State or other jurisdiction of incorporation or organization)*

* *

*(I.R.S. Employer Identification No.)*

**20 Burton Hills Boulevard, Suite 100Nashville, TN 37215**(Address and zip code of principal executive offices)**(615) 665-6000**(Registrant’s telephone number, including area code)

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed under Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe 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.   Yesx   Noo

          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.Large accelerated filero Accelerated Filero   Non-accelerated filerx

          Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yeso   Nox

          There were 749,550 shares of common stock outstanding as of February 1, 2006 (all of which are privately owned and not traded on a public market).
********
**VANGUARD HEALTH SYSTEMS, INC.QUARTERLY REPORT ON FORM 10-QTABLE OF CONTENTS**

** **

** **

** **

**Page**

**PART I.**

 

**FINANCIAL INFORMATION**

 

 Item 1.

 

Financial Statements:

 

 

 

 

Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2005 (unaudited)

 

3

 

Unaudited Condensed Consolidated Statements of Operations for the three months ended December 31, 2004 and 2005

 

4

 

Condensed Consolidated Statements of Operations for the predecessor period July 1, 2004 through September 22, 2004, the period September 23, 2004 through December 31, 2004, (unaudited) the six months ended December 31, 2004(combined basis, unaudited) and the six months ended December 31, 2005 (unaudited)

 

5

 

Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2004 (combined basis) and the six months ended December 31, 2005

 

6

 

 

Condensed Consolidated Statements of Cash Flows for the predecessor period July 1, 2004 through September 22, 2004, the period September 23, 2004 through December 31, 2004 (unaudited) and the sixmonths ended December 31, 2004 (combined basis, unaudited)

 

7

 

 

Notes to Condensed Consolidated Financial Statements

 

8

 Item 2.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

37

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

59

Item 4.

 

Controls and Procedures

59

**PART II. **

 

**OTHER INFORMATION**

 

Item 6.

 

Exhibits

 

60

 

 

Signature

 

61

 

Index to Exhibits

62

-2-
****
**Table of Contents**

**PART IFINANCIAL INFORMATION**

**Item 1.    Financial Statements.**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**

 

 

**June 30, 2005**

 

 

 

**(Unaudited) December 31, 2005**

 

 

 

 

 

 

**ASSETS**

 

*(In millions except share and per share amounts)*

 

 

Current assets:

 

 

 

 

 

 

 

 

   Cash and cash equivalents

$

79.2

$

162.5

   Accounts receivable, net of allowance for uncollectible accounts of       approximately $90.1 and $103.3 at June 30, 2005 and       December 31, 2005, respectively

286.0

282.0

 

   Inventories

43.5

45.1

 

   Prepaid expenses and other current assets

36.1

51.6

 

 

 

        Total current assets

444.8

541.2

 

Property, plant and equipment, net of accumulated depreciation

1,072.8

1,114.7

 

Goodwill

813.1

820.0

 

Intangible assets, net of accumulated amortization

74.3

71.3

 

Investments in unconsolidated subsidiaries

9.0

9.3

Other assets

57.7

38.1

 

 

 

        Total assets

$

2,471.7

$

2,594.6

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

Current liabilities:

 

   Accounts payable

$

145.5

$

140.5

 

   Accrued salaries and benefits

86.4

72.3

   Accrued health claims

51.2

31.3

 

   Accrued interest

14.5

13.6

 

   Other accrued expenses and current liabilities

61.9

44.7

 

   Current maturities of long-term debt

7.6

8.6

 

 

 

        Total current liabilities

367.1

311.0

 

Minority interests in equity of consolidated entities

10.4

9.9

 

Other liabilities

68.9

83.2

 

Long-term debt, less current maturities

1,349.5

1,504.2

 

Commitments and contingencies

Stockholders’ Equity:

Common Stock; $.01 par value, 1,000,000 shares authorized, 749,550 shares     issued and outstanding at June 30, 2005 and December 31, 2005

–

–

Additional paid-in capital

643.2

642.8

Retained earnings

32.6

43.5

 

        Total stockholders’ equity

675.8

686.3

 

 

        Total liabilities and stockholders’ equity

$

2,471.7

$

2,594.6

 

 

 

See accompanying notes.

-3-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**

**Three months ended December 31,**

**2004**

**2005**

*(In millions)*

Patient service revenues

 

$

416.1

 

$

552.3

 

Premium revenues

 

 

83.7

89.4

 

 

      Total revenues

 

 

499.8

641.7

 

 

 

Costs and Expenses:

 

 

   Salaries and benefits (includes stock compensation of $0.2         and $0.3, respectively)

 

 

200.4

276.5

   Supplies

 

 

80.6

102.8

   Medical claims expense

 

 

56.6

63.0

   Purchased services

 

 

25.3

38.7

   Provision for doubtful accounts

 

 

35.5

39.3

   Other operating expenses

 

 

40.5

52.1

   Rents and leases

 

 

6.9

8.7

   Depreciation and amortization

 

 

20.8

24.5

   Interest, net

 

 

25.0

28.2

   Debt extinguishment costs

–

0.1

   Other

 

 

1.1

2.0

 

 

 

Income before income taxes

 

 

7.1

5.8

Income tax expense

 

 

2.5

2.2

 

 

 

Net income

 

$

4.6

 

$

3.6

 

 

See accompanying notes.

-4-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Continued)**

****

 

 

 

**Predecessor**

 

 

 

** **

 

 

 

** **

 

 

** **

 

** **

 

** **

** **

** **

**(Unaudited)****September 23, 2004 through December 31, 2004**

** **

** **

** **

**(Unaudited) Six months ended December 31, 2004 (combined)**

** **

** **

**(Unaudited) Six months ended December 31, 2005**

** **

**July 1, 2004 through September 22, 2004**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*(In millions)*

 

 

 

Patient service revenues

$

377.3

 

 

$

453.1

 

 

$

830.4 

 

$

1,113.9

 

 

Premium revenues

 

72.3

 

 

 

90.8

 

 

 

163.1 

 

 

175.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

     Total revenues

 

449.6

 

 

 

543.9

 

 

 

993.5 

 

 

1,289.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Salaries and benefits (includes stock compensation of $96.7,       $0.2, $96.9 and $0.6, respectively)

 

275.4

 

 

 

217.6

 

 

 

493.0 

 

 

546.1

 

 

   Supplies

 

72.3

 

 

 

87.7

 

 

 

160.0 

 

 

207.4

 

 

   Medical claims expense

 

55.0

 

 

 

61.9

 

 

 

116.9 

 

 

122.4

 

 

   Purchased services

 

22.1

 

 

 

27.7

 

 

 

49.8 

 

 

74.3

 

 

   Provision for doubtful accounts

 

31.5

 

 

 

38.5

 

 

 

70.0 

 

 

89.4

 

 

   Other operating expenses

 

37.2

 

 

 

44.1

 

 

 

81.3 

 

 

107.1

 

 

   Rents and leases

 

5.7

 

 

 

7.5

 

 

 

13.2 

 

 

17.0

 

 

   Depreciation and amortization

 

17.4

 

 

 

22.5

 

 

 

39.9 

 

 

49.0

 

 

   Interest, net

 

9.8

 

 

 

27.1

 

 

 

36.9 

 

 

54.6

 

 

   Debt extinguishment costs

 

62.2

 

 

 

–

 

 

 

62.2 

 

 

0.1

 

   Merger expenses

 

23.1

 

 

 

–

 

 

 

23.1 

 

 

–

 

 

   Other

 

(0.1

)

 

 

1.2

 

 

 

1.1 

 

 

3.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

(162.0

)

 

 

8.1

 

 

 

(153.9)

 

 

18.6

 

 

Income tax expense (benefit)

 

(51.3

)

 

2.9

 

 

(48.4)

 

7.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

(110.7

)

 

5.2

 

 

(105.5)

 

10.9

 

 

Preferred stock dividends

 

(1.0

)

 

 

–

 

 

 

(1.0)

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common stockholders

$

(111.7

)

 

$

5.2

 

 

$

(106.5)

 

$

10.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

-5-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 

 

 

**Combined Basis**

 

 

 

 

 

 

 

 

**Six months ended December 31, 2004**

** **

** **

 

**Six months ended December 31, 2005**

 

 

 

 

 

 

 

 

 

 

 

*(In millions)*

Operating activities:

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(105.5

)

 

    $

10.9

 

Adjustments to reconcile net income (loss) to    net cash provided by operating activities:

 

 

 

 

 

 

 

 

   Depreciation and amortization

 

 

39.9

 

 

 

49.0

 

   Provision for doubtful accounts

 

 

70.0

 

 

 

89.4

 

   Deferred income taxes

 

 

(48.4

)

 

6.4

   Amortization of loan costs

 

 

1.4

 

 

 

2.0

 

   Accretion of principal on senior discount notes

 

 

3.8

 

7.6

 

   Gain on sale of assets

 

 

0.8

 

 

 

–

 

   Stock compensation

 

 

96.9

 

 

 

0.6

 

   Debt extinguishment costs

 

 

62.2

 

 

 

0.1

 

   Merger expenses

 

 

23.1

 

 

 

–

 

   Changes in operating assets and liabilities, net of effects          of acquisitions:

 

 

 

 

 

 

 

 

      Accounts receivable

 

 

(83.6

)

 

 

(85.9

)

      Inventories

 

 

(1.3

)

 

 

(1.7

)

      Prepaid expenses and other current assets

 

 

4.5

 

 

 

(3.4

)

      Accounts payable

 

 

20.1

 

 

 

(2.4

)

      Accrued expenses and other current liabilities

 

 

0.9

 

 

 

(41.2

)

      Other liabilities

 

 

9.5

 

 

14.0

 

 

 

 

 

 

 

 

Net cash provided by operating activities

 

 

94.3

 

 

 

45.4

 

 

 

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

 

 

 

Acquisitions, including working capital settlement payments

 

 

(138.2

)

 

 

(0.4

)

Capital expenditures

 

 

(72.4

)

 

 

(113.7

)

Purchases of short-term investments

 

 

(40.0

) 

 

 

(68.4

)

Sales of short-term investments

70.0

68.4

 

Proceeds from asset dispositions

 

 

0.7

 

 

 

4.9

 

Other

 

 

(0.1

)

 

 

0.8

 

 

 

 

 

 

 

Net cash used in investing activities

 

 

(180.0

)

 

 

(108.4

)

 

 

 

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

 

 

 

Proceeds from long-term debt

 

 

1,234.7

 

 

 

175.0

 

Payments of long-term debt and capital leases

 

 

(685.9

)

 

 

(27.0

)

Payments of loan costs and debt termination fees

 

 

(42.7

)

 

(0.6

)

Proceeds from joint venture partner contributions

8.0

–

Exercise of stock options

 

 

0.1

 

 

 

–

 

Payments to retire stock and stock options

 

 

(964.9

)

 

–

Payments to repurchase equity incentive units

–

(1.1

)

Proceeds from common stock issuances

 

 

494.9

 

 

 

–

 

 

 

 

 

 

 

 

Net cash provided by financing activities

 

 

44.2

 

 

146.3

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

 

(41.5

)

 

 

83.3

Cash and cash equivalents, beginning of period

 

 

50.1

 

 

79.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

8.6

 

 

$

162.5

 

 

 

 

 

 

 

 

Net cash paid for interest

 

$

26.2

 

 

$

50.5

 

 

 

 

 

 

 

Net cash paid for income taxes

 

$

–

 

 

$

0.8

 

 

 

 

 

 

 

 

 

See accompanying notes.

-6-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Continued)**

 

 

 

**Predecessor**

 

 

 

 

 

 

 

 

 

 

 

** **

 

 

 

**(Unaudited) September 23, 2004 through December 31, 2004**

 

 

 

**(Unaudited) Six months ended December 31, 2004 (combined basis)**

 

**July 1, 2004 through September 22, 2004**

 

 

 

 

 

 

 

 

 

 

 

 

 

*(In millions)*

Operating activities:

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(110.7

)

$

5.2

 

$

(105.5

)

Adjustments to reconcile net income (loss) to    net cash provided by operating activities:

 

 

 

 

 

 

 

 

 

 

 

   Depreciation and amortization

 

 

17.4

 

 

 

22.5

 

 

 

39.9

 

   Provision for doubtful accounts

 

 

31.5

 

 

 

38.5

 

 

 

70.0

 

   Deferred income taxes

 

 

(50.9

)

2.5

 

(48.4

)

   Amortization of loan costs

 

 

0.5

 

 

 

0.9

 

 

 

1.4

 

   Accretion of principal on senior discount notes

 

 

–

3.8

3.8

   Loss on sale of assets

 

 

0.6

 

 

 

0.2

 

 

 

0.8

 

   Stock compensation

 

 

96.7

 

 

 

0.2

 

 

 

96.9

 

   Debt extinguishment costs

 

 

62.2

 

 

 

–

 

 

 

62.2

 

   Merger expenses

 

 

23.1

 

 

 

–

 

 

 

23.1

 

   Changes in operating assets and liabilities, net of effects          of acquisitions:

 

 

 

 

 

 

 

 

 

 

 

 

      Accounts receivable

 

 

(42.1

)

 

 

(41.5

)

 

 

(83.6

)

      Inventories

 

 

(0.3

)

 

 

(1.0

)

 

 

(1.3

)

      Prepaid expenses and other current assets

 

 

2.4

 

 

 

2.1

 

 

 

4.5

 

      Accounts payable

 

 

41.4

 

 

 

(21.3

)

 

 

20.1

 

      Accrued expenses and other current liabilities

 

 

9.0

 

 

 

(8.1

)

 

 

0.9

 

      Other liabilities

 

 

(2.0

)

 

 

11.5

 

 

 

9.5

 

 

 

 

 

 

 

 

 

 

Net cash provided by operating activities

 

 

78.8

 

 

 

15.5

 

 

94.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

 

 

 

 

 

 

 

Acquisitions, including working capital settlement payments

 

 

(50.8

)

 

 

(87.4

)

 

 

(138.2

)

Capital expenditures

 

 

(29.8

)

 

 

(42.6

)

 

 

(72.4

)

Purchases of short-term investments

 

–

(40.0

)

(40.0

)

Sales of short-term investments

30.0

40.0

 

 

 

70.0

Proceeds from asset dispositions

 

 

0.5

 

 

 

0.2

 

 

 

0.7

 

Other

 

 

0.1

 

 

 

(0.2

)

 

 

(0.1

)

 

 

 

 

 

 

 

 

 

 

Net cash used in investing activities

 

 

(50.0

)

 

 

(130.0

)

 

 

(180.0

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

 

 

 

 

 

Proceeds from long-term debt

 

 

1,174.7

 

 

 

60.0

 

 

 

1,234.7

 

Payments of long-term debt and capital leases

 

 

(683.9

)

 

 

(2.0

)

 

 

(685.9

)

Payments of loan costs and debt termination fees

 

 

(40.9

)

(1.8

)

(42.7

)

Proceeds from joint venture partner contributions

–

 

8.0

 

8.0

Exercise of stock options

 

 

0.1

 

 

 

–

 

 

 

0.1

 

Payments to retire stock and stock options

 

 

(964.9

)

–

 

(964.9

)

Proceeds from common stock issuances

 

 

494.9

 

 

 

–

 

 

 

494.9

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

 

(20.0

)

 

 

64.2

 

 

44.2

 

 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

 

8.8

 

 

(50.3

)

 

 

(41.5

)

Cash and cash equivalents, beginning of period

 

 

50.1

 

 

 

58.9

 

 

 

50.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

58.9

 

 

$

8.6

 

 

$

8.6

 

 

 

 

 

 

 

 

 

 

 

Net cash paid for interest

 

$

23.6

 

 

$

2.6

 

 

$

26.2

 

 

 

 

 

 

 

 

 

 

 

Net cash paid (received) for income taxes

 

$

(0.1

)

 

$

0.1

 

 

$

–

 

 

 

 

See accompanying notes.

-7-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2005(Unaudited)**

**1.             MERGER TRANSACTION**

                On September 23, 2004, affiliates of The Blackstone Group (“Blackstone”), a private equity firm, purchased a majorityequity interest in VHS Holdings LLC (“Holdings”), which became the principal stockholder of Vanguard Health Systems, Inc. (“Vanguard”) in a merger transaction (the “merger”). Pursuant to the merger agreement, the former holders ofVanguard shares received $1.22 billion, net of debt repayments, transaction costs, tender premiums and consent fees and the redemption of payable-in-kind preferred stock. The transaction was valued at approximately $1.97 billion prior to transaction fees andexpenses.

                Immediately subsequent to the merger, Blackstone beneficially owned approximately 66% of the equity interests in Vanguard through itssubscription and purchase of approximately $494.9 million aggregate amount of Class A membership units in Holdings and common stock of Vanguard.

                Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively, “MSCP”), Vanguard’s previousprivate equity sponsor, contributed $130.0 million and management (along with certain other investors) contributed approximately $124.1 million by contributing shares of Vanguard common stock and/or utilizing cash proceeds from the merger to purchase Class Amembership units in Holdings. These stockholders, on a combined basis, beneficially owned approximately 34% of the equity interests in Vanguard. Certain members of management also purchased $5.7 million of the equity incentive units in Holdings.

                Vanguard accounted for the transaction as a purchase under the guidance set forth in Emerging Issues Task Force Number 88-16, *Basisin Leveraged Buyout Transactions,* (“EITF 88-16”). Under EITF 88-16, the transaction was deemed to be a purchase by new controlling investors for which Holdings’ interests in Vanguard were valued using a partial change in accounting basis. Ineffect, the membership units of Holdings owned by the management investors were valued using predecessor basis, while the membership units of Holdings owned by Blackstone, MSCP and other certain investors were recorded at fair value.

                The following equity capitalization and financing transactions occurred in connection with the merger:

               •

 

$494.9 million cash equity contribution made by Blackstone;

 

 

 

               •

 

$130.0 million rollover equity contribution made by MSCP;

 

 

 

               •

 

$119.1 million rollover equity and cash equity contributions made by management investors and certain other investors;

 

 

 

               •

 

$5.0 million equity contribution made by Baptist Health Services from some of the proceeds of its prior investment in Vanguard;

 

 

 

               •

 

$5.7 million purchase of equity incentive units in Holdings by certain members of senior management;

 

 

 

               •

 

Execution of a new credit agreement governing new senior secured term loan credit facilities of $800.0 million, of which $475.0 million was drawn at closing, and a new revolving loan facility of $250.0 million, none of whichwas utilized at closing with the exception of $27.7 million of outstanding letters of credit; and

 

 

 

               •

 

Issuance and sale of $575.0 million of 9.0% senior subordinated notes due 2014 (the “9.0% Notes”) and $216.0 million aggregate principal amount at maturity ($124.7 million in gross proceeds) of 11.25% seniordiscount notes due 2015 (the “11.25% Notes”)

-8-
****
**Table of Contents**

The proceeds from the equity capitalization and financing transactions were used to:

               •

 

Pay security holders of Vanguard under the terms of the merger agreement;

 

 

 

               •

 

Repay all indebtedness under Vanguard’s existing senior secured credit facilities;

 

 

 

               •

 

Repurchase substantially all of Vanguard’s 9.75% senior subordinated notes due 2011 (the “9.75% Notes”) and pay related tender premium and consent fees, pursuant to a tender offer and consent solicitation byVanguard; and

 

 

 

               •

 

Pay the fees and expenses related to the merger and the related financing transactions

                Vanguard incurred $96.7 million in stock compensation expense in connection with the merger related to the payment to stock optionholders under its various former stock option plans as calculated under the provisions of Accounting Principles Board Opinion No. 25 for option grants prior to July 1, 2003, and under Statement of Financial Accounting Standards No. 123 for option grants on or afterJuly 1, 2003. Vanguard incurred debt extinguishment costs of $62.2 million in connection with the merger representing the write-off of loan costs under the 2004 senior secured credit facility and related fees of $16.6 million, tender premiums and consent fees of$50.2 million and a $4.6 million credit for the recognition of the remaining deferred gain under an interest rate swap agreement related to the 9.75% Notes. Vanguard capitalized $41.6 million of fees and expenses related to the execution of the new senior securedcredit facilities and the issuance of the 9.0% Notes and the 11.25% Notes on the merger date.

                Vanguard also incurred costs of $51.6 million directly related to the merger, of which $23.1 million is reflected as merger expenses onthe accompanying condensed consolidated statements of operations for the combined six months ended December 31, 2004. In addition, $28.3 million is included in goodwill on the accompanying condensed consolidated balance sheet as of December 31, 2005 as set forth bythe provisions of Statement of Financial Accounting Standards No. 141 (“SFAS 141”).  The table below provides a detail of the merger-related costs incurred during fiscal 2005 (in millions).

** **

 

** **

**Merger Expenses**

**Goodwill**

 

 

 

 

 

Advisory fees

 

$

        10.0

 

$

           4.0

Legal and accounting fees

 

 

          1.4

 

 

           3.8

Transaction completion fees to Blackstone and bonuses to management

 

 

          6.1

 

 

         20.3

Bridge loan commitment fees

 

 

          5.3

 

 

             –

Other

 

 

          0.5

 

 

           0.2

 

 

 

 

 

 

 

$

        23.3

 

$

         28.3

 

 

 

 

 

                Vanguard has completed the allocation of the merger excess purchase price that resulted in changes to the stated values of property,plant and equipment, goodwill and intangible assets based upon information obtained from an independent, third party appraisal and from guidance set forth by EITF 88-16, SFAS 141 and Statement of Financial Accounting Standards No. 142.

**2.             BUSINESS AND BASIS OF PRESENTATION**

****

**Business**

                Vanguard is an investor-owned healthcare company whose affiliates own and operate hospitals and related healthcare businesses in urbanand suburban areas.  As of December 31, 2005, Vanguard’s affiliates owned and operated 19 acute care hospitals with 4,517 licensed beds and related outpatient service locations complementary to the hospitals providing healthcare services in San Antonio,Texas; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; Orange County, California, and Massachusetts. Vanguard also owns managed health plans in Chicago, Illinois and Phoenix, Arizona.

