**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 March 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: 333-120436**_______________
**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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yeso   Nox

          There were 749,550 shares of common stock outstanding as of May 1, 2005 (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, 2004 and March 31, 2005

 

3

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

 

4

 

 

Condensed Consolidated Statements of Operations for the nine months ended March 31, 2004 and 2005

 

5

Condensed Consolidated Statements of Cash Flows for the nine months ended March 31, 2004 and 2005

 

6

 

 

Condensed Consolidated Statements of Cash Flows for the predecessor period July 1, 2004 through September 22, 2004 and the successor period September 23, 2004 through March 31, 2005

 

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

60

Item 4.

 

Controls and Procedures

60

**PART II. **

 

**OTHER INFORMATION**

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

61

Item 6.

 

Exhibits

 

61

 

 

Signature

 

63

 

Index to Exhibits

64

-2-
****
**PART IFINANCIAL INFORMATION**

**Item 1.    Financial Statements.**

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

 

 

**Predecessor**

 

 

 

**(Unaudited) March 31, 2005**

 

 

**June 30, 2004**

 

 

 

 

 

**ASSETS**

 

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

 

 

** **

 

 

Current assets:

 

 

 

 

 

 

 

 

   Cash and cash equivalents

$

108.1

$

99.4

   Accounts receivable, net of allowance for uncollectible accounts of       approximately $63.5 and $80.6 at June 30, 2004 and       March 31, 2005, respectively

224.7

294.5

 

   Supplies

34.6

42.1

 

   Income tax receivable

1.4

–

   Prepaid expenses and other current assets

32.3

38.0

 

 

 

        Total current assets

401.1

474.0

 

Property, plant and equipment, net of accumulated depreciation

866.9

982.1

 

Goodwill

109.3

806.1

 

Intangible assets, net of accumulated amortization

41.8

76.0

 

Other assets

8.7

62.7

 

 

 

        Total assets

$

1,427.8

$

2,400.9

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

Current liabilities:

 

   Accounts payable

$

80.7

$

122.0

 

   Accrued health claims

41.6

52.1

 

   Accrued interest

14.1

28.9

 

   Other accrued expenses and current liabilities

95.7

122.8

 

   Current maturities of long-term debt

6.3

8.0

 

 

 

        Total current liabilities

238.4

333.8

 

Other liabilities

99.2

75.3

 

Long-term debt, less current maturities

617.2

1,324.6

 

Payable-In-Kind Preferred Stock; $.01 par value, 150,000 combined shares of     Preferred Stock and Payable-In-Kind Preferred Stock authorized, 27,210     shares of Payable-In-Kind Preferred Stock issued and outstanding at     June 30, 2004, and 31,875 shares of Series B Payable-in-Kind Preferred Stock     issued and outstanding at June 30, 2004, at redemption value

61.0

–

Commitments and contingencies

Stockholders’ Equity:

Preferred Stock; $1,000 par value, 150,000 combined shares of Preferred Stock     and Payable-In-Kind Preferred Stock authorized, no shares of Preferred     Stock issued and outstanding at June 30, 2004

–

–

Common Stock; $.01 par value, 600,000 shares authorized, 232,749 shares issued and     outstanding at June 30, 2004 and 1,000,000 shares authorized, 749,550 shares     issued and outstanding at March 31, 2005, respectively

–

–

Additional paid-in capital

348.7

642.4

Retained earnings

63.3

24.8

 

        Total stockholders’ equity

412.0

667.2

 

 

        Total liabilities and stockholders’ equity

$

1,427.8

$

2,400.9

 

 

 

See accompanying notes.

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSFor the three months ended March 31, 2004 and 2005(Unaudited)**

** **

 

** **

**Predecessor**

** **

** **

** **

** **

 

 

 

 

 

 

 

** **

 

** **

**Three months ended March  31, 2004**

** **

** **

** **

**Three months ended March  31, 2005**

 

 

 

 

 

 

 

 

 

*(in millions)*

 

 

 

Patient service revenues

 

$

385.0

 

 

$

559.3

Premium revenues

 

 

76.7

 

 

 

83.7

 

 

 

 

 

 

     Total revenues

 

 

461.7

 

 

 

643.0

 

 

 

 

 

 

 

 

Costs and Expenses:

 

 

 

 

 

 

 

   Salaries and benefits (includes stock compensation of $0.1 and $0.2,       respectively)

 

 

190.3

 

 

 

271.6

   Supplies

 

 

73.7

 

 

 

108.8

   Medical claims expense

 

 

55.8

 

 

 

62.2

   Purchased services

 

 

22.6

 

 

 

36.9

   Provision for doubtful accounts

 

 

29.4

 

 

 

40.2

   Other operating expenses

 

 

36.5

 

 

 

41.6

   Rents and leases

 

 

6.1

 

 

 

8.4

   Depreciation and amortization

 

 

15.7

 

 

 

13.1

   Interest, net

 

 

11.1

 

 

25.4

   Merger expenses

 

 

–

 

 

 

0.1

   Other

 

 

(1.2

)

 

 

1.5

 

 

 

 

 

 

Income before income taxes

 

 

21.7

 

 

 

33.2

Income tax expense

 

7.9

 

 

 

13.6

 

 

 

 

 

 

Net income

 

13.8

 

19.6

Preferred stock dividends

 

 

(1.0

)

 

 

–

 

 

 

 

 

 

Net income attributable to common stockholders

 

$

12.8

 

 

$

19.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSFor the nine months ended March 31, 2004 and 2005(Unaudited)**

** **

 

**Predecessor**

** **

** **

** **

**Predecessor**

** **

** **

** **

** **

** **

** **

** **

** **

 

 

 

 

 

 

 

 

 

 

 

 

 

** **

 

**Nine months ended March 31, 2004**

** **

** **

** **

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

** **

** **

** **

**September 23, 2004 through March 31, 2005**

** **

** **

**Nine months ended March 31, 2005 (combined)**

** **

 

 

 

 

 

 

 

 

 

 

 

 

*(in millions)*

 

Patient service revenues

$

1,100.0

 

 

$

377.3

 

 

$

1,012.4

 

$

1,389.7 

 

Premium revenues

 

213.6

 

 

 

72.3

 

 

 

174.5

 

 

246.8 

 

 

 

 

 

 

 

 

 

 

 

 

     Total revenues

 

1,313.6

 

 

 

449.6

 

 

 

1,186.9

 

 

1,636.5 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Salaries and benefits (includes stock       compensation of $0.1, $96.7, $0.4       and $97.1, respectively)

 

549.3

 

 

 

275.4

 

 

 

489.2

 

 

764.6 

 

   Supplies

 

207.5

 

 

 

72.3

 

 

 

196.5

 

 

268.8 

 

   Medical claims expense

 

156.7

 

 

 

55.0

 

 

 

124.1

 

 

179.1 

 

   Purchased services

 

67.3

 

 

 

22.1

 

 

 

64.5

 

 

86.6 

 

   Provision for doubtful accounts

 

89.7

 

 

 

31.5

 

 

 

78.7

 

 

110.2 

 

   Other operating expenses

 

104.2

 

 

 

37.2

 

 

 

85.7

 

 

122.9 

 

   Rents and leases

 

17.2

 

 

 

5.7

 

 

 

16.0

 

 

21.7 

 

   Depreciation and amortization

 

46.7

 

 

 

17.4

 

 

 

35.6

 

 

53.0 

 

   Interest, net

 

32.4

 

 

 

9.8

 

 

 

52.5

 

 

62.3 

 

   Debt extinguishment costs

 

–

 

 

 

62.2

 

 

 

–

 

 

62.2 

   Merger expenses

 

–

 

 

 

23.1

 

 

 

0.1

 

 

23.2 

 

   Other

 

(5.7

)

 

 

(0.1

)

 

 

2.7

 

 

2.6 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

48.3

 

 

 

(162.0

)

 

 

41.3

 

 

(120.7)

 

Income tax expense (benefit)

 

18.4

 

 

(51.3

)

 

16.5

 

(34.8)

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

29.9

 

 

(110.7

)

 

24.8

 

(85.9)

 

Preferred stock dividends

 

(2.9

)

 

 

(1.0

)

 

 

–

 

(1.0)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common    stockholders

$

27.0

 

 

$

(111.7

)

 

$

24.8

 

$

(86.9)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSFor the nine months ended March 31, 2004 and 2005(Unaudited)**

 

 

 

**Predecessor**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Nine months ended March 31, 2004**

** **

** **

 

**Nine months ended March 31, 2005 (combined basis)**

 

 

 

 

 

 

 

 

 

 

 

*(in millions)*

 

 

 

Operating activities:

 

 

 

 

 

 

 

 

Net income (loss)

 

$

29.9

 

 

$

(85.9

)

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

 

 

 

 

 

 

 

 

   Depreciation and amortization

 

 

46.7

 

 

 

53.0

 

   Provision for doubtful accounts

 

 

89.7

 

 

 

110.2

 

   Deferred income taxes

 

 

11.3

 

 

(34.8

)

   Amortization of loan costs

 

 

1.4

 

 

 

2.3

 

   Accretion of principal on senior discount notes

 

 

–

 

 

7.3

   (Gain) loss on sale of assets

 

 

(0.8

)

 

 

1.0

 

   Stock compensation

 

 

0.1

 

 

 

97.1

 

   Debt extinguishment costs

 

 

–

 

 

 

62.2

 

   Merger expenses

 

 

–

 

 

 

23.2

 

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

 

 

 

 

 

 

 

 

      Accounts receivable

 

 

(115.0

)

 

 

(126.8

)

      Buildup of accounts receivable for recent acquisitions

–

(53.2

)

      Supplies

 

 

(1.9

)

 

 

(1.5

)

      Prepaid expenses and other current assets

 

 

2.9

 

 

7.8

 

      Accounts payable

 

 

(1.2

)

 

 

34.0

 

      Accrued expenses and other current liabilities

 

 

(4.6

)

 

 

31.8

 

      Other liabilities

 

 

0.9

 

 

 

13.8

 

 

 

 

 

 

 

 

Net cash provided by operating activities

 

 

59.4

 

 

 

141.5

 

 

 

 

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

 

 

 

Acquisitions

 

 

(12.3

)

 

 

(138.6

)

Capital expenditures

 

 

(102.1

)

 

 

(137.3

)

Proceeds from asset dispositions

 

 

6.2

 

 

 

0.7

 

Other

 

 

(0.7

)

 

 

(6.0

)

 

 

 

 

 

 

 

Net cash used in investing activities

 

 

(108.9

)

 

 

(281.2

)

 

 

 

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

 

 

 

Proceeds from long-term debt

 

 

177.5

 

 

 

1,324.7

 

Payments of long-term debt and capital leases

 

 

(130.6

)

 

 

(688.3

)

Payments of loan costs and debt termination fees

 

 

–

 

 

(44.1

)

Proceeds from joint venture partner contributions

 

 

3.0

 

 

 

8.0

 

Exercise of stock options

 

 

0.1

 

 

 

0.1

 

Payments to retire stock and stock options

 

 

(0.1

)

 

(964.9

)

Proceeds from common stock issuances

 

 

–

 

 

495.5

 

 

 

 

 

 

 

 

Net cash provided by financing activities

 

 

49.9

 

 

 

131.0

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

 

0.4

 

 

(8.7

)

Cash and cash equivalents, beginning of period

 

 

27.2

 

 

 

108.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

27.6

 

 

$

99.4

 

 

 

 

 

 

 

 

Net cash paid for interest

 

$

41.1

 

 

$

41.1

 

 

 

 

 

 

 

Net cash paid for income taxes

 

$

1.6

 

 

$

–

 

See accompanying notes.

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSFor the predecessor period July 1, 2004 through September 22, 2004 andthe successor period September 23, 2004 through March 31, 2005(Unaudited)**

 

 

 

**Predecessor**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

** **

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

 

 

 

**September 23, 2004 through March 31, 2005**

 

 

 

**Nine months ended March 31, 2005 (combined basis)**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*(in millions)*

 

 

 

Operating activities:

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(110.7

)

 

$

24.8

 

 

$

(85.9

)

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

 

 

 

 

 

 

 

 

 

 

 

   Depreciation and amortization

 

 

17.4

 

 

 

35.6

 

 

 

53.0

 

   Provision for doubtful accounts

 

 

31.5

 

 

 

78.7

 

 

 

110.2

 

   Deferred income taxes

 

 

(50.9

)

16.1

(34.8

)

   Amortization of loan costs

 

 

0.5

 

 

 

1.8

 

 

 

2.3

 

   Accretion of principal on senior discount notes

 

 

–

7.3

7.3

   Loss on sale of assets

 

 

0.6

 

 

 

0.4

 

 

 

1.0

 

   Stock compensation

 

 

96.7

 

 

 

0.4

 

 

 

97.1

 

   Debt extinguishment costs

 

 

62.2

 

 

 

–

 

 

 

62.2

 

   Merger expenses

 

 

23.1

 

 

 

0.1

 

 

 

23.2

 

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

 

 

 

 

 

 

 

 

 

 

 

 

      Accounts receivable

 

 

(42.1

)

 

 

(84.7

)

 

 

(126.8

)

      Buildup of accounts receivable for recent acquisitions

–

(53.2

)

(53.2

)

      Supplies

 

 

(0.3

)

 

 

(1.2

)

 

 

(1.5

)

      Prepaid expenses and other current assets

 

 

2.4

 

 

 

5.4

 

 

 

7.8

 

      Accounts payable

 

 

41.4

 

 

 

(7.4

)

 

 

34.0

 

      Accrued expenses and other current liabilities

 

 

9.0

 

 

 

22.8

 

 

31.8

 

      Other liabilities

 

 

(2.0

)

 

 

15.8

 

 

 

13.8

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by operating activities

 

 

78.8

 

 

 

62.7

 

 

 

141.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

 

 

 

 

 

 

 

Acquisitions

 

 

(50.8

)

 

 

(87.8

)

 

 

(138.6

)

Capital expenditures

 

 

(29.8

)

 

 

(107.5

)

 

 

(137.3

)

Proceeds from asset dispositions

 

 

0.5

 

 

 

0.2

 

 

 

0.7

 

Other

 

 

0.1

 

 

 

(6.1

)

 

 

(6.0

)

 

 

 

 

 

 

 

 

 

 

Net cash used in investing activities

 

 

(80.0

)

 

 

(201.2

)

 

 

(281.2

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

 

 

 

 

 

Proceeds from long-term debt

 

 

1,174.7

 

 

 

150.0

 

 

 

1,324.7

 

Payments of long-term debt and capital leases

 

 

(683.9

)

 

 

(4.4

)

 

 

(688.3

)

Payments of loan costs and debt termination fees

 

 

(40.9

)

(3.2

)

(44.1

)

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

 

 

 

0.6

 

 

495.5

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

 

(20.0

)

 

 

151.0

 

 

 

131.0

 

 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

 

(21.2

)

 

 

12.5

 

 

(8.7

)

Cash and cash equivalents, beginning of period

 

 

108.1

 

 

 

86.9

 

 

 

108.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

86.9

 

 

$

99.4

 

 

$

99.4

 

 

 

 

 

 

 

 

 

 

 

Net cash paid for interest

 

$

23.6

 

 

$

17.5

 

 

$

41.1

 

 

 

 

 

 

 

 

 

 

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 STATEMENTSMarch 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. (the “Company” or “Vanguard”) in a merger transaction (the “merger”). Pursuant to the mergeragreement, the former holders of Vanguard 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 priorto transaction fees and expenses.

                Subsequent to the merger, Blackstone beneficially owns approximately 66% of the equity interests in the Company 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”), the Company’sprevious 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 shareholders, on a combined basis, beneficially own approximately 34% of the equity interests in the Company. Certain members of management also purchased $5.8 million of the equity incentive units in Holdings.

                The Company accounted for the transaction as a purchase under the guidance set forth in Emerging Issues Task Force Number 88-16,*Basis in 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 accountingbasis. In effect, 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 madeby Blackstone;

                •               $130.0 million rollover equity contributionmade by MSCP;

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

                •               $5.0 million equity contribution made byBaptist Health Services from the proceeds of the conversion of its                                8.18% subordinated convertible notes and Series B Payable-In-Kind PreferredStock into the right to                                receive common shares of Vanguard;

                •               $5.8 million purchase of the equityincentive units in Holdings by certain members of management;

                •               Execution of a new credit agreementgoverning new senior secured term loan credit facilities of $800.0                                million, of which $475.0 million was drawn at closing, and a new revolving loanfacility of $250.0 million,                                 none of which was utilized at closing with the exception of $27.7 million ofoutstanding 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 grossproceeds) of 11.25% senior                                 discount 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 theterms of the merger agreement;

                        •       Repay all indebtedness underVanguard’s existing senior secured credit facilities;

                        •       Repurchase substantially all ofVanguard’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 andconsent solicitation by                                 Vanguard; and

                        •       Pay the fees and expenses related to themerger and the related financing transactions

                The Company incurred $96.7 million in stock compensation expense in connection with the merger related to the payment to stock optionholders under the Company’s 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 optiongrants on or after July 1, 2003. The Company 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 premiumsand 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. The Company capitalized $41.6 million of fees and expenses related to the execution of thenew senior secured credit facilities and the issuance of the 9.0% Notes and the 11.25% Notes on the merger date.

