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

_______________**FORM 10-Q**_______________

| **(Mark One)** |  |                                                                 |
|----------------|--|-----------------------------------------------------------------|
| ** **     |  |                                                                 |
| **x**          |  | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**         |
|           |  | **THE SECURITIES EXCHANGE ACT OF 1934**                         |
|           |  |                                                                 |
|           |  | **For the quarterly period ended December 31, 2003**            |
|           |  |                                                                 |
|           |  | **OR**                                                          |
| ** **     |  |                                                                 |
| **o**          |  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF**        |
|           |  | **THE SECURITIES EXCHANGE ACT OF 1934**                         |
|           |  |                                                                 |
|           |  | **For the transition period from ____________ to ____________** |

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

**Delaware**

**62-1698183**

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

* *

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

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

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed under Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yesx   Noo

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

          There were 232,800 shares of common stock outstanding as of February 1, 2004 (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, 2003 and December 31, 2003

 

3

 

 

Condensed Consolidated Income Statements for the Three Months and Six Months ended December 31, 2002 and 2003

 

4

 

 

Condensed Consolidated Statements of Cash Flows for the Six Months ended December 31, 2002 and 2003

 

5

 

 

Notes to Condensed Consolidated Financial Statements

 

6

 Item 2.

 

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

25

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

45

Item 4.

 

Controls and Procedures

45

**PART II. **

 

**OTHER INFORMATION**

 

Item 1.

Legal Proceedings

46

Item 2.

Changes in Securities and Use of Proceeds

46

Item 4.

Submission of Matters to a Vote of Security Holders

46

Item 6.

 

Exhibits and Reports on Form 8-K

 

47

 

 

Signature

 

49

 

Index to Exhibits

50

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

**Item 1.    Financial Statements.**

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

 

 

**June 30, 2003**

 

 

 

**(Unaudited) December 31, 2003**

 

 

 

 

 

**ASSETS**

 

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

 

 

** **

 

 

Current assets:

 

 

 

 

 

 

 

 

   Cash and cash equivalents

$

27.2

$

16.4

   Accounts receivable, net of allowance for uncollectible accounts of       approximately $45.5 and $56.6 at June 30, 2003 and       December 31, 2003, respectively

213.9

228.2

 

   Supplies

32.1

32.5

 

   Prepaid expenses and other current assets

25.0

29.9

 

 

 

        Total current assets

298.2

307.0

 

Property, plant and equipment, net of accumulated depreciation

777.2

807.3

 

Goodwill

100.2

105.6

 

Intangible assets, net of accumulated amortization

38.6

37.0

 

Other assets

12.7

12.1

 

 

 

        Total assets

$

1,226.9

$

1,269.0

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

Current liabilities:

 

   Accounts