-9-
****
**Table of Contents**

**Basis of Presentation**

                The accompanying unaudited condensed consolidated financial statements include the accounts of subsidiaries and affiliates controlledby Vanguard. Vanguard generally considers control to represent the majority of an entity’s voting interests. Vanguard also consolidates any entities for which it receives the majority of the entity’s expected returns or is at risk for the majority of theentity’s expected losses based upon its investment or financial interest in the entity. All material intercompany accounts and transactions have been eliminated. As none of Vanguard’s common shares are publicly held, no earnings per share information ispresented in the accompanying unaudited condensed consolidated financial statements. The majority of Vanguard’s expenses are “cost of revenue” items. Costs that could be classified as general and administrative include certain Vanguard corporateoffice costs, which approximated $11.8 million and $15.8 million for the six months ended December 31, 2004 (combined basis) and 2005 respectively.

                The unaudited condensed consolidated financial statements as of December 31, 2005 and for the three months ended December 31, 2004 and2005 and the six months ended December 31, 2004 (combined basis) and 2005 have been prepared in conformity with accounting principles generally accepted in the United States for interim reporting and in accordance with Rule 10-01 of Regulation S-X.  Accordingly,they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements.  In the opinion of management, the unaudited condensed consolidated financial statements reflect alladjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position and the results of operations for the periods presented.  The results of operations for the periods presented are not necessarily indicative ofthe expected results for the fiscal year ending June 30, 2006.  The interim unaudited condensed consolidated financial statements should be read in connection with the audited consolidated financial statements as of and for the year ended June 30, 2005 includedin Vanguard’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 13, 2005.

                *Use of Estimates*

                In preparing Vanguard’s financial statements in conformity with accounting principles generally accepted in the United States,management makes estimates and assumptions that affect the amounts recorded or classification of items in the unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

**Reclassifications**

                Vanguard adjusted its unaudited condensed consolidated statement of cash flows for the predecessor period July 1, 2004 throughSeptember 22, 2004 to reflect $30.0 million of gross sales of certain auction rate securities contracts held as of June 30, 2004.  Vanguard also adjusted its unaudited condensed consolidated statement of cash flows for the six months ended December 31, 2004(combined basis) to reflect $68.4 million of gross sales and $68.4 million of gross purchases of auction rate securities contracts.  These contracts were previously considered to be cash and cash equivalents for statement of cash flows presentationpurposes.  Vanguard now presents activity related to these contracts as investing activities in accordance with Statement of Financial Accounting Standards No. 95, *Statement of Cash Flows*, due to the fact that the original maturity of the securitiesunderlying the contracts is greater than 90 days.  The beginning and ending cash balances included in the statement of cash flows for the combined six months ended December 31, 2004 were reduced by $58.0 million and $28.0 million, respectively, to exclude theoutstanding short-term investments as of June 30, 2004 and December 31, 2004, respectively.  There were no short-term investments outstanding as of June 30, 2005 or December 31, 2005.  The reclassification had no impact on net income or cash provided byoperating activities during the predecessor period July 1, 2004 through September 22, 2004 or the six months ended December 31, 2004 (combined basis).  Certain other prior year amounts have been reclassified to conform to current year presentation.

**3.             STOCK-BASED COMPENSATION**

                Prior to the merger, Vanguard had four stock option plans.  Effective July 1, 2003, Vanguard adopted the fair value method ofaccounting for stock-based employee compensation set forth by Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”). Vanguard elected to use the prospective transition method set forth byStatement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure.* This transition method requires that only stock options granted subsequent to the adoption of SFAS 123 be measured at fair value.During the predecessor period July 1, 2004 through September 22, 2004, Vanguard recorded stock

-10-
****
**Table of Contents**

compensation of $0.1 million prior to the merger and $96.6 million directly related to the merger, which represents the stock compensation calculated under APB No. 25 for those stock options granted prior to July 1, 2003, andcalculated under SFAS 123 for those stock options granted on or after July 1, 2003. The four stock option plans were terminated in connection with the merger, which was deemed a liquidity event under the definitions set forth in the respective plan documents, andVanguard made cash payments to the option holders based upon the per share merger consideration less the applicable exercise price of the option grants.  Subsequent to the merger, during the three months ended December 31, 2004, Vanguard recorded stockcompensation of $0.2 million related to stock options granted under its 2004 Stock Option Plan.  Vanguard recorded $0.6 million of stock compensation related to its 2004 Stock Option Plan during the six months ended December 31, 2005.  Stock compensation isincluded in salaries and benefits on the accompanying unaudited condensed consolidated statements of operations.

                The following table provides the pro forma effect on Vanguard’s net income or loss as if the fair value method had been appliedto all outstanding stock option grants since the date of grant for those periods presented.  Those options whose number of exercisable shares was contingent upon a future event are not included in the fair value method estimate, and the estimated fair value ofthe stock options was amortized to expense over the respective vesting periods for those options whose number of exercisable shares was not contingent upon a future event.  The amounts below are presented in millions.

** **

 

** **

** **

** **

** **

**Predecessor**

** **

** **

** **

**September 23, 2004 through December 31, 2004**

** **

** **

** **

**Six  months ended December 31, 2004 (combined basis)**

** **

**July 1, 2004 through September 22, 2004**

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

 

 

$

(110.7

)

 

$

5.2

 

 

$

(105.5

)

Add:  Stock-based compensation    expense included in net income (loss),    net of taxes

 

 

 

 

 

66.1

 

 

 

–

 

 

 

66.1

 

Less: Pro forma stock-based compensation    expense determined under fair value    method, net of taxes

 

 

 

 

(76.7

)

 

 

–

 

 

 

(76.7

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma net income (loss)

 

 

 

$

(121.3

)

 

$

5.2

 

 

$

(116.1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

                Vanguard used the following weighted average assumptions to estimate the stock compensation expense recorded for the six months endedDecember 31, 2005:  risk-free interest rate of 4.5%; dividend yield of 0.0%; and expected option life of 10 years.

**4.             ACQUISITIONS**

**Fiscal 2005 Acquisition**

                On December 31, 2004, certain of Vanguard’s subsidiaries acquired the property, plant and equipment, investments and certaincurrent assets and assumed certain current liabilities of three acute-care hospitals with a total of 768 licensed beds and related healthcare businesses located in or around Worcester, Framingham and Natick, Massachusetts (the “Massachusetts hospitals”)from subsidiaries of Tenet Healthcare Corporation.  Vanguard paid $87.7 million including the base purchase price of $103.5 million for the property, plant and equipment and investments of the Massachusetts hospitals less $15.8 million for the excess of thecurrent liabilities assumed and closing costs incurred over the current assets acquired.  Vanguard funded the purchase price by borrowing $60.0 million from the $150.0 million acquisition delayed draw term facility under its senior secured credit facilities,entered into in connection with the merger, and using $27.7 million of cash on hand.  Vanguard invested an estimated additional $37.4 million during the third quarter of fiscal 2005 related to the build-up of working capital at the Massachusetts hospitals. On February 18, 2005, Vanguard borrowed the remaining $90.0 million available to it under the acquisition delayed draw term facility to fund the working capital build-up at the Massachusetts hospitals and to fund capital projects.  The results of operations ofthe Massachusetts hospitals are included in the accompanying condensed consolidated statement of operations for the three months and six months ended December 31, 2005.

-11-
****
**Table of Contents**

                The purchase price for the fiscal 2005 acquisition was allocated as follows (in millions).

 

 

 

**Massachusetts Hospitals**

 

Fair value of assets acquired:

 

 
****
 

   Current assets

 

$

7.3

 

   Property, plant and equipment

 

 

101.4

 

   Other tangible assets

 

 

2.1

 

 

 

 
****
 

Gross assets acquired 

 

 

110.8

 

Liabilities assumed

 

 

23.1

 

 

 

 
****
 

Cash paid for net assets acquired

 

$

87.7

 

 

 

 
****
 

**Pro Forma Results**

                The following table shows the unaudited pro forma results of consolidated operations as if the acquisition of the Massachusettshospitals had occurred as of July 1, 2004, after giving effect to certain adjustments, including the depreciation and amortization of the assets acquired based upon their estimated fair values, changes in net interest expense resulting from changes in consolidateddebt and changes in income taxes (in millions).

 

  

 

**Predecessor**

 

 

 

** **

 

 

 

**Combined Basis**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**July 1, 2004 through September 22, 2004**

** **

** **

** **

**September 23, 2004 through December 31, 2004**

 

 

 

**Six  months ended December 31, 2004**

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

$

549.9

 

 

        $

664.6

 

 

       $

1,214.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

$

(169.8

)

 

$

(2.4

)

 

$

(172.2

)

Income tax benefit

 

 

(54.2

)

 

 

(1.1

)

 

 

(55.3

)

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(115.6

)

 

$

(1.3

)

 

$

(116.9

)

 

 

 

 

 

 

 

 

 

 

-12-
****
**Table of Contents**

**5.             GOODWILL AND INTANGIBLE ASSETS**

                The following table provides information regarding the intangible assets, including deferred loan costs, included on the accompanyingcondensed consolidated balance sheets as of June 30, 2005 and December 31, 2005 (in millions).

 

 

**Gross Carrying Amount**

 

 

**Accumulated Amortization**

 

 

 
****
 

**Class of Intangible Asset**

 

**June 30, 2005**

 

 

**December 31, 2005**

 

 

**June 30, 2005**

 

 

**December 31, 2005**

 

Amortized intangible assets:

 
****
    Deferred loan costs

 

$

43.2

 

 

$

43.8

 

 

$

2.7

 

 

$

4.7

 

    Contracts

 

 

31.4

 

 

 

31.4

 

 

 

2.4

 

 

 

3.9

 

    Other

 

 

1.3

 

 

 

1.3

 

 

 

0.1

 

 

 

0.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Subtotal

 

 

75.9

 

 

 

76.5

 

 

 

5.2

 

 

 

8.8

 

 Indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

 

    License and accreditation

 

 

3.6

 

 

 

3.6

 

 

 

–

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

79.5

 

 

$

80.1

 

 

$

5.2

 

 

$

8.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                Changes in the carrying amount of goodwill from June 30, 2005 to December 31, 2005 follows (in millions).

 

 

**Acute Care Services**

 

 

**Health Plans**

 

 

**Total**

 

 

 

 

 

 

 

Balance as of June 30, 2005

 

$

745.0

 

 

$

68.1

 

 

$

813.1

Blackstone merger adjustments

 

 

6.9

 

 

 

–

 

 

 

6.9

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2005

 

$

751.9

 

 

$

68.1

 

 

$

820.0

 

 

 

 

 

 

 

 

 

                Amortization expense for the predecessor period July 1, 2004 through September 22, 2004, the combined six months ended December 31,2004 and the six months ended December 31, 2005 was $0.5 million, $1.0 million and $0.8 million, respectively.

-13-
****
**Table of Contents**

**6.             FINANCING ARRANGEMENTS**

                A summary of Vanguard’s long-term debt as of June 30, 2005 and December 31, 2005 follows (in millions):

 

 

**June 30, 2005**

        

**December 31, 2005**

 

 

 

 

 

9.75% Senior Subordinated Notes

 

$

1.0

 

$

–

 

9.0% Senior Subordinated Notes

 

 

575.0

 

 

575.0

 

11.25% Senior Discount Notes

 

 

135.7

 

 

143.3

Term loans payable under credit facility

 

 

620.7

 

 

793.7

 

Revolving loans payable under credit facility

 

 

23.0

 

 

–

 

Capital leases

 

 

1.7

 

 

0.8

 

 

 

 

 

 

 

 

 

 

1,357.1

 

 

1,512.8

 

Less: current maturities

 

 

(7.6

)

 

(8.6

)

 

 

 

 

 

 

 

 

$

1,349.5

 

$

1,504.2

 

 

 

 

 

 

 

**9.75% Notes**

                On July 30, 2001, Vanguard received gross proceeds of $300.0 million through the issuance of the 9.75% Notes due 2011.  Intereston the 9.75% Notes was payable semi-annually on February 1 and August 1. Payment of the principal and interest of the 9.75% Notes was subordinate to amounts owed for existing and future senior indebtedness of Vanguard and was guaranteed, jointly and severally, on anunsecured senior subordinated basis by most of Vanguard’s subsidiaries. Vanguard was subject to certain restrictive covenants under the Indenture governing the 9.75% Notes. In connection with the merger, Vanguard completed a tender offer to repurchase the 9.75%Notes and a consent solicitation adopting amendments to the indenture governing the notes that amended or eliminated substantially all of the restrictive covenants contained in the indenture. In connection with the merger, holders of $299.0 million of the outstanding9.75% Notes tendered their notes for repurchase by Vanguard and consented to the proposed amendments to the indenture. Vanguard repurchased the remaining $1.0 million of 9.75% Notes in October 2005. Vanguard paid tender premiums and consent fees of $50.3 millionrelated to the repurchases.

**9.0% Notes**

                In connection with the merger on September 23, 2004, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding CompanyII, LLC and Vanguard Holding Company II, Inc. (collectively the “Issuers”) completed a private placement of the $575.0 million 9.0% Notes. Interest on the 9.0% Notes is payable semi-annually on October 1 and April 1, with the first interest payment madeon April 1, 2005. The 9.0% Notes are general unsecured senior subordinated obligations and rank junior in right of payment to all existing and future senior indebtedness of the Issuers. All payments on the 9.0% Notes are guaranteed jointly and severally on a seniorsubordinated basis by Vanguard and its domestic subsidiaries, other than those subsidiaries that do not guarantee the obligations of the borrowers under the senior credit facilities.

                At any time prior to October 1, 2007, the Issuers may redeem up to 35% of the aggregate principal amount of the 9.0% Notes with the netproceeds of certain equity offerings at a redemption price of 109% of the principal amount of the 9.0% Notes plus accrued and unpaid interest. Prior to October 1, 2009, the issuers may redeem the 9.0% Notes, in whole or in part, at a price equal to 100% of theprincipal amount thereof plus a make-whole premium. On or after October 1, 2009, the issuers may redeem all of part of the 9.0% Notes at various redemption prices given the date of redemption as set forth in the indenture governing the 9.0% Notes.

                On January 26, 2005, Vanguard exchanged all of its outstanding 9.0% Notes for new 9.0% senior subordinated notes due 2014 withidentical terms and conditions, except that they were registered under the Securities Act of 1933.  Terms and conditions of the exchange offer were set forth in the registration statement on Form S-4 filed with the Securities and Exchange Commission that becameeffective on December 23, 2004.

-14-
****
**Table of Contents**

**11.25% Notes**

**

                In connection with the merger on September 23, 2004, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding CompanyI, LLC and Vanguard Holding Company I, Inc. (collectively the “Discount Issuers”), completed a private placement of $216.0 million aggregate principal amount ($124.7 million in gross proceeds) of 11.25% Notes. The 11.25% Notes accrete at the stated ratecompounded semi-annually on April 1 and October 1 of each year to, but not including, October 1, 2009. From and after October 1, 2009, cash interest on the 11.25% Notes will accrue at 11.25% per annum, and will be payable on April 1 and October 1 of each year,commencing on April 1, 2010 until maturity. The 11.25% Notes are general senior unsecured obligations and rank junior in right of payment to all existing and future senior indebtedness of the Discount Issuers but senior to any of the Discount Issuers’ futuresenior subordinated indebtedness. All payments on the 11.25% Notes are guaranteed by Vanguard as a holding company guarantee.

                At any time prior to October 1, 2007, the Discount Issuers may redeem up to 35% of the aggregate principal amount at maturity of the11.25% Notes with the net proceeds of certain equity offerings at 111.25% of the accreted value of the 11.25% Notes plus accrued and unpaid interest. Prior to October 1, 2009, the issuers may redeem the 11.25% Notes, in whole or in part, at a price equal to 100% ofthe accreted value thereof, plus accrued and unpaid interest, plus a make-whole premium. On or after October 1, 2009, the Discount Issuers may redeem all of part of the 11.25% Notes at various redemption prices given the date of redemption as set forth in theindenture governing the 11.25% Notes.

                On January 26, 2005, Vanguard exchanged all of its outstanding 11.25% Notes for new 11.25% senior discount notes due 2015 withidentical terms and conditions, except that they were registered under the Securities Act of 1933.  Terms and conditions of the exchange offer were set forth in the registration statement on Form S-4 filed with the Securities and Exchange Commission that becameeffective on December 23, 2004.

**Credit Facility Debt**

                On May 18, 2004, Vanguard entered into the 2004 credit facility, which refinanced a previous credit facility. The 2004 credit facilityconsisted of $300.0 million in seven-year term loans and a $245.0 million, five-year revolving credit facility. The interest rate on the term loans was either: 1) LIBOR plus a margin of 2.00% to 2.25% per annum dependent upon Vanguard’s consolidated leverageratio or 2) a base rate plus a margin of 1.00% to 1.25% per annum dependent upon Vanguard’s consolidated leverage ratio. Proceeds from the 2004 credit facility were used to repay all outstanding term and revolving loans under the previous credit facility, topay closing and other refinancing costs and to provide funds for working capital, capital expenditures and general corporate purposes. As of the merger date, Vanguard had no cash borrowings under this revolving credit facility but had utilized capacity related to theissuance of letters of credit totaling $27.7 million in respect of its self-insured workers’ compensation program, as well as, a performance guaranty required by the state agency that regulates Phoenix Health Plan, which is wholly owned by a subsidiary ofVanguard.

                In connection with the merger on September 23, 2004, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding CompanyII, LLC and Vanguard Health Company II, Inc. (the “Co-borrowers”), entered into new senior secured credit facilities (the “merger credit facilities”) with various lenders and Bank of America, N.A. as administrative agent and Citicorp NorthAmerica, Inc. as syndication agent, and repaid all amounts outstanding under the 2004 credit facility. The merger credit facilities included a seven-year term loan facility in the aggregate principal amount of $800.0 million (of which $475.0 million was funded atclosing) and a six-year $250.0 million revolving credit facility (of which $27.7 million of capacity was utilized at closing for letters of credit related to certain performance guarantees). Of the $325.0 million unfunded term loans, $150.0 million was made availableto finance the acquisition of hospitals and related businesses provided that the acquisition occurred on or prior to February 20, 2005, and to fund capital expenditures and other corporate needs.  Also, $175.0 million was made available for working capital,capital expenditures and other general corporate purposes until September 23, 2005.  Vanguard borrowed $60.0 million of the available $150.0 million acquisition delayed draw term loan facility in order to fund a portion of the acquisition purchase price of theMassachusetts hospitals on December 31, 2004 and borrowed the remaining $90.0 million on February 18, 2005 to fund the working capital of the Massachusetts hospitals and to fund capital expenditures. Vanguard borrowed the final $175.0 million of delayed draw termloans in September  2005.  All of such term loans were scheduled to mature on September 23, 2011.

                On September 26, 2005, the Co-borrowers refinanced and repriced all $795.7 million of the then outstanding term loans under the mergercredit facilities by borrowing $795.7 million of replacement term loans that also mature on September 23, 2011 (the “2005 term loan facility”).  In addition, upon the occurrence of certain events, the Co-borrowers may request an

-15-
****
**Table of Contents**

incremental term loan facility to be added to the 2005 term loan facility in an amount not to exceed $300.0 million in the aggregate, subject to receipt of commitments by existing lenders or other financing institutions and tothe satisfaction of certain other conditions.  The revolving loan facility under the merger credit facilities did not change in connection with the term loan refinancing.

                The 2005 term loan facility borrowings bear interest at a rate equal to, at Vanguard’s option, a base rate plus 1.25% per annumor LIBOR plus 2.25% per annum.  These interest rates reflect a savings of 1.00% per annum over the interest rate options for term loan borrowings under the merger credit facilities.  The borrowings under the revolving credit facility currently bear interestat a rate equal to, at Vanguard’s option, a base rate plus 1.00% per annum or LIBOR plus 2.00% per annum, subject to an increase of up to 0.50% per annum should Vanguard’s leverage ratio increase over certain designated levels.  Vanguard pays acommitment fee to the lenders under the revolving credit facility in respect of unutilized commitments thereunder at a rate equal to 0.50% per annum.  Vanguard also pays customary letter of credit fees.

                Vanguard is subject to certain restrictive and financial covenants under the credit agreement governing the 2005 term loan facility andthe revolving credit facility including a total leverage ratio, senior leverage ratio, interest coverage ratio and capital expenditure restrictions. Vanguard was in compliance with each of these financial covenants as of December 31, 2005. Obligations under thecredit agreement are unconditionally guaranteed by Vanguard and Vanguard Health Holding Company I, LLC (“VHS Holdco I”) and, subject to certain exceptions, each of VHS Holdco I’s wholly-owned domestic subsidiaries (the “U.S.Guarantors”). Obligations under the credit agreement are also secured by substantially all of the assets of Vanguard Health Holding Company II, LLC (“VHS Holdco II”) and the U.S. Guarantors including a pledge of 100% of the membership interests ofVHS Holdco II, 100% of the capital stock of substantially all U.S. Guarantors (other than VHS Holdco I) and 65% of the capital stock of each of VHS Holdco II’s non-U.S. subsidiaries that are directly owned by VHS Holdco II or one of the U.S. Guarantors and asecurity interest in substantially all tangible and intangible assets of VHS Holdco II and each U.S. Guarantor.

**7.             INCOME TAXES**

                Significant components of the provision for income taxes are as follows (in millions).

 

 

**Six months ended **

 

 

 

 

 

**December 31, 2004 (combined basis)**

 

 

**December 31, 2005**

 

Current:

 

 

   Federal

 

$

–

 

$

0.9

 

   State

 

 

–

 

 

0.4

 

Total current

 

 

–

 

 

1.3

 

 

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

 

 

   Federal

 

 

(44.0

)

 

6.2

 

   State

 

 

(4.4

)

 

0.8

 

 

 

 

(48.4

)

 

7.0

 

Change in valuation allowance

 

 

–

 

 

(0.6

)

 

 

 

 

 

   Total income tax expense (benefit)

 

$

(48.4

)

$

7.7

 

 

 

 

 

 

 

-16-
****
**Table of Contents**

                The effective income tax rate differed from the federal statutory rate for the periods presented as follows:

 

 

**Six months ended**

 

 

 

 

**December 31, 2004 (combined basis)**

 

    

**December 31, 2005**

 

 

 

 

Income tax at federal statutory rate

 

(35.0%

)

    

35.0%

 

Income tax at state statutory rate

(3.4%

)

6.3%

 

Nondeductible expenses and other

 

6.9%

 

 

3.1%

 

Decrease in valuation allowance

0.0%

(3.0%

)

 

 

 

 

 

Effective income tax rate

 

(31.5%

)

 

41.4%

 

 

 

 

 

 

                Net non-current deferred tax assets of $49.7 million and $30.7 million are included in other assets in the accompanying condensedconsolidated balance sheets as of June 30, 2005 and December 31, 2005, respectively.  Net current deferred tax assets of $3.1 million and $9.9 million of current deferred tax liabilities are included in prepaid expenses and other current assets on theaccompanying condensed consolidated balance sheets as of June 30, 2005 and December 31, 2005, respectively.