The Company also incurred costs of $51.5 million directly related to the merger, of which $23.2 million is reflected as merger expenses on the accompanying condensed consolidated statement of operations for the nine monthsended March 31, 2005.  The remaining $28.3 million is included in goodwill on the accompanying condensed consolidated balance sheet as of March 31, 2005 as set forth by the provisions of Statement of Financial Accounting Standards No. 141.  The table belowprovides a detail of the merger-related costs (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

 

        0.4

 

             0.2

 

 

 

 

 

$   23.2

 

      $   28.3

 

 

 

**2.             BASIS OF PRESENTATION AND ORGANIZATION**

****

                The unaudited condensed consolidated financial statements as of March 31, 2005 and for the three months and nine months then endedinclude the accounts of the Company and its wholly owned and majority-owned subsidiaries and 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 RegulationS-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 all adjustments (consisting of normalrecurring 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 of the expected results for the yearending June 30, 2005.  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, 2004

-9-
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**Table of Contents**

included in the Company’s Registration Statement on Form S-4 (Registration No. 333-120436) originally filed with the Securities and Exchange Commission on November 12, 2004.

                The preparation of financial statements in conformity with accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reported in the accompanying unaudited condensed consolidated financial statements and notes.  Actual results could differ from those estimates.

                As of March 31, 2005, the Company owned 19 hospitals with a total of 4,518 licensed beds and related outpatient service facilitiescomplementary to the hospitals in metropolitan Phoenix, Arizona; Orange County, California; metropolitan Chicago, Illinois; San Antonio, Texas and Massachusetts.  The Company also owned two health plans:  a Medicaid managed health plan, Phoenix Health Plan,which served approximately 100,000 members in Arizona as of March 31, 2005; and MacNeal Health Providers, which had responsibility, under capitated contracts covering certain physician and outpatient services, for approximately 46,800 member lives in metropolitanChicago, Illinois as of March 31, 2005.

                Certain prior year amounts have been reclassified to conform to current year presentation.  The majority of the Company’sexpenses are “cost of revenue” items.  Costs that could be classified as general and administrative include certain Vanguard corporate office costs, which approximated $11.4 million and $14.7 million for the nine months ended March 31, 2004 and 2005,respectively.

**3.             STOCK-BASED COMPENSATION**

                Prior to the merger, the Company had four stock option plans.  Until July 1, 2003, the Company accounted for stock-based employeecompensation in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees.* Effective July 1, 2003, the Company adopted the fair value method of accounting for stock-basedemployee compensation set forth by Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”). The Company elected to use the prospective transition method set forth by Statement of FinancialAccounting 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 nine monthsended March 31, 2004, the Company recorded stock compensation of approximately $72,000 for stock options granted during the period. During the predecessor period July 1, 2004 through September 22, 2004, the Company recorded stock compensation of $0.1 million prior tothe 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, and calculated 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, and the Company made cash payments to the option holders based upon the per sharemerger consideration less the applicable exercise price of the option grants.  During the successor period September 23, 2004 through March 31, 2005, the Company recorded stock compensation of $0.4 million related to stock options granted under its new 2004Stock Option Plan.  Stock compensation is included in salaries and benefits on the accompanying condensed consolidated statements of operations.

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**Table of Contents**

                The following table provides the pro forma effect on net income as if the fair value method had been applied to all outstanding stockoption grants since the date of grant for those periods presented. For purposes of the pro forma disclosures for the three months and nine months ended March 31, 2004, those options whose number of exercisable shares was contingent upon a future event are notincluded in the fair value method estimate, and the estimated fair value of the 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 amountsbelow are presented in millions.

** **

 

** **

**Predecessor**

** **

** **

** **

** **

** **

** **

** **

**Predecessor**

** **

** **

** **

**Predecessor**

** **

** **

** **

** **

** **

** **

** **

** **

** **

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

** **

 

** **

**Three months ended March 31, 2004**

** **

** **

** **

**Three months ended March 31, 2005**

** **

** **

** **

**Nine months ended March 31, 2004**

** **

** **

** **

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

** **

** **

** **

**September 23, 2004 through March 31, 2005**

** **

** **

** **

**Nine months ended March 31, 2005 (combined basis)**

** **

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$            13.8

 

 

$             19.6

 

 

$               29.9

 

 

$         (110.7)

 

$                 24.8

 

 

 

$                  (85.9)

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

 

 

                    –

                  0.1

 

 

 

                       –

 

 

 

                66.1

 

 

 

                      0.2

 

 

 

                       66.3

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

 

 

               (0.4)

 

 

                 (0.1)

 

 

                  (1.4)

 

 

              (76.7)

 

 

                    (0.2)

 

 

                     (76.9)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma net income (loss)

 

$            13.4

 

 

$             19.6

 

 

$               28.5

 

 

$         (121.3)

 

$                 24.8

 

 

$

                     (96.5)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                The Company used the following weighted average assumptions to estimate the stock compensation expense for the three months and ninemonths ended March 31, 2005:  risk-free interest rate of 4.6%; dividend yield of 0.0%; and expected option life of 10 years.  The Company used the following weighted average assumptions to calculate the pro forma information presented above for the threemonths and nine months ended March 31, 2004:  risk-free interest rate of 4.1%; dividend yield of 0.0%; and expected option life of 10 years.

**4.             ACQUISITIONS**

****

**Fiscal 2004 Acquisition**

                Effective May 1, 2004, the Company purchased substantially all of the assets of one diagnostic imaging center from a subsidiary ofRadiologix, Inc. and purchased such subsidiary’s partnership interests in five other diagnostic imaging centers, in respect of which the Company already owned all other partnership interests. Each of these diagnostic imaging centers is located in and around SanAntonio, Texas, and is complementary to the Company’s hospitals and related businesses in that area.  The Company paid $9.7 million of cash to acquire such assets and partnership interests. The Company accounted for the transaction using the purchasemethod of accounting and funded the purchase price using available cash on hand.

**Fiscal 2005 Acquisition**

                On December 31, 2004, certain of the Company’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.  The Company paid $87.4 million at closing, including the base purchase price of $103.6 million for the property, plant and equipment and investments of the Massachusetts Hospitals less $16.2 million for theexcess of the current liabilities assumed and closing costs incurred over the current assets acquired.  The Company funded the purchase price by borrowing $60.0 million from the $150.0 million acquisition delayed draw term facility under its senior securedcredit facilities, entered into in connection with the merger, and using $27.4 million of cash on hand.  The Company invested an estimated additional $37.4 million during its third fiscal quarter related to the build-up of working capital at the MassachusettsHospitals.  On February 18, 2005, the Company 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 expendituresprojects.  The results of operations of the Massachusetts hospitals are included in the accompanying condensed consolidated statement of operations for the three months ended March 31, 2005.

-11-
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**Table of Contents**

                The purchase price for the fiscal 2004 and 2005 acquisitions was allocated as follows (in millions).

 

**San Antonio Imaging Centers**

**Massachusetts Hospitals**

**Total**

 

Fair value of assets acquired:

 

 

 

   Cash

       $          2.7 

      $              –

       $          2.7 

   Other current assets

                   0.1

                   9.7

                   9.8

   Property, plant and equipment

                   7.2

               101.5

               108.7

   Goodwill and intangible assets

                   6.4

                      –

                   6.4

   Other assets

                      –

                   2.1

                   2.1

 

Gross assets acquired 

                 16.4

               113.3

               129.7

Equity method investments written off

                  (5.9)

                      –

                  (5.9)

Liabilities assumed

                   0.8

                 25.9

                 26.7

 

Cash paid for net assets acquired

       $          9.7

       $        87.4

       $        97.1

 

                The purchase price allocation for the Massachusetts Hospitals is preliminary and may change upon the Company’s receipt ofappraisal reports estimating the value of the tangible and intangible assets acquired.  The Company does not expect adjustments to the purchase price allocation to significantly affect its financial position or results of operations.

**Pro Forma Results**

                The following table shows the unaudited pro forma results of consolidated operations as if the acquisition of the MassachusettsHospitals had occurred at the beginning of the period presented, 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 fromchanges in consolidated debt and changes in income taxes (in millions).

 

  

 

**Predecessor**

 

 

 

** **

 

 

 

**Predecessor**

 

 

 

**Combined Basis**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Three months ended March 31, 2004**

** **

** **

** **

**Three months ended March 31, 2005**

 

 

 

**Nine months ended March 31, 2004**

 

 

 

**Nine months ended March 31, 2005**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues                             

                       

$

574.1

 

 

$

643.0

 

 

$

1,616.8

 

 

$

1,857.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

$

10.0

 

$

33.2

 

$

1.9

$

(139.0

)

Income tax expense (benefit)

 

 

3.6

 

 

13.6

 

 

1.1

 

 

(41.7

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

6.4

 

$

19.6

 

$

0.8

 

$

(97.3

)

 

 

 

 

 

 

 

 

 

 

 

 

 

**5.             UNALLOCATED PURCHASE PRICE**

                During its third fiscal quarter, the Company completed the allocation of the Blackstone merger excess purchase price to reflect therevised values of property, plant and equipment, intangible assets and goodwill as of the merger date based upon information provided by an independent third party appraisal firm.  Prior to this allocation, the Blackstone merger excess purchase price wasincluded in unallocated purchase price on the Company's balance sheet.

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

                The following table summarizes the Blackstone merger excess purchase price allocation (in millions).

 

 

**Property, plant and equipment, net**

**Intangible assets, net**

**Goodwill**

**Unallocated purchase price**

 

 

Initial allocation as of the merger date

   $        869.0

   $          66.3

   $        109.3

   $        678.0

Appraisal adjustments

              (75.1)

               11.5

             741.6

            (678.0)

 

Adjusted allocation as of the merger date

   $        793.9

   $          77.8

   $        850.9

   $           –

 

                During its third fiscal quarter, the Company recorded a $8.4 million decrease to depreciation and a $0.7 million increase toamortization recognized subsequent to the merger date based upon the appraised values of the property, plant and equipment and intangible assets acquired and the remaining estimated useful lives of those assets as of the merger date.

**6.             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, 2004 and March 31, 2005 (in millions).

 

 

** **

** **

**Gross Carrying Amount**

** **

**Accumulated Amortization**

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

 

** **

** **

**June 30, 2004**

**  **

**March 31, 2005**

**  **

**June 30, 2004**

**  **

**March 31, 2005**

 

 

**Class of Intangible Asset**

** **

** **
****
 

Amortized intangible assets:

** **

** **

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Deferred loan costs

 

$

18.7

 

 

$

43.2

 

 

$

2.2

 

 

$

1.8

 

 

    Contracts

 

 

7.9

 

 

 

31.4

 

 

 

3.4

 

 

 

1.6

 

 

    Customer lists

 

 

4.1

 

 

 

–

 

 

 

2.4

 

 

 

–

 

 

    Other

 

 

4.6

 

 

 

1.2

 

 

 

1.9

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Subtotal

 

 

35.3

 

 

 

75.8

 

 

 

9.9

 

 

 

3.4

 

 

 Indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

    License and accreditation

 

 

9.8

 

 

 

3.6

 

 

 

–

 

 

 

–

 

 

    Other

 

 

6.6

 

 

 

–

 

 

 

–

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Subtotal

 

 

16.4

 

 

 

3.6

 

 

 

–

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

51.7

 

 

$

79.4

 

 

$

9.9

 

 

$

3.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-13-
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**Table of Contents**

                Changes in the carrying amount of goodwill from June 30, 2004 to March 31, 2005 follows (in millions).

 

** **

** **

**Acute Care Services**

** **

** **

** **

**Health Plans**

** **

** **

** **

**Total**

** **

 

 

 

 

 

 

 

 

 

 

Balance as of June 30, 2004

 

$

            100.6

 

   

$

               8.7

 

   

$

           109.3

 

Blackstone merger appraisal adjustments    (net of tax effects)

 

 

633.7

 

 

 

63.3

 

 

 

697.0

Adjustments to purchase accounting liabilities

 

 

(0.2

)

 

 

–

 

 

 

(0.2

)

 

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2005

 

$

734.1

 

 

$

72.0

 

 

$

806.1

 

 

 

 

 

 

 

 

 

 

 

**7.             FINANCING ARRANGEMENTS**

                A summary of the Company’s long-term debt as of June 30, 2004 and March 31, 2005 follows (in millions):

 

 

**Predecessor**

 

** **

 

 

 

 

** **

 

 

 

**June 30, 2004**

 

               

**March 31, 2005**

 

 

 

 

9.75% Senior Subordinated Notes

 

$

300.0

 

$

1.0

 

9.0% Senior Subordinated Notes

 

 

–

 

 

575.0

 

11.25% Senior Discount Notes

 

 

–

 

 

132.0

Term loans payable under the senior credit facilities

 

 

300.0

 

 

622.3

 

8.18% Convertible Subordinated Notes

 

 

17.6

 

 

–

 

Capital leases

 

 

5.9

 

 

2.3

 

 

 

 

 

 

 

 

 

 

623.5

 

 

1,332.6

 

Less: current maturities

 

 

(6.3

)

 

(8.0

)

 

 

 

 

 

 

 

 

$

617.2

 

$

1,324.6

 

 

 

 

 

 

 

**9.75% Notes**

                On July 30, 2001, the Company received gross proceeds of $300.0 million through the issuance of the 9.75% Notes due 2011. Interest on 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 the Company and was guaranteed, jointly andseverally, on an unsecured senior subordinated basis by most of the Company’s subsidiaries. The Company was subject to certain restrictive covenants under the Indenture governing the 9.75% Notes. In connection with the merger, the Company completed a tenderoffer 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. As of March 31, 2005, holders of $299.0million of the outstanding 9.75% Notes had tendered their notes for repurchase by the Company and consented to the proposed amendments to the indenture. The Company paid tender premiums and consent fees of $50.2 million related to the repurchase.

**9.0% Notes**

                In connection with the merger on September 23, 2004, two of the Company’s wholly owned subsidiaries, Vanguard Health HoldingCompany II, LLC and Vanguard Holding Company II, Inc. (collectively the “Issuers”) completed a private placement of $575.0 million aggregate principal amount of 9.0% senior subordinated notes due 2014. Interest on the 9.0% Notes is payable semi-annuallyon October 1 and April 1, with the first interest payment due on April 1, 2005. The 9.0%

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**Table of Contents**

Notes are general unsecured senior subordinated obligations and rank junior in right of payment to all existing and future senior indebtedness of the Company. All payments on the 9.0% Notes are guaranteed jointly and severallyon a senior subordinated basis by the Company 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% senior subordinated notes due 2014 for new 9.0% senior subordinatednotes due 2014 with identical 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 ExchangeCommission that became effective on December 23, 2004.

**11.25% Notes**

**

                In connection with the merger on September 23, 2004, two of the Company’s wholly owned subsidiaries, Vanguard Health HoldingCompany I, 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% senior discount notes due 2015. The 11.25%Notes accrete at the stated rate compounded 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 1and 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 Company but senior to any of the issuers’future senior subordinated indebtedness. All payments on the 11.25% Notes are guaranteed by the Company 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% senior discount notes due 2015 for new 11.25% senior discountnotes due 2015 with identical 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 ExchangeCommission that became effective on December 23, 2004.

**Credit Facility Debt**

                Upon the acquisition of the Baptist Health System (“BHS”) in January 2003, the Company expanded its existing creditfacility by adding a $150.0 million term loan facility to its existing $125.0 million revolving loan facility (the “amended 2001 credit facility”). The Company utilized proceeds from the $150.0 million in term loans to fund a portion of the cash purchaseprice of the BHS acquisition.

                On May 18, 2004, the Company entered into a new senior secured credit facility (the “2004 credit facility”) whichrefinanced the amended 2001 credit facility. The 2004 credit facility consisted 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% to2.25% per annum dependent upon the Company’s consolidated leverage ratio or 2) a base rate plus a margin of 1.00% to 1.25% per annum dependent upon the Company’s consolidated leverage ratio. Proceeds from the 2004 credit facility were used to repay alloutstanding term and revolving loans under the amended 2001 credit facility, to pay closing and other refinancing costs and to provide funds for working capital, capital expenditures and general corporate purposes. As of the merger date, the Company had no cashborrowings under its previous revolving credit facility but had utilized capacity

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**Table of Contents**

related to the issuance 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 PhoenixHealth Plan, which is wholly owned by a subsidiary of the Company.

                In connection with the merger on September 23, 2004, two of the Company’s wholly owned subsidiaries, Vanguard Health HoldingCompany II, 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 CiticorpNorth America, Inc. as syndication agent, and repaid all amounts outstanding under the 2004 credit facility. The merger credit facilities include a seven-year term loan facility in the aggregate principal amount of $800.0 million (of which $475.0 million was fundedat closing) 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 madeavailable to 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 workingcapital, capital expenditures and other general corporate purposes until September 23, 2005.  The Company 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 purchaseprice of the Massachusetts 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.

                The term loans bear interest at a rate equal to either LIBOR plus 3.25% per annum or a base rate plus 2.25% per annum, at theCompany’s option. The revolving loans bear interest at a rate equal to either LIBOR plus 2.50% per annum or a base rate plus 1.50% per annum, at the Company’s option.  Following the delivery of the Company’s financial statements for its fiscalquarter ended March 31, 2005, the applicable margin for borrowings under the revolving credit facility may be reduced by up to 50 basis points subject to its attaining certain leverage ratios.  The Company also pays a commitment fee to the lenders under therevolving credit facility in respect of unutilized commitments thereunder at a rate equal to 0.50% per annum and for the unutilized portions of the $150.0 million and $175.0 million delayed draw term loan facilities at rates equal to 1.50% and 2.25% per annum,respectively. The Company pays customary letter of credit fees.