                As of December 31, 2005, Vanguard had generated net operating loss (“NOL”) carryforwards for federal income tax and stateincome tax purposes of approximately $198.0 million and $333.0 million, respectively, that expire from 2022 to 2025.  Certain of these NOLs are subject to annual limitation for federal purposes.  These limitations are not expected to significantly affectVanguard’s ability to ultimately recognize the benefit of these NOLs in future years.

                Vanguard must make estimates in recording its provision for income taxes, including the determination of deferred tax assets andliabilities and any valuation allowance that may be required against the deferred tax assets.  Vanguard had a valuation allowance of $7.2 million at June 30, 2005 and $6.6 million at December 31, 2005 attributable to state net operating losscarryforwards.

                On July 27, 2005, Vanguard received notification from the Internal Revenue Service of its intention to examine the federal income taxreturn of an affiliated partnership for the year ended June 30, 2003.  On October 18, 2005 the IRS informed Vanguard of its intention to expand the scope of its audit to include the consolidated corporate income tax return of Vanguard and its corporatesubsidiaries for the fiscal years ended June 30, 2003 and 2004.  Management believes that adequate provisions have been reflected in the condensed consolidated financial statements for issues that may arise in the audit based upon current facts andcircumstances.

-17-
****
**Table of Contents**

**8.             STOCKHOLDERS’ EQUITY AND RELATED BENEFIT PLANS**

**Common Stock of Vanguard and Class A Membership Units of Holdings**

                Immediately prior to the merger, Vanguard had authorized 600,000 shares of common stock, of which 232,784 shares were outstanding. Aportion of the proceeds of the merger were used to pay the holders of the common stock for their stock and the holders of outstanding options under the 1998 Stock Option Plan, the 2000 Stock Option Plan, the Initial Option Plan and the Carry Option Plan for theexcess of the merger consideration over the exercise prices of such options. In connection with the merger, Blackstone, MSCP, management and other investors purchased $624.0 million of Class A membership units of Holdings. Holdings then invested the $624.0 million inthe common stock of Vanguard, and in addition Blackstone invested $125.0 million directly in the common stock of Vanguard.  In February 2005, other investors purchased approximately $0.6 million of Class A membership units of Holdings. Holdings then invested the$0.6 million in the common stock of Vanguard.

**Equity Incentive Membership Units of Holdings**

                In connection with the merger, certain members of management purchased Class B, Class C and Class D membership units in Holdings(collectively the “equity incentive units”) for approximately $5.7 million pursuant to the Amended and Restated Limited Liability Company Operating Agreement of Holdings dated September 23, 2004 (“LLC Agreement”).  The value of the equityincentive units was determined by an independent third party appraisal. The Class B and D units vest 20% on each anniversary of the purchase date, while the Class C units vest on the eighth anniversary of the purchase date subject to accelerated vesting upon theoccurrence of a sale by Blackstone of at least 25% of its Class A units at a price per unit exceeding 2.5 times the per unit price paid on September 23, 2004.  Upon a change of control (as defined in the LLC Agreement), all Class B and D units fully vest, andClass C units fully vest if the change in control constitutes a Liquidity Event (as defined in the LLC Agreement).  In exchange for a cash payment of $5.7 million, Vanguard issued to Holdings 83,890 warrants with an exercise price of $1,000 per share and 35,952warrants with an exercise price of $3,000 per share to purchase Vanguard’s common stock. The warrants may be exercised at any time. Vanguard reserved 119,842 shares of its common stock to be issued upon exercise of the warrants.

                In November 2005, Vanguard and Holdings repurchased 22,471 of outstanding equity incentive units from two former executive officers forapproximately $1.1 million.  The purchase price was based upon the lower of cost or fair market value (determined by an independent appraisal as of September 30, 2005) or the lower of cost or fair market value less a 25% discount, as set forth in the LLCAgreement.  All 22,471 of the repurchased units are being held in treasury.  Also, as part of this transaction, Vanguard was assigned 2,921 warrants to purchase 2,921 shares of its own common stock previously held by Holdings.

**Stock Option Plans**

                Upon the payment of merger consideration to the option holders, Vanguard’s 1998 Stock Option Plan, 2000 Stock Option Plan,Initial Option Plan and Carry Option Plan were terminated. After the merger, Vanguard adopted the 2004 Stock Incentive Plan (“the 2004 Option Plan”). The 2004 Option Plan, as amended, allows for the issuance of up to 89,880 options to purchase commonstock of Vanguard to its employees. The stock options may be granted as Liquidity Event Options, Time Options or Performance Options at the discretion of the Board. The Liquidity Event Options vest 100% at the eighth anniversary of the date of grant and have anexercise price per share as determined by the Board or a committee thereof.  The Time Options vest 20% at each of the first five anniversaries of the date of grant and have an exercise price per share as determined by the Board or a committee thereof.  ThePerformance Options vest 20% at each of the first five anniversaries of the date of grant and have an exercise price per share as determined by the Board or a committee thereof.  The Time Options and Performance Options immediately vest upon a change of control,while the Liquidity Event Options immediately vest only upon a qualifying Liquidity Event, as defined in the Plan Document. As of December 31, 2005, 69,596 options were outstanding under the 2004 Option Plan.

**9.             RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**

                In November 2005, the FASB issued FASB Staff Position No. 45-3, *Application of FASB Interpretation No. 45 to Minimum RevenueGuarantees Granted to a Business or Its Owners* (“FSP 45-3”).  FSP 45-3 expands the scope of FASB Interpretation No. 45 (“FIN 45”) to include certain contracts, agreements or guarantees that contingently obligate an entityto

-18-
****
**Table of Contents**

make payments to another party.  FSP 45-3 specifically provides that physician income guarantees are subject to the provisions of FIN 45.  FSP 45-3 is effective for new minimum revenue guarantees issued or modifiedon or after January 1, 2006 on a prospective basis only. Vanguard is still assessing the impact of FSP 45-3 on its future results of operations and statements of position.

                In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, *Accounting Changes and Error Corrections*(“SFAS 154”), which revises the accounting and reporting requirements of a change in accounting principle.  SFAS 154, among other things, eliminates the requirement under APB No. 20 that a cumulative effect of a change in accounting principle berecognized during the period of change.  Rather, SFAS 154 requires retrospective application of the direct effects of changes in accounting principle to the beginning of the first period presented to enhance comparability between periods.  Under SFAS 154,the cumulative effect of a change in accounting principle is recognized in the carrying value of the assets and liabilities as of the first period presented with offsetting adjustments recorded to opening retained earnings.  The retrospective application is notdeemed to be a restatement.  SFAS 154 is effective for accounting changes and error corrections made during fiscal years beginning after December 15, 2005.  SFAS 154 may only affect Vanguard’s future reporting of currently presented consolidatedfinancial statements to the extent it experiences accounting changes covered by SFAS 154 during periods subsequent to the year ending June 30, 2006.

                In March 2005, the FASB issued Interpretation No. 47, *Accounting for Conditional Asset Retirement Obligations* (“FIN47”).  FIN 47 clarifies guidance set forth in SFAS 143, *Asset Retirement Obligations*, regarding the timing of liability recognition for legal obligations associated with the retirement of a tangible long-lived asset for which timing or method ofsettlement is outside the entity’s control.  FIN 47 is effective for fiscal years ending after December 15, 2005.  The adoption of FIN 47 did not have a significant effect on Vanguard’s operating results or cash flows.

                In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based Payment*(“SFAS 123R”), which revised SFAS 123 and superseded APB 25.  SFAS 123R requires all share-based payments granted to employees to be measured and recorded in the financial statements at fair value. SFAS 123R uses a “modified grant date”approach whereby fair value of the equity award is estimated without regard to service or performance conditions and compensation expense is recognized over the vesting period of the award.  Vanguard expects to adopt SFAS 123R on July 1, 2006.  Vanguarddoes not expect SFAS 123R to have a significant impact on its future results of operations since it previously adopted SFAS 123 on July 1, 2003. However, SFAS 123R could have an impact on Vanguard’s future statements of cash flows.

                In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, *Exchanges of Nonmonetary Assets*(“SFAS 153”).  SFAS 153 amends APB Opinion No. 29, *Accounting for Nonmonetary Transactions*, to eliminate the exception for the measurement of nonmonetary exchanges of similar productive assets at carrying value and replaces it with anexception for carrying value measurement applied to nonmonetary assets that have no commercial substance.  Nonmonetary exchanges of similar productive assets with commercial substance would be measured at fair value under SFAS 153.  SFAS 153 is effectivefor fiscal periods beginning after June 15, 2005, with early adoption encouraged.  The adoption of SFAS 153 did not have a significant effect on Vanguard’s operating results or cash flows.

-19-
****
**Table of Contents**

**10.          SEGMENT INFORMATION**

                Vanguard’s acute care hospitals and related healthcare businesses are similar in their activities and the economic environmentsin which they operate (i.e. urban markets).  Accordingly, Vanguard’s reportable operating segments consist of 1) acute care hospitals and related healthcare businesses, collectively, and 2) health plans consisting of MacNeal Health Providers, a contractingentity for MacNeal Hospital and Weiss Memorial Hospital in the metropolitan Chicago area, and Phoenix Health Plan, a Medicaid managed health plan operating solely in Arizona.

                The following tables provide condensed unaudited financial information by business segment for the three months ended December 31, 2004and 2005, the six months ended December 31, 2004 (combined basis) and 2005, the predecessor period July 1, 2004 through September 22, 2004 and the period September 23, 2004 through December 31, 2004, respectively, including a reconciliation of Segment EBITDA toincome or loss before income taxes (in millions).

 

 

**Three months ended December 31, 2004**

** **

**Three months ended December 31, 2005**

 

 
****
** **
****
 

 

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**

** **

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**
********
Patient service revenues

$

–

$

416.1

$

–

$

416.1

$

–

$

552.3

$

–

$

552.3

 

Premium revenues

83.7

–

–

83.7

89.4

–

–

89.4

 

Inter-segment revenues

–

11.9

(11.9

)

–

–

9.3

(9.3

)

–

 

 

      Total revenues

83.7

428.0

(11.9

)

499.8

89.4

561.6

(9.3

)

641.7

 

 

Operating expenses - external

64.1

381.5

–

445.6

71.2

509.7

–

580.9

 

Operating expenses - inter-segment

11.9

–

(11.9

)

–

9.3

–

(9.3

)

–

 

 

      Total operating expenses

76.0

381.5

(11.9

)

445.6

80.5

509.7

(9.3

)

580.9

 

 

      Segment EBITDA(1)

7.7

46.5

–

54.2

8.9

51.9

–

60.8

 

 

Less:

 

Interest, net

0.2

24.8

–

25.0

(0.5

)

28.7

–

28.2

 

Depreciation and amortization

0.5

20.3

–

20.8

1.1

23.4

–

24.5

 

Minority interests

–

(0.3

)

–

(0.3

)

–

0.9

–

0.9

 

Equity method income

–

(0.1

)

–

(0.1

)

–

(0.2

)

(0.2

)

 

Stock compensation

–

0.2

–

0.2

–

0.3

–

0.3

 

Debt extinguishment costs

–

–

–

–

–

0.1

–

0.1

 

Loss (gain) on sale of assets

–

0.2

–

0.2

–

(0.1

)

–

(0.1

)

 

Monitoring fees

–

1.3

–

1.3

–

1.3

–

1.3

 

 

      Income (loss) before income taxes

$

7.0

$

0.1

$

–

$

7.1

$

8.3

$

(2.5

)

$

–

$

5.8

 

 

-20-
****
**Table of Contents**

**Combined Basis**
****
 

 

**Six months ended December 31, 2004**

** **

**Six months ended December 31, 2005**

 

 
****
** **
****
 

 

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**

** **

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**
********
Patient service revenues

$

–

$

830.4

$

–

$

830.4

$

–

$

1,113.9

$

–

$

1,113.9

 

Premium revenues

163.1

–

–

163.1

175.5

–

–

175.5

 

Inter-segment revenues

–

19.0

(19.0

)

–

–

19.3

(19.3

)

–

 

 

      Total revenues

163.1

849.4

(19.0

)

993.5

175.5

1,133.2

(19.3

)

1,289.4

 

 

Operating expenses - external

131.1

756.2

–

887.3

138.0

1,025.1

–

1,163.1

 

Operating expenses - inter-segment

19.0

–

(19.0

)

–

19.3

–

(19.3

)

–

 

 

      Total operating expenses

150.1

756.2

(19.0

)

887.3

157.3

1,025.1

(19.3

)

1,163.1

 

 

      Segment EBITDA(1)

13.0

93.2

–

106.2

18.2

108.1

–

126.3

 

 

Less:

 

Interest, net

0.5

36.4

–

36.9

(0.6

)

55.2

–

54.6

 

Depreciation and amortization

1.1

38.8

–

39.9

2.2

46.8

–

49.0

 

Minority interests

–

(0.8

)

–

(0.8

)

–

1.6

–

1.6

 

Equity method income

–

(0.3

)

–

(0.3

)

–

(0.8

)

(0.8

)

 

Stock compensation

–

96.9

–

96.9

–

0.6

–

0.6

 

Debt extinguishment costs

–

62.2

–

62.2

–

0.1

–

0.1

 

Merger expenses

–

23.1

–

23.1

–

–

–

–

 

Loss on sale of assets

–

0.8

–

0.8

–

–

–

–

 

Monitoring fees

–

1.4

–

1.4

–

2.6

–

2.6

 

 

      Income (loss) before income taxes

$

11.4

$

(165.3

)

$

–

$

(153.9

)

$

16.6

$

2.0

$

–

$

18.6

 

 

Capital expenditures

$

0.9

$

71.5

$

72.4

$

0.1

$

113.6

$

–

$

113.7

 

 

Segment assets

$

28.7

$

2,204.4

$

2,233.1

$

161.9

$

2,432.7

$

–

$

2,594.6

 

 

-21-
****
**Table of Contents**

 

 

**Predecessor**

** **

** **

 

 
****
** **

** **

**July 1, 2004 through September 22, 2004**

**September 23, 2004 through December 31, 2004**
********
**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**

**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**
********
Patient service revenues

$

–

$

377.3

$

–

$

377.3

$

–

$

453.1

$

–

$

453.1

 

Premium revenues

72.3

–

–

72.3

90.8

–

–

90.8

 

Inter-segment revenues

–

6.4

(6.4

)

–

–

12.6

(12.6

)

–

 

 

      Total revenues

72.3

383.7

(6.4

)

449.6

90.8

465.7

(12.6

)

543.9

 

 

Operating expenses - external

61.2

341.3

–

402.5

69.9

414.9

–

484.8

 

Operating expenses - inter-segment

6.4

–

(6.4

)

–

12.6

–

(12.6

)

–

 

 

      Total operating expenses

67.6

341.3

(6.4

)

402.5

82.5

414.9

(12.6

)

484.8

 

 

      Segment EBITDA(1)

4.7

42.4

–

47.1

8.3

50.8

–

59.1

 

 

Less:

 

Interest, net

0.2

9.6

–

9.8

0.3

26.8

–

27.1

 

Depreciation and amortization

0.6

16.8

–

17.4

0.5

22.0

–

22.5

 

Minority interests

–

(0.5

)

–

(0.5

)

–

(0.3

)

–

(0.3

)

 

Equity method income

–

(0.2

)

–

(0.2

)

–

(0.1

)

–

(0.1

)

 

Stock compensation

–

96.7

–

96.7

–

0.2

–

0.2

 

Debt extinguishment costs

–

62.2

–

62.2

–

–

–

–

 

Merger expenses

–

23.1

–

23.1

–

–

–

–

 

Loss on sale of assets

–

0.6

–

0.6

–

0.2

–

0.2

 

Monitoring fees

–

–

–

–

–

1.4

–

1.4

 

 

      Income (loss) before income taxes

$

3.9

$

(165.9

)

$

–

$

(162.0

)

$

7.5

$

0.6

$

–

$

8.1

 

 

Capital expenditures

$

0.7

$

29.1

$

29.8

$

0.2

$

42.4

$

42.6

 

 

____________________(1) Segment EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation and amortization, minority interests, equity method income or loss, stock compensation, debt extinguishment costs, merger expenses, gain or loss onsale of assets and monitoring fees.  Management uses Segment EBITDA to measure performance for Vanguard’s segments and to develop strategic objectives and operating plans for those segments.  Segment EBITDA eliminates the uneven effect of non-cashdepreciation of tangible assets and amortization of intangible assets, much of which results from acquisitions accounted for under the purchase method of accounting.  Segment EBITDA also eliminates the effects of changes in interest rates which managementbelieves relate to general trends in global capital markets, but are not necessarily indicative of the operating performance of Vanguard’s segments.  Management believes that Segment EBITDA provides useful information about the financial performance ofVanguard’s segments to investors, lenders, financial analysts and rating agencies.  Additionally, management believes that investors and lenders view Segment EBITDA as an important factor in making investment decisions and assessing the value ofVanguard.  Segment EBITDA is not 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.  Segment EBITDA, as presented, may not becomparable to similarly titled measures of other companies.

**11.          COMMITMENTS AND CONTINGENCIES**

****

                Vanguard has committed to meet certain construction and facility expansion obligations.  In addition, management evaluatescontingencies based upon the best available information and believes that adequate provision for potential losses associated with contingencies has been made.  In management’s opinion, based on current available information, these commitments describedbelow will not have a material effect on Vanguard’s results of operations or financial position, but the construction and facility expansion obligations could have an effect on the timing of Vanguard’s cash flows, including its need to borrow availableamounts under its revolving credit facility.

-22-
****
**Table of Contents**

**Capital Expenditures and****Construction Commitments**

                Vanguard currently has multiple capital expansion and replacement projects underway.  As of December 31, 2005, Vanguardestimatesits remaining commitments to complete the expansion projects in San Antonio and Phoenix and its remaining obligations for other capital projects in process to be approximately $117.3 million.

**Litigation**

                Vanguard is presently, and from time to time, subject to various claims and lawsuits arising in the ordinary course of business. Although the results of these claims and lawsuits cannot be predicted with certainty, management believes that the ultimate resolution of these claims and lawsuits will not have a material adverse effect on Vanguard’s business, financial condition or results ofoperations.

**Patient Service Revenues**

                Final determinations of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits bythe programs, rights of appeal and the application of numerous technical provisions.  Differences between original estimates and subsequent revisions (including final settlements) are included in the condensed consolidated statements of operations in the periodin which the revisions are made.  Management believes that adequate provision has been made for adjustments that may result from final determination of amounts earned under the Medicare and Medicaid programs.  Net adjustments for final third partysettlements resulted in increases to income before income taxes of $0.2 million and $1.1 million for the three months ended December 31, 2004 and 2005, respectively, and $2.5 million and $3.4 million for the six months ended December 31, 2004 (combined basis) and2005, respectively.  Vanguard recorded $12.5 million and $20.5 million of charity care deductions during the three months ended December 31, 2004 and 2005, respectively, and $23.4 million and $37.5 million for the six months ended December 31, 2004 (combinedbasis) and 2005, respectively.

**Governmental Regulation**

                Laws and regulations governing the Medicare, Medicaid and other federal healthcare programs are complex and subject tointerpretation.  Vanguard’s management believes that it is in compliance with all applicable laws and regulations in all material respects. However, compliance with such laws and regulations can be subject to future government review and interpretation aswell as significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal healthcare programs.   In accordance with its established compliance program policies, in September 2004 Vanguard made a voluntarydisclosure to the Office of Inspector General of the U.S. Department of Health and Human Services (“OIG”) and to the local U.S. Attorney’s Office regarding certain physician lease documentation discrepancies at one of its hospitals. Vanguard has notdetermined that a violation of any laws or regulations has occurred, nor has Vanguard determined that any restitution or other payment is legally due to the federal government in respect of this matter.  However, since the OIG is investigating this matter,Vanguard has entered into settlement negotiations with the OIG during fiscal 2006 due to the risks of litigation and its associated expenses.  Vanguard expects to complete settlement negotiations with the OIG in the near future to resolve this issue and hasaccrued a reasonable estimate of the settlement cost to it of this matter.  The estimated settlement accrual is considered part of the merger purchase price allocation and is reflected in goodwill on the accompanying condensed consolidated balance sheet as ofDecember 31, 2005.  Vanguard does not expect the settlement of this matter to have a material impact on its future results of operations or cash flows. Except for this OIG investigation, Vanguard is not aware of any other material regulatory proceeding orinvestigation underway or threatened involving allegations of potential wrongdoing.

**Acquisitions**

                Vanguard has acquired and will continue to acquire businesses with prior operating histories.  Acquired companies may have unknownor contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations, such as billing and reimbursement, anti-kickback and physician self-referral laws.  Although Vanguard institutes policies designed to conform practicesto its standards following completion of acquisitions and attempts to structure its acquisitions as asset acquisitions in which Vanguard does not assume liability for seller wrongful actions, there can be no assurance that Vanguard will not become liable for pastactivities that may later be alleged to be improper by private plaintiffs or government agencies.  Although Vanguard obtains general indemnifications from sellers covering such matters, there can be

-23-
****
**Table of Contents**

no assurance that any specific matter will be covered by such indemnifications, or if covered, that such indemnifications will be adequate to cover potential losses and fines.

**Professional and General Liability Risks**

                As is typical in the healthcare industry, Vanguard is subject to potential claims and legal actions in the ordinary course of businessincluding patient care.  Effective June 1, 2002, the Company established a wholly owned captive subsidiary to insure its professional and general liability risks at a $10.0 million retention level.  Vanguard maintains excess coverage on a claims-made basiswith third party insurers covering individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate.  The captive insurance subsidiary funds claims costs from premium payments received fromVanguard.  Vanguard’s reserve for reported and unreported professional and general liability claims was $61.7 million as of December 31, 2005.  The market for professional liability excess insurance has improved during the past two years resulting ina stabilization of premiums.  However, Vanguard’s professional liability costs remain sensitive to market factors affecting premiums for excess coverage and the quantity and severity of professional liability claims.  Also, Vanguard is exposed toincreased payments to malpractice claimants in the event physicians practicing at Vanguard’s hospitals are unable to obtain adequate malpractice insurance or in the event Vanguard employs more physicians.  As Vanguard’s period of ownership of itshospitals lengthens, management expects Vanguard’s professional liability claims payments to increase.

**Guarantees**

                As part of its contract with the Arizona Health Care Cost Containment System (“AHCCCS”), one of Vanguard’s healthplans, Phoenix Health Plan, is required to maintain a performance guarantee in the amount of $18.0 million, an amount determined based upon Plan membership and capitation premiums received.  As of December 31, 2005, Vanguard maintained this performance guaranteeentirely in the form of surety bonds with independent third party insurers that expire on September 30, 2006.  Vanguard arranged for $5.3 million in letters of credit to collateralize its $18.0 million in surety bonds with the third party insurers.

**Variable Interest Entities**

                Vanguard is a party to two contractual agreements whereby it may be required to make monthly payments to the developers and managers oftwo medical office buildings located on its hospital campuses through minimum rent revenue guarantees.  Vanguard entered into these agreements to provide an incentive to the developers to fund the construction of the medical office buildings and manage thebuildings upon their completion in order to make physician office space available near its hospital campuses.  One of the contracts commenced prior to the effective date of Financial Interpretation Number 46, *Variable Interest Entities*, (as amended by FIN46R) and is scheduled to terminate in March 2016.  Vanguard is currently assessing the impact of FIN 46R on this contract.  Should Vanguard be required to consolidate this variable interest entity (“VIE”) under FIN 46R, its cash flows, resultsof operations or compliance with debt covenants would not be materially affected.  Should the contract remain in place, Vanguard expects to pay approximately $1.1 million under this contract during the remainder of its term.  The second contract commencedin June 2004 for a period of 12 years.  Vanguard deemed this contract a VIE in which Vanguard is not the primary beneficiary.  The maximum annual amount Vanguard would pay under the contract assuming no changes to current occupancy levels would beapproximately $0.6 million.  Vanguard does not expect to pay any material amounts under this contract during the remainder of its term.

**12.          FINANCIAL INFORMATION FOR SUBSIDIARY GUARANTORS AND                NON-GUARANTOR SUBSIDIARIES**

                Vanguard conducts substantially all of its business through its subsidiaries. Most of Vanguard’s subsidiaries jointly andseverally guarantee the 9.0% Notes on an unsecured senior subordinated basis. Certain of Vanguard’s other consolidated wholly-owned and non wholly-owned entities do not guarantee the 9.0% Notes in conformity with the provisions of the indenture governing the9.0% Notes and do not guarantee Vanguard’s senior secured credit facilities in conformity with the provisions thereof. The condensed consolidating financial information for the parent company, the issuers of the 9.0% Notes, the issuers of the 11.25% Notes, thesubsidiary guarantors, the non-guarantor subsidiaries, certain eliminations and consolidated Vanguard as of June 30, 2005 and December 31, 2005 and for the three months ended December 31, 2004 and 2005, for the six months ended December 31, 2004 (combined basis) and2005, the predecessor period July 1, 2004 through September 22, 2004 and the period September 23, 2004 through December 31, 2004, follows.

-24-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSJune 30, 2005**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
**ASSETS**

*(In millions)*

Current assets:

Cash and cash equivalents

$         0.8

$             –

$             –

$        (5.9)

$      84.3

$             –

$        79.2

Accounts receivable, net

           –

               –

               –

       239.4

        46.6

               –

        286.0

Inventories

           –

                –

                –

         37.7

          5.8

                –

          43.5

Prepaid expenses and other current assets

            3.1

                –

                –

         17.1

        53.1

          (37.2)

          36.1

 

    Total current assets

            3.9

                –

                –

       288.3

      189.8

          (37.2)

        444.8

             

Property, plant and equipment, net

           –

               –

               –

       979.7

        93.1

               –

     1,072.8

Goodwill

            4.6

               –

               –

       732.6

        75.9

               –

        813.1

Intangible assets, net

           –

            36.7

              3.8

           1.2

        32.6

               –

          74.3

Investments in consolidated subsidiaries

        408.8

               –

               –

             –

        22.6

        (431.4)

             –

Other assets

         49.6

               –

               –

         17.0

          0.1

               –

          66.7

    Total assets

$      466.9

$          36.7

$            3.8

$  2,018.8

$    414.1

$      (468.6)

$   2,471.7

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

Current liabilities:

Accounts payable

$         –

$             –

$             –

$     128.9

$      16.6

$             –

$      145.5

Accrued expenses and other current liabilities

            0.6

            14.4

               –

       127.3

        81.1

            (9.4)

        214.0

Current maturities of long-term debt

            –

              6.3

               –

           0.4

          0.9

                –

            7.6

    Total current liabilities

            0.6

            20.7

               –

       256.6

        98.6

            (9.4)

        367.1

Other liabilities

           0.8

               –

               –

         28.5

        89.1

          (39.1)

          79.3

Long-term debt, less current maturities

           –

       1,213.4

          135.7

           0.3

          0.1

               –

     1,349.5

Intercompany

     (210.3)

     (1,124.7)

        (120.8)

    1,369.8

      125.0

          (39.0)

             –

Stockholders’ equity

        675.8

          (72.7)

          (11.1)

       363.6

      101.3

        (381.1)

        675.8

 

    Total liabilities and stockholders’ equity

$      466.9

$          36.7

$            3.8

$  2,018.8

$    414.1

$      (468.6)

$   2,471.7

-25-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSDecember 31, 2005(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
**ASSETS**

*(In millions)*

Current assets:

Cash and cash equivalents

$      0.8

$             –

$             –

$       68.9

$      92.8

$             –

$      162.5

Accounts receivable, net

           –

               –

               –

       242.1

        39.9

               –

        282.0

Inventories

           –

                –

                –

         39.3

          5.8

                –

          45.1

Prepaid expenses and other current assets

       14.1

                –

                –

         21.8

        35.6

         (19.9)

          51.6

 

    Total current assets

       14.9

                –

                –

       372.1

      174.1

         (19.9)

        541.2

             

Property, plant and equipment, net

           –

               –

               –

    1,026.3

        88.4

               –

     1,114.7

Goodwill

           –

               –

               –

       732.7

        87.3

               –

        820.0

Intangible assets, net

           –

          35.4

              3.7

           2.0

        30.2

               –

          71.3

Investments in consolidated subsidiaries

     408.8

               –

               –

           9.3

        22.6

       (431.4)

            9.3

Other assets

      30.7

               –

               –

           7.3

          0.1

               –

          38.1

    Total assets

$   454.4

$        35.4

$            3.7

$  2,149.7

$    402.7

$     (451.3)

$   2,594.6

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

Current liabilities:

Accounts payable

$         –

$             –

$             –

$     123.3

$      17.2

$             –

$      140.5

Accrued expenses and other current liabilities

         1.6

          13.6

               –

       102.6

        54.2

         (10.1)

        161.9

Current maturities of long-term debt

            –

            8.0

               –

          (0.2)

          0.8

                –

            8.6

    Total current liabilities

         1.6

          21.6

               –

       225.7

        72.2

         (10.1)

        311.0

Other liabilities

        0.8

               –

               –

         26.4

        83.6

         (17.7)

          93.1

Long-term debt, less current maturities

           –

     1,360.7

          143.3

           0.2

           –

               –

     1,504.2

Intercompany

  (234.3)

     (1,194.9)

        (120.8)

    1,467.6

        35.4

           47.0

             –

Payable-In-Kind Preferred Stock

           –

               –

               –

             –

           –

               –

             –

Stockholders’ equity

     686.3

      (152.0)

          (18.8)

       429.8

      211.5

       (470.5)

        686.3

 

    Total liabilities and stockholders’ equity

$   454.4

$        35.4

$            3.7

$  2,149.7

$    402.7

$     (451.3)

$   2,594.6

-26-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the three months ended December 31, 2004(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$         –

    $     –

    $      –

   $  365.0

   $    60.7

    $   (9.6)

   $   416.1

Premium revenues

           –

           –

            –

         10.6

        80.0

          (6.9)

          83.7

 

    Total revenues

           –

           –

            –

       375.6

      140.7

        (16.5)

        499.8

 

 

 

 

 

 

 

 

Salaries and benefits

           –

           –

            –

       168.5

        31.9

            –

        200.4

Supplies

           –

           –

            –

         69.8

        10.8

            –

          80.6

Medical claims expense

           –

           –

            –

           6.3

        59.9

            –

          56.6

Purchased services

           –

           –

            –

         19.4

          5.9

          (9.6)

          25.3

Provision for doubtful accounts

           –

           –

            –

         31.2

          4.3

            –

          35.5

Other operating expenses

           –

           –

            –

         32.1

        15.3

          (6.9)

          40.5

Rents and leases

           –

           –

            –

           5.3

          1.6

            –

            6.9

Depreciation and amortization

           –

           –

            –

         18.4

          2.4

            –

          20.8

Interest, net

           –

       22.3

           3.5

          (1.5)

          0.7

            –

          25.0

Management fees

           –

           –

            –

          (2.0)

          2.0

            –

             –

Debt extinguishment costs

           –

           –

            –

            –

            –

            –

             –

Merger expenses

           –

           –

            –

            –

            –

            –

             –

Other

           –

           –

            –

           1.1

            –

            –

            1.1

 

    Total costs and expenses

           –

       22.3

           3.5

       348.6

      134.8

        (16.5)

        492.7

 

Income (loss) before income taxes

           –

      (22.3)

          (3.5)

         27.0

          5.9

            –

            7.1

Income tax benefit

         2.5

           –

            –

            –

            –

            –

            2.5

Equity in earnings of subsidiaries

         7.1

           –

            –

            –

            –

          (7.1)

             –

 

Net income (loss)

$     4.6

$    (22.3)

    $    (3.5)

   $    27.0

   $      5.9

    $    (7.1)

   $       4.6

 

-27-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the three months ended December 31, 2005(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$         –

    $     –

    $      –

   $  499.1

   $    59.8

    $    (6.6)

   $   552.3

Premium revenues

           –

           –

            –

         11.6

        86.5

          (8.7)

          89.4

 

    Total revenues

           –

           –

            –

       510.7

      146.3

        (15.3)

        641.7

 

 

 

 

 

 

 

 

Salaries and benefits

         0.3

           –

            –

       243.9

        32.3

            –

        276.5

Supplies

           –

           –

            –

         92.5

        10.3

            –

        102.8

Medical claims expense

           –

           –

            –

           6.6

        63.0

          (6.6)

          63.0

Purchased services

           –

           –

            –

         33.0

          5.7

            –

          38.7

Provision for doubtful accounts

           –

           –

            –

         37.0

          2.3

            –

          39.3

Other operating expenses

           –

           –

            –

         42.9

        17.9

          (8.7)

          52.1

Rents and leases

           –

           –

            –

           6.9

          1.8

            –

            8.7

Depreciation and amortization

           –

           –

            –

         20.5

          4.0

            –

          24.5

Interest, net

           –

       26.9

           3.9

          (3.0)

          0.4

            –

          28.2

Management fees

           –

           –

            –

          (1.6)

          1.6

            –

             –

Debt extinguishment costs

         0.1

           –

            –

            –

            –

            –

            0.1

Merger expenses

           –

           –

            –

            –

            –

            –

             –

Other

           –

           –

            –

           2.0

            –

            –

            2.0

 

    Total costs and expenses

         0.4

       26.9

           3.9

       480.7

      139.3

        (15.3)

        635.9

 

Income (loss) before income taxes

      (0.4)

      (26.9)

          (3.9)

         30.0

          7.0

            –

            5.8

Income tax expense (benefit)

         2.2

           –

            –

            –

          1.2

          (1.2)

            2.2

Equity in earnings of subsidiaries

         6.2

           –

            –

            –

            –

          (6.2)

             –

 

Net income (loss)

$       3.6

$    (26.9)

    $    (3.9)

   $    30.0

   $      5.8

    $    (5.0)

   $       3.6

 

-28-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the six months ended December 31, 2004**

**(Combined Basis)(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$         –

    $     –

    $      –

   $  725.2

   $  119.7

    $  (14.5)

   $   830.4

Premium revenues

           –

           –

            –

         21.2

      155.8

        (13.9)

        163.1

 

    Total revenues

           –

           –

            –

       746.4

      275.5

        (28.4)

        993.5

 

 

 

 

 

 

 

 

Salaries and benefits

           –

           –

            –

       429.8

        63.2

            –

        493.0

Supplies

           –

           –

            –

       138.8

        21.2

            –

        160.0

Medical claims expense

           –

           –

            –

         13.3

      118.1

        (14.5)

        116.9

Purchased services

           –

           –

            –

         38.5

        11.3

            –

          49.8

Provision for doubtful accounts

           –

           –

            –

         60.9

          9.1

            –

          70.0

Other operating expenses

           –

           –

            –

         64.8

        30.4

        (13.9)

          81.3

Rents and leases

           –

           –

            –

           9.9

          3.3

            –

          13.2

Depreciation and amortization

           –

           –

            –

         35.3

          4.6

            –

          39.9

Interest, net

           –

       24.1

           3.8

           7.1

          1.9

            –

          36.9

Management fees

           –

           –

            –

          (4.0)

          4.0

            –

             –

Debt extinguishment costs

       50.2

           –

            –

         12.0

            –

            –

          62.2

Merger expenses

       17.0

           –

            –

           6.1

            –

            –

          23.1

Other

           –

           –

            –

           1.2

         (0.1)

            –

            1.1

 

    Total costs and expenses

       67.2

       24.1

           3.8

       813.7

      267.0

        (28.4)

     1,147.4

 

Income (loss) before income taxes

    (67.2)

      (24.1)

          (3.8)

        (67.3)

          8.5

            –

       (153.9)

Income tax expense (benefit)

    (48.4)

           –

            –

            –

            –

            –

         (48.4)

Equity in earnings of subsidiaries

    (86.7)

           –

            –

            –

            –

         86.7

             –

 

Net income (loss)

$ (105.5)

$    (24.1)

    $    (3.8)

   $  (67.3)

   $      8.5

    $   86.7

   $ (105.5)

 

-29-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the six months ended December 31, 2005(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$         –

    $     –

    $      –

   $ 1,007.1

   $  120.8

    $  (14.0)

   $ 1,113.9

Premium revenues

           –

           –

            –

         22.6

      170.3

        (17.4)

        175.5

 

    Total revenues

           –

           –

            –

    1,029.7

      291.1

        (31.4)

     1,289.4

 

 

 

 

 

 

 

 

Salaries and benefits

         0.6

           –

            –

       481.7

        63.8

            –

        546.1

Supplies

           –

           –

            –

       187.6

        19.8

            –

        207.4

Medical claims expense

           –

           –

            –

         13.3

      123.1

        (14.0)

        122.4

Purchased services

           –

           –

            –

         62.5

        11.8

            –

          74.3

Provision for doubtful accounts

           –

           –

            –

         82.0

          7.4

            –

          89.4

Other operating expenses

         0.1

           –

            –

         88.9

        35.5

        (17.4)

        107.1

Rents and leases

           –

           –

            –

         13.3

          3.7

            –

          17.0

Depreciation and amortization

           –

           –

            –

         41.0

          8.0

            –

          49.0

Interest, net

           –

       53.1

           7.7

          (7.3)

          1.1

            –

          54.6

Management fees

           –

           –

            –

          (3.2)

          3.2

            –

             –

Debt extinguishment costs

         0.1

           –

            –

            –

            –

            –

            0.1

Other

           –

           –

            –

           3.4

            –

            –

            3.4

 

    Total costs and expenses

         0.8

       53.1

           7.7

       963.2

      277.4

        (31.4)

     1,270.8

 

Income (loss) before income taxes

      (0.8)

      (53.1)

          (7.7)

         66.5

        13.7

            –

          18.6

Income tax expense (benefit)

         7.7

           –

            –

            –

          0.3

          (0.3)

            7.7

Equity in earnings of subsidiaries

       19.4

           –

            –

            –

            –

        (19.4)

             –

 

Net income (loss)

$     10.9

$    (53.1)

    $    (7.7)

   $    66.5

   $    13.4

    $  (19.1)

   $     10.9

 

-30-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the Predecessor Period July 1, 2004 through September 22, 2004**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$        –

    $     –

      $    –

   $  323.6

   $    53.7

     $     –

   $   377.3

Premium revenues

          –

           –

            –

           9.7

        69.0

          (6.4)

          72.3

 

    Total revenues

          –

           –

            –

       333.3

      122.7

          (6.4)

        449.6

 

 

 

 

 

 

 

 

Salaries and benefits

          –

           –

            –

       246.8

        28.6

            –

        275.4

Supplies

          –

           –

            –

         62.8

          9.5

            –

          72.3

Medical claims expense

          –

           –

            –

           1.9

        53.1

            –

          55.0

Purchased services

          –

           –

            –

         17.2

          4.9

            –

          22.1

Provision for doubtful accounts

          –

           –

            –

         27.1

          4.4

            –

          31.5

Other operating expenses

          –

           –

            –

         29.9

        13.7

          (6.4)

          37.2

Rents and leases

          –

           –

            –

           4.2

          1.5

            –

            5.7

Depreciation and amortization

          –

           –

            –

         15.4

          2.0

            –

          17.4

Interest, net

          –

           –

            –

           8.6

          1.2

            –

            9.8

Management fees

          –

           –

            –

          (2.0)

          2.0

            –

             –

Debt extinguishment costs

       50.2

           –

            –

         12.0

            –

            –

          62.2

Merger expenses

       17.0

           –

            –

           6.1

            –

            –

          23.1

Other

          –

           –

            –

            –

         (0.1)

            –

           (0.1)

  

    Total costs and expenses

       67.2

           –

            –

       430.0

      120.8

          (6.4)

        611.6

 

Income (loss) before income taxes

    (67.2)

           –

            –

        (96.7)

          1.9

            –

       (162.0)

Income tax benefit

    (51.3)

           –

            –

             –

            –

            –

         (51.3)

Equity in earnings of subsidiaries

    (94.8)

           –

            –

             –

            –

         94.8

             –

 

Net income (loss)

$ (110.7)

    $     –

      $    –

   $  (96.7)

   $      1.9

     $  94.8

   $ (110.7)

 

-31-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the Period September 23, 2004 through December 31, 2004(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

** **

** **

Patient service revenues

$        –

   $       –

   $       –

   $  401.6

   $    66.0

   $  (14.5)

   $   453.1

Premium revenues

          –

            –

            –

         11.5

        86.8

          (7.5)

          90.8

 

    Total revenues

          –

            –

            –

       413.1

      152.8

        (22.0)

        543.9

 

 

 

 

 

 

 

 

Salaries and benefits

          –

            –

            –

       183.0

        34.6

            –

        217.6

Supplies

          –

            –

            –

         76.0

        11.7

            –

          87.7

Medical claims expense

          –

            –

            –

         11.4

        65.0

        (14.5)

          61.9

Purchased services

          –

            –

            –

         21.3

          6.4

            –

          27.7

Provision for doubtful accounts

          –

            –

            –

         33.8

          4.7

            –

          38.5

Other operating expenses

          –

            –

            –

         34.9

        16.7

          (7.5)

          44.1

Rents and leases

          –

            –

            –

           5.7

          1.8

            –

            7.5

Depreciation and amortization

          –

            –

            –

         19.9

          2.6

            –

          22.5

Interest, net

          –

         24.1

           3.8

          (1.5)

          0.7

            –

          27.1

Management fees

          –

            –

            –

          (2.0)

          2.0

            –

              –

Stock compensation

          –

            –

            –

            –

            –

            –

              –

Debt extinguishment costs

          –

            –

            –

            –

            –

            –

              –

Merger expenses

          –

            –

            –

            –

            –

            –

              –

Other

          –

            –

            –

           1.2

            –

            –

            1.2

 

    Total costs and expenses

          –

         24.1

           3.8

       383.7

      146.2

        (22.0)

        535.8

 

Income (loss) before income taxes

          –

        (24.1)

          (3.8)

         29.4

           6.6

            –

            8.1

Income tax expense

         2.9

            –

            –

            –

            –

            –

            2.9

Equity in earnings of subsidiaries

         8.1

            –

            –

            –

            –

          (8.1)

              –

 

Net income (loss)

$       5.2

   $  (24.1)

   $    (3.8)

   $    29.4

   $      6.6

   $    (8.1)

   $       5.2

 

-32-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the six months ended December 31, 2004(Combined Basis)(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

Operating activities:

 

 

 

 

 

 

 

Net income (loss)

$ (105.5)

$    (24.1)

$        (3.8)

$     (67.3)

$        8.5

$       86.7

$     (105.5)

Adjustments to reconcile net income (loss) to net    cash provided by operating activities

 

 

 

 

 

 

 

Depreciation and amortization

          —

           —

             —

         35.3

          4.6

             —

           39.9

Provision for doubtful accounts

          —

           —

             —

         60.9

          9.1

             —

           70.0

Deferred income taxes

    (48.4)

           —

             —

            —

            —

             —

         (48.4)

Amortization of loan costs

          —

         0.9

             —

           0.5

            —

             —

             1.4

Accretion of principal on senior discount notes

          —

           —

           3.8

            —

            —

             —

             3.8

(Gain) loss on sale of assets

          —

           —

             —

           0.8

            —

             —

             0.8

Stock compensation

          —

           —

             —

         96.9

            —

             —

           96.9

Debt extinguishment costs

       50.2

           —

             —

         12.0

            —

             —

           62.2

Merger expenses

       17.0

           —

             —

           6.1

            —

             —

           23.1

Changes in operating assets and liabilities, net of    effects of acquisitions:

             

              

                

               

              

               

                 

    Equity in earnings (loss) of subsidiaries

       86.7

           —

             —

            —

            —

        (86.7)

               —

    Accounts receivable

          —

           —

             —

       (71.7)

       (11.9)

             —

         (83.6)

    Inventories

          —

           —

             —

         (1.2)

         (0.1)

             —

           (1.3)

    Prepaid expenses and other current assets

         6.1

           —

             —

       (19.6)