                The Company is subject to certain restrictive and financial covenants under the merger credit facilities including a total leverageratio, senior leverage ratio, interest coverage ratio and capital expenditure restrictions. The Company was in compliance with each of these financial covenants as of March 31, 2005. Obligations under the merger credit facilities are unconditionally guaranteed by theCompany 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”). The obligations under the merger credit facilitiesare 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 of VHS Holdco II, 100% of the capital stock of substantiallyall 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 a security interest in substantially all tangible andintangible assets of VHS Holdco II and each U.S. Guarantor.

**8.18% Convertible Subordinated Notes**

                Upon the acquisition of BHS in January 2003, the Company issued approximately $17.6 million of its convertible subordinated notes thatprovided for annual interest payments at 8.18% until maturity on January 3, 2013. The notes were convertible at any time into the Company’s common stock at a $3,500 per share conversion price. In connection with the merger on September 23, 2004, the principalbalance of the 8.18% convertible subordinated notes was converted into per share merger consideration based upon the notes’ conversion into the right to receive common shares of the Company at the $3,500 per share conversion price.  The Company repaid incash the outstanding accrued interest related to the 8.18% convertible subordinated notes as of the merger date.

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**Table of Contents**

**8.             INCOME TAXES**

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

 

 

**Nine months ended **

 

 

 

 

 

**March 31, 2004 (predecessor)**

 

 

**March 31, 2005 (combined basis)**

 

Current:

 

 

   Federal

 

$

5.3

 

$

(0.5

)

   State

 

 

1.8

 

 

0.5

 

Total current

 

 

7.1

 

 

–

 

 

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

 

 

   Federal

 

 

10.7

 

 

(31.6

)

   State

 

 

6.4

 

 

(3.2

)

Total deferred

 

 

11.3

 

 

(34.8

)

   Total income tax expense (benefit)

 

$

18.4

$

(34.8

)

 

 

 

 

 

 

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

 

 

**Nine months ended **

 

 

 

 

 

**March 31, 2004 (predecessor)**

 

               

**March 31, 2005 (combined basis)**

 

 

 

 

Income tax at federal statutory rate

 

 

35.0%

 

 

(35.0%

)

Income tax at state statutory rate

 

3.7%

 

(3.2%

)

Nondeductible expenses and other

 

 

(0.6%

)

 

9.4%

 

 

 

 

 

 

Effective income tax rate

 

 

38.1%

 

 

(28.8%

)

 

 

 

 

 

 

                Net current deferred tax assets of $3.1 million and $11.3 million as of June 30, 2004 and March 31, 2005, respectively, are included inprepaid expenses and other current assets in the accompanying consolidated balance sheets.  Net non-current deferred tax liabilities of $40.9 million are included in other liabilities on the accompanying consolidated balance sheet as of June 30, 2004.  Netnon-current deferred tax assets of $45.9 million are included in other assets on the accompanying consolidated balance sheet as of March 31, 2005.  During its third fiscal quarter, the Company recorded a $44.6 million reduction to goodwill representing thedeferred tax effect of the appraisal adjustments to the book basis of its property, plant and equipment and intangible assets, which resulted in a significant increase in current and noncurrent deferred tax assets.   In addition, during the first quarter offiscal 2005, the Company recorded a $15.6 million deferred tax asset and a corresponding increase to additional paid-in capital for the excess of tax stock compensation over stock compensation reported in the statement of operations.

                As of March 31, 2005, the Company had generated net operating loss (“NOL”) carryforwards for federal income tax and stateincome tax purposes of approximately $186.0 million and $116.0 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 affectthe Company's ability to ultimately recognize the benefit of these NOLs in future years.

                The Company 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.  The Company has not recorded any valuation allowance as of March 31, 2005, because management believes that future taxable

-17-
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**Table of Contents**

income will, more likely than not, be sufficient to realize the benefits of those assts as the temporary differences reverse in future periods.

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

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

                Immediately prior to the merger, the Company 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 Plan 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 transaction, certain members of management purchased Class B, Class C and Class D membership units inHoldings (collectively the “equity incentive units”) for approximately $5.8 million pursuant to the Amended and Restated Limited Liability Company Operating Agreement of Holdings dated September 23, 2004 (“LLC Agreement”).  The value ofthe equity incentive units was determined by an independent third party appraiser. 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 vestingupon the occurrence 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 fullyvest, and Class 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 $5.8 million, Vanguard issued to Holdings 83,890 warrants with an exercise price of $1,000 per shareand 35,952 warrants with an exercise price of $3,000 per share to purchase Vanguard’s common stock.  Vanguard reserved 119,842 shares of its common stock to be issued upon exercise of the warrants.

**Stock Option Plans**

                Upon the payment of merger consideration to the option holders, the Company’s 1998 Stock Option Plan, 2000 Stock Option Plan,Initial Option Plan and Carry Option Plan were terminated. After the merger, the Company adopted the 2004 Stock Incentive Plan (“the 2004 Option Plan”). The 2004 Option Plan allows for the issuance of up to 67,409 options to purchase common stock of theCompany to employees of the Company. 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 of Directors 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 of Directors or acommittee thereof.  The Performance Options vest 20% at each of the first five anniversaries of the date of grant and have an exercise price equal to three times the exercise price per share assigned to the Liquidity Event Options and Time Options. The TimeOptions 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 March 31, 2005, 33,002 options were outstanding under the 2004Option Plan.

**10.          RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**

                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 the end of fiscal years ending after December 15, 2005.  Vanguard does not expect FIN 47 to have a significant effect on its future operating results or cash flows.

-18-
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**Table of Contents**

                In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based Payment*, whichrevised FASB Statement No. 123, *Accounting for Stock-Based Compensation*, and superseded APB Opinion No. 25, *Accounting for Stock Issued to Employees*.  SFAS 123(R) requires all share-based payments granted to employees to be measured and recorded inthe financial statements at fair value. SFAS 123(R) 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 vestingperiod of the award.  The Company expects to adopt SFAS 123(R) on July 1, 2006.  The Company does not expect SFAS 123(R) to have a significant impact on its future results of operations since the Company previously adopted SFAS 123 on July 1,2003.

                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 is effective forfiscal periods beginning after June 15, 2005, with early adoption encouraged.  Vanguard does not expect SFAS 153 to have a significant effect on its future operating results or cash flows.

                In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity* (“SFAS 150”).  SFAS 150 represents the first phase of the FASB’s project to clarify the accounting treatment of certain instruments that possess characteristics of both liabilities andequity.  SFAS 150 generally requires that freestanding financial instruments that obligate the issuer to redeem the holder’s shares, or are indexed to such an obligation, and are settled in cash or settled with shares meeting certain conditions be treatedas liabilities.  The provisions of SFAS 150 are effective immediately for instruments entered into or modified after May 31, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15,2003, with the exception of mandatorily redeemable instruments of non-public companies, which become subject to SFAS 150 for fiscal periods beginning after December 15, 2003.  Additionally, the FASB indefinitely deferred the application of the provisions of SFAS150 relating to non-controlling interests that are classified as equity in the financial statements of the subsidiary but would be classified as a liability in the parent’s financial statements.  The Company does not expect SFAS 150 to impact theCompany’s financial statements.

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**Table of Contents**

**11.          SEGMENT INFORMATION**

                The Company’s acute care hospitals and related healthcare businesses are similar in their activities and the economicenvironments in which they operate (i.e. urban markets).  Accordingly, the Company’s reportable operating segments consist of 1) acute care hospitals and related healthcare businesses, collectively, and 2) health plans consisting of MacNeal HealthProviders, a contracting entity 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 financial information by business segment for the three months ended March 31, 2004 and 2005,the nine months ended March 31, 2004, and the predecessor period July 1, 2004 through September 22, 2004 and the successor period September 23, 2004 through March 31, 2005, respectively, including a reconciliation of Segment EBITDA to income before income taxes (inmillions).

 

 

**Predecessor**

** **

** **

 

 
****
** **

** **

 

 

**Three months ended March 31, 2004**

** **

**Three months ended March 31, 2005**

 

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

 

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**

** **

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

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

$

–

$

385.0

$

–

$

385.0

$

–

$

559.3

$

–

$

559.3

 

Premium revenues

76.7

–

–

76.7

83.7

–

–

83.7

 

Inter-segment revenues

–

7.6

(7.6

)

–

–

7.6

(7.6

)

–

 

 

      Total revenues

76.7

392.6

(7.6

)

461.7

83.7

566.9

(7.6

)

643.0

 

 

Operating expenses - external

62.7

351.6

–

414.3

69.7

499.8

–

569.5

 

Operating expenses - inter-segment

7.6

–

(7.6

)

–

7.6

–

(7.6

)

–

 

 

      Total operating expenses

70.3

351.6

(7.6

)

414.3

77.3

499.8

(7.6

)

569.5

 

 

      Segment EBITDA(1)

6.4

41.0

–

47.4

6.4

67.1

–

73.5

 

 

Less:

 

Depreciation and amortization

0.4

10.7

–

11.1

1.6

11.5

–

13.1

 

Interest, net

0.5

15.2

–

15.7

(0.2

)

25.6

–

25.4

 

Minority interests

–

(0.4

)

–

(0.4

)

–

0.3

–

0.3

 

Equity method loss (income)

–

(0.8

)

–

(0.8

)

–

(0.3

)

(0.3

)

 

Stock compensation

–

0.1

–

0.1

–

0.2

–

0.2

 

Loss (gain) on sale of assets

–

–

–

–

–

0.2

–

0.2

 

Merger expenses

–

–

–

–

–

0.1

–

0.1

 

Monitoring fees

–

–

–

–

–

1.3

–

1.3

 

 

      Income before income taxes

$

5.5

$

16.2

$

–

$

21.7

$

5.0

$

28.2

$

–

$

33.2

 

 

-20-
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**Table of Contents**

 

 

**Predecessor**

** **

**Combined Basis**

 

 
****
** **
****
**Nine months ended March 31, 2004**

**Nine months ended March 31, 2005**
********
**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**

**Health Plans**

**Acute Care Services**

**Eliminations**

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

$

–

$

1,100.0

$

–

$

1,100.0

$

–

$

1,389.7

$

–

$

1,389.7

 

Premium revenues

213.6

–

–

213.6

246.8

–

–

246.8

 

Inter-segment revenues

–

21.0

(21.0

)

–

–

26.6

(26.6

)

–

 

 

      Total revenues

213.6

1,121.0

(21.0

)

1,313.6

246.8

1,416.3

(26.6

)

1,636.5

 

 

Operating expenses - external

176.0

1,015.8

–

1,191.8

200.8

1,256.0

–

1,456.8

 

Operating expenses - inter-segment

21.0

–

(21.0

)

–

26.6

–

(26.6

)

–

 

 

      Total operating expenses

197.0

1,015.8

(21.0

)

1,191.8

227.4

1,256.0

(26.6

)

1,456.8

 

 

      Segment EBITDA(1)

16.6

105.2

–

121.8

19.4

160.3

–

179.7

 

 

Less:

 

Depreciation and amortization

1.5

30.9

–

32.4

2.7

50.3

–

53.0

 

Interest, net

1.5

45.2

–

46.7

0.3

62.0

–

62.3

 

Minority interests

–

(2.3

)

–

(2.3

)

–

(0.5

)

–

(0.5

)

 

Equity method loss (income)

–

(2.6

)

–

(2.6

)

–

(0.6

)

–

(0.6

)

 

Stock compensation

–

0.1

–

0.1

–

97.1

–

97.1

 

Debt extinguishment costs

–

–

–

–

–

62.2

–

62.2

 

Merger expenses

–

–

–

–

–

23.2

–

23.2

 

Loss (gain) on sale of assets

–

(0.8

)

–

(0.8

)

–

1.0

–

1.0

 

 

Monitoring fees

–

–

–

–

–

2.7

–

2.7

 

 

      Income (loss) before income taxes

$

13.6

$

34.7

$

–

$

48.3

$

16.4

$

(137.1

)

$

–

$

(120.7

)

 

 

Segment assets

$

28.0

$

1,280.1

$

1,308.1

$

57.1

$

2,343.8

$

2,400.9

 

 

Capital expenditures

$

0.4

$

101.7

$

102.1

$

1.1

$

136.2

$

137.3

 

 

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

 

 

**Predecessor**

** **

**Successor**

 

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

**September 23, 2004 through March 31, 2005**
********
**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**

**Health Plans**

**Acute Care Services**

**Eliminations**

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

$

–

$

377.3

$

–

$

377.3

$

–

$

1,012.4

$

–

$

1,012.4

 

Premium revenues

72.3

–

–

72.3

174.5

–

–

174.5

 

Inter-segment revenues

–

6.4

(6.4

)

–

–

20.2

(20.2

)

–

 

 

      Total revenues

72.3

383.7

(6.4

)

449.6

174.5

1,032.6

(20.2

)

1,186.9

 

 

Operating expenses - external

61.2

341.3

–

402.5

138.5

915.8

–

1,054.3

 

Operating expenses - inter-segment

6.4

–

(6.4

)

–

20.2

–

(20.2

)

–

 

 

      Total operating expenses

67.6

341.3

(6.4

)

402.5

158.7

915.8

(20.2

)

1,054.3

 

 

      Segment EBITDA(1)

4.7

42.4

–

47.1

15.8

116.8

–

132.6

 

 

Less:

 

Depreciation and amortization

0.6

16.8

–

17.4

2.1

33.5

–

35.6

 

Interest, net

0.2

9.6

–

9.8

0.1

52.4

–

52.5

 

Minority interests

–

(0.5

)

–

(0.5

)

–

–

–

–

 

Equity method loss (income)

–

(0.2

)

–

(0.2

)

–

(0.4

)

–

(0.4

)

 

Stock compensation

–

96.7

–

96.7

–

0.4

–

0.4

 

Debt extinguishment costs

–

62.2

–

62.2

–

–

–

–

 

Merger expenses

–

23.1

–

23.1

–

0.1

–

0.1

 

Loss (gain) on sale of assets

–

0.6

–

0.6

–

0.4

–

0.4

 

Monitoring fees

–

–

–

–

–

2.7

–

2.7

 

 

      Income (loss) before income taxes

$

3.9

$

(165.9

)

$

–

$

(162.0

)

$

13.6

$

27.7

$

–

$

41.3

 

 

Capital expenditures

$

0.7

$

29.1

$

29.8

$

0.4

$

107.1

$

107.5

 

 

____________________(1) Segment EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation and amortization, minority interests, gain or loss on sale of assets, equity method income or loss, debt extinguishment costs, stock compensation,merger expenses and monitoring fees.  Management uses Segment EBITDA to measure performance for the Company’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 the Company’s segments.  Management believes that Segment EBITDA provides useful information about the financial performance ofthe Company’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 of theCompany.  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.

**12.          COMMITMENTS AND CONTINGENCIES**

****

                The Company 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 the Company’s results of operations or financial position, but the construction and facility expansion obligations could have an effect on the timing of the Company’s cash flows, including its need to borrowavailable amounts under its revolving credit facility or its $175.0 million delayed draw term loan facility.

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

**Construction Commitments**

****

                The Company currently has multiple capital expansion and replacement projects underway.  The Company estimates its remainingcommitment to complete the expansion projects in San Antonio and Phoenix and its remaining obligations for other capital projects in process to be approximately $182.2 million.

**Litigation**

                The Company is presently, and from time to time, subject to various claims and lawsuits arising in the ordinary course ofbusiness.  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 the Company’s business, financialcondition or results of operations.

**Net Revenue**

                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 $5.0 million and $1.9 million for the three months ended March 31, 2004 and 2005, respectively, and $9.4 million and $4.4 million for the nine months ended March 31, 2004 and 2005, respectively. The Company recorded $8.4 million and $14.3 million of charity care revenue deductions during the three months ended March 31, 2004 and 2005, respectively, and $25.4 million and $37.7 million of charity care revenue deductions during the nine months ended March 31,2004 and 2005, respectively.

**Governmental Regulation**

                Laws and regulations governing the Medicare, Medicaid and other federal healthcare programs are complex and subject tointerpretation.  The Company’s management believes that the Company is in compliance with all applicable laws and regulations in all material respects and is not aware of any material pending or threatened proceeding involving allegations of potentialwrongdoing.  While no such material regulatory proceedings are underway, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusionfrom the Medicare, Medicaid and other federal healthcare programs.

**Acquisitions**

                The Company has acquired and will continue to acquire businesses with prior operating histories.  Acquired companies may haveunknown or 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 the Company institutes policies designed to conformpractices to its standards following completion of acquisitions and attempts to structure its acquisitions as asset acquisitions in which the Company does not assume liability for seller wrongful actions, there can be no assurance that the Company will not becomeliable for past activities that may later be alleged to be improper by private plaintiffs or government agencies.  Although the Company obtains general indemnifications from sellers covering such matters, there can be no assurance that any specific matter willbe 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, the Company is subject to potential claims and legal actions in the ordinary course ofbusiness including 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.  The Company maintains excess coverage on aclaims-made basis with 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 paymentsreceived from the Company.  The market for professional liability excess insurance has

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

improved during the past two years resulting in a stabilization of premiums.  However, the Company’s professional liability costs remain sensitive to market factors affecting premiums for excess coverage and thequantity and severity of professional liability claims.  Also, the Company is exposed to increased payments to malpractice claimants in the event physicians practicing at the Company’s hospitals are unable to obtain adequate malpractice insurance or in theevent the Company employs more physicians.  As the Company’s period of ownership of its hospitals lengthens, management expects the Company’s professional liability claims payments to increase.

**Guarantees**

                The Company currently guarantees minimum rent revenues to the developers and managers of two medical office buildings located on thecampuses of two of its hospitals through rental shortfall arrangements.  The Company may also from time to time enter into parent-subsidiary guarantee arrangements in the ordinary course of operating its business.  The Company does not expect payments underany of these arrangements to have a significant impact on the Company’s future results of operations or cash flows.

                As part of its contract with the Arizona Health Care Cost Containment System (“AHCCCS”), one of the Company’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 March 31, 2005, the Company maintained this performance guaranteeentirely in the form of surety bonds with independent third party insurers that expire on September 30, 2005.  The Company is also required to arrange for $5.3 million in letters of credit to collateralize its $18.0 million in surety bonds with the third partyinsurers.

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

                The Company conducts substantially all of its business through its subsidiaries. Most of the Company’s subsidiaries jointly andseverally guarantee the 9.0% Notes on an unsecured senior subordinated basis. Certain of the Company’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 the Company’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,the subsidiary guarantors, the non-guarantor subsidiaries, certain eliminations and the consolidated Company as of June 30, 2004 and March 31, 2005 and for the three months and nine months ended March 31, 2004 and 2005 and the predecessor period July 1, 2004 throughSeptember 22, 2004, and the successor period September 23, 2004 through March 31, 2005, follows.

-24-
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**Table of Contents**

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSJune 30, 2004(Predecessor)**

 

 

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

 
**
 

 

 

*(in millions)*

 

**ASSETS**

Current assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

–

 

 

$

71.4

 

$

36.7

 

 

$

–

 

$

 

108.1

 

Accounts receivable, net

 

 

–

 

 

 

188.9

 

35.8

 

 

 

–

 

 

 

224.7

 

Supplies

 

 

–

 

 

 

29.5

 

5.1

 

 

 

–

 

 

 

34.6

 

Prepaid expenses and other current assets

 

 

3.1

 

 

 

28.6

 

39.4

 

 

 

(37.4

)

 

 

33.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current assets

 

 

3.1

 

 

 

318.4

 

117.0

 

 

 

(37.4

)

 

 

401.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property, plant and equipment, net

 

 

–

 

 

 

785.4

 

81.5

 

 

 

–

 

 

 

866.9

 

Goodwill

 

 

–

 

 

 

109.3

 

–

 

 

 

–

 

 

 

109.3

 

Intangible assets, net

 

 

–

 

 

 

40.2

 

1.6

 

 

 

–

 

 

 

41.8

 

Investments in subsidiaries

 

 

408.8

 

 

 

–

 

–

 

 

 

(408.8

)

 

 

–

 

Other assets

 

 

–

 

 

 

8.7

 

–

 

 

 

–

 

 

8.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total assets

 

$

411.9

 

 

$

1,262.0

 

$

200.1

 

 

$

(446.2

)

 

$

1,427.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

 

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

–

 

 

 

67.6

 

$

13.1

 

 

 

–

 

 

$

80.7

 

Accrued expenses and other current liabilities

 

 

–

 

 

 

140.9

 

11.6

 

 

 

(1.1

)

 

 

151.4

 

Current maturities of long-term debt

 

 

–

 

 

 

5.2

 

1.1

 

 

 

–

 

 

 

6.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current liabilities

 

 

–

 

 

 

213.7

 

25.8

 

 

 

(1.1

)

 

 

238.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other liabilities

 

 

40.9

 

 

 

18.4

 

65.3

 

 

 

(25.4

)

 

 

99.2

 

Long-term debt, less current maturities

 

 

–

 

 

 

616.6

 

0.6

 

 

 

–

 

 

 

617.2

 

Intercompany

 

 

(102.0

)

 

 

27.4

 

71.9

 

 

 

2.7

 

 

 

–

 

Payable-In-Kind Preferred Stock

 

 

61.0

 

 

 

–

 

–

 

 

 

–

 

 

 

61.0

 

Stockholders’ equity

 

 

412.0

 

 

 

385.9

 

36.5

 

 

 

(422.4

)

 

 

412.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total liabilities and stockholders’ equity

 

$

411.9

 

 

$

1,262.0

 

$

200.1

 

 

$

(446.2

)

 

$

1,427.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

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

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(in millions)*

**ASSETS**
****
Current assets:

Cash and cash equivalents

$      0.8

$             –

$             –

$       35.3

$      63.3

$             –

$        99.4

Accounts receivable, net

           –

               –

               –

       248.5

        46.0

               –

        294.5

Supplies

           –

                –

                –

         36.5

          5.6

                –

          42.1

Prepaid expenses and other current assets

       19.8

                –

                –

           9.4

        19.3

         (10.5)

          38.0

 

    Total current assets

       20.6

                –

                –

       329.7

      134.2

         (10.5)

        474.0

             

Property, plant and equipment, net

           –

               –

               –

       888.2

        93.9

               –

        982.1

Goodwill

     710.7

               –

               –

         82.8

        12.6

               –

        806.1

Intangible assets, net

           –

          37.6

              3.8

         16.4

        18.2

               –

          76.0

Investments in subsidiaries

     408.8

               –

               –

             –

        27.0

       (435.8)

             –

Other assets

      45.9

               –

               –

         16.7

          0.1

               –

          62.7

    Total assets

$ 1,186.0

$        37.6

$            3.8

$  1,333.8

$    286.0

$     (446.3)

$   2,400.9

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

Current liabilities:

Accounts payable

$         –

$             –

$             –

$     109.0

$      13.0

$             –

$      122.0

Accrued expenses and other current liabilities

      (1.0)

          28.8

               –

       105.4

        74.8

           (4.2)

        203.8

Current maturities of long-term debt

            –

            6.3

               –

           0.7

          1.0

                –

            8.0

    Total current liabilities

      (1.0)

          35.1

               –

       215.1

        88.8

           (4.2)

        333.8

Other liabilities

        0.8

               –

               –

         17.0

        64.5

           (7.0)

          75.3

Long-term debt, less current maturities

           –

     1,191.0

          132.0

           1.3

          0.3

               –

     1,324.6

Intercompany

     519.0

     (1,140.2)

        (120.8)

       747.7

        21.2

         (26.9)

             –

Payable-In-Kind Preferred Stock

           –

               –

               –

             –

           –

               –

             –

Stockholders’ equity

     667.2

        (48.3)

            (7.4)

       352.7

      111.2

       (408.2)

        667.2

 

    Total liabilities and stockholders’ equity

$ 1,186.0

$        37.6

$            3.8

$  1,333.8

$    286.0

$     (446.3)

$   2,400.9

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

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

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Patient service revenues

$

–

$

348.6

$

36.4

$

–

$

385.0

Premium revenues

–

76.7

4.8

(4.8

)

76.7

        Total revenues

–

425.3

41.2

(4.8

)

461.7

Salaries and benefits

–

171.4

18.8

–

190.2

Supplies

–

67.1

6.6

–

73.7

Medical claims expense

–

55.8

–

–

55.8

Purchased services

–

19.4

3.2

–

22.6

Provision for doubtful accounts

–

26.9

2.5

–

29.4

Other operating expenses

–

30.8

10.1

(4.8

)

36.1

Rents and leases

–

5.2

0.9

–

6.1

Depreciation and amortization

–

14.6

1.1

–

15.7

Interest, net

–

10.3

0.8

–

11.1

Management fees

–

(0.8

)

0.8

–

–

Other

–

(0.7

)

–

–

(0.7

)

        Total costs and expenses

–

400.0

44.8

(4.8

)

440.0

Income (loss) before income taxes

–

25.3

(3.6

)

–

21.7

Income tax expense

7.9

–

–

–

7.9

Equity in earnings of subsidiaries

21.7

–

–

(21.7

)

–

Net income (loss)

$

13.8

$

25.3

$

(3.6

)

$

(21.7

)

$

13.8

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the three months ended March 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

$         –

    $     –

    $      –

   $  503.9

   $    60.8

    $    (5.4)

   $   559.3

Premium revenues

           –

           –

            –

         10.6

        80.9

          (7.8)

          83.7

 

    Total revenues

           –

           –

            –

       514.5

      141.7

        (13.2)

        643.0

Salaries and benefits

           –

           –

            –

       238.3

        33.3

            –

        271.6

Supplies

           –

           –

            –

         98.1

        10.7

            –

        108.8

Medical claims expense

           –

           –

            –

           6.7

        60.9

          (5.4)

          62.2

Purchased services

           –

           –

            –

         31.1

          5.8

            –

          36.9

Provision for doubtful accounts

           –

           –

            –

         35.5

          4.7

            –

          40.2

Other operating expenses

         0.1

           –

            –

         33.0

        16.3

          (7.8)

          41.6

Rents and leases

           –

           –

            –

           6.6

          1.8

            –

            8.4

Depreciation and amortization

           –

           –

            –

         10.3

          2.8

            –

          13.1

Interest, net

           –

       24.2

           3.6

          (2.9)

          0.5

            –

          25.4

Management fees

           –

           –

            –

          (2.0)

          2.0

            –

             –

Debt extinguishment costs

           –

           –

            –

            –

            –

            –

             –

Merger expenses

           –

           –

            –

           0.1

            –

            –

            0.1

Other

           –

           –

            –

           1.5

            –

            –

            1.5

 

    Total costs and expenses

         0.1

       24.2

           3.6

       456.3

      138.8

        (13.2)

        609.8

 

Income (loss) before income taxes

      (0.1)

      (24.2)

          (3.6)

         58.2

          2.9

            –

          33.2

Income tax expense

       13.6

           –

            –

            –

            –

            –

          13.6

Equity in earnings of subsidiaries

       33.3

           –

            –

            –

            –

        (33.3)

             –

 

Net income (loss)

$     19.6

    $ (24.2)

    $    (3.6)

   $    58.2

   $      2.9

    $  (33.3)

   $     19.6

 

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

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

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Patient service revenues

$

–

$

990.7

$

109.3

$

–

$

1,100.0

Premium revenues

–

213.6

14.4

(14.4

)

213.6

        Total revenues

–

1,204.3

123.7

(14.4

)

1,313.6

Salaries and benefits

–

495.4

53.8

–

549.2

Supplies

–

189.2

18.3

–

207.5

Medical claims expense

–

156.7

–

–

156.7

Purchased services

–

57.1

10.2

–

67.3

Provision for doubtful accounts

–

80.4

9.3

–

89.7

Other operating expenses

–

85.7

30.6

(14.4

)

101.9

Rents and leases

–

14.9

2.3

–

17.2

Depreciation and amortization

–

43.3

3.4

–

46.7

Interest, net

–

29.6

2.8

–

32.4

Management fees

–

(2.3

)

2.3

–

–

Other

–

(3.3

)

–

–

(3.3

)

        Total costs and expenses

–

1,146.7

133.0

(14.4

)

1,265.3

Income (loss) before income taxes

–

57.6

(9.3

)

–

48.3

Income tax expense

18.4

–

–

–

18.4

Equity in earnings of subsidiaries

48.3

–

–

(48.3

)

–

Net income (loss)

$

29.9

$

57.6

$

(9.3

)

$

(48.3

)

$

29.9

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS For the nine months ended March 31, 2005(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

$        –

    $     –

      $    –

   $ 1,229.1

   $  180.5

   $  (19.9)

   $ 1,389.7

Premium revenues

          –

           –

            –

         31.8

      236.7

        (21.7)

        246.8

 

    Total revenues

          –

           –

            –

    1,260.9

      417.2

        (41.6)

     1,636.5

Salaries and benefits

          –

           –

            –

       668.1

        96.5

            –

        764.6

Supplies

          –

           –

            –

       236.9

        31.9

            –

        268.8

Medical claims expense

          –

           –

            –

         20.0

      179.0

        (19.9)

        179.1

Purchased services

          –

           –

            –

         69.5

        17.1

            –

          86.6

Provision for doubtful accounts

          –

           –

            –

         96.4

        13.8

            –

        110.2

Other operating expenses

         0.1

           –

            –

         97.8

        46.7

        (21.7)

        122.9

Rents and leases

          –

           –

            –

         16.6

          5.1

            –

          21.7

Depreciation and amortization

          –

           –

            –

         45.6

          7.4

            –

          53.0

Interest, net

          –

       48.3

           7.4

           4.2

          2.4

            –

          62.3

Management fees

          –

           –

            –

          (6.0)

          6.0

            –

             –

Debt extinguishment costs

       50.2

           –

            –

         12.0

            –

            –

          62.2

Merger expenses

       17.0

           –

            –

           6.2

            –

            –

          23.2

Other

          –

           –

            –

           2.7

         (0.1)

            –

            2.6

  

    Total costs and expenses

       67.3

       48.3

           7.4

    1,270.0

      405.8

        (41.6)

     1,757.2

 

Income (loss) before income taxes

    (67.3)

      (48.3)

          (7.4)

          (9.1)

        11.4

            –

       (120.7)

Income tax expense (benefit)

    (34.8)

           –

            –

             –

            –

            –

         (34.8)

Equity in earnings of subsidiaries

    (53.4)

           –

            –

             –

            –

         53.4

             –

 

Net income (loss)

$  (85.9)

    $ (48.3)

      $  (7.4)

   $    (9.1)

   $    11.4

     $  53.4

   $   (85.9)

 

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

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

$        –

   $       –

    $       –

   $  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

          –

            –

             –

       150.1

        28.6

            –

        178.7

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

            –

              –

Stock compensation

          –

            –

             –

         96.7

            –

            –

          96.7

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 expense (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 OPERATIONS For the Successor Period September 23, 2004 through March 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

$        –

    $      –

      $      –

    $ 905.5

    $ 126.8

$     (19.9)

$   1,012.4

Premium revenues

          –

            –

              –

          22.1

      167.7

       (15.3)

        174.5

 

    Total revenues

          –

            –

              –

        927.6

      294.5

       (35.2)

     1,186.9

Salaries and benefits

          –

            –

              –

        421.3

        67.9

            –

        489.2

Supplies

          –

            –

              –

        174.1

        22.4

            –

        196.5

Medical claims expense

          –

            –

              –

          18.1

      125.9

       (19.9)

        124.1

Purchased services

          –

            –

              –

          52.3

        12.2

            –

          64.5

Provision for doubtful accounts

          –

            –

              –

          69.3

          9.4

            –

          78.7

Other operating expenses

         0.1

            –

              –

          67.9

        33.0

       (15.3)

          85.7

Rents and leases

          –

            –

              –

          12.4

          3.6

            –

          16.0

Depreciation and amortization

          –

            –

              –

          30.2

          5.4

            –

          35.6

Interest, net

          –

        48.3

            7.4

          (4.4)

          1.2

            –

          52.5

Management fees

          –

            –

              –

          (4.0)

          4.0

            –

              –

Debt extinguishment costs

          –

            –

              –

             –

            –

            –

              –

Merger expenses

          –

            –

              –

            0.1

            –

            –

            0.1

Other

          –

            –

              –

            2.7

            –

            –

            2.7

 

    Total costs and expenses

         0.1

         48.3

            7.4

        840.0

      285.0

       (35.2)

     1,145.6

 

Income (loss) before income taxes

      (0.1)

       (48.3)

           (7.4)

          87.6

          9.5

            –

          41.3

Income tax expense

       16.5

            –

              –

 

            –

            –

          16.5

Equity in earnings of subsidiaries

       41.4

            –

              –

             –

            –

       (41.4)

              –

 

Net income (loss)

$    24.8

    $ (48.3)

      $   (7.4)

    $   87.6

    $    9.5

$     (41.4)

     $   24.8

 

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the nine months ended March 31, 2004(Predecessor)(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Operating activities:

Net income (loss)

$

29.9

$

57.6

$

(9.3

)

$

(48.3

)

$

29.9

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

    Depreciation and amortization

–

43.3

3.4

–

46.7

    Provision for doubtful accounts

–

80.4

9.3

–

89.7

    Deferred income taxes

11.3

–

–

–

11.3

    Amortization of loan costs

–

1.4

–

–

1.4

    Loss (gain) on sale of assets

–

(0.8

)

–

–

(0.8

)

    Stock compensation

–

0.1

–

–

0.1

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

    Equity in earnings of subsidiaries

(48.3

)

–

–

48.3

–

    Accounts receivable

–

(107.7

)

(7.3

)

–

(115.0

)

    Supplies

–

(1.0

)

(0.9

)

–

(1.9

)

    Prepaid expenses and other current assets

0.4

(15.2

)

17.7

–

2.9

    Accounts payable

–

0.6

(1.8

)

–

(1.2

)

    Accrued expenses and other current liabilities

(1.7

)

1.5

(4.4

)

–

(4.6

)

    Other liabilities

3.1

(1.7

)

(0.5

)

–

0.9

Net cash provided by (used in) operating activities

(5.3

)

58.5

6.2

–

59.4

Investing activities:

Acquisitions

–

(12.3

)

–

–

(12.3

)

Capital expenditures

–

(95.2

)

(6.9

)

–

(102.1

)