        18.0

             —

             4.5

    Accounts payable

          —

           —

             —

         20.6

         (0.5)

             —

           20.1

    Accrued expenses and other liabilities

      (4.7)

       23.2

             —

       (21.7)

        13.6

             —

           10.4

Net cash provided by operating activities

         1.4

           —

             —

         51.6

        41.3

             —

           94.3

Investing activities:

             

              

                

               

              

             —

                 

Acquisitions

    (50.8)

           —

             —

       (87.4)

            —

             —

       (138.2)

Capital expenditures

          —

           —

             —

       (64.7)

         (7.7)

             —

         (72.4)

Purchases of short-term investments

          —

           —

             —

       (40.0)

            —

             —

         (40.0)

Sales of short-term investments

          —

           —

             —

         70.0

            —

             —

           70.0

Proceeds from asset dispositions

          —

           —

             —

           0.7

            —

             —

             0.7

Other

          —

           —

             —

           0.2

       (21.3)

          21.0

           (0.1)

Net cash provided by (used in) investing activities

    (50.8)

           —

             —

     (121.2)

       (29.0)

          21.0

       (180.0)

Financing activities:

             

              

                

               

              

               

                 

Proceeds from long-term debt

  1,234.7

           —

             —

            —

            —

             —

      1,234.7

Payments of long-term debt and capital leases

  (684.3)

           —

             —

         (1.2)

         (0.4)

             —

       (685.9)

Payments of loan costs and debt termination fees

    (42.7)

           —

             —

            —

            —

             —

         (42.7)

Proceeds from joint venture partner contributions

          —

           —

             —

           8.0

            —

             —

             8.0

Proceeds from common stock issuances

     494.9

           —

             —

            —

            —

             —

         494.9

Payments to retire stock and stock options

  (964.9)

           —

             —

            —

            —

             —

       (964.9)

Cash provided by (used in) intercompany activity

       12.4

           —

             —

         56.0

       (47.4)

         (21.0)

               —

Exercise of stock options

         0.1

           —

             —

            —

            —

             —

             0.1

Net cash provided by (used in) financing activities

       50.2

           —

             —

         62.8

       (47.8)

         (21.0)

           44.2

Net increase (decrease) in cash and cash equivalents

         0.8

           —

             —

         (6.8)

       (35.5)

             —

         (41.5)

Cash and cash equivalents, beginning of period

          —

           —

             —

       (24.8)

        74.9

             —

           50.1

Cash and cash equivalents, end of period

$       0.8

$          —

$           —

$     (31.6)

$      39.4

$           —

$           8.6

-33-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the six months ended December 31, 2005(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

Operating activities:

 

 

 

 

 

 

 

Net income (loss)

$     10.9

$    (53.1)

$        (7.7)

$       66.5

$      13.4

$      (19.1)

$         10.9

Adjustments to reconcile net income (loss) to net    cash provided by (used in) operating activities

 

 

 

 

 

 

 

Depreciation and amortization

          —

           —

             —

         41.0

          8.0

             —

           49.0

Provision for doubtful accounts

          —

           —

             —

         82.0

          7.4

             —

           89.4

Deferred income taxes

         6.4

           —

             —

            —

            —

             —

             6.4

Amortization of loan costs

          —

         1.9

           0.1

            —

            —

             —

             2.0

Accretion of principal on senior discount notes

          —

           —

           7.6

            —

            —

             —

             7.6

(Gain) loss on sale of assets

          —

           —

             —

            —

            —

             —

               —

Stock compensation

         0.6

           —

             —

            —

            —

             —

             0.6

Debt extinguishment costs

         0.1

           —

             —

            —

            —

             —

           (1.1)

Changes in operating assets and liabilities, net of    effects of acquisitions:

             

              

                

               

              

               

                 

    Equity in earnings (loss) of subsidiaries

    (19.4)

           —

             —

            —

            —

         19.4

               —

    Accounts receivable

          —

           —

             —

       (85.3)

         (0.6)

             —

         (85.9)

    Inventories

          —

           —

             —

         (1.6)

         (0.1)

             —

           (1.7)

    Prepaid expenses and other current assets

      (4.2)

           —

             —

       (16.7)

        17.5

             —

           (3.4)

    Accounts payable

          —

           —

             —

         (3.0)

          0.6

             —

           (2.4)

    Accrued expenses and other liabilities

         0.2

        (0.8)

             —

           4.2

       (30.5)

          (0.3)

         (27.2)

Net cash provided by (used in) operating activities

      (5.4)

      (52.0)

             —

         87.1

        15.7

             —

           45.4

Investing activities:

             

              

                

               

              

             —

                 

Acquisitions

          —

           —

             —

         (0.4)

            —

             —

           (0.4)

Capital expenditures

          —

           —

             —

     (110.4)

         (3.3)

             —

       (113.7)

Purchase of short-term investments

          —

          —

             —

            —

       (68.4)

             —

         (68.4)

Sales of short-term investments

          —

           —

             —

            —

        68.4

             —

           68.4

Other

      (0.2)

           —

             —

       (16.7)

            —

          22.6

             5.7

Net cash used in investing activities

      (0.2)

           —

             —

     (127.5)

         (3.3)

          22.6

       (108.4)

Financing activities:

             

              

                

               

              

               

                 

Proceeds from long-term debt

          —

     175.0

             —

            —

            —

             —

         175.0

Payments of long-term debt and capital leases

          —

      (26.1)

             —

         (0.7)

         (0.2)

             —

         (27.0)

Payments of loan costs and debt termination fees

          —

           —

             —

         (0.6)

            —

             —

           (0.6)

Repurchase of equity incentive units

      (1.1)

           —

             —

            —

            —

             —

           (1.1)

Cash provided by (used in) intercompany activity

         6.7

      (96.9)

             —

       116.5

         (3.7)

         (22.6)

               —

Net cash provided by (used in) financing activities

         5.6

       52.0

             —

       115.2

         (3.9)

         (22.6)

         146.3

Net increase in cash and cash equivalents

          —

           —

             —

         74.8

          8.5

             —

           83.3

Cash and cash equivalents, beginning of period

         0.8

           —

             —

         (5.9)

        84.3

             —

           79.2

Cash and cash equivalents, end of period

$       0.8

$         —

$           —

$       68.9

$      92.8

$           —

$       162.5

-34-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the Predecessor Period July 1, 2004 through September 22, 2004**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

Operating activities:

Net income (loss)

$ (110.7)

  $       —

    $       —

    $  (96.7)

    $    1.9

     $  94.8

    $ (110.7)

Adjustments to reconcile net income (loss) to net    cash provided by operating activities

 

 

 

 

 

 

 

Depreciation and amortization

          —

           —

             —

         15.4

         2.0

            —

         17.4

Provision for doubtful accounts

          —

           —

             —

         27.1

         4.4

            —

         31.5

Deferred income taxes

     (50.9)

           —

             —

           —

          —

            —

        (50.9)

Amortization of loan costs

          —

           —

             —

           0.5

          —

            —

           0.5

Accretion of principal on senior discount notes

          —

           —

             —

           —

          —

            —

            —

(Gain) loss on sale of assets

          —

           —

             —

           0.6

          —

            —

           0.6

Stock compensation

          —

           —

             —

         96.7

          —

            —

         96.7

Debt extinguishment costs

       50.2

           —

             —

         12.0

          —

            —

         62.2

Merger expenses

       17.0

           —

             —

           6.1

          —

            —

         23.1

Changes in operating assets and liabilities, net of    effects of acquisitions:

           

              

                

               

             

              

              

    Equity in earnings (loss) of subsidiaries

       94.8

           —

             —

           —

          —

        (94.8)

            —

    Accounts receivable

          —

           —

             —

       (37.2)

        (4.9)

            —

        (42.1)

    Inventories

          —

           —

             —

           —

        (0.3)

            —

          (0.3)

    Prepaid expenses and other current assets

         6.3

           —

             —

       (14.7)

       10.8

            —

           2.4

    Accounts payable

          —

           —

             —

         41.9

        (0.5)

            —

         41.4

    Accrued expenses and other liabilities

       (1.1)

           —

             —

         (1.8)

         9.9

            —

           7.0

Net cash provided by operating activities

         5.6

           —

             —

         49.9

       23.3

            —

         78.8

Investing activities:

           

              

                

               

              

              

                

Acquisitions

     (50.8)

           —

             —

           —

          —

            —

        (50.8)

Capital expenditures

          —

           —

             —

       (26.8)

        (3.0)

            —

        (29.8)

Sales of short-term investments

          —

           —

             —

         30.0

          —

            —

         30.0

Proceeds from asset sales

          —

           —

             —

           0.5

          —

            —

           0.5

Other

          —

           —

             —

           0.4

         (0.3)

            —

           0.1

Net cash provided by (used in) investing activities

     (50.8)

           —

             —

           4.1

        (3.3)

            —

        (50.0)

Financing activities:

           

              

                

               

              

              

                

Proceeds from long-term debt

  1,174.7

           —

             —

           —

          —

            —

    1,174.7

Payments of long-term debt and capital leases

   (683.2)

           —

             —

         (0.4)

        (0.3)

            —

      (683.9)

Payments of loan costs and debt termination fees

     (40.9)

           —

             —

           —

          —

            —

        (40.9)

Proceeds from issuance of common stock

     494.9

           —

             —

           —

          —

            —

       494.9

Payments to retire stock and stock options

   (964.9)

           —

             —

           —

          —

            —

      (964.9)

Cash provided by (used in) intercompany activity

       64.8

           —

             —

       (51.1)

      (13.7)

            —

            —

Exercise of stock options

         0.1

           —

             —

           —

          —

            —

           0.1

Net cash provided by (used in) financing activities

       45.5

           —

             —

        (51.5)

      (14.0)

            —

        (20.0)

Net increase in cash and cash equivalents

         0.3

           —

             —

           2.5

         6.0

            —

           8.8

Cash and cash equivalents, beginning of period

          —

           —

             —

        (24.8)

        74.9

            —

         50.1

Cash and cash equivalents, end of period

$       0.3

$         —

    $       —

    $  (22.3)

    $  80.9

     $     —

    $   58.9

-35-
****
**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the Period September 23, 2004 through December 31, 2004(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

** **
****
** **

*(In millions)*

Operating activities:

Net income (loss)

$      5.2

$     (24.1)

$         (3.8)

$       29.4

$       6.6

$        (8.1)

    $     5.2

Adjustments to reconcile net income (loss) to net    cash provided by (used in) operating activities

 

 

 

 

 

 

 

Depreciation and amortization

        —

           —

             —

         19.9

         2.6

            —

         22.5

Provision for doubtful accounts

        —

           —

             —

         33.8

         4.7

            —

         38.5

Deferred income taxes

        2.5

           —

             —

           —

          —

            —

           2.5

Amortization of loan costs

        —

          0.9

             —

           —

          —

            —

           0.9

Accretion of principal on senior discount notes

        —

           —

            3.8

           —

          —

            —

           3.8

Loss on sale of assets

        —

           —

             —

           0.2

          —

            —

           0.2

Stock compensation

        —

           —

             —

           0.2

          —

            —

           0.2

Changes in operating assets and liabilities, net of    effects of acquisitions:

           

              

                

               

             

              

              

    Equity in earnings (loss) of subsidiaries

      (8.1)

           —

             —

           —

          —

           8.1

            —

    Accounts receivable

        —

           —

             —

       (34.5)

        (7.0)

            —

        (41.5)

    Inventories

        —

           —

             —

         (1.2)

         0.2

            —

          (1.0)

    Prepaid expenses and other current assets

      (0.2)

           —

             —

         (4.9)

         7.2

            —

           2.1

    Accounts payable

        —

           —

             —

       (21.3)

          —

            —

        (21.3)

    Accrued expenses and other liabilities

      (3.6)

        23.2

             —

       (19.9)

         3.7

            —

           3.4

Net cash provided by (used in) operating activities

      (4.2)

           —

             —

           1.7

       18.0

            —

         15.5

Investing activities:

           

              

                

               

              

              

                

Acquisitions, including working capital settlements

        —

           —

             —

       (87.4)

          —

            —

        (87.4)

Capital expenditures

        —

           —

             —

       (37.9)

        (4.7)

            —

        (42.6)

Purchases of short-term investments

        —

           —

             —

       (40.0)

          —

            —

        (40.0)

Sales of short-term investments

        —

           —

             —

         40.0

          —

            —

         40.0

Proceeds from asset dispositions

        —

           —

             —

           0.2

          —

            —

           0.2

Other

        —

           —

             —

         (0.2)

      (21.0)

         21.0

          (0.2)

Net cash used in investing activities

        —

           —

             —

     (125.3)

      (25.7)

         21.0

      (130.0)

Financing activities:

           

              

                

               

              

              

                

Proceeds from long-term debt

      60.0

           —

             —

           —

          —

            —

         60.0

Payments of long-term debt and capital leases

      (1.1)

           —

             —

         (0.8)

        (0.1)

            —

          (2.0)

Payments of loan costs and debt termination fees

      (1.8)

           —

             —

           —

          —

            —

          (1.8)

Cash provided by (used in) intercompany activity

    (52.4)

           —

             —

       107.1

      (33.7)

        (21.0)

            —

Proceeds from joint venture partner contributions

        —

           —

             —

           8.0

          —

            —

           8.0

Net cash provided by (used in) financing activities

        4.7

           —

             —

       114.3

      (33.8)

       (21.0)

         64.2

Net increase (decrease) in cash and cash equivalents

        0.5

           —

             —

         (9.3)

      (41.5)

            —

        (50.3)

Cash and cash equivalents, beginning of period

        0.3

           —

             —

           5.7

       52.9

            —

         58.9

Cash and cash equivalents, end of period

$      0.8

$          —

$           —

$       (3.6)

$     11.4

$          —

$         8.6

-36-
****
**Table of Contents**

**13.          SUBSEQUENT EVENT**

                On January 19, 2006, certain subsidiaries of Vanguard executed a contract to sell its medical office buildings in California to anindependent third party. Vanguard expects to sell the property, plant and equipment, which had a carrying value of approximately $14.7 million (excluding allocated goodwill) as of December 31, 2005, for a purchase price of $30.3 million (approximately $29.0 millionnet of sales commissions). Vanguard is unable to determine the expected gain on sale of the assets at this time. The medical office building operations are included in Vanguard’s acute care services operating segment for financial reporting purposes. Vanguardexpects the sale to be completed during its third fiscal quarter.

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

                The following discussion and analysis of our financial condition and results of operations covers periods prior to and subsequent tothe merger (as discussed below).  We have presented the information for the six months ended December 31, 2004 on a predecessor period and successor period combined basis to facilitate meaningful comparisons of operating results to the current year period andhave discussed the merger-related items recorded during the six months ended December 31, 2004. You should read this discussion together with our unaudited condensed consolidated financial statements and related notes included within this report.

**Forward Looking Statements**

                This report on Form 10-Q contains “forward-looking statements” within the meaning of the federal securities laws which areintended to be covered by the safe harbors created thereby.  Forward-looking statements are those statements that are based upon management’s current plans and expectations as opposed to historical and current facts and are often identified in this reportby use of words including but not limited to  “may,” “believe,” “will,” “project,” “expect,” “estimate,” “anticipate,” and “plan.”  These statements are basedupon estimates and assumptions made by Vanguard’s management that, although believed to be reasonable, are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. These factors, risks and uncertainties include, among others, the following:

                •  Our high degree of leverage

                •  Our ability to incur substantially more debt

                •  Operating and financial restrictions in our debt agreements

                •  Our ability to successfully implement our business strategies

                •  Our ability to successfully integrate our recent and any future acquisitions

                •  The highly competitive nature of the healthcare industry

                •  Governmental regulation of the industry, including Medicare and Medicaid reimbursement levels

                •  Pressures to contain costs by managed care organizations and other insurers and our ability to negotiateacceptable                    terms with these third party payers

                •  Our ability to attract and retain qualified management and healthcare professionals, including physicians                    and nurses

                •  Potential federal or state reform of healthcare

                •  Future governmental investigations

                •  Costs associated with HIPAA regulations and other management information systems integrations

                •  The availability of capital to fund our corporate growth strategy

-37-
****
**Table of Contents**

                •  Potential lawsuits or other claims asserted against us

                •  Our ability to maintain or increase patient membership and control costs of our managed healthcare plans

                •  Changes in general economic conditions

                •  Our exposure to the increased amounts of and collection risks associated with uninsured accounts and the co-pay                    and deductible portions of insured accounts

                •  The impact of changes to our charity care and self-pay discounting policies 

                •  Increased cost of professional and general liability insurance and increases in the quantity and severity                   of professional liability claims

                •  Our ability to maintain and increase patient volumes and control the costs of providing services, including                   salaries and benefits, supplies and bad debts

                •  Potential substantial liabilities arising from unfavorable retrospective reviews by governmental or otherpayers                   of the medical necessity of medical procedures performed at our hospitals

                •  Lost future revenues from payer contract terminations resulting from their unfavorable retrospective reviews                   of the medical necessity of medical procedures performed at our hospitals

                •  Our failure to comply, or allegations of our failure to comply, with applicable laws and regulations

                •  The geographic concentration of our operations

                •  Technological and pharmaceutical improvements that increase the cost of providing, or reduce the demand for,                   healthcare services

                Our forward-looking statements speak only as of the date made.  Except as required by law, we undertake no obligation to publiclyupdate or revise any forward-looking statements contained herein, whether as a result of new information, future events or otherwise.  We advise you, however, to consult any additional disclosures we make in our other filings with the Securities and ExchangeCommission, including, without limitation, the discussion of risks and other uncertainties under the caption “Item 1. Business - Risk Factors” contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2005.  You are cautioned tonot rely on such forward-looking statements when evaluating the information contained in this report.  In light of the significant uncertainties inherent in the forward-looking statements included in this report, you should not regard the inclusion of suchinformation as a representation by us that our objectives and plans anticipated by the forward-looking statements will occur or be achieved, or if any of them do, what impact they will have on our results of operations and financial condition.

**Merger Transaction**

                On September 23, 2004, certain affiliates of The Blackstone Group (collectively “Blackstone”) purchased approximately 66%of our equity interests (the “merger”). Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively “MSCP”) and certain of our senior members of management and other shareholders (collectively the “RolloverManagement Investors”) purchased the remaining 34% of our equity interests. The transaction was treated as a leveraged buyout purchase for accounting purposes. In connection with the merger, we repaid $299.0 million of our outstanding $300.0 million 9.75%senior subordinated notes (we repaid the remaining $1.0 million in October 2005), our outstanding $17.6 million 8.18% subordinated notes and the $300.0 million Term B loans outstanding under our 2004 senior secured credit facility.  We financed the merger byissuing $575.0 million of 9.0% senior subordinated notes (the “9.0% Notes”), by issuing 11.25% senior discount notes (the “11.25% Notes”) having an aggregate principal amount at maturity of $216.0 million, by borrowing $475.0 million ofinitial Term B loans under new senior secured credit facilities (the “merger credit facilities”) and with equity proceeds totaling approximately $749.0 million (valued at approximately $635.7 million for accounting purposes).  Certain members ofsenior management also purchased $5.7 million of the equity incentive units in VHS Holdings LLC.  The merger credit facilities included a $250.0 million revolving credit facility, of which $38.8 million

-38-
****
**Table of Contents**

of capacity was utilized for letters of credit as of December 31, 2005.  The merger credit facilities also included $325.0 million in delayed draw term loan facilities. We borrowed $60.0 million under the delayed drawterm loan facilities to finance the acquisition of three acute-care hospitals and related healthcare businesses in Massachusetts from subsidiaries of Tenet Healthcare Corporation on December 31, 2004, and we borrowed $90.0 million on February 18, 2005 to fund theworking capital buildup of the Massachusetts hospitals and to fund capital expenditures.  We borrowed the remaining $175.0 million under the delayed draw term loan facilities during September 2005.

**Executive Overview**

                As of December 31, 2005, we owned and operated 19 hospitals with a total of 4,517 licensed beds, and related outpatient servicefacilities complementary to the hospitals in San Antonio, Texas, metropolitan Phoenix, Arizona, metropolitan Chicago, Illinois, Orange County, California, and Massachusetts.  We also owned two health plans: a Medicaid managed health plan, Phoenix Health Plan(“PHP”), which served approximately 99,500 members in Arizona; and MacNeal Health Providers (“MHP”), which has responsibility, under capitated contracts covering certain physician and outpatient services, for approximately 45,900 member livesin metropolitan Chicago, Illinois, as of December 31, 2005.  Our objective is to provide high-quality, cost-effective healthcare services through an integrated delivery platform serving the needs of the communities in which we operate.  We focus ourbusiness development efforts and operations on hospital and other related healthcare facilities where we see an opportunity to improve operating performance and profitability and increase market share.  We were incorporated in July 1997 and acquired our firsthospital, Maryvale Hospital, on June 1, 1998.

                We have implemented multiple operating strategies to achieve our objective of providing high-quality, cost-effective healthcareservices in the communities we serve.  These strategies include quality control, expansion of services, partnering with physicians and healthcare professionals and identifying growing geographic areas that provide opportunities for acquisitions orexpansions.  If we achieve these strategies, we expect to realize the patient volume and revenue growth that is key to our operating performance.  We must also identify and manage the risks associated with our growth strategies including acquisition risks,payer reimbursement risks, case and resource management risks and competition.  Recent trends that management will continue to monitor and address include fluctuations in bad debts due to payer mix changes and difficulties in collecting self-pay accountsreceivable, expanded charity care and self-pay discount programs, potential Medicaid funding cuts, volatile professional liability risks and related costs, nurse staffing regulations and resource constraints and increased cost of compliance in the healthcareindustry.  The following paragraphs more fully describe the strategies, risks and trends mentioned above.

**Operating Strategies and Related Risks**

                We believe the following operating initiatives, among others, will improve our operating results.

               •

   

*Implementing programs and procedures to improve the quality of healthcare services provided to our patients*.  We have implemented or are in the process of implementing multiple initiatives to improvequality of care including: 1) Facilitating a working environment from the top down that prioritizes quality of care; 2) Refining and updating our training programs for chief nursing officers, quality directors, physicians and other clinical staff on a continualbasis; 3) Sharing information among our hospitals to implement best practices and 4) Employing chief medical officers at the regional level to review and improve clinical protocols. We have implemented clinical information systems in our hospitals that allow us tomonitor compliance with clinical protocols and standards including those necessary to meet or exceed accreditation and regulatory requirements.  We also utilize patient care evaluations and satisfaction surveys from patients, physicians and employees to measurethe results of our quality of care objectives.  We believe that the core of our success is the quality of care we provide, and that each of our strategic goals and objectives is an extension of this core principle.