Proceeds from asset dispositions

–

6.2

–

–

6.2

Other

–

5.7

(6.4

)

–

(0.7

)

Net cash used in investing activities

–

(95.6

)

(13.3

)

–

(108.9

)

Financing activities:

Proceeds from long-term debt

–

177.5

–

–

177.5

Payments of long-term debt and capital leases

–

(127.3

)

(3.3

)

–

(130.6

)

Proceeds from joint venture partner contributions

–

3.0

–

–

3.0

Exercise of stock options

–

0.1

–

–

0.1

Payment to retire common stock

–

(0.1

)

–

–

(0.1

)

Cash provided by (used in) intercompany activity

5.3

(33.6

)

28.3

–

–

Net cash provided by financing activities

5.3

19.6

25.0

–

49.9

Net increase (decrease) in cash and cash equivalents

–

(17.5

)

17.9

–

0.4

Cash and cash equivalents, beginning of period

–

21.2

6.0

–

27.2

Cash and cash equivalents, end of period

$

–

$

3.7

$

23.9

$

–

$

27.6

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

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

$     (85.9)

$    (48.3)

$        (7.4)

$       (9.1)

$      11.4

$       53.4

$        (85.9)

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

 

 

 

 

 

 

 

Depreciation and amortization

          —

           —

             —

         45.6

          7.4

             —

           53.0

Provision for doubtful accounts

          —

           —

             —

         96.4

        13.8

             —

         110.2

Deferred income taxes

       (34.8)

           —

             —

            —

            —

             —

          (34.8)

Amortization of loan costs

          —

         1.7

           0.1

           0.5

            —

             —

             2.3

Accretion of principal on senior discount notes

          —

           —

           7.3

            —

            —

             —

             7.3

(Gain) loss on sale of assets

          —

           —

             —

           1.0

            —

             —

             1.0

Stock compensation

          —

           —

             —

         97.1

            —

             —

           97.1

Debt extinguishment costs

        50.2

           —

             —

         12.0

            —

             —

           62.2

Merger expenses

        17.0

           —

             —

           6.2

            —

             —

           23.2

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

               

              

                

               

              

               

                 

    Equity in earnings (loss) of subsidiaries

        53.4

           —

             —

            —

            —

        (53.4)

               —

    Accounts receivable

          —

           —

             —

     (105.8)

       (21.0)

             —

        (126.8)

    Buildup of accounts receivables for recent        acquisitions

          —

           —

             —

       (53.2)

            —

             —

          (53.2)

    Supplies

          —

           —

             —

         (1.2)

         (0.3)

             —

            (1.5)

    Prepaid expenses and other current assets

         (5.1)

           —

             —

       (12.6)

        25.5

             —

             7.8

    Accounts payable

          —

           —

             —

         36.7

         (2.7)

             —

           34.0

    Accrued expenses and other liabilities

         (2.5)

       28.8

             —

           3.5

        15.8

             —

           45.6

Net cash provided by operating activities

         (7.7)

      (17.8)

             —

       117.1

        49.9

             —

         141.5

Investing activities:

               

              

                

               

              

             —

                 

Acquisitions

       (51.2)

           —

             —

       (87.4)

            —

             —

        (138.6)

Capital expenditures

          —

           —

             —

     (124.7)

       (12.6)

             —

        (137.3)

Proceeds from asset sales

          —

           —

             —

           0.7

            —

             —

             0.7

Other

          6.7

           —

             —

       (12.7)

       (27.0)

          27.0

            (6.0)

Net cash used in investing activities

       (44.5)

           —

             —

     (224.1)

       (39.6)

          27.0

        (281.2)

Financing activities:

               

              

                

               

              

               

                 

Proceeds from long-term debt

   1,324.7

           —

             —

            —

            —

             —

      1,324.7

Payments of long-term debt and capital leases

     (682.0)

        (2.8)

             —

         (3.0)

         (0.5)

             —

        (688.3)

Payments of loan costs and debt termination fees

       (44.1)

           —

             —

            —

            —

             —

          (44.1)

Proceeds from joint venture partner contributions

          —

           —

             —

           8.0

            —

             —

             8.0

Proceeds from issuance of common stock

      495.5

           —

             —

            —

            —

             —

         495.5

Payments to retire stock and stock options

     (964.9)

           —

             —

            —

            —

             —

        (964.9)

Cash provided by (used in) intercompany activity

       (76.3)

       20.6

             —

       104.1

       (21.4)

         (27.0)

               —

Exercise of stock options

          0.1

           —

             —

            —

            —

             —

             0.1

Net cash provided by (used in) financing activities

        53.0

       17.8 

             —

       109.1

       (21.9)

         (27.0)

         131.0

Net increase (decrease) in cash and cash equivalents

          0.8

           —

             —

           2.1

       (11.6)

             —

            (8.7)

Cash and cash equivalents, beginning of period

          —

           —

             —

         33.2

        74.9

             —

         108.1

Cash and cash equivalents, end of period

$        0.8

$         —

$           —

$       35.3

$      63.3

$           —

$         99.4

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

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

$ (110.7)

  $       —

    $       —

    $  (96.7)

    $    1.9

     $  94.8

    $ (110.7)

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

    Supplies

          —

           —

             —

           —

        (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 (used in) 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)

Proceeds from asset sales

          —

           —

             —

           0.5

          —

            —

           0.5

Other

          —

           —

             —

           0.4

         (0.3)

            —

           0.1

Net cash used in investing activities

    (50.8)

           —

             —

       (25.9)

        (3.3)

            —

        (80.0)

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 (decrease) in cash and cash equivalents

         0.3

           —

             —

       (27.5)

         6.0

            —

        (21.2)

Cash and cash equivalents, beginning of period

          —

           —

             —

         33.2

        74.9

            —

       108.1

Cash and cash equivalents, end of period

$       0.3

$         —

    $       —

    $     5.7

    $  80.9

     $     —

    $   86.9

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the Successor Period September 23, 2004 through March 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)

$    24.8

$     (48.3)

$         (7.4)

$       87.6

$       9.5

$      (41.4)

    $   24.8

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

 

 

 

 

 

 

 

Depreciation and amortization

        —

           —

             —

         30.2

         5.4

            —

         35.6

Provision for doubtful accounts

        —

           —

             —

         69.3

         9.4

            —

         78.7

Deferred income taxes

      16.1

           —

             —

           —

          —

            —

         16.1

Amortization of loan costs

        —

          1.7

            0.1

           —

          —

            —

           1.8

Accretion of principal on senior discount notes

        —

           —

            7.3

           —

          —

            —

           7.3

(Gain) loss on sale of assets

        —

           —

             —

           0.4

          —

            —

           0.4

Stock compensation

        —

           —

             —

           0.4

          —

            —

           0.4

Debt extinguishment costs

        —

           —

             —

           —

          —

            —

            —

Merger expenses

        —

           —

             —

           0.1

          —

            —

           0.1

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

           

              

                

               

             

              

              

    Equity in earnings (loss) of subsidiaries

    (41.4)

           —

             —

           —

          —

         41.4

            —

    Accounts receivable

        —

           —

             —

       (68.6)

      (16.1)

            —

        (84.7)

    Buildup of accounts receivable for recent        acquisitions

        —

           —

             —

       (53.2)

          —

            —

        (53.2)

    Supplies

        —

           —

             —

         (1.2)

          —

            —

          (1.2)

    Prepaid expenses and other current assets

    (11.4)

           —

             —

           2.1

       14.7

            —

           5.4

    Accounts payable

        —

           —

             —

         (5.2)

        (2.2)

            —

          (7.4)

    Accrued expenses and other liabilities

      (1.4)

        28.8

             —

           5.3

         5.9

            —

         38.6

Net cash provided by (used in) operating activities

    (13.3)

       (17.8)

             —

         67.2

       26.6

            —

         62.7

Investing activities:

           

              

                

               

              

              

                

Acquisitions

      (0.4)

           —

             —

       (87.4)

          —

            —

        (87.8)

Capital expenditures

        —

           —

             —

       (97.9)

        (9.6)

            —

      (107.5)

Proceeds from asset sales

        —

           —

             —

           0.2

          —

            —

           0.2

Other

        6.7

           —

             —

       (13.1)

      (26.7)

         27.0

          (6.1)

Net cash used in investing activities

        6.3

           —

             —

     (198.2)

      (36.3)

         27.0

      (201.2)

Financing activities:

           

              

                

               

              

              

                

Proceeds from long-term debt

    150.0

           —

             —

           —

          —

            —

       150.0

Payments of long-term debt and capital leases

        1.2

         (2.8)

             —

         (2.6)

        (0.2)

            —

          (4.4)

Payments of loan costs and debt termination fees

      (3.2)

           —

             —

           —

          —

            —

          (3.2)

Proceeds from joint venture partner contributions

        —

           —

             —

           8.0

          —

            —

           8.0

Proceeds from issuance of common stock

        0.6

           —

             —

           —

          —

            —

           0.6

Payments to retire stock and stock options

        —

           —

             —

           —

          —

            —

            —

Cash provided by (used in) intercompany activity

  (141.1)

        20.6

             —

       155.2

        (7.7)

       (27.0)

            —

Exercise of stock options

        —

           —

             —

           —

          —

            —

            —

Net cash provided by (used in) financing activities

        7.5

        17.8

             —

       160.6

        (7.9)

       (27.0)

       151.0

Net increase (decrease) in cash and cash equivalents

        0.5

           —

             —

         29.6

      (17.6)

            —

         12.5

Cash and cash equivalents, beginning of period

        0.3

           —

             —

           5.7

       80.9

            —

         86.9

Cash and cash equivalents, end of period

$      0.8

$          —

$           —

$       35.3

$      63.3

$          —

$       99.4

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

****

**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 Blackstone transaction (as discussed below).  Accordingly, the discussion and analysis of historical periods do not reflect the significant impact the Blackstone transaction had on us.  We have presented the information for the nine months ended March31, 2005 on a predecessor period and successor period combined basis to facilitate meaningful comparisons of operating results to the prior year period.  You should read this discussion together with our unaudited condensed consolidated financial statements andrelated 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 the Company’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 thoseprojected.  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 newly effective HIPAA regulations and other management information systemsintegrations

                •  The availability of capital to fund our corporate growth strategy

                •  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

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

                •  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

                •  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

                •  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 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 “Risk Factors” contained in our Registration Statement on Form S-4 (Registration No. 333-120436) originally filed with the Securities and ExchangeCommission on November 12, 2004 and with a final prospectus dated December 23, 2004.  You are cautioned to not rely on such forward-looking statements when evaluating the information contained in this report.  In light of the significant uncertaintiesinherent in the forward-looking statements included in this report, you should not regard the inclusion of such information as a representation by the Company that its objectives and plans anticipated by the forward-looking statements will occur or be achieved, or ifany of them do, what impact they will have on the Company’s results of operations and financial condition.

**Blackstone Transaction**

                On September 23, 2004, The Blackstone Group and certain of its affiliates (collectively “Blackstone”) purchasedapproximately 66% of our equity interests. Certain investment funds affiliated with Morgan Stanley Capital Partners (collectively “MSCP”) and certain of our senior members of management and other shareholders (collectively the “Rollover ManagementInvestors”) own the remaining 34% of our equity interests. The transaction was treated as a leveraged buyout purchase for accounting purposes. In connection with the Blackstone transaction, we repaid $299.0 million of our outstanding $300.0 million 9.75% seniorsubordinated notes, 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 transaction by issuing $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 of initial Term B loans under our new senior secured creditfacilities and with equity proceeds totaling approximately $749.0 million (valued at approximately $635.7 million for accounting purposes).  Certain members of senior management also purchased $5.8 million of the equity incentive units in Holdings.  Our newsenior secured credit facilities also include a $250.0 million revolving credit facility, of which $27.0 million of capacity was utilized for letters of credit as of March 31, 2005, and $325.0 million in delayed draw term loan facilities.  We borrowed $60.0million under the delayed draw term 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 borrowed an additional $90.0million under the delayed draw term loan facilities on February 18, 2005 to fund the working capital buildup of the Massachusetts hospitals and to fund capital expenditures.  We are allowed to borrow the remaining $175.0 million under the delayed draw term loanfacilities at any time prior to September 23, 2005.

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

**Basis of Presentation and Overview**

****

                We present financial information relating to Vanguard Health Systems, Inc., and its subsidiaries in this discussion and analysis on apredecessor period and successor period combined basis.

                As of March 31, 2005, we owned and operated 19 hospitals with a total of 4,518 licensed beds, and related outpatient service facilitiescomplementary 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, which servedapproximately 100,000 members in Arizona; and MacNeal Health Providers, which has responsibility, under capitated contracts covering certain physician and outpatient services, for approximately 46,800 member lives in metropolitan Chicago, Illinois, as of March 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 our business development efforts and operations on hospital andother 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 first hospital, 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, newly enacted Medicare regulations, 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 ofcompliance in the healthcare industry.  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 continually challenge and update our training programs for senior hospital management, chief nursingofficers, quality directors, physicians and other clinical staff to identify opportunities to improve the delivery of healthcare services.  We share information among our hospital management to implement best practices and monitor quality of care standards tomeet or exceed accreditation and regulatory requirements.  We utilize patient care evaluations and satisfaction surveys from patients, physicians and employees to measure the results of our quality of care objectives.  We believe that the core of oursuccess 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 the range of servicesthat 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 patient volumes, we musteffectively recruit and retain physicians and nurses and invest resources in capital projects including upgrading our existing facility framework and expanding facilities.  Also, we believe completing strategic acquisitions to achieve in-market and new marketgrowth will allow us to better serve our patients while improving our operating performance.  Our facility expansion strategies include constructing new facilities in underserved areas of our markets, as demonstrated by our construction of West Valley Hospitalin western metropolitan Phoenix, and increasing the capacities of our hospitals such as the expansion initiatives underway or in the planning stages at six of our hospitals in San Antonio and metropolitan Phoenix, for which we have spent $64.7 million through March31, 2005 and expect to spend approximately an additional $271.3 million through fiscal 2009.

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               •

   

Fostering a partnership culture with physicians and healthcare professionals.  We believe that the key to providing the most effective and efficient healthcare services lies in both effective recruiting and retentionprograms, 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 Chicago at ourMacNeal 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 partnering relationshipswith 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 joint venturepartnerships with physicians in those situations where such relationships fit our strategic objectives.

 

 

 

               •

   

Identifying geographic markets  that provide a strategic fit with the Company’s goals and objectives and leveraging population growth in existing markets.  We expect to continue pursuing acquisition activitiesin existing 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 are approximately 35 million Americans aged 65 or older in the United States in2000, comprising approximately 12.4% of the total U.S. population.  By the year 2010 the number of these elderly persons is expected to climb to 40 million, or 13.0% of the total population.  We believe our initiatives will position us to capitalize on thisdemographic trend.  Obtaining significant market share in key geographic markets and improving market share in existing markets provide opportunities to expand services to those communities, provide flexibility in negotiations with managed care and other thirdparty payers and strengthen recruiting initiatives.

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

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Managed care, Medicare and Medicaid revenues are significant to our business and are all subject to pricing pressures.  For the nine months ended March 31, 2005, managed care (including Medicare and Medicaid managed careplans), Medicare and Medicaid payers accounted for 46.1%, 30.6% and 6.6% of patient service revenues, respectively.  We continue to aggressively renegotiate managed care contracts in order to improve pricing for the healthcare services we provide.  Managedcare 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 the managed care payers.  Management continuallyreviews 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 flowscould 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 by payers under pre-determined, fixed rates such as Medicare diagnosis related grouppayments.

 

 

 

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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 patients in a lessexpensive setting have driven the increase in outpatient utilization.  During the nine months ended March 31, 2005, 66% of total surgeries performed in our facilities were performed on an outpatient basis.  Outpatient revenues as a percentage of total grosspatient revenues were 34.6% and 37.4% during the nine months ended March 31, 2004 and 2005, respectively.  The significance of outpatient utilization is offset somewhat by the aging of the baby boomer population, which we expect to increase demand for inpatientservices.  Typically, the payments 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.

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               •

   

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 hospitals intofor-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 markets 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 $87.4 million at closing, including the base purchase price of $103.6 million for the property, plant and equipment and investments of the Massachusetts hospitals less $16.2 million for the excess of thecurrent liabilities 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 our new senior secured credit facilities, enteredinto in connection with the Blackstone transaction, and by using $27.4 million of cash on hand.  We invested an additional $37.4 million during our third fiscal quarter related to the build-up of working capital at the Massachusetts hospitals.  On February18, 2005, we borrowed the remaining $90.0 million available to us under the 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 otherhospitals.  Operating results for the Massachusetts hospitals are included in our condensed consolidated statements of operations for the three months ended March 31, 2005.

**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 nine months ended March 31, 2005, we experienced a 13.1% increase in dischargesand a 17.1% increase in hospital adjusted discharges compared to the same period in fiscal 2004 partially due to the acquisition of the Massachusetts hospitals.  On a same hospital basis, the period over period increases in discharges and hospital adjusteddischarges were 5.4% and 7.0%, respectively.  The following table provides details of discharges by payer for the three months and nine months ended March 31, 2005 compared to the same periods ended March 31, 2004.

**Three months ended March 31,**

**Nine months ended March 31,**

 

 

 

 

 

 

 

 

**2004**

 

**2005**

 

 

 

**2004**

 

 

**2005**

 

Medicare

12,227

15,478

 

34,067

 

38,436

 

Medicaid

3,994

5,464

12,173

15,209

Managed care

19,989

25,153

59,312

65,688

Self pay

1,198

1,462

3,526

3,843

Other

479

806

1,371

1,694

 

 

 

 

 

 

 

 

 

   Total

37,887

48,363

 

110,449

124,870

 

 

 

 

 

 

 

 

 

 

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                We attribute the same hospital volume improvements to expanded service offerings including complementary subacute services, newcontracts negotiated with certain managed care providers and our market-driven management strategies.  We expect these strategies to continue to result in future growth in revenues and volumes.  However, restoring the community’s confidence inhospitals we have acquired from previous owners and staying ahead of our competition in the markets we serve may be difficult to achieve.

                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 7.6% from$6,439 during the first nine months of fiscal 2004 to $6,926 during the same period in fiscal 2005.  This increase reflects improved reimbursement for services provided under negotiated managed care contracts and improved Medicare reimbursements. Additionally, the ability of our hospitals to provide the appropriate mix of services having favorable reimbursement structures and meeting the needs of our patients impacts this statistic.  Increases in levels of charity care and negotiated self-pay discountsalso impact this statistic by decreasing revenues and decreasing the provision for doubtful accounts.  On a same hospital basis, patient revenues per adjusted hospital discharge increased by 7.3% to $6,912 during the nine months ended March 31, 2005, from $6,439during the prior year period.  We cannot assure you that future reimbursement rates, even if improved, 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 patients who require more costly treatmentthan 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 cost thresholdused 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 announced its intent to revise the current rulesfor determining outlier payments.  Based upon data from our most recently filed Medicare cost reports, our ratio of Medicare outlier payments to Medicare DRG payments is 1.5%.  Thus, we do not believe that we have a high level of outlier payments.  Wealso do not believe that our current level of outlier payments will be materially affected by recent regulations set forth by CMS.

                We recognize premium revenues from Phoenix Health Plan, our Medicaid managed health plan in Phoenix, and from MacNeal Health Providersin Chicago, which is a payer for certain capitated physician and outpatient services for certain member lives.  Premium revenues increased by $33.2 million or 15.5% during the first nine months of fiscal 2005 compared to the same period in fiscal 2004.  Theprimary reason for this revenue increase was the 17,000-member increase in Phoenix Health Plan membership during October 2003.  The increase was primarily due to the withdrawal of one competing plan from the AHCCCS program effective October 1, 2003.  Ourcontract with AHCCCS was renewed during fiscal 2004 for the three-year period ending September 30, 2006, with an option for AHCCCS to renew the contract for two additional one-year periods thereafter.  Should our contract with AHCCCS terminate, our futureoperating 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.

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                *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 accounts receivable.  The following table provides a summary of our accounts receivable by age since discharge date for both insured and uninsured payers as of March 31, 2004, June 30, 2004 and March 31, 2005 (in millions).

**March 31, 2004**

**0-90 days**

**91-180 days**

**Over 180 days**

**Total**

Insured

$         263.4

$           30.9

$             19.4

$          313.7

Self-Pay (1)

              40.3

              32.0

                  8.8

               81.1

 

     Total (2)

$         303.7

$           62.9

$             28.2

$          394.8

 

 

 

 

 

 

 

 

 

 

 

**June 30, 2004**

**0-90 days**

**91-180 days**

**Over 180 days**

**Total**

Insured

$         258.5

$           29.0

$             16.7

$          304.2

Self-Pay (1)

              42.2

              35.3

                10.2

               87.7

     Total (2)

$         300.7

$           64.3

$             26.9

$          391.9

 

 

 

 

 

 

 

 

 

 

 

**March 31, 2005**

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

**91-180 days**

**Over 180 days**

**Total**

Insured

$        388.0

$           32.3

$             20.2

$          440.5

Self-Pay (1)

             52.3

              37.3

                10.8

             100.4

 

     Total (2)

$        440.3

$           69.6

$             31.0

$          540.9

 

____________________(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 recently acquired Massachusetts hospitals.

                Our allowance for bad debts and allowance for charity care covered 75.2%, 76.4% and 85.6% of self-pay accounts receivable as of March31, 2004, June 30, 2004 and March 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, reductions in coverage by certain state Medicaid 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 andprocedures designed to expedite upfront cash collections and promote repayment plans from our patients.  However, we believe bad debts will remain sensitive to changes in payer mix, pricing and general economic conditions for the hospital industry during theforeseeable future.

                *Effects of the 2003 Medicare Prescription Drug Bill*

                The Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or the “2003 Act”, which was signed into law onDecember 8, 2003, made a number of significant changes to the Medicare program. In addition to a highly

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publicized prescription drug benefit that will provide direct relief to Medicare beneficiaries starting in 2006, the 2003 Act provides a number of direct benefits to our hospitals including, but not limited to:

               •

 

a provision effective October 1, 2004 setting a lower threshold for determining when CMS is required to provide additional reimbursement for new technologies that would receive inadequate payment if assigned to a standarddiagnosis related group;

 

 

 

               •

provisions basically providing hospitals with more reimbursement for outpatient drugs;

 

 

 

               •

 

a provision increasing the payments teaching hospitals receive for the indirect operating expenses incurred for training interns and residents in the last half of federal fiscal year 2004 and all of federal fiscal years 2005and 2006, but decreasing such amount slightly in federal fiscal year 2007;

 

 

 

               •

 

 a provision increasing our reimbursement by reducing the labor share percentage from 71% to 62% for hospitals with wage indices less than 1.0;

 

 

 

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a provision allocating $250.0 million per year for federal years 2005-2008 to pay for healthcare costs of undocumented aliens;

 

 

 

               •

 

 a provision eliminating the requirement that hospitals must obtain secondary payment information from all Medicare beneficiaries receiving reference laboratory services; and

 

 

 

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a provision mandating that CMS pay the routine costs associated with category A (experimental/investigational) clinical trials beginning January 1, 2005.

                The 2003 Act also decreases hospital reimbursement in a few areas, including, but not limited to, a provision denying updates tohospitals with “high-cost” direct medical education programs.  In addition, for federal fiscal years 2005, 2006 and 2007, the Act confirms current law that hospitals are to receive full market basket updates for these years, but now conditions suchupdate amounts upon a hospital providing CMS with specific quality data relating to the quality of services provided. Those hospitals failing to provide CMS with the required data will receive an update equal to the market basket minus 0.4%. Our hospitals arecomplying with this reporting requirement.  Overall, we believe that the 2003 Act may have a positive impact on our operating results, especially if future legislation does not decrease the full market basket updates for federal fiscal years 2005, 2006 and 2007for those hospitals complying with the new reporting requirement.

                *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.  In June 2004, we adopted revised policies that provideexpanded discounts from billed charges and alternative 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 federalpoverty guidelines.  CMS has indicated that it is aware of no regulations or guidelines preventing implementation of such policies.  We deduct these discounts from revenues.  During the nine months ended March 31, 2004 and 2005, we deducted $25.4million and $37.7 million of charity care from 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, pressure exists at the federal level to reduce Medicaid matchingfunds provided to states.  We are unable to assess the financial impact of enacted or proposed state or federal funding cuts at this time.

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                *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. During the past three years, the cost of insurance has negatively affected operating results and cash flows throughout the healthcare industry due to pricing pressures on insurers and fewer carriers willing to underwrite professional and general liabilityinsurance.  While premium price increases have abated somewhat during the past year, the total cost of professional and general liability insurance remains sensitive to the volume and severity of cases reported.  Malpractice premiums have adversely affectedthe ability of physicians to obtain malpractice insurance at reasonable rates in certain markets, particularly in metropolitan Chicago, Illinois, resulting in physicians relocating to different geographic areas.  In the event physicians practicing in ourhospitals are unable to obtain adequate malpractice insurance coverage, our hospitals 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, have recently passed tort reform legislation or are considering such legislation to place limits on non-economic damages.  While we have implemented multiple steps at our facilities to reduce our professional liability exposures, absentsignificant additional legislation to curb the size of malpractice judgments in other states in which we operate, our insurance costs may increase in the future.

*                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.  Recentreports forecast 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 programeducational opportunities, leadership training and our focus on clinical and service excellence has partially mitigated the effects of the nursing shortage.

                We operate the School of Health Professionals (“SHP”) in San Antonio, which is primarily a school of nursing.  The SHPtrains approximately 72 nurses each year, of whom approximately 80% choose permanent employment with us.  Plans are underway to transition SHP’s current diploma program to a degree granting program that will be more attractive to potential students. In January 2005, we began training 25 nursing students in our metropolitan Phoenix market 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 equipment expenses in return for a commitment to work at one of our hospitals for a defined period of time.  Should we be unsuccessful in our attempts to maintain nursing coverage adequate for our present and future needs, our future operating resultscould 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 have nowtaken effect.  We estimate that our additional staffing costs from existing regulations could exceed $2.5 million on an annual basis in California.  If similar regulations were adopted in other states in which we operate, our future operating results andcash 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.  The financial resources necessary for program oversight, enforcement and periodicimprovements to our program continue to grow,

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especially when we add new features to our program 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.  We have since entered into a tolling agreement with the OIG related to this matter suspending the period for the running of the statute of limitations and similar****defenses forseven months.  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 has occurred, nor have we determined that any restitution or otherpayment is due to the federal government in respect of this matter.

**Critical Accounting Policies**

                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*

                We recognize patient service revenues during the period the healthcare services are provided based upon estimated amounts due frompayers. We estimate contractual adjustments and allowances based upon payment terms set forth in managed care health plan contracts and by federal and state regulations. For the majority of our patient service revenues, contractual adjustments are applied to patientaccounts at the time of billing using specific payer contract terms entered into the accounts receivable systems, but in some cases we record an estimated allowance until we receive payment. We derive most of our patient service revenues from healthcare servicesprovided to patients with Medicare or managed care insurance coverage. During the nine month periods ended March 31, 2004 and 2005, combined Medicare and managed care revenues accounted for 76.9% and 76.7% of total net patient revenues, respectively.  For thosesame periods, Medicaid revenues accounted for 7.1% and 6.6% of total net patient revenues, respectively. Services provided to Medicare patients are generally reimbursed at prospectively determined rates per diagnosis (“PPS”), while services provided tomanaged care patients are generally reimbursed based upon predetermined rates per diagnosis, per diem rates or discounted fee-for-service rates. Medicaid reimbursements vary by state. Other than Medicare, no individual payer represents more than 10% of our patientservice revenues, either on a gross or net basis.

                Medicare regulations and our principal managed care contracts are often complex and may include multiple reimbursement mechanisms fordifferent types of services provided in our healthcare facilities. To obtain reimbursement for certain services under the Medicare program, we must submit annual cost reports and record estimates of amounts owed to or receivable from Medicare. These cost reportsinclude complex calculations and estimates because the level of services authorized and provided and the related reimbursement for such services are often subject to interpretation that could result in payments that differ from our estimates. We include differencesbetween original estimates and subsequent revisions to those estimates (including final cost report settlements) in the consolidated statements of operations in the period in which the revisions are made. Net adjustments for final third party settlements resulted inincreases to patient service revenues of $9.4 million and $4.4 million during the nine month periods ended March 31, 2004 and 2005, respectively. Additionally, updated regulations and contract negotiations occur frequently, which necessitates continual review ofestimation processes by management.

                We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently thoseuninsured patients whose incomes are equal to or less than 200% of the current federal poverty guidelines set forth by the Department of Health and Human Services). We deduct charity care accounts from revenues when we determine that the account meets our charitycare guidelines.  In June 2004, we adopted revised policies that provide

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expanded discounts from billed charges and alternative payment structures for uninsured patients who do not qualify for charity care but meet certain other minimum income guidelines, primarily those uninsured patients withincomes between 200% and 500% of the federal poverty guidelines. We deduct these discounts from revenues similar to charity care adjustments.  During the nine month periods ended March 31, 2004 and 2005, we deducted $25.4 million and $37.7 million of charitycare from revenues, respectively.

                We had premium revenues of $213.6 million and $246.8 million during the nine month periods ended March 31, 2004 and 2005,respectively.  Our health plans have agreements with AHCCCS and various health maintenance organizations (“HMOs”) to contract to provide medical services to subscribing participants. Under these agreements, our health plans receive monthly paymentsbased on the number of HMO participants or the number of AHCCCS enrollees in the plans.  Our health plans recognize the payments as revenues in the month in which members are entitled to healthcare services.

*                Allowance for Doubtful Accounts and Provision for Doubtful Accounts*

                Our ability to collect outstanding receivables from third party payers is critical to our operating performance and cash flows. Theallowance for doubtful accounts was approximately 22.0% and 21.5% of accounts receivable, net of contractual discounts, as of June 30, 2004 and March 31, 2005, respectively. The primary collection risk relates to uninsured patient accounts and patient accounts forwhich primary insurance has paid but patient deductibles or co-insurance portions remain outstanding. We estimate the allowance for doubtful accounts primarily using a standard policy that reserves 100% of accounts receivable that remain outstanding for apre-determined number of days subsequent to discharge date and reserves a pre-determined percentage of accounts receivable due from patients. We continually monitor our accounts receivable balances and utilize multiple tools to ensure that our allowance for doubtfulaccounts policy provides a reasonable basis for our estimate. These tools include a quarterly hindsight calculation that utilizes write-off data from the previous twelve-month period to estimate the allowance for doubtful accounts at a point in time, cash collectionsanalyses and other key ratios that consider payer mix and other relevant data. We believe that our standard policy is flexible to adapt to changing collection trends and our procedures for testing the standard policy provide timely and accurate information.Significant changes in payer mix, business office operations, general economic conditions or healthcare coverage provided by federal or state governments or private insurers may have a significant impact on our estimates.

                *Insurance Reserves*

                Given the nature of our operating environment, we are subject to professional and general liability and workers compensation claims andrelated lawsuits in the ordinary course of business.  Effective June 1, 2002, we established a wholly owned captive subsidiary to insure our professional and general liability risks at a $10.0 million retention level. We maintain excess coverage from independentthird party insurers 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 the aggregate. We estimate our reserve for professional and general liability and workerscompensation risks using historical claims data, demographic factors, severity factors, current incident and case logs and other actuarial data.  As of June 30, 2004 and March 31, 2005, our professional and general liability accrual for asserted and unassertedclaims was approximately $41.0 million and $47.7 million, respectively.  During the nine months ended March 31, 2004 and 2005, our total provision for professional and general liability losses was approximately $17.5 million and $14.2 million,respectively.  During the nine months ended March 31, 2004 and 2005, we paid approximately $4.4 million and $7.5 million, respectively, in professional and general liability claims and expenses. The estimated accrual for professional and general liability andworkers compensation claims could be significantly affected should current and future occurrences differ from historical claims trends. The estimation process is also complicated by the relatively short period of time in which we have owned many of our healthcarefacilities as occurrence data under previous ownership or for the industry as a whole may not necessarily reflect occurrence data under our ownership.  While management monitors current claims closely and considers outcomes when estimating its reserve, thecomplexity of the claims and wide range of potential outcomes often hamper timely adjustments to the assumptions used in the estimates.

                *Medical Claims Reserves*

                During the nine months ended March 31, 2004 and 2005, medical claims expense was approximately $156.7 million and $179.1 million,respectively, primarily representing medical claims of enrollees in our Medicaid managed health plan in Phoenix, Arizona. We estimate our reserve for medical claims incurred but not reported using historical claims experience (including severity and payment lag time)and other actuarial data including number of enrollees, age of enrollees and certain

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enrollee health indicators. The reserve for medical claims, including incurred but not reported claims, for our health plans was approximately $41.6 million and $52.1 million as of June 30, 2004 and March 31, 2005,respectively. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from its estimates given changes in the healthcare cost structure or adverse experience. During thenine months ended March 31, 2004 and 2005, approximately $21.0 million and $26.6 million, respectively, of accrued and paid claims for services provided to our health plan enrollees by our hospitals and our other healthcare facilities were eliminated inconsolidation. Our operating results and cash flows could be materially affected by increased or decreased utilization of our healthcare facilities by enrollees in our health plans.