 

 

 

               •

   

*Expanding the spectrum of healthcare services provided by our facilities*.  Each of the markets we serve is unique.  We believe that a key factor in increasing patient volumes is to provide therange of services that our patients need.  Our strategy of developing market-focused healthcare networks provides us greater flexibility in implementing broader service offerings in an efficient manner.  As we expand our service offerings and grow patientvolumes, we seek to recruit and retain physicians and nurses and to invest resources in capital projects including upgrading our existing facility framework and expanding facilities.  Expanding facilities may include constructing new facilities or increasingcapacities at

-39-
****
**Table of Contents**

 

 

existing facilities.  For example, during 2003, we built West Valley Hospital in underserved western metropolitan Phoenix.  Also, construction has begun or is in the planning stages that will increase capacities atseven of our hospitals in San Antonio and metropolitan Phoenix.  We have spent approximately $171.9 million related to six of these expansion projects through December 31, 2005 and expect to spend approximately an additional $162.8 million through fiscal 2008for these six projects.

 

 

 

               •

   

*Fostering a partnership culture with physicians and healthcare professionals*.  We believe that the keys to providing the most effective and efficient healthcare services are effective recruiting andretention programs, continual training and education support for physicians and other healthcare professionals and maintenance of facilities and equipment that are desirable vehicles for the practice of medicine.  Our relationships with the University of Chicagoat our MacNeal and Weiss hospitals in metropolitan Chicago, Illinois, demonstrate our commitment to professional development for physicians and other healthcare professionals.  We believe these initiatives will serve as a cornerstone to build partneringrelationships with employees and physicians to ensure we have the expertise necessary to carry out our mission in all areas of our healthcare facilities.  We also intend to increase our participation, consistent with applicable laws, in the development of jointventure partnerships with physicians in those situations where such relationships fit our strategic objectives.

 

 

 

               •

   

*Identifying geographic markets that provide a strategic fit with our goals and objectives and leveraging population growth in existing markets*.  We expect to continue pursuing acquisition activities inexisting or new markets where we can obtain significant market share and capture additional business from the aging U.S. population.  According to the U.S. Census Bureau, there were approximately 35 million Americans aged 65 or older in the United States in2000, comprising approximately 12.4% of the total U.S. population.  The number of these elderly persons is expected to climb to 40 million, or 13.0% of the total population, by the year 2010 and to climb to over 54 million or 16.3% of the total population by theyear 2020.  We believe our initiatives will position us to capitalize on this demographic trend.  Obtaining significant market share in key geographic markets and improving market share in existing markets provide opportunities to expand services to thosecommunities, to provide flexibility in negotiations with managed care and other third party payers and to strengthen recruiting initiatives.

                Although we expect the above initiatives to increase our patient volumes, the following risk factors could offset those increases torevenues:

               •

   

*Managed care, Medicare and Medicaid revenues are significant to our business and are all subject to pricing pressures*.  During the six months ended December 31, 2004 and 2005, managed care (includingMedicare and Medicaid managed care plans and commercial plans), Medicare and Medicaid payers accounted for 45.2%, 30.6% and 6.7% and 48.5%, 29.2% and 7.1%, respectively, of patient service revenues.  We continue to aggressively renegotiate managed care contractsin order to improve pricing for the healthcare services we provide.  Managed care payers are subject to cost pressures that often complicate our renegotiation efforts.  After renegotiating contracts with improved reimbursement, we have, in some cases,experienced volume declines from managed care payers.  Management continually reviews its portfolio of managed care relationships and attempts to balance pricing and volume issues.  However, as long as strong competition remains in the markets we serve,these challenges will continue.  Our future operating results and cash flows could be materially adversely affected to the extent we are unable to improve reimbursement and maintain patient volumes.  We are also at risk for highly acute cases reimbursed bypayers under pre-determined, fixed rates such as Medicare diagnosis related group payments.

 

 

 

               •

   

*Many procedures once performed exclusively on an inpatient basis at hospitals are now being provided on an outpatient basis*.  Advances in technology and the focus of payers on treating lower acuity patientsin a less expensive setting have driven the increase in outpatient utilization.   During the six months ended December 31, 2004 and 2005, 65.1% and 67.0%, respectively, of total surgeries performed in our facilities were performed on an outpatient basis. Outpatient revenues as a percentage of total gross patient revenues were 36.4% and 41.0% during the six months ended December 31, 2004 and 2005, respectively.  The significance of outpatient utilization is offset somewhat by the aging of the baby boomerpopulation, which we expect to increase demand for inpatient services.  Typically, the payments

-40-
****
**Table of Contents**

 

 

we receive for outpatient procedures are less than those for the same procedures performed in an inpatient setting.  Additionally, even our less expensive outpatient surgery volumes are threatened by an increasing numberof outpatient surgery centers and specialty hospitals that have commenced operations in the past few years.  We anticipate that competition for outpatient services will remain intense during the foreseeable future.

 

 

 

               •

   

*Intense market competition may limit our ability to enter choice markets or to recruit and retain quality healthcare personnel*.  We face growing competition in our industry.  Consolidation of hospitalsinto for-profit or not-for-profit systems continues to increase as other hospital companies realize that regional market strength is pivotal in efficiently providing comprehensive healthcare services, recruiting and retaining qualified healthcare professionals andeffectively managing payer relationships.

**Impact of Acquisitions**

                Acquiring acute care hospitals in urban and suburban areas that fit our strategic objectives is a key part of our businessstrategy.  Since we have grown most years through acquisitions, it is difficult to make meaningful comparisons between our financial statements for the fiscal periods presented.  In addition, since we own a relatively small number of hospitals, even asingle hospital acquisition can have a material effect on our overall operating performance.  When we acquire a hospital, we generally implement a number of measures to lower costs, and we often make significant investments in the facility to expand services,strengthen the medical staff and improve our overall market position.  The effects of these initiatives are not generally realized immediately.  Therefore, the financial performance of a newly acquired hospital may adversely affect our overall performancein the short term.

                On December 31, 2004, certain of our subsidiaries acquired the property, plant and equipment, investments and certain current assetsand assumed certain current liabilities of three acute-care hospitals with a total of 768 licensed beds and related healthcare businesses located in or around Worcester, Framingham and Natick, Massachusetts (the “Massachusetts hospitals”) fromsubsidiaries of Tenet Healthcare Corporation.  We paid $87.7 million, including the base purchase price of $103.5 million for the property, plant and equipment and investments of the Massachusetts hospitals less $15.8 million for the excess of the currentliabilities assumed and closing costs incurred over the current assets acquired.  We funded the purchase price by borrowing $60.0 million of the $150.0 million acquisition delayed draw term facility under the merger credit facilities and by using $27.7 millionof cash on hand.  We invested an additional $37.4 million during the third quarter of fiscal 2005 related to the build-up of working capital at the Massachusetts hospitals.  On February 18, 2005, we borrowed the remaining $90.0 million available to us underthe acquisition delayed draw term loan facility to fund the working capital build-up at the Massachusetts hospitals and to fund capital expenditures at the Massachusetts hospitals and our other hospitals.  Operating results for the Massachusetts hospitals areincluded in our condensed consolidated statements of operations for the three months and six months ended December 31, 2005.

-41-
****
**Table of Contents**

**Revenue/Volume Trends**

                Our revenues depend upon inpatient occupancy levels, outpatient procedures performed at our facilities, the ancillary services andtherapy programs ordered by physicians and provided to patients and our ability to successfully negotiate appropriate rates for these services with third party payers.  During the six months ended December 31, 2005, we experienced an 18.1% increase in dischargesand a 28.3% increase in hospital adjusted discharges compared to the prior year period primarily due to the acquisition of the Massachusetts hospitals.  On a same hospital basis, period over period discharges decreased by 2.8% while hospital adjusted dischargesincreased by 0.2%.  The following table provides details of discharges by payer for the quarter and six months ended December 31, 2005 compared to the prior year periods.

 

 

**Quarter ended December 31,**

 

**Six months ended December 31,**

 

 

 

 

 

**2004**

 

**2005**

 

**2004**

 

**2005**

 

 

 

 

 

Medicare

 

11,677

 

30.3%

 

13,612

 

30.5%

      

22,958

 

30.0%

 

26,837

 

29.7%

Medicaid

 

4,918

 

12.8%

 

5,712

 

12.8%

 

9,745

 

12.7%

 

12,023

 

13.3%

Managed care

 

20,310

 

52.7%

 

23,190

 

51.9%

 

40,535

 

53.0%

 

46,897

 

51.9%

Self pay

 

1,148

 

3.0%

 

1,504

 

3.4%

 

2,381

 

3.1%

 

3,133

 

3.5%

Other

468

1.2%

669

1.5%

 

888

1.2%

1,433

1.6%

 

 

 

 

 

 

 

 

 

Total

 

38,521

 

100.0%

 

44,687

 

100.0%

 

76,507

 

100.0%

 

90,323

 

100.0%

 

 

 

 

 

 

 

 

 

                We attribute the decrease in same hospital discharges to a general reduction in demand for inpatient healthcare services during thecurrent year period. We have been successful in capturing outpatient volumes as a result of our emergency room expansion and design improvements and our physician initiatives. We expect our inpatient volumes to improve in future quarters as a result of expandedservice offerings including complementary subacute services, new contracts negotiated with certain managed care providers and our market-driven management strategies.  We also expect that as we complete our significant expansion projects volumes will improve atfacilities where growth is currently restrained by physical plant limitations and patient throughput inefficiencies.  However, the success of each of our growth initiatives is dependant upon maintaining the community’s confidence in our services andstaying ahead of our competition in the markets we serve.

                The majority of our revenues are based on negotiated, per diem or pre-determined payment structures.  Our facilities’ grosscharges typically do not reflect what the facilities are actually paid.  In addition to volume factors described above, patient mix, acuity factors and pricing trends affect our revenues.  Patient revenues per adjusted hospital discharge increased 4.6% from$6,883 during the six months ended December 31, 2004 to $7,200 during the six months ended December 31, 2005.  This increase reflects improved reimbursement for services provided under negotiated managed care contracts and improved Medicare reimbursements. Our Medicare net revenues increased during the current year period partly due to the fiscal 2006 Medicare market basket update of 3.7% for diagnosis related group payments.  Additionally, the ability of our hospitals to provide the appropriate mix of serviceshaving favorable reimbursement structures and meeting the needs of our patients impacts this statistic.  Increases in levels of charity care and negotiated self-pay discounts also impact this statistic by decreasing revenues and decreasing the provision fordoubtful accounts.  On a same hospital basis, patient revenues per adjusted hospital discharge increased by 5.5% to $7,264 during the current year period from $6,883 during the prior year period.  We cannot be sure that future reimbursement rates, even ifimproved, will sufficiently cover potential increases in the cost of providing healthcare services to our patients.

                Medicare outlier payments are additional funds provided to hospitals for the treatment of Medicare patients who require more costlytreatment than the typical patient.  Congress has mandated that CMS limit Medicare outlier payments to between five and six percent of total diagnosis related group payments.  To achieve this mandate, in recent years CMS has periodically increased the costthreshold used to determine eligibility for and allocation of available Medicare outlier payments.  In December 2002, CMS began analyzing data to identify hospitals with high outlier payments for further audit or review and ultimately revised the rules fordetermining outlier payments.  Based upon data from our most recently filed Medicare cost reports, our ratio of Medicare outlier payments to Medicare DRG payments is 1.7%.  Thus, we do not believe

-42-
****
**Table of Contents**

that we have a high level of outlier payments.  We also do not believe that our current level of outlier payments will be materially affected by the recent outlier regulations issued by CMS.

                We recognize premium revenues from PHP and MHP. Premium revenues increased by $12.4 million or 7.6% during the six months endedDecember 31, 2005 compared to the prior year period.  This increase resulted from a 1.3% period over period increase in the average number of enrollees at PHP and increases in payment rates including reinsurance and supplemental rates.  PHP added a programon January 1, 2006 to provide healthcare services for Medicare recipients and for those individuals eligible for Medicare who also receive full Medicaid benefits.  We do not anticipate a significant increase in premium revenues or membership for our health planreporting segment during the current fiscal year but could realize significant increases during future fiscal years.  Our contract with AHCCCS was renewed during fiscal 2004 for the three-year period ending September 30, 2006, with an option for AHCCCS to renewthe contract for two additional one-year periods thereafter.  Should our contract with AHCCCS terminate, our future operating results and cash flows could be materially reduced.

**General Trends**

                The following paragraphs discuss recent trends that we believe are significant factors in our current and/or future operating resultsand cash flows.  Many of these trends apply to the entire hospital industry while others may more specifically apply to us, and the trends could be relatively short-term in nature or could require our long-term focus.  While these trends may involve certainfactors that are outside of our control, the extent to which these trends affect us and our ability to manage the impact of these trends play vital roles in our current and future success.  In many cases, we are unable to predict what impact these trends, ifany, will have on us.

                *Accounts Receivable Collection Risks Leading to Increased Bad Debts*

                Similar to others in the hospital industry, the collectibility of our accounts receivable has deteriorated primarily due to an increasein self-pay receivables.  The following table provides a summary of our accounts receivable by age since discharge date for both insured and uninsured payers as of each respective period presented (in millions).

**December 31, 2004**

 

**0-90 days**

**91-180 days**

**Over180 days**

 

**Total****(2)**

 

**% of Total**

Insured

 

$

295.2

 

 

$

32.4

 

$

18.3

 

$

345.9

 

 

79.0

%

Self-Pay(1)

 

 

41.4

 

 

 

40.8

 

 

9.6

 

 

91.8

 

 

21.0

% 

 

 

 

 

 

 

 

 

 

 

 

    Total

 

$

336.6

 

 

$

73.2

 

$

27.9

 

$

437.7

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**June 30, 2005**

 

**0-90 days****(3)**

**91-180 days****(3)**

**Over180 days**

 

**Total****(2)**

 

**% of Total**

Insured

 

$

360.9

 

 

$

44.8

 

$

21.5

 

$

427.2

 

 

79.6

%

Self-Pay(1)

 

 

53.8

 

 

 

45.4

 

 

10.0

 

 

109.2

 

 

20.4

% 

 

 

 

 

 

 

 

 

 

 

 

    Total

 

$

414.7

 

 

$

90.2

 

$

31.5

 

$

536.4

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**December 31, 2005****(3)**

 

**0-90 days**

**91-180 days**

**Over180 days**

 

**Total****(2)**

 

**% of Total**

Insured

 

$

343.9

 

 

$

37.2

 

$

21.9

 

$

403.0

 

 

76.4

%

Self-Pay(1)

 

 

57.4

 

 

 

52.8

 

 

14.3

 

 

124.5

 

 

23.6

% 

 

 

 

 

 

 

 

 

 

 

 

    Total

 

$

401.3

 

 

$

90.0

 

$

36.2

 

$

527.5

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

-43-
****
**Table of Contents**

____________________(1)           Includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the primary payer.(2)           The total accounts receivable balances reflected on these tables differ from the net accounts receivable balances as stated on the consolidated                balance sheets for those respective periods because the aging reports include certain accounts for which the applicable contractual discounts                have yet to be deducted from the account balance.(3)           Includes accounts receivable balances for the Massachusetts hospitals acquired on December 31, 2004.

                Our combined allowance for bad debts and allowance for charity care represented 83.8%, 90.5% and 91.1% of self-pay accounts receivableas of December 31, 2004, June 30, 2005 and December 31, 2005, respectively.

                The increase in self-pay accounts receivable has led to increased write-offs and older accounts receivable outstanding, resulting inthe need for an increased allowance for doubtful accounts.  The increase in self-pay accounts receivable results from a combination of factors including increased patient volumes, price increases, higher levels of patient deductibles and co-insurance undermanaged care programs and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs.  We have implemented policies and procedures designed to expedite upfront cash collections and promoterepayment plans from our patients.  Our upfront cash collections increased by 6.9% on a same hospital basis during the six months ended December 31, 2005 compared to the prior year period.  However, we believe bad debts will remain sensitive to changes inpayer mix, pricing and general economic conditions for the hospital industry during the foreseeable future.

                *Expansion of Charity Care and Self-Pay Discount Programs*

We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federalpoverty guidelines set forth by the Department of Health and Human Services).  We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines.  We provide expanded discounts from billed charges andalternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients with incomes between 200% and 500% of the federal poverty guidelines.  During thequarters ended December 31, 2004 and 2005, we deducted $12.5 million and $20.5 million of charity care from gross charges, respectively.  During the six months ended December 31, 2004 and 2005, we deducted $23.4 million and $37.5 million of charity care fromgross revenues, respectively.

                *Medicaid Funding Cuts*

                Many states, including certain states in which we operate, have reported budget deficits as a result of increased costs and lower thanexpected tax collections.  Health and human service programs, including Medicaid and similar programs, represent a significant component of state spending.  To address these budgetary concerns, certain states have decreased funding for these programs andother states may make similar funding cuts.  These cuts may include tightened participant eligibility standards, reduction of benefits, enrollment caps or payment reductions.  Additionally, the U.S. Congress recently passed legislation to reduce futurespending for federal Medicaid matching funds provided to states.  We are unable to assess the financial impact of enacted or proposed state or federal funding cuts at this time.

                *Volatility of Professional Liability Costs*

                We maintain professional and general liability insurance coverage through a wholly owned captive insurance subsidiary for individualclaims up to $10.0 million.  We maintain excess insurance coverage with independent third party carriers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in theaggregate. The total cost of professional and general liability insurance is sensitive to the volume and severity of cases reported.  Increased malpractice premiums have adversely affected the ability of physicians to obtain malpractice insurance at reasonablerates in certain markets, particularly in metropolitan Chicago, Illinois, resulting in physicians relocating to different geographic areas.  In the event physicians practicing in our hospitals are unable to obtain adequate malpractice insurance coverage, ourhospitals are likely to incur a greater percentage of the amounts paid to claimants.  Our professional liability exposures also increase when we employ physicians.  Some states, including Texas and Illinois in which we operate hospitals, have recentlypassed tort reform legislation placing limits on non-economic damages or are considering such type of legislation.  While we have implemented multiple steps at our facilities to reduce our professional liability exposures, absent significant additionallegislation to curb the size of malpractice judgments in other states in which we operate, our insurance costs may increase in the future.

-44-
****
**Table of Contents**

                *Nursing Shortage and Nursing Ratio Requirements*

                The hospital industry continues to face a nationwide shortage of nurses.  We have experienced particular difficulties in retainingand recruiting nurses in our metropolitan Phoenix, Arizona, and Orange County, California markets.  As a result of this shortage, we have utilized more contract labor resources that are typically more costly and less reliable than employed nurses.  Weexpect this shortage to continue for the foreseeable future.  We believe that our comprehensive recruiting and retention plan for nurses, which focuses on competitive salaries and benefits, employee satisfaction, best practices, nursing program educationalopportunities, leadership training and our focus on clinical and service excellence has partially mitigated the effects of the nursing shortage.

                We operate the Baptist Health System School of Health Professions (“SHP”) in San Antonio, which offers eight differentprograms with the greatest enrollment in the professional nursing program.  The SHP trains approximately 350 students each year, of whom we expect approximately 70%-80% to choose permanent employment with us.  SHP enrollment increased by 14.4% during thespring 2006 semester.  Plans are underway to transition SHP’s current diploma program to a degree granting program that will be more attractive to potential students.  SHP enrollment includes 57 students in our metropolitan Phoenix market that aretrained using state of the art distance learning technology maximizing utilization of SHP instructors.  Students are provided with company-funded scholarships that cover tuition, books and fees in return for a commitment to work at one of our hospitals for adefined period of time.  Should we be unsuccessful in our attempts to maintain adequate nursing staff for our present and future needs, our future operating results could be adversely impacted.

                Effective January 1, 2004, minimum nurse to patient ratios for various hospital departments went into effect in the state ofCalifornia.  These requirements apply at all times, including scheduled break and meal periods, and place an additional burden on our already challenging California nurse staffing strategies.  Even more stringent ratios for medical/surgical units tookeffect in California in 2005.  We estimate that our additional staffing costs from existing regulations approximate $5.1 million on an annual basis in California.  If similar regulations were adopted in other states in which we operate, our future operatingresults and cash flows could be materially adversely affected.

                *Increased Cost of Compliance in a Heavily Regulated Industry*

                We conduct business in a heavily regulated industry.  Accordingly, we maintain a comprehensive, company-wide compliance program toaddress healthcare regulatory and other compliance requirements since if a determination were ever made that we were in material violation of any of the federal or state statutes regulating our healthcare operations, our operations and financial results could bematerially adversely affected.  This compliance program includes, among other things, initial and periodic ethics and compliance training, a toll-free reporting hotline for employees, annual fraud and abuse audits and annual coding audits.  Theorganizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee.  Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and Chief ExecutiveOfficer and to our board of directors, serves as Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program.  We have recently established six regional compliance officers in our markets and staffedthe new positions with compliance professionals 100% dedicated to compliance duties.  The financial resources necessary for program oversight, enforcement and periodic improvements to our program continue to grow, especially when we add new features to ourprogram or engage external resources to assist with these highly complex matters.

                In the course of our 2004 internal fraud and abuse compliance audit, we identified that certain documentation discrepancies hadoccurred in the administration of renewal provisions of certain leases with physicians for medical office space at one of our hospitals.  After our review of the leases, the hospital entered into lease extension agreements and then new leases with each suchphysician. In accordance with established company compliance program policies, in September 2004 we made a voluntary disclosure regarding these lease discrepancies and actions we had taken to the Office of Inspector General of the U.S. Department of Health and HumanServices (the “OIG”) and to the local U.S. Attorney’s Office.  Recently, we have voluntarily provided****the OIG with additional information regarding this matter.  We have not determined that a violation of any laws or regulations hasoccurred, nor have we determined that any restitution or other payment is legally due to the federal government in respect of this matter.  However, due to the risks of litigation and its associated expenses, we have recently entered into settlement negotiationswith the OIG which we expect to conclude in the near future.  We do not expect the settlement of this matter to have a material impact on our future results of operations or cash flows.