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**Table of Contents**

**Selected Operating Statistics**

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

 

 

 

**(Unaudited) Three months ended March 31,**

 

 

 

**(Unaudited) Nine months ended March 31,**

 

 

 

 

**2004**

 

 

**2005**

 

 

 

**2004**

 

 

**2005**

 

**Actual:**

 

 

 

Number of hospitals at end of period

 

 

16

 

 

19

 

 

 

16

 

 

19

Number of licensed beds at end of period

 

 

3,784

 

 

4,518

 

 

 

3,784

 

 

4,518

Discharges (a)

 

 

37,887

 

 

48,363

 

 

 

110,449

 

 

124,870

Adjusted discharges - hospitals (b)

 

 

54,714

 

 

74,957

 

 

 

160,810

 

 

188,371

Net revenue per adjusted discharge - hospitals (c)

 

$

6,658

 

$

6,990

 

 

$

6,439

 

$

6,926

Patient days (d)

 

 

161,127

 

 

214,373

 

 

 

464,699

 

 

531,159

Adjusted patient days - hospitals (e)

 

 

232,688

 

 

332,253

 

 

 

676,588

 

 

801,272

Average length of stay (days) (f)

 

 

4.25

 

 

4.43

 

 

 

4.21

 

 

4.25

Outpatient surgeries (g)

 

 

15,317

 

 

21,062

 

 

 

44,747

 

 

52,854

Emergency room visits (h)

 

 

128,052

 

 

167,605

 

 

 

383,753

 

 

426,646

Occupancy rate (i)

46.8

%

52.7

%

45.1

%

47.7

%

Average daily census (j)

1,771.0

2,382.0

1,690.0

1,939.0

Member lives (k)

144,000

146,800

144,000

146,800

Medical claims percentage (l)

72.7

%

74.4

%

73.4

%

72.6

%

 

 

 

**(Unaudited) Three months ended March 31,**

 

 

 

**(Unaudited) Nine months ended March 31,**

 

 

 

 

**2004**

 

 

**2005**

 

 

 

**2004**

 

 

**2005**

 

**Same hospital:**

 

 

 

Number of hospitals at end of period

 

 

16

 

 

16

 

 

 

16

 

 

16

Total revenues (m)

 

$

461.7

 

$

521.5

 

 

$

1,313.6

 

$

1,515.0

Discharges (n)

 

 

37,887

 

 

39,870

 

 

 

110,449

 

 

116,377

Adjusted discharges - hospitals (o)

 

 

54,714

 

 

58,696

 

 

 

160,810

 

 

172,105

Net revenue per adjusted discharge - hospitals (p)

 

$

6,658

 

$

6,967

 

 

$

6,439

 

$

6,912

Average length of stay (days) (q)

 

 

4.25

 

 

4.32

 

 

 

4.21

 

 

4.20

Outpatient surgeries (r)

 

 

15,317

 

 

16,268

 

 

 

44,747

 

 

48,060

Emergency room visits (s)

 

 

128,052

 

 

139,822

 

 

 

383,753

 

 

398,863

____________________

(a)

 

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.

 

 

 

(b)

 

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.

 

 

 

(c)

 

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.

 

 

 

(d)

 

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

 

 

 

(e)

 

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 volume.

 

 

 

(f)

 

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

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**Table of Contents**

(g)

 

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

 

 

 

(h)

 

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.

 

 

 

(i)

 

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

 

 

 

(j)

 

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

 

 

 

(k)

 

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 period.

 

 

 

(l)

 

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

 

 

 

(m)

 

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

 

 

 

(n)

 

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

 

 

 

(o)

 

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 nine-month periods of both years presented.

 

 

 

(p)

 

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 nine-month periods ofboth years presented.  This statistic measures the average net payment expected to be received for a patient’s stay in those hospitals.

 

 

 

(q)

 

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

 

 

 

(r)

 

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 nine-monthperiods of both years presented.

 

 

 

(s)

 

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 nine-month periods of both years presentedregardless of whether an overnight stay is subsequently required.

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**R****esults of Operations**

                The following tables present summaries of our operating results for the three months and nine months ended March 31, 2004 and2005.

 

 

**(Unaudited) Three months ended March 31,**

 

 

 

 

 

 

**2004**

 

 

 

 

 

**2005**

 

 

 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 
****
Patient service revenues

 

$

385.0

 

 

 

83.4

%

 

$

559.3

 

 

 

87.0

%

Premium revenues

 

 

76.7

 

 

 

16.6

%

 

 

83.7

 

 

 

13.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

461.7

 

 

 

100.0

%

 

643.0

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits (includes stock compensation of $0.1    and $0.2, respectively)

 

 

190.3

 

 

 

41.2

%

 

 

271.6

 

 

 

42.2

%

Supplies

 

 

73.7

 

 

 

16.0

%

 

 

108.8

 

 

 

16.9

%

Medical claims expense

 

 

55.8

 

 

 

12.1

%

 

 

62.2

 

 

 

9.7

%

Provision for doubtful accounts

 

 

29.4

 

 

 

6.4

%

 

 

40.2

 

 

 

6.3

%

Other operating expenses

 

 

65.2

 

 

 

14.1

%

 

 

86.9

 

 

 

13.5

%

Depreciation and amortization

 

 

15.7

 

 

 

3.4

%

 

 

13.1

 

 

 

2.0

%

Interest, net

 

 

11.1

 

 

 

2.4

%

 

 

25.4

 

 

 

4.0

%

Merger expenses

–

0.0

%

0.1

0.0

%

Minority interests and other expenses

 

 

(1.2

)

 

 

(0.3)

%

 

 

1.5

 

 

 

0.2

%

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

21.7

 

 

 

4.7

%

 

 

33.2

 

 

 

5.2

%

Provision for income taxes

 

 

7.9

 

 

 

1.7

%

 

 

13.6

 

 

 

2.1

%

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

13.8

 

 

 

3.0

%

 

$

19.6

 

 

 

3.1

%

 

 

 

 

 

 

 

 

 

 

 

 

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**(Unaudited) Nine months ended March 31,**

 

 

 

 

 

 

**2004**

 

 

 

 

 

**2005**

 

 

 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 
****
Patient service revenues

 

$

1,100.0

 

 

 

83.7

%

 

$

1,389.7

 

 

 

84.9

%

Premium revenues

 

 

213.6

 

 

 

16.3

%

 

 

246.8

 

 

 

15.1

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

1,313.6

 

 

 

100.0

%

 

1,636.5

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits (includes stock compensation of $0.1    and $97.1, respectively)

 

 

549.3

 

 

 

41.8

%

 

 

764.6

 

 

 

46.7

%

Supplies

 

 

207.5

 

 

 

15.8

%

 

 

268.8

 

 

 

16.4

%

Medical claims expense

 

 

156.7

 

 

 

11.9

%

 

 

179.1

 

 

 

11.0

%

Provision for doubtful accounts

 

 

89.7

 

 

 

6.8

%

 

 

110.2

 

 

 

6.8

%

Other operating expenses

 

 

188.7

 

 

 

14.4

%

 

 

231.2

 

 

 

14.1

%

Depreciation and amortization

 

 

46.7

 

 

 

3.5

%

 

 

53.0

 

 

 

3.3

%

Interest, net

 

 

32.4

 

 

 

2.5

%

 

 

62.3

 

 

 

3.8

%

Debt extinguishment costs

–

0.0

%

62.2

3.8

%

Merger expenses

–

0.0

%

23.2

1.4

%

Minority interests and other expenses

 

 

(5.7

)

 

 

(0.4)

%

 

 

2.6

 

 

 

0.1

%

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

 

48.3

 

 

 

3.7

%

 

 

(120.7

)

 

 

(7.4

)%

Provision for income taxes

 

 

18.4

 

 

 

1.4

%

 

 

(34.8

)

 

 

(2.1

)%

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

29.9

 

 

 

2.3

%

 

$

(85.9

)

 

 

(5.3

)%

 

 

 

 

 

 

 

 

 

 

 

 

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

           *Revenues*.  Revenues increased by $181.3 million during the quarter ended March 31, 2005 compared to the prior year quarter due to the acquisition of theMassachusetts hospitals, same hospital volumes increases and improved reimbursement for services provided.  Hospital adjusted discharges increased by 37.0% during the 2005 quarter.  Emergency room visits increased by 30.9% and outpatient surgery volumesincreased by 37.5% during the 2005 quarter.  Same hospital revenues increased by $59.8 million or 13.0% as a result of increases in same hospital adjusted discharges, emergency room visits and outpatient surgeries of 7.3%, 9.2% and 6.2%, respectively.  Inaddition, same hospital net revenue per hospital adjusted discharge increased 4.6% quarter over quarter.  Our service expansion initiatives and managed care contracting strategies played significant roles in inpatient and outpatient volume improvements and wereresponsive to increased demand for such health care services created by the high population growth in the markets we serve.  We expect same hospital growth to continue during the remainder of our current fiscal year, although factors outside our controlincluding patient demand for healthcare services and increased competition could limit our ability to sustain revenue growth.

                Premium revenues increased by 9.1% during the 2005 quarter as a result of a quarter over quarter enrollee increase at our PhoenixHealth Plan, per member rate increases and increases in reinsurance and supplemental revenues.

                Revenues, exclusive of health plan premium and other non-hospital revenues, per adjusted discharge increased 5.0% during the 2005quarter.  We continue to negotiate with managed care payers to receive favorable reimbursement for our services.  We have made considerable progress in these negotiations during the past two years but challenges still remain to adjust these rates toappropriate levels to reflect rising healthcare costs.  The acuity of care required by our patients also

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affects this statistic.  We continually identify and implement 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, surgery unit expansion, 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 technology for obstetrics, emergency services,radiation therapy, women’s services, cardiac, radiology and general surgery units as well as real estate projects to support hospital buildouts and construction of medical office buildings and surgery centers.

                *Costs and Expenses*.  Total costs and expenses, exclusive of income taxes, were $609.8 million or 94.8% of total revenuesduring the 2005 quarter, compared to 95.3% 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 42.2% during the 2005 quarter from 41.2% during the prior year quarter.  The increase is due to the higher salaries andbenefits costs at our Massachusetts hospitals acquired on December 31, 2004, in which a majority of employees are unionized and participate in collective bargaining agreements with the hospitals.  On a same hospital basis, salaries and benefits as a percentageof total revenues decreased to 40.0% during the current year quarter 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 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 adversely impacted by increased salaries and benefits.

 

 

 

               •

Supplies.  Supplies as a percentage of total revenues increased to 16.9% during the 2005 quarter from 16.0% during the 2004 quarter primarily due to increased acuity of services provided to our patients and increasedcosts of supplies and pharmaceuticals.  On a same hospital basis, supplies as a percentage of total revenues increased to 16.7% during the current year quarter.  We expect this ratio to stabilize as we continue to implement our materials managementstrategies.  These improvements may be offset, however, by continued price increases for pharmaceuticals and medical supplies, including the impact of increased use of drug eluting stents.

 

 

** **

               •

Medical claims.  Medical claims expense as a percentage of premium revenues increased to 74.4% during the 2005 quarter compared to 72.7% during the prior year quarter.  Medical claims expense represents the amountspaid by the 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.  Revenues and expenses between the health plans and ourhospitals and related outpatient service providers of approximately $7.6 million, or 10.9% of gross health plan medical claims expense, were eliminated in consolidation during the 2005 quarter.

 

 

** **

               •

Provision for doubtful accounts.  During the 2005 quarter, the provision for doubtful accounts as a percentage of patient service revenues decreased to 7.2% from 7.6% during the 2004 quarter.  During the 2005quarter, our self-pay revenues as a percentage of net patient revenues decreased to 10.6% from 11.1% during the prior year quarter partly due to lower self pay utilization at our Massachusetts hospitals.  Collecting outstanding self-pay accounts remainsdifficult; however, we have experienced improved 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 ourpolicy of deducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines.  During the fourth quarter of fiscal 2004, we

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expanded our charity care guidelines resulting in a decrease in revenues and a reduction in bad debts.  During the quarters ended March 31, 2004 and 2005, we recorded $8.4 million and $14.3 million of charity care revenuedeductions, respectively.  On a combined basis, the provision for doubtful accounts and charity care expense as a percentage of patient service revenues decreased slightly during the 2005 quarter compared to the 2004 quarter.  On a same hospital basis, thecombined provision of doubtful accounts and charity care expense as a percentage of patient service revenues increased from 9.8% during the 2004 quarter to 10.3% during the 2005 quarter.

                *Income taxes*.  Our effective tax rate increased from approximately 36.4% during the 2004 quarter to approximately 41.0%during the 2005 quarter as a result of an increase in business operations in states with higher state tax rates.

                *Net income*.  The $5.8 million quarter over quarter increase in net income resulted primarily from our improved operatingresults offset by increased interest expense during the current year quarter.

**Nine months ended March 31, 2005 compared to Nine months ended March 31, 2004**

                *Revenues.* $121.5 million of the $322.9 million increase in total revenues during fiscal 2005 related to our acquisition of theMassachusetts hospitals, while same hospital revenues improved by $201.4 million.  Hospital adjusted discharges increased by 17.1% during fiscal 2005.  Emergency room visits and outpatient surgeries increased by 11.2% and 18.1%, respectively, during fiscal2005.  Same hospital adjusted discharges, emergency room visits and outpatient surgeries increased 7.0%, 3.9% and 7.4% during fiscal 2005.  Our service expansion initiatives and managed care contracting strategies played significant roles in inpatient andoutpatient volume improvements and were responsive to increased demand for such healthcare services created by the high population growth in most of the markets we serve. We expect same hospital growth to continue during the remainder of our current fiscal year 2005,although factors outside our control including patient demand for healthcare services and increased competition could limit our ability to sustain revenue growth.

                Plan premium revenues increased by $33.2 million during fiscal 2005 due to an increase in average membership in our Phoenix Health Planand a per member rate increase during fiscal 2005.  Average membership in Phoenix Health Plan increased from approximately 93,100 during the nine months ended March 31, 2004 to approximately 98,500 during the nine months ended March 31, 2005.  Themembership increase primarily related to the increased number of individuals eligible for coverage under the Arizona state Medicaid program as a result of significant population growth and the decision during October 2003 by a competing plan to discontinue itsservices in counties that we serve.  We anticipate that enrollment will not fluctuate significantly during the foreseeable future.

                Revenues, exclusive of health plan premium and other non-hospital revenues, per adjusted discharge increased 7.6% during fiscal 2005.We continue to negotiate with our managed care payers to receive increased reimbursement for our services. We have made considerable progress in these negotiations during the past two years but challenges still remain to increase these rates to levels we considerappropriate to reflect rising healthcare costs. The acuity of care required by our patients also affects this statistic. We continually identify and implement services to help improve our return on investment and meet the needs of our patients.

                We continue to implement physician recruitment, emergency department expansion, surgery unit expansion, 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 technology for obstetrics, emergency services, radiationtherapy, women’s services, cardiac, radiology and general surgery units as well as real estate projects to support hospital buildouts and construction of medical office buildings and surgery centers.

                *Costs and Expenses.*  Total costs and expenses, exclusive of income taxes, were $1,757.2 million or 107.4% of total revenuesduring fiscal 2005 compared to 96.3% during fiscal 2004.  The increase resulted primarily from significant merger, stock compensation and debt extinguishment costs incurred in connection with the Blackstone transaction.  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 level of fluctuation period over period.

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               •

  

Salaries and Benefits.  Salaries and benefits as a percentage of total revenues increased to 46.7% during fiscal 2005 from 41.8% during fiscal 2004 primarily due to recognition of $97.1 million of stock compensationduring fiscal 2005.  Excluding the impact of stock compensation, salaries and benefits as a percentage of total revenues decreased to 40.8% during fiscal 2005 from 41.8% during fiscal 2005.  The decrease resulted partly from a $33.2 million increase inpremium revenues, which did not result in a significant increase in related salaries and benefits.  Also, we benefited from our service expansion initiatives that improve efficiencies in utilization of nursing resources.  However, salaries and benefits as apercentage of total revenues will continue to be negatively affected by our acquisition of the Massachusetts hospitals, in which a majority of the employees are unionized and participate in collective bargaining agreements with the hospitals.

 

 

** **

 

The national nursing shortage has hindered our ability to control salaries and benefits. We have experienced particular difficulty in retaining and recruiting nurses in our metropolitan Phoenix and Orange County 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 have hired additional nurses andutilized 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 educational 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 for our present and future needs, andespecially 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 increased to 16.4% during fiscal 2005 from 15.8% during fiscal 2004. Supplies as a percentage of patient service revenues increased to 19.3% during fiscal 2005compared to 18.9% during fiscal 2004. These increases were primarily due to the increase in the acuity of services provided during fiscal 2005, including increased orthopedic and cardiology services. We expect this ratio to stabilize as we continue to implement ourmaterials management strategies. These improvements may be offset, however, by increased utilization of higher acuity services and continued price increases for pharmaceuticals and medical supplies, including the impact of increased use of drug elutingstents.

 

 

** **

               •

Medical Claims.  The $22.4 million increase in medical claims was due to the significant increase in period over period average enrollees at our Phoenix Health Plan. Medical claims expense as a percentage of premiumrevenues decreased to 72.6% during fiscal 2005 compared to 73.4% during fiscal 2004 primarily due to a methodology change during our second quarter of fiscal year 2005 in how we eliminate in consolidation Phoenix Health Plan medical claims expenses for servicesprovided to its enrollees by our hospitals and related healthcare businesses in Phoenix.  This change had no impact on net income during the current fiscal year.  Medical claims expense represents the amounts paid by the health plans for healthcare servicesprovided to their members, including an estimate of incurred but not reported claims that is determined based upon lag data and other actuarial assumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers ofapproximately $26.6 million, or 12.9% of gross health plan medical claims expense, were eliminated in consolidation during fiscal 2005.

 

 

** **

               •

Provision for Doubtful Accounts.  During fiscal 2005, the provision for doubtful accounts as a percentage of patient service revenues decreased to 7.9% compared to 8.2% during fiscal 2004 primarily as a result of theacquisition of the Massachusetts hospitals.  Collecting outstanding self-pay accounts remains difficult; however, we have experienced improved up front cash collections and success in qualifying patients for coverage under Medicaid or similar programs.  Ourprovision 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 fiscal 2004 and 2005, we recorded $25.4million and $37.7 million of charity care revenue deductions, respectively.  On a same hospital basis, the combined provision for doubtful accounts and charity care expense as a percentage of patient service revenues increased to 10.9% during fiscal 2005compared to 10.5% during fiscal 2004.