-45-
****
**Table of Contents**

**Update of Critical Accounting Policies and Estimates**

                The unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generallyaccepted in the United States. In preparing these financial statements, we make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements. Management bases its estimates on historicalexperience and other available information, the results of which form the basis of the estimates and assumptions. We consider the following accounting policies to be critical accounting policies because they involve the most subjective and complex assumptions andassessments, are subject to a great degree of fluctuation period over period and are the most critical to our operating performance:  revenues and revenue deductions, allowance for doubtful accounts and provision for doubtful accounts, insurance reserves,medical claims reserves and income taxes. Other than the update provided below, there have been no changes in the nature or application of our critical accounting policies and estimates as discussed in Note 3 to our consolidated financial statements included in ourAnnual Report on Form 10-K for the fiscal year ended June 30, 2005.

                During the six months ended December 31, 2004 and 2005, medical claims expense was approximately $116.9 million and $122.4 million,respectively, primarily representing medical claims of PHP enrollees.  Medical claims expense as a percentage of premium revenues decreased to 69.7% during the six months ended December 31, 2005 compared to 71.7% during the prior year period.  During thecurrent year period, we recorded a $4.4 million reduction to the medical claims reserve at PHP based upon newly updated historical claims payment information.  We estimate our reserve for medical claims incurred but not reported using internal models thatconsider historical claims experience, number of enrollees and type of service provided.  During the current year period, we began utilizing an independent third party actuary to supplement our internal analysis.  Additionally, we reserve for expectedfuture payments related to members who qualify for special coverage under AHCCCS guidelines.  These reserve estimates are especially sensitive to recurring adjustments due to the additional burden of separately tracking the members provided this coverage and theunique calculations required by these guidelines.  The reserve for medical claims, including incurred but not reported claims, for our health plans was approximately $51.2 million and $31.3 million as of June 30, 2005 and December 31, 2005, respectively. The significant decrease in the reserve balance was due to the reserve adjustment previously discussed and an acceleration of claims payments during the current year period.  While management believes that its estimation methodology effectively captures trendsin medical claims costs, actual payments could differ significantly from its estimates given changes in the demand for and costs of healthcare services.

-46-
****
**Table of Contents**

**Selected Operating Statistics**

The following table sets forth certain operating statistics for each of the periods presented.

 

 

 

 

**(Unaudited) Quarter ended December 31,**

 

 

 

**(Unaudited) Six months ended December 31,**

 

 

 

 

 

 

 

 

 

 **Actual:**

 

 

 

**2004**

 

 

**2005**

 

**2004**

**2005**

 

Number of hospitals at end of period (a)

 

 

 

19

 

 

 

19

 

 

 

19

 

 

 

19

 

Number of licensed beds at end of period (a)

 

 

 

4,518

 

 

4,517

4,518

4,517

Discharges (b)

 

 

 

38,521

 

 

44,687

76,507

90,323

Adjusted discharges - hospitals (c)

 

 

 

56,852

 

 

70,853

113,420

145,475

Net revenue per adjusted discharge - hospitals (d)

 

 

$

6,918

 

$

7,322

 

 

$

6,883

$

7,200

Patient days (e)

 

 

 

160,914

 

 

196,322

316,786

393,161

Adjusted patient days - hospitals (f)

 

 

 

237,489

 

 

311,278

469,627

633,230

Average length of stay (days) (g)

 

 

 

4.18

 

 

4.39

4.14

4.35

Outpatient surgeries (h)

 

 

 

15,803

 

 

19,623

31,792

40,398

Emergency room visits (i)

 

 

 

129,498

 

 

161,507

259,041

324,603

Occupancy rate (j)

43.6

%

47.1

%

44.5

%

47.0

Average daily census (k)

1,749.0

2,134.0

1,722.0

2,137.0

Member lives (l)

146,500

145,400

146,500

145,400

PHP average member lives (m)

100,200

99,400

98,100

99,400

Medical claims percentage (n)

67.6

%

70.5

%

71.7

%

69.7

%

 

 

 

 

**(Unaudited) Quarter ended December 31,**

 

 

 

**(Unaudited) Six months ended December 31,**

 

 

 

 

 

 

 

 

 

**Same hospital:**

 

 

 

**2004**

 

 

**2005**

 

**2004**

**2005**

 

Number of hospitals at end of period

 

 

 

16

 

 

 

16

 

 

 

16

 

 

 

16

 

Total revenues (in millions) (o)

 

 

$

499.8

 

$

520.9

$

993.5

$

1,052.2

Discharges (p)

 

 

 

38,521

 

 

36,761

76,507

74,358

Adjusted discharges - hospitals (q)

 

 

 

56,852

 

 

55,288

113,420

113,622

Net revenue per adjusted discharge - hospitals (r)

 

 

$

6,918

 

$

7,344

 

 

$

6,883

$

7,264

Average length of stay (days) (s)

 

 

 

4.18

 

 

4.34

4.14

4.29

Outpatient surgeries (t)

 

 

 

15,803

 

 

14,859

31,792

30,835

Emergency room visits (u)

 

 

 

129,498

 

 

134,559

259,041

268,337

____________________

(a)

 

The Massachusetts hospitals are included in our number of hospitals and number of licensed beds as of December 31, 2004, but none of the other statistics reported on this table for the quarter or six months ended December 31,2004 reflect any operations for these hospitals.

 

 

 

(b)

 

Discharges represent the total number of patients discharged (in the facility for a period in excess of 23 hours) from our hospitals and is used by management and certain investors as a general measure of inpatientvolume.

 

 

 

(c)

 

Adjusted discharges-hospitals is used by management and certain investors as a general measure of combined hospital inpatient and outpatient volume.  Adjusted discharges-hospitals is computed by multiplying discharges bythe sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues.  This computation enables management to assess hospital volume by a combined measure of inpatient and outpatientutilization.

 

 

 

(d)

 

Net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by hospital adjusted discharges and measures the average net payment expected to be received for a patient’s stay inthe hospital.

-47-
****
**Table of Contents**

(e)

 

Patient days represent the number of days (calculated as overnight stays) our beds were occupied by patients during the periods.

 

 

 

(f)

 

Adjusted patient days-hospitals is calculated by multiplying patient days by the sum of gross hospital inpatient and outpatient revenues and then dividing the result by gross hospital inpatient revenues.  This computationis an indicator of combined inpatient and outpatient volumes.

 

 

 

(g)

 

Average length of stay represents the average number of days an admitted patient stays in our hospitals.

 

 

 

(h)

 

Outpatient surgeries represent the number of surgeries performed at hospitals or ambulatory surgery centers on an outpatient basis (patient overnight stays not necessary).

 

 

 

(i)

 

Emergency room visits represent the number of patient visits to a hospital or freestanding emergency room where treatment is received, regardless of whether an overnight stay is subsequently required.

 

 

 

(j)

 

Occupancy rate represents the percentage of hospital licensed beds occupied by patients.  Occupancy rate provides a measure of the utilization of inpatient rooms.

 

 

 

(k)

 

Average daily census represents the average number of patients in our hospitals each day during our ownership.

 

 

 

(l)

 

Member lives represent the total number of enrollees in our Arizona prepaid managed health plan and our Chicago managed care organization as of the end of the respective periods.

 

 

 

(m)

 

PHP average member lives represents the average number of enrollees in PHP during the each of the respective periods presented.

 

 

 

(n)

 

Medical claims percentage is calculated by dividing medical claims expense by premium revenues.

 

 

 

(o)

 

Same hospital total revenues represent revenues from entities owned (including health plans) for the entire three-month and six-month periods of both years presented.

 

 

 

(p)

 

Same hospital discharges represent discharges for hospitals owned for the entire three-month and six-month periods of both years presented.

 

 

 

(q)

 

Same hospital adjusted discharges-hospitals is calculated by multiplying discharges by the sum of hospital gross inpatient and outpatient revenues and then dividing the result by hospital gross inpatient revenues for thosehospitals owned for the entire three-month and six-month periods of both years presented.

 

 

 

(r)

 

Same hospital net revenue per adjusted discharge-hospitals is calculated by dividing hospital net patient revenues by adjusted discharges-hospitals for those hospitals owned for the entire three-month and six-month periods ofboth years presented.   This statistic measures the average net payment expected to be received for a patient’s stay in those hospitals.

 

 

 

(s)

 

Same hospital average length of stay represents average length of stay for hospitals owned for the entire three-month and six-month periods of both years presented.

 

 

 

(t)

 

Same hospital outpatient surgeries represent the number of surgeries performed on an outpatient basis (overnight stays not necessary) at hospitals or ambulatory surgery centers owned for the entire three-month and six-monthperiods of both years presented.

 

 

 

(u)

 

Same hospital emergency room visits represent the number of patient visits to receive treatment at the emergency departments of hospitals owned for the entire three-month and six-month periods of both years presentedregardless of whether an overnight stay is subsequently required.

-48-
****
**Table of Contents**

**Results of Operations**

                The following tables present summaries of our operating results for the quarters and six months ended December 31, 2004 and2005.

 

 

**(Unaudited) Quarter ended December 31,**

 

 

 

 

 

 

**2004**

 

 

 

 

 

**2005**

 

 

 

 
****
 
****
 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 

** **

Patient service revenues

 

$

416.1

 

 

 

83.3

%

 

$

552.3

 

 

 

86.1

%

Premium revenues

 

 

83.7

 

 

 

16.7

%

 

 

89.4

 

 

 

13.9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

499.8

 

 

 

100.0

%

 

641.7

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits (includes stock compensation of $0.2    and $0.3, respectively)

 

 

200.4

 

 

 

40.1

%

 

 

276.5

 

 

 

43.1

%

Supplies

 

 

80.6

 

 

 

16.1

%

 

 

102.8

 

 

 

16.0

%

Medical claims expense

 

 

56.6

 

 

 

11.3

%

 

 

63.0

 

 

 

9.8

%

Provision for doubtful accounts

 

 

35.5

 

 

 

7.1

%

 

 

39.3

 

 

 

6.1

%

Other operating expenses

 

 

72.7

 

 

 

14.5

%

 

 

99.5

 

 

 

15.5

%

Depreciation and amortization

 

 

20.8

 

 

 

4.2

%

 

 

24.5

 

 

 

3.8

%

Interest, net

 

 

25.0

 

 

 

5.0

%

 

 

28.2

 

 

 

4.4

%

Debt extinguishment costs

–

 

 

 

0.0

%

 

 

0.1

 

 

 

0.1

%

Minority interests and other expenses

 

 

1.1

 

 

0.2

%

 

 

2.0

 

 

 

0.3

%

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

7.1

 

 

 

1.4

%

 

 

5.8

 

 

 

0.9

%

Provision for income taxes

 

 

2.5

 

 

 

0.5

%

 

 

2.2

 

 

 

0.3

%

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

4.6

 

 

 

0.9

%

 

$

3.6

 

 

 

0.6

%

 

 

 

 

 

 

 

 

 

 

 

 

-49-
****
**Table of Contents**

 

 

**(Unaudited) Six months ended December 31,**

 

 

 

 

 

 

**2004**

 

 

 

 

 

**2005**

 

 

 

 
****
 
****
 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 

** **

Patient service revenues

 

$

830.4

 

 

 

83.6

%

 

$

1,113.9

 

 

 

86.4

%

Premium revenues

 

 

163.1

 

 

 

16.4

%

 

 

175.5

 

 

 

13.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

993.5

 

 

 

100.0

%

 

1,289.4

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits (includes stock compensation of $96.9    and $0.6, respectively)

 

 

493.0

 

 

 

49.6

%

 

 

546.1

 

 

 

42.4

%

Supplies

 

 

160.0

 

 

 

16.1

%

 

 

207.4

 

 

 

16.1

%

Medical claims expense

 

 

116.9

 

 

 

11.8

%

 

 

122.4

 

 

 

9.5

%

Provision for doubtful accounts

 

 

70.0

 

 

 

7.1

%

 

 

89.4

 

 

 

6.9

%

Other operating expenses

 

 

144.3

 

 

 

14.5

%

 

 

198.4

 

 

 

15.4

%

Depreciation and amortization

 

 

39.9

 

 

 

4.0

%

 

 

49.0

 

 

 

3.8

%

Interest, net

 

 

36.9

 

 

 

3.7

%

 

 

54.6

 

 

 

4.2

%

Debt extinguishment costs

 

 

62.2

 

 

 

6.3

%

 

 

0.1

 

 

 

0.1

%

Merger expenses

 

 

23.1

 

 

 

2.3

%

 

 

–

 

 

 

0.0

%

Minority interests and other expenses

 

 

1.1

 

 

0.1

%

 

 

3.4

 

 

 

0.2

%

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

 

(153.9

)

 

 

(15.5

)%

 

 

18.6

 

 

 

1.4

%

Provision for income taxes

 

 

(48.4

)

 

 

(4.9

)%

 

 

7.7

 

 

 

0.6

%

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(105.5

)

 

 

(10.6

)%

 

$

10.9

 

 

 

0.8

%

 

 

 

 

 

 

 

 

 

 

 

 

-50-
****
**Table of Contents**

**Quarter ended December 31, 2005 compared to Quarter ended December 31, 2004**

           *Revenues*.  Revenues increased by $141.9 million during the quarter ended December 31, 2005 compared to the prior year quarter due to the acquisition ofthe Massachusetts hospitals and improved reimbursement for services provided.  Hospital adjusted discharges increased by 24.6% during the 2005 quarter.  Emergency room visits increased by 24.7% and outpatient surgeries increased by 24.2% during the 2005quarter.  Same hospital revenues increased by $21.1 million or 4.2% primarily as a result of a quarter over quarter increase in same hospital net revenue per hospital adjusted discharge of 6.2%.  Our service expansion initiatives and managed carecontracting strategies played significant roles in our rate improvements.  We expect same hospital revenues growth to continue during the remainder of our current fiscal year, although factors outside our control including patient demand for healthcare servicesand increased competition could limit such growth.

                Premium revenues increased by 6.8% during the 2005 quarter as a result of a PHP capitation rate increase, increased settlement revenuesat MHP and increases in reinsurance and supplemental revenues.

                We have made considerable progress in negotiations with managed care payers to improve reimbursement for our services during the pasttwo years but challenges still remain to adjust these rates to appropriate levels to reflect rising healthcare costs.  The acuity of care required by our patients also affects this statistic.  We continually identify and implement services that enable us tomaximize our return on investment and meet the needs of our patients.

                We continue to implement physician recruitment, emergency department expansion and patient throughput design improvements, surgery unitexpansions, specialty service expansions, certain sub-acute unit expansions and intra-market resource sharing strategies.  Current capital projects underway, or initiatives expected to begin during the next 12 months, include expansions and upgraded technologyfor obstetrics, emergency services, endoscopy, cardiology, radiology and general surgery units as well as real estate projects to support hospital buildouts and construction of primary care clinics.

                *Costs and Expenses*.  Total costs and expenses, exclusive of income taxes, were $635.9 million or 99.1% of total revenuesduring the 2005 quarter, compared to 98.6% during the prior year quarter.  Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent the most significant of our normal costs and expenses or those subject to the greatest levelof fluctuation period over period.

               •

  

**Salaries and benefits**.  Salaries and benefits as a percentage of total revenues increased to 43.1% during the current year quarter from 40.1% during the prior year quarter.  This increase was dueto the higher salaries and benefits costs at our Massachusetts hospitals acquired on December 31, 2004, in which approximately 1,500 of our employees are subject to collective bargaining agreements.  On a same hospital basis, salaries and benefits as apercentage of total revenues increased slightly to 40.4% during the current year quarter.

 

 

** **

                

The national nursing shortage continues to hinder our ability to fully manage salaries and benefits.  We have experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and OrangeCounty markets.  Recent industry reports forecast this shortage to continue for the foreseeable future, especially in California where state mandated increased nurse-staffing ratios went into effect on January 1, 2004.  As a result of these factors, we havehired additional nurses and utilized more costly outsourced nursing personnel.  We believe that our comprehensive recruiting and retention plan for nurses which focuses on competitive salaries and benefits, employee satisfaction, best practices, nursing programeducational opportunities, leadership training and our commitment to clinical and service excellence have mitigated some of the effects of the nursing shortage.   However, should we be unsuccessful in our attempts to maintain nursing coverage adequate forour present and future needs, and especially if additional states in which we operate enact new laws mandating nurse-staffing ratios, our future operating results could be materially adversely impacted by increased salaries and benefits.

 

 

 

               •

**Supplies**.  Supplies as a percentage of total revenues decreased slightly to 16.0% during the current year quarter compared to 16.1% during the prior year quarter. On a same hospital basis, supplies as apercentage of total revenues decreased to 15.4% during the current year quarter. Because most of our growth strategies include expansion of high acuity services, we do not expect to realize significant future decreases in this ratio.  We continue to streamlineour materials management processes, which should help offset increased supplies costs related to high acuity services.  However, price increases for pharmaceuticals and medical supplies, including the impact of increased use of drug-eluting stents, could have asignificant adverse impact on future supplies costs.

-51-
****
**Table of Contents**

               •

**Medical claims**.  Medical claims expense as a percentage of premium revenues increased to 70.5% during the current year quarter compared to 67.6% during the prior year quarter.  Medical claims expenserepresents the amounts paid by our health plans for healthcare services provided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions.  The prior year percentage waslower than normal due to a methodology change in how we eliminate in consolidation medical claims expenses incurred by Phoenix Health Plan for services provided to its enrollees by our hospitals and other healthcare businesses in Phoenix.  Revenues and expensesbetween the health plans and our hospitals and related outpatient service providers of approximately $9.3 million, or 12.9% of gross health plan medical claims expense, were eliminated in consolidation during the current year quarter compared to $11.9 million or17.4% of gross health plan medical claims expense during the prior year quarter.

 

 

** **

               •

**Provision for doubtful accounts**.  The provision for doubtful accounts as a percentage of patient service revenues decreased to 7.1% during the current year quarter from 8.5% during the prior yearquarter.  During the current year quarter, our self-pay revenues as a percentage of net patient revenues decreased to 9.5% from 11.8% during the prior year quarter due to lower self pay utilization at our Massachusetts hospitals.  Under our hindsightestimation methodology, our provision for doubtful accounts may be adversely affected by delays in the timing of non self-pay account collections period over period.  Collecting outstanding self-pay accounts remains difficult; however, we have experiencedimproved up front cash collections and success in qualifying patients for coverage under Medicaid or similar programs.  Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts fromrevenues at the time in which those accounts meet our charity care guidelines. During the quarters ended December 31, 2004 and 2005, we recorded $12.5 million and $20.5 million of charity care revenue deductions, respectively.  On a combined basis, the provisionfor doubtful accounts and charity care deductions as a percentage of patient service revenues (prior to charity deductions) decreased to 10.4% during the current year quarter compared to 11.2% during the prior year quarter.  On a same hospital basis, thecombined provision for doubtful accounts and charity care deductions as a percentage of patient service revenues (prior to charity deductions) remained consistent quarter over quarter.

                *Other operating expenses*.  Other operating expenses as a percentage of total revenues increased from 14.5% during the prioryear quarter to 15.5% during the current year quarter primarily as a result of a change in policy in accounting for out of network payments under capitated payer contracts.  During previous fiscal years, we recorded these payments as revenue deductions. During the current year quarter, we recorded these payments of $4.6 million as purchased services.  The remainder of the increase relates to increased repairs and maintenance costs during the current year quarter.

                *Income taxes*.  Our effective tax rate increased from approximately 35.2% during the prior year quarter to approximately37.9% during the current year quarter. The effective tax rate increased during the current year quarter due to acquisition of the Massachusetts hospitals for which the state tax rate is higher than the blended rate in the other states in which we operate.

                *Net income*.  The $1.0 million quarter over quarter decrease in net income resulted primarily from the increase in netinterest incurred during the current year quarter as a result of our $175.0 million term loan borrowing in September 2005.

**Six months ended December 31, 2005 compared to six months ended December 31, 2004**

                *Revenues.* $237.2 million of the $295.9 million increase in total revenues during 2005 related to our acquisition of theMassachusetts hospitals, while same hospital revenues improved by $58.7 million primarily due to a 5.5% period over period increase in same hospital net revenue per adjusted hospital discharge. Hospital adjusted discharges increased by 28.3% during 2005. Emergencyroom visits and outpatient surgeries increased by 25.3% and 27.1%, respectively, during 2005. During 2005, on a same hospital basis, hospital adjusted discharges and emergency room visits increased 0.2% and 3.6%, respectively, while outpatient surgeries decreased3.0% primarily as a result of our sale of the majority of our partnership interests in an outpatient surgery in San Antonio to an independent third party.

                Premium revenues increased by $12.4 million during 2005 primarily due to a PHP capitation rate increase and increased settlementrevenues at MHP during 2005.  PHP average member lives increased slightly from approximately 98,100 during the six months ended December 31, 2004 to approximately 99,400 during the six months ended December 31, 2005.  We anticipate that total health planenrollment will not fluctuate significantly during the foreseeable future.

-52-
****
**Table of Contents**

                We continue to negotiate with managed care payers to receive favorable reimbursement for our services. We have made considerableprogress in these negotiations during the past two years but challenges still remain to adjust these rates to appropriate levels to reflect rising healthcare costs. The acuity of care required by our patients also affects this statistic. We continually identify andimplement services that enable us to maximize our return on investment and meet the needs of our patients.

                We continue to implement physician recruitment, emergency department expansion and patient throughput design improvements, surgery unitexpansion, specialty service expansions and intra-market resource sharing strategies. Current capital projects underway, or initiatives expected to begin during the next 12 months, include expansions and upgraded technology for obstetrics, emergency services,endoscopy, cardiology, radiology and general surgery units as well as real estate projects to support hospital buildouts and construction of primary care clinics.

                *Costs and Expenses.*  Total costs and expenses, exclusive of income taxes, were $1,270.8 million or 98.6% of total revenuesduring 2004 compared to 115.5% during 2004.  The 2004 costs included significant merger, stock compensation and debt extinguishment costs incurred in connection with the merger.  Salaries and benefits, supplies, medical claims and provision for doubtfulaccounts represent the most significant of our normal costs and expenses or those subject to the greatest level of fluctuation period over period.