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                *Income Taxes.*  Our effective tax rate decreased from 38.1% in 2004 to 28.8% during fiscal 2005.  We were unable torecognize the full tax benefit of the net loss incurred during the nine months ended March 31, 2005 due to certain costs related to the Blackstone transaction being non-deductible for tax purposes.

**

*                Net Income.*  The $115.8 million year over year decrease in net income resulted from the significant costs andexpenses related to the Blackstone transaction, including merger expenses, stock compensation and debt extinguishment costs.

**Liquidity and Capital Resources**

                *Operating Activities. * At March 31, 2005, we had working capital of $140.2 million, including cash and cash equivalents of$99.4 million.  Approximately $15.3 million of the cash balance was restricted for use by our captive insurance subsidiary and for indemnification required under the merger agreement.  Working capital at June 30, 2004 was $162.7 million.  The decreasein working capital was primarily due to cash used to pay a portion of the acquisition price for the Massachusetts hospitals and to fund capital expenditures.  Cash provided by operating activities increased from $59.4 million during the nine months ended March31, 2004 to $141.5 million during the nine months ended March 31, 2005.  The significant increase was primarily due to our improved operational performance during the current year period.

**

                *Investing Activities*.  Cash used in investing activities increased from $108.9 million during the nine months ended March31, 2004 to $281.2 million during the nine months ended March 31, 2005, primarily as a result of the $51.2 million of direct acquisition costs we paid during 2005 related to the Blackstone transaction, the $87.4 million purchase price paid for the Massachusettshospitals acquisition and a $35.2 million period over period increase in capital expenditures.

                We spent $137.3 million for capital expenditures during the nine months ended March 31, 2005.  The funding of capital expenditureswas affected by the timing of capital expenditures at our hospitals in San Antonio, Texas (the “BHS hospitals”) that are required under the purchase agreement for those hospitals.  As of March 31, 2005, we have funded or committed to fund all of our$200.0 million commitment in respect of the BHS hospitals.

                In May 2004, our board of directors approved material new internal construction projects at six of our existing hospitals in SanAntonio and metropolitan Phoenix.  We have spent $64.7 million for these projects through March 31, 2005 and expect to spend an estimated additional $271.3 million through fiscal year 2009.  All of these projects will result in expanded capacity at each ofthe six hospitals. In addition, most of the projects will facilitate an expansion of clinical service capabilities.

                The following table summarizes these major expansion projects.

**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

 

Q3 FY 06

 

100

 

P

 

P

 

(1)

Paradise Valley Hospital

 

Q2 FY 06

 

Q4 FY 07

 

60

 

(2)

 

P

 

P

West Valley Hospital

 

Q1 FY 06

 

Q1 FY 07

 

44

 

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

 

Q3 FY 06

 

33(3)

 

P

 

P

 

P

Southeast Baptist Hospital

 

Q4 FY 06

 

Q2 FY 08

 

(4)

 

P

 

(5)

 

P

____________________(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 project will allow for the utilization of an additional 67            previously licensed beds.(4)       Project scope has not been finalized.(5)       Expanded operating room capacity will be part of Phase II of this project to begin in 2009.

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**Table of Contents**

                We anticipate spending a total of $220.0 million to $250.0 during fiscal 2005 including the $137.3 million spent through March 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 flows from operations and availability under our senior creditfacilities. 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 from $49.9 million during the nine months endedMarch 31, 2004 to $131.0 million during the nine months ended March 31, 2005, as a result of the Blackstone transaction on September 23, 2004.

                As a result of the Blackstone transaction and our acquisition of the Massachusetts hospitals, we have significantly more debt. Weexpect to fund our future liquidity needs with cash from operations and amounts available under our senior credit facilities, which availability is subject to certain conditions. We expect that our primary liquidity requirements will be for debt service, workingcapital and capital expenditures.

                As of March 31, 2005, we had outstanding $1,332.6 million in aggregate indebtedness, with an additional $223.0 million of availableborrowing capacity under our revolving credit facility ($250.0 million net of outstanding letters of credit of $27.0 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, the issuers’ interest expense on the 11.25% Notes will consist solely of non-cash accretions of principal.

                Our senior credit facilities consist of a revolving credit facility and term loan facilities. Our revolving credit facility providesfor loans in a total principal amount of up to $250.0 million, and matures in six years. The initial term loan facility, which matures in seven years, provides for loans in a total principal amount of up to $800.0 million as follows: (1) $475.0 million borrowed onSeptember 23, 2004 to finance the Blackstone transaction, to refinance our existing indebtedness and to pay fees and expenses relating thereto; (2) up to $150.0 million available to finance the acquisition(s) of hospitals and related businesses provided that any suchacquisition(s) occurred by February 20, 2005 and (3) until September 23, 2005, up to $175.0 million available for working capital, capital expenditures and other general corporate purposes.  We borrowed $60.0 million under the $150.0 million acquisition delayeddraw term loan facility on December 31, 2004 in order to fund the acquisition purchase price of the Massachusetts hospitals.  On February 18, 2005, we borrowed the remaining $90.0 million to fund the working capital buildup at the Massachusetts hospitals and tofund capital expenditures.  In addition, upon the occurrence of certain events, we may request that incremental term loans be added to our existing senior credit facilities in amounts not to exceed $300.0 million in the aggregate, subject to receipt ofcommitments by existing lenders or other financing institutions and to the satisfaction of certain other conditions.

                The term borrowings under the senior credit facilities bear interest at a rate equal to, at our option, either a base rate plus 2.25%per annum or LIBOR plus 3.25% per annum. The borrowings under the revolving credit facility bear interest at a rate equal to, at our option, either a base rate plus 1.50% per annum or LIBOR plus 2.50% per annum.  Following delivery of our financial statementsfor our fiscal quarter ending March 31, 2005, the applicable margin for borrowings under the revolving credit facility may be reduced by up to 50 basis points subject to our attaining certain leverage ratios. The applicable margin for borrowings under the initialterm loan facility will not be subject to adjustment.

                In addition to paying interest on outstanding principal under the senior credit facilities, we are required to pay a commitment fee tothe lenders under the revolving credit facility in respect of the unutilized commitments thereunder at a rate equal to 0.50% per annum.  We are also required to pay commitment fees to the lenders under the credit facility at a rate equal to (1) 0.75% per annumin respect of the aggregate unutilized commitments under the term loan to finance the acquisition of hospitals and related businesses provided that any such acquisition occurs by February 20, 2005 and (2) 2.25% per annum in respect of the unutilized commitments underthe $175.0 million term loan facility that expires on September 23, 2005 for working capital, capital expenditures and other general corporate purposes. We also pay customary letter of credit fees.

                The senior credit facilities contain a number of covenants that, among other things, restrict, subject to certain exceptions, ourability, and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, repay other indebtedness (including the notes), 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

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**Table of Contents**

indebtedness, including the notes, change the business conducted by our subsidiaries and enter into hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: amaximum total leverage ratio, a maximum senior leverage ratio, a minimum interest coverage ratio and a maximum capital expenditures limitation.

                As of March 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

 

        1.80x

 

      2.77x

Total leverage ratio limit

 

        6.35x

 

      3.97x

Senior leverage ratio limit

 

        3.95x

 

      1.69x

                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.

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

**Standard & Poor’s**

**Moody’s**

 

Corporate credit rating

B

N/A

9% Senior Subordinated Notes            

CCC+

Caa1

111⁄4% Senior Discount Notes

CCC+

Caa2

Senior credit facilities

B

B2

                We expect that cash generated from our operations and cash available to us under the revolving credit facility and the term loanfacilities will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs that we consider necessary to continue our growth. However, we cannot assure you that our operations will generate sufficient cash orthat future borrowings under our senior credit facilities will be available to enable us to meet these requirements and needs.

                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

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for other corporate purposes. However, should our operating results and borrowing capacities not sufficiently support these capital projects or acquisition opportunities, our growth strategies may not be fully realized. Ourfuture 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 are beyond 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.

**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 March 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

 

$

88.2

 

 

$

198.3

 

 

$ 

194.8

 

 

$

1,856.3

 

$

 

2,337.6

 

Capital lease obligations

 

1.9

 

 

0.6

 

–

 

 

–

 

 

2.5

 

Operating leases

 

 

20.0

 

 

 

30.3

 

16.9

 

 

 

26.1

 

 

 

93.3

 

Purchase obligations

 

 

42.9

 

 

 

–

 

–

 

 

 

–

 

 

 

42.9

 

Health claims payable

52.1

–

–

–

52.1

Estimated self-insurance liabilities

 

 

16.5

 

 

 

28.2

 

11.5

 

 

 

3.8

 

 

 

60.0

 

 

 

 

 

 

 

 

 

 

 

    Subtotal

 

$

221.6

 

 

$

257.4

 

$

223.2

 

 

$

1,886.2

 

 

$

2,588.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**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

$

149.1

 

 

$

21.0

$

0.5

 

 

$

11.6

 

$

 

182.2

 

Guarantees of surety bonds

 

18.0

 

 

–

 

 

–

 

 

–

 

 

18.0

 

Letters of credit

 

–

 

 

–

 

–

 

 

27.0

 

 

27.0

 

Physician commitments

 

 

4.3

 

 

 

–

 

–

 

 

 

–

 

 

 

4.3

 

Minimum rent revenue commitments

0.3

0.1

0.1

0.2

0.7

 

    Subtotal

 

$

171.7

 

 

$

21.1

 

$

0.6

 

 

$

38.8

 

 

$

232.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total obligations and commitments

$

393.3

$

278.5

$

223.8

 

 

$

1,925.0

$

2,820.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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**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 March 31, 2005, we had outstanding $622.3 million of senior debt subject to variable interestrates and $708.0 million of outstanding 9.0% Notes, 9.75% Notes and 11.25% Notes subject to fixed interest rates. As of March 31, 2005, the fair values of the 9.0% Notes and the 11.25% Notes were $605.2 million and $144.2 million, respectively.

                In connection with the Blackstone transaction on September 23, 2004, we entered into new senior secured credit facilities comprised ofa $475.0 million term 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 Blackstone transaction,borrowed $60.0 million under the delayed draw 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 tofund the working capital buildup of the Massachusetts hospitals and to fund capital expenditures.  As of March 31, 2005, we had utilized $27.0 million of borrowing capacity under the revolving facility for letters of credit.  The weighted average interestrate on the $622.3 million of outstanding term loan borrowings was approximately 6.33% as of March 31, 2005 (LIBOR of 3.08% plus a fixed margin of 3.25%).

                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 $6.2 million.  A hypothetical 1 percentage point change in interest rates would not have a material impact on the fair value of our fixed rate 9.0% Notesand 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 March 31, 2005, that hasmaterially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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**Table of Contents**

**PART IIOTHER INFORMATION**

**Item 2.    Unregistered Sales of Equity Securities and Use ofProceeds.**

                (a)           During the quarterly period ended March 31, 2005, we issued thefollowing securities that were not registered under the Securities Act of 1933. The transaction described below was conducted in reliance upon the exemption from registration provided in Sections 4(2) of the Securities Act for a transaction not involving a publicoffering. This sale was made without the use of an underwriter, and the certificate evidencing the securities issued in connection with this transaction bears a restrictive legend permitting transfer of the securities only upon registration under the Securities Actor pursuant to an exemption from registration. Each share of common stock issued was issued for cash consideration at a purchase price of $1,000 per share.

                On February 22, 2005, we issued to VHS Holdings LLC, our principal stockholder, 550 shares of our common stock, for an aggregatepurchase price of $550,000. Immediately prior to this transaction, VHS Holdings LLC owned 624,000 of our then outstanding 749,000 shares of common stock.

****

**Item 6.    Exhibits.**

**Exhibit No.   **

     

**Description**

 

 

 

3.1

  

Amended and Restated Certificate of Incorporation.  (Incorporated by reference from Exhibit 3.1 to the Company’s Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

3.2

 

By-Laws.  (Incorporated by reference from Exhibit 3.2 to the Company’s Registration Statement on Form S-1 having Registration No. 333-71934.)

 

 

 

4.1

 

Indenture, relating to the 9% Senior Subordinated Notes, dated as of September 23, 2004, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee. (Incorporated by reference from Exhibit 4.1 to the Company’s Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.2

 

First Supplemental Indenture, dated as of November 5, 2004 among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee.  (Incorporated by reference fromExhibit 4.2 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.3

 

Indenture, relating to the 111⁄4% Senior Discount Notes, dated as of September 23, 2004, among Vanguard Health Holding Company I, LLC, Vanguard Holding Company I, Inc., Vanguard Health Systems, Inc. and the Trustee. (Incorporated by reference from Exhibit 4.3 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.4

 

Registration Rights Agreement relating to the 9% Senior Subordinated Notes, dated as of September 23, 2004, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto,Citigroup Global Markets Inc., Banc of America Securities LLC, Bear Stearns & Co., Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Wachovia Capital Markets, LLC and ABN AMRO Incorporated.  (Incorporated by referencefrom Exhibit 4.4 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.5

 

Registration Rights Agreement, relating to the 11 1/4% Senior Discount Notes, dated as of September 23, 2004, among Vanguard Health Holding Company I, LLC, Vanguard Holding Company I, Inc., Vanguard Health Systems, Inc.,Citigroup Global Markets Inc., Banc of America Securities LLC, Bear Stearns & Co., Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Wachovia Capital Markets, LLC and ABN AMRO Incorporated.  (Incorporated by referencefrom Exhibit 4.5 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

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**Table of Contents**

               

     

 

4.6

 

Registration Rights Agreement, concerning Vanguard Health Systems, Inc., dated as of September 23, 2004.  (Incorporated by reference from Exhibit 4.6 to the Company's Registration Statement on Form S-4 having RegistrationNo. 333-120436.)

 

 

 

4.7

 

Stockholders Agreement Concerning Vanguard Health Systems, Inc., dated as of November 4, 2004, by and among Vanguard Health Systems, Inc., VHS Holdings LLC, Blackstone FCH Capital Partners IV L.P. and its affiliates identifiedon the signature pages thereto and the employees identified on the signature pages thereto.  (Incorporated by reference from Exhibit 10.35 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.8

 

Amended and Restated Limited Liability Company Operating Agreement of VHS Holdings LLC, dated as of September 23, 2004.  (Incorporated by reference from Exhibit 10.7 to the Company's Registration Statement on Form S-4having Registration No. 333-120436.)

 

 

 

4.9

Second Supplemental Indenture, dated as of March 28, 2005, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee.

 

 

 

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.

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**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:     May 10,2005                                                                      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)

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**Table of Contents**

**INDEX TO EXHIBITS**

**Exhibit No.   **

               

**Description**

 

 

 

3.1

  

Amended and Restated Certificate of Incorporation.  (Incorporated by reference from Exhibit 3.1 to the Company’s Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

3.2

 

By-Laws.  (Incorporated by reference from Exhibit 3.2 to the Company’s Registration Statement on Form S-1 having Registration No. 333-71934.)

 

 

 

4.1

 

Indenture, relating to the 9% Senior Subordinated Notes, dated as of September 23, 2004, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee. (Incorporated by reference from Exhibit 4.1 to the Company’s Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.2

 

First Supplemental Indenture, dated as of November 5, 2004 among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee.  (Incorporated by reference fromExhibit 4.2 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.3

 

Indenture, relating to the 111⁄4% Senior Discount Notes, dated as of September 23, 2004, among Vanguard Health Holding Company I, LLC, Vanguard Holding Company I, Inc., Vanguard Health Systems, Inc. and the Trustee. (Incorporated by reference from Exhibit 4.3 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.4

 

Registration Rights Agreement relating to the 9% Senior Subordinated Notes, dated as of September 23, 2004, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto,Citigroup Global Markets Inc., Banc of America Securities LLC, Bear Stearns & Co., Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Wachovia Capital Markets, LLC and ABN AMRO Incorporated.  (Incorporated by referencefrom Exhibit 4.4 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.5

 

Registration Rights Agreement, relating to the 11 1/4% Senior Discount Notes, dated as of September 23, 2004, among Vanguard Health Holding Company I, LLC, Vanguard Holding Company I, Inc., Vanguard Health Systems, Inc.,Citigroup Global Markets Inc., Banc of America Securities LLC, Bear Stearns & Co., Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Wachovia Capital Markets, LLC and ABN AMRO Incorporated.  (Incorporated by referencefrom Exhibit 4.5 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.6

 

Registration Rights Agreement, concerning Vanguard Health Systems, Inc., dated as of September 23, 2004.  (Incorporated by reference from Exhibit 4.6 to the Company's Registration Statement on Form S-4 having RegistrationNo. 333-120436.)

 

 

 

4.7

 

Stockholders Agreement Concerning Vanguard Health Systems, Inc., dated as of November 4, 2004, by and among Vanguard Health Systems, Inc., VHS Holdings LLC, Blackstone FCH Capital Partners IV L.P. and its affiliates identifiedon the signature pages thereto and the employees identified on the signature pages thereto.  (Incorporated by reference from Exhibit 10.35 to the Company's Registration Statement on Form S-4 having Registration No. 333-120436.)

 

 

 

4.8

 

Amended and Restated Limited Liability Company Operating Agreement of VHS Holdings LLC, dated as of September 23, 2004.  (Incorporated by reference from Exhibit 10.7 to the Company's Registration Statement on Form S-4having Registration No. 333-120436.)

 

 

 

4.9

 

Second Supplemental Indenture, dated as of March 28, 2005, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee.

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**Table of Contents**

               

               

 

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.

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