               •

  

**Salaries and Benefits.**  Salaries and benefits as a percentage of total revenues decreased to 42.4% during 2005 from 49.6% during 2004. During 2004, we incurred $96.9 million of stock compensation including$96.7 million directly related to the merger compared to only $0.6 million during 2005.  Absent the impact of stock compensation during both periods, salaries and benefits as a percentage of total revenues would have increased from 39.9% during 2004 to 42.3%during 2005.  This increase resulted from the higher salaries and benefits costs at our Massachusetts hospitals acquired on December 31, 2004, in which approximately 1,500 of our employees are subject to collective bargaining agreements.  On a same hospitalbasis and exclusive of stock compensation, salaries and benefits as a percentage of total revenues decreased to 39.5% during 2005 from 39.9% during 2004 as a result of our care management, nurse utilization and service expansion strategies.

 

 

** **

 

 

The national nursing shortage continues to hinder our ability to fully manage salaries and benefits. We have experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and Orange Countymarkets. Recent industry reports forecast this shortage to continue for the foreseeable future, especially in California where state mandated increased nurse-staffing ratios went into effect on January 1, 2004. As a result of these factors, we have hired additionalnurses and utilized more costly outsourced nursing personnel.  We believe that our comprehensive recruiting and retention plan for nurses which focuses on competitive salaries and benefits, employee satisfaction, best practices, nursing program educationalopportunities, leadership training and our commitment to clinical and service excellence has mitigated some of the effects of the nursing shortage. However, should we be unsuccessful in our attempts to maintain nursing coverage adequate for our present and futureneeds, and especially if additional states in which we operate enact new laws regarding nurse-staffing ratios, our future operating results could be materially adversely impacted by increased salaries and benefits.

 

 

 

               •

 

**Supplies.**  Supplies as a percentage of total revenues remained consistent at 16.1% during 2005 compared to 2004. On a same hospital basis, supplies as a percentage of total revenues decreased to 15.3% during2005. We are still transitioning our Massachusetts hospitals to our materials management processes. Because most of our growth strategies include expansion of high acuity services, we do not expect to realize significant future decreases in this ratio. Priceincreases for pharmaceuticals and medical supplies, including the impact of increased use of drug-eluting stents, could have a significant adverse impact on future supplies costs.

 

 

** **

               •

 

**Medical Claims.**  Medical claims expense as a percentage of premium revenues decreased to 69.7% during 2005 compared to 71.7% during 2004. The decrease during the current year period primarily relates to a$4.4 million cumulative adjustment to reduce our medical claims reserve at PHP in September 2005 based upon updated historical claims payment information.  Absent the impact of this cumulative adjustment, medical claims expense as a percentage of premiumrevenues would have been 72.3% during the current year period. Medical claims expense represents the amounts paid by the health plans for healthcare services provided to their members, including an estimate of incurred but not reported claims that is determined basedupon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $19.3 million, or 13.6% of gross health plan medical claims expense, were

-53-
****
**Table of Contents**

 

 

eliminated in consolidation during 2005 compared to $19.0 million or 14.0% of gross health plan medical claims expense during 2004.

 

 

 

               •

 

**Provision for Doubtful Accounts**.  During 2005, the provision for doubtful accounts as a percentage of patient service revenues decreased to 8.0% compared to 8.4% during 2004.  During the current yearperiod, our self pay revenues as a percentage of net patient revenues decreased to 10.6% from 12.5% during the prior year period due to lower self pay utilization at our Massachusetts hospitals. Under our hindsight estimation methodology, our provision for doubtfulaccounts may be adversely affected by delays in the timing of non self-pay account collections period over period.  Collecting outstanding self pay accounts remains difficult, but we have improved our upfront cash collections and succeeded in qualifying patientsfor coverage under Medicaid or similar programs. Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines.During 2004 and 2005, we recorded $23.4 million and $37.5 million of charity care deductions, respectively.  On a combined basis, our provision for doubtful accounts and charity care deductions as a percentage of patient service revenues (prior to charitydeductions) increased to 11.0% during the current year period compared to 10.9% during the prior year period.  On a same hospital basis, the combined provision for doubtful accounts and charity care deductions as a percentage of patient service revenues (priorto charity deductions) increased to 11.8% during the current year period from 10.9% during the prior year period.

                *Other operating expenses*.  Other operating expenses as a percentage of total revenues increased from 14.5% during 2004 to15.4% during 2005 primarily as a result of a change in policy in accounting for out of network payments under capitated payer contracts.  During previous fiscal years, we recorded these payments as revenue deductions.  During the current year period, werecorded these payments of $6.6 million as purchased services.  Also, we experienced increased repairs and maintenance costs during the current year period.

                *Income Taxes.*  The effective tax rate increased from 31.4% in 2004 to 41.4% in 2005.  We were unable to recognize thefull tax benefit of the net loss incurred during the six months ended December 31, 2004 due to certain costs related to the Blackstone transaction being non-deductible for tax purposes.

                *Net Income.*  The $116.4 million year over year increase in net income resulted from the significant costs and expensesrelated to the merger, including merger expenses, stock compensation and debt extinguishment costs incurred during 2004.

**Liquidity and Capital Resources**

                *Operating Activities. * At December 31, 2005, we had working capital of $230.2 million, including cash and cash equivalentsof $162.5 million. Working capital at June 30, 2005 was $77.7 million.  The increase in working capital was primarily due to cash received from the borrowing of the $175.0 million of delayed draw term loans during September 2005.  Cash provided by operatingactivities decreased from $94.3 million during the six months ended December 31, 2004 to $45.4 million during the six months ended December 31, 2005.  The significant decrease was primarily due to a significant change in the timing of payments of liabilitiesincluding (1) a net paydown of accounts payable and other liabilities of $29.6 million during the current year period compared to a buildup of $30.5 million during the prior year period; (2) a $24.3 million increase in interest payments during the current yearperiod; and (3) accelerated payments of PHP medical claims during the current year period compared to the prior year period.

                *Investing Activities*.  Cash used in investing activities decreased from $180.0 million during the six months ended December31, 2004 to $108.4 million during the six months ended December 31, 2005, primarily as a result of $138.2 million paid during 2004 for acquisition costs related to the merger and the purchase of the Massachusetts hospitals offset by a $41.3 million period over periodincrease in capital expenditures.

                We spent $113.7 million for capital expenditures during the six months ended December 31, 2005.  In May 2004 and July 2005, ourboard of directors approved material new internal construction projects at six of our existing hospitals in San Antonio and metropolitan Phoenix.  We have spent $171.9 million for these projects since inception through December 31, 2005 and expect to spend anestimated additional $162.8 million through fiscal year 2008.  All of these projects will result in expanded capacity at each of the six hospitals. In addition, most of the projects will facilitate an expansion of clinical service capabilities.

-54-
****
**Table of Contents**

                The following table summarizes these major expansion projects as of February 1, 2006.

**Hospital**

 

**Estimated Construction Period**

** **

**Approximate Additional Licensed Bed Capacity**

** **

**Additional Emergency Room Positions**

** **

**Additional Operating Rooms**

** **

**Additional Labor & Delivery Rooms**

**Begin**

** **

**Open**

 

 

 

 

 

 

**Phoenix**

 

 

 

 

 

 

 

 

 

 

 

 

Arrowhead Community Hospital

Q4 FY 04

 

Q1 FY 07

 

100 (5)

 

P

 

P

 

P

Paradise Valley Hospital

 

Q3 FY 06

 

Q1 FY 08

 

22 (4)

 

(2)

 

P

 

P

West Valley Hospital

 

Q1 FY 06

 

Q2 FY 07

 

39     

 

P

 

P

 

(1)

** **

 

 

 

 

 

 

 

 

 

 

 

 

**San Antonio**

 

 

 

 

 

 

 

 

 

 

 

 

North Central Baptist Hospital

 

Q4 FY 04

 

Q1 FY 07

 

140     

 

P

 

P

 

P

Northeast Baptist Hospital

 

Q4 FY 04

 

Q4 FY 06

 

33 (3)

 

P

 

P

 

P

St. Luke’s Baptist Hospital

 

Q2 FY 06

 

Q3 FY 07

 

27     

 

____________________(1)       Will increase post partum capacity to better utilize labor, delivery and recovery suites.(2)       An expanded emergency room was opened in July 2004, expanding capacity from 16 to 28 bays.(3)       In addition to increasing the number of licensed beds by 33, the expansion will allow for the utilization of an additional 67            previously licensed beds.(4)       In addition to increasing the number of licensed beds by 22, the expansion will allow for the utilization of an additional 18 previously licensed beds.(5)       40 of these beds were added during the fourth quarter of fiscal 2005.

                We anticipate spending a total of $275.0 million to $300.0 million in capital expenditures during fiscal 2006 including the $113.7million spent through December 31, 2005.  This estimate includes the expansion projects mentioned above and all other renovation projects and technology upgrades at our facilities. These capital expenditures will be funded by cash on hand, cash flows fromoperations and availability under our revolving credit facility. We believe our capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our quality objectives.

                *Financing Activities*.  Cash provided by financing activities increased by $102.1 million during the six months endedDecember 31, 2005 compared to the six months ended December 31, 2004, primarily as a result of the $175.0 million in term loan borrowings made in September 2005.

                As of December 31, 2005, we had outstanding $1,512.8 million in aggregate indebtedness, with an additional $211.2 million of availableborrowing capacity under our revolving credit facility ($250.0 million net of outstanding letters of credit of $38.8 million). Our liquidity requirements are significant, primarily due to debt service requirements. The 9.0% Notes require semi-annual interestpayments. Prior to October 1, 2009, our interest expense on the 11.25% Notes will consist solely of non-cash accretions of principal.

                Our previous senior secured credit facilities executed in September 2004 consisted of a revolving credit facility and the initial termloan facility. Our revolving credit facility provides for loans in a total principal amount of up to $250.0 million, and matures in September 2010. The initial term loan facility, which was scheduled to mature in September 2011, provided for loans in a totalprincipal amount of up to $800.0 million as follows: (1) $475.0 million borrowed on September 23, 2004 to finance the merger, to refinance our then existing indebtedness and to pay fees and expenses relating thereto; (2) $150.0 million borrowed on December 31, 2004and February 18, 2005 to finance the acquisition of the Massachusetts hospitals and for other general corporate purposes and (3) $175.0 million borrowed in September 2005 to fund capital expenditures and for other general corporate purposes.

                On September 26, 2005, we refinanced and repriced all $795.7 million of the outstanding term loans under the initial term loan facilityby borrowing $795.7 million of replacement term loans (the “2005 term loan facility”).  In addition, upon the incurrence of certain events and subject to receipts of commitments from lenders, we may request an incremental term loan facility be addedto the 2005 term loan facility in an amount not to exceed $300.0 million in the aggregate.  No changes were made to the revolving credit facility in the refinancing.

-55-
****
**Table of Contents**

                The 2005 term loan facility borrowings bear interest at a rate equal to, at our option, either a base rate plus 1.25% per annum orLIBOR plus 2.25% per annum. These rates reflect a savings of 1.00% per annum over the interest rate options for the previous initial term loan facility. The borrowings under the revolving credit facility currently bear interest at a rate equal to, at our option,either a base rate plus 1.00% per annum or LIBOR plus 2.00% per annum.  These rates are subject to an increase of up to 0.50% per annum should our leverage ratio increase over certain designated levels.

                We are required to pay a commitment fee to the lenders under the revolving credit facility in respect of the unutilized commitmentsthereunder at a rate equal to 0.50% per annum. We also pay customary letter of credit fees.

                The 2005 term loan facility and the revolving credit facility contain a number of covenants that, among other things, restrict, subjectto certain exceptions, our ability, and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, repay other indebtedness, pay dividends and distributions or repurchase our capital stock, create liens on assets, makeinvestments, loans or advances, make certain acquisitions, engage in mergers or consolidations, enter into sale and leaseback transactions, engage in certain transactions with affiliates, amend certain material agreements governing our indebtedness, change thebusiness conducted by our subsidiaries and enter into hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: a maximum total leverage ratio, a maximum senior leverage ratio, a minimum interest coverageratio and a maximum capital expenditures limitation.

                As of December 31, 2005, we were in compliance with the debt covenant ratios as defined in our senior secured credit agreement, asfollows.

** **

** **

**Debt Covenant Ratio**

** **

**Actual Ratio**

 

 

 

Interest coverage ratio requirement

 

1.90x

 

2.99x

Total leverage ratio limit

 

6.15x

 

3.83x

Senior leverage ratio limit

 

3.75x

 

1.65x

                The senior credit facilities and the indentures governing the 9.0% Notes and the 11.25% Notes limit our ability to:

              •  incur additional indebtedness or issue preferred stock;

              •  pay dividends on or make other distributions or repurchase our capital stock or make other restricted payments;

              •  make investments;

              •  enter into certain transactions with affiliates;

              •  pay dividends or other similar payments by our subsidiaries;

              •  create liens on *pari passu* or subordinated indebtedness without securing the Notes;

              •  designate the issuers’ subsidiaries as unrestricted subsidiaries; and

              •  sell certain assets or merge with or into other companies or otherwise dispose of all or substantially all of their                   assets.

-56-
****
**Table of Contents**

                The table below summarizes our credit ratings as of the date of this filing.

**Standard & Poor’s**

**Moody’s**

 

Corporate credit rating

B

B2

9% Senior Subordinated Notes            

CCC+

Caa1

111⁄4% Senior Discount Notes

CCC+

Caa2

Senior credit facilities

B

B2

                *Capital Resources*.  Our debt has increased during the past 12 months as a result of our delayed draw term borrowings. Weexpect that cash on hand, cash generated from our operations and cash available to us under the revolving credit facility will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs that we considernecessary to continue our growth during the foreseeable future. However, we cannot assure you that our operations will generate sufficient cash or that future borrowings under our revolving credit facility will be available to enable us to meet these requirements andneeds.

                We also intend to continue to pursue acquisitions or partnering arrangements, either in existing markets or new markets, which fit ourgrowth strategies. To finance such transactions, we might have to draw upon amounts available under our senior secured credit facilities or seek additional funding sources. We continually assess our capital needs and may seek additional financing, including debt orequity, as considered necessary to fund potential acquisitions, fund capital projects or for other corporate purposes. However, should our operating results and borrowing capacities not sufficiently support these capital projects or acquisition opportunities, ourgrowth strategies may not be fully realized. Our future operating performance, ability to service or refinance our new debt and ability to draw upon other sources of capital will be subject to future economic conditions and other business factors, many of which arebeyond our control.

****

**Guarantees and Off Balance Sheet Arrangements**

                We are a party to certain rent shortfall agreements with certain unconsolidated entities and other guarantee arrangements, includingparent-subsidiary guarantees, in the ordinary course of business. We have not engaged in any transaction or arrangement with an unconsolidated entity that is reasonably likely to materially affect liquidity.

-57-
****
**Table of Contents**

**Obligations and Commitments**

                The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portionsof long-term debt and capital leases, with payment dates as of December 31, 2005.

 

 

**Payments due by period**

** **

** **

 

 

 
****
** **

** **

 

 

 

**Within 1 year**
** **
**During Years 2-3**

** **

**During Years 4-5**

** **

**After 5 years**

** **

**Total**

 

 

 
**
 

**Contractual Cash Obligations:**

 

*(In millions)*

 

Long-term debt

 

$

114.6

 

 

$

227.6

 

 

$

225.4

 

 

$

1,917.2

 

$

 

2,484.8

 

Capital lease obligations

 

0.7

 

 

0.1

 

–

 

 

–

 

 

0.8

 

Operating leases

 

 

26.5

 

 

 

42.0

 

26.4

 

 

 

43.8

 

 

 

138.7

 

Purchase obligations

 

 

40.7

 

 

 

–

 

–

 

 

 

–

 

 

 

40.7

 

Health claims payable

31.3

–

–

–

31.3

Estimated self-insuranceliabilities                               

 

 

17.1

 

 

 

38.8

 

16.9

 

 

 

5.7

 

 

 

78.5

 

 

 

 

 

 

 

 

 

 

 

    Subtotal

 

$

230.9

 

 

$

308.5

 

$

268.7

 

 

$

1,966.7

 

 

$

2,774.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Payments due by period**

 

** **

 

 

 
****
** **

** **

 

 

 

**Within 1 year**
** **
**During Years 2-3**

** **

**During Years 4-5**

** **

**After 5 years**

** **

**Total**

 

 

 
**
 

**Other Commitments:**

 

*(In  millions)*

 

Construction and improvements commitments             

$

87.7

 

 

$

23.9

$

5.0

 

 

$

13.0

 

$

 

129.6

 

Guarantees of surety bonds

 

18.0

 

 

–

 

 

–

 

 

–

 

 

18.0

 

Letters of credit

 

–

 

 

–

 

–

 

 

38.8

 

 

38.8

 

Physician commitments

 

 

7.1

 

 

 

–

 

–

 

 

 

–

 

 

 

7.1

 

Minimum rent revenue commitments

0.3

0.3

0.3

0.9

1.8

 

    Subtotal

 

$

113.1

 

 

$

24.2

 

$

5.3

 

 

$

52.7

 

 

$

195.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total obligations and commitments

$

344.0

$

332.7

$

274.0

 

 

$

2,019.4

$

2,970.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-58-
****
**Table of Contents**

**Item 3.    Quantitative and Qualitative Disclosures About Market Risk.**

****

                We are exposed to market risk related to changes in interest rates.  We utilize interest rate swap derivatives from time to timeto manage this risk.  We do not hold or issue derivative instruments for trading purposes and are not a party to any instruments with leverage features.  As of December 31, 2005, we had outstanding $793.7 million of senior debt subject to variable interestrates and $718.3 million of outstanding 9.0% Notes and 11.25% Notes subject to fixed interest rates. As of December 31, 2005, the fair values of the 9.0% Notes and the 11.25% Notes were $616.7 million and $160.9 million, respectively.

                In connection with the merger on September 23, 2004, we entered into new senior secured credit facilities comprised of a $475.0 millionterm loan facility, a $250.0 million revolving facility and delayed draw term loan facilities totaling $325.0 million.  We made $475.0 million in term loan borrowings on September 23, 2004 to fund a portion of the merger, borrowed $60.0 million under the delayeddraw term loan facilities on December 31, 2004 to fund a portion of the acquisition purchase price of the Massachusetts hospitals and borrowed $90.0 million under the delayed draw term loan facilities on February 18, 2005 to fund the working capital buildup of theMassachusetts hospitals and to fund capital expenditures.  We borrowed the remaining $175.0 million under the delayed draw term loan facilities in September 2005.  On September 26, 2005, we repriced and refinanced all the then outstanding term loans with$795.7 million of replacement term loans resulting in 1.00% per annum in interest rate savings over the previous term loan facilities.  As of December 31, 2005, we had utilized $38.8 million of borrowing capacity under the revolving facility for letters ofcredit.  The weighted average interest rate on our $793.7 million of outstanding term loan borrowings was approximately 6.95% as of December 31, 2005 (LIBOR of 4.70% plus a fixed margin of 2.25%).

                Based upon a hypothetical 1 percentage point change to the current interest rate applicable to the outstanding term loans under ourcredit facility debt, annualized interest expense for the term loan borrowings would change by approximately $8.0 million.  We believe that a hypothetical 1 percentage point change in interest rates would not have a material impact on the fair value of our fixedrate 9.0% Notes and 11.25% Notes.

**Item 4.    Controls and Procedures.**

**                Evaluation of Disclosure Controls and Procedures**

                As of the end of the period covered by this report, our management conducted an evaluation, with the participation of our chiefexecutive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation, ourchief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, asappropriate to allow timely decisions regarding required disclosure.

**                Changes in Internal Control Over Financial Reporting**

                There were no changes in our internal control over financial reporting during our fiscal quarter ended December 31, 2005, that hasmaterially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

-59-
****
**Table of Contents**

**PART IIOTHER INFORMATION**

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

                The following persons were re-elected to our board of directors by the holders of 100% of our outstanding common stock by action takenpursuant to a written consent dated November 3, 2005 of such holders in lieu of an annual stockholders’ meeting:

Michael A. Dal BelloEric T. FryBenjamin J. JenkinsCharles N. Martin, Jr.Neil P. Simpkins

**Item 6.    Exhibits.**

                The exhibits filed as part of this report are listed in the Index to Exhibits which is located at the end of this report.

-60-
****
**Table of Contents**

**SIGNATURE**

****

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

DATE:     February 9,2006                                                                 VANGUARD HEALTH SYSTEMS, INC.

                                                                                                               BY:          /s/ Phillip W.Roe                                                                                                                                                                               *Phillip W. Roe                                                                                                                               Senior Vice President, Controller and                                                                                                                               Chief Accounting Officer*                                                                                                                               (Authorized Officer and Chief Accounting Officer)

-61-
****
**Table of Contents**

**INDEX TO EXHIBITS**

**Exhibit No.     **

  

**Description**

10.1

 

Amendment No. 2 to Amended and Restated Employment Agreement between Vanguard Health Systems, Inc. and Charles N. Martin, Jr., dated as of December 1, 2005.

 

 

 

10.2

 

Amendment No. 2 to Amended and Restated Employment Agreement between Vanguard Health Systems, Inc. and Joseph D. Moore , dated as of December 1, 2005.

 

 

 

10.3

 

Amendment No. 2 to Amended and Restated Employment Agreement between Vanguard Health Systems, Inc. and Ronald P. Soltman, dated as of December 1, 2005.

 

 

 

10.4

 

  Amendment No. 2 to Amended and Restated Employment Agreement between Vanguard Health Systems, Inc. and Keith B. Pitts, dated as of December 1, 2005.

 

 

 

10.5

 

Amendment No. 1, dated as of November 3, 2005, to Amended and Restated Limited Liability Company Operating Agreement of VHS Holdings LLC.

 

 

 

10.6

Amendment Number 1 to the Vanguard Health Systems, Inc. 2004 Stock Incentive Plan, effective November 28, 2005.

 

 

 

10.7

Contract Amendment Number 12, executed on December 21, 2005, but effective as of January 1, 2006, to the Arizona Health Care Cost Containment System Administration Contract No. YH04-0001-06 between VHS Phoenix Health Plan andthe Arizona Health Care Cost Containment System.

 

 

 

31.1

 

Certification of CEO pursuant to Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification of CFO pursuant to Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification of CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

-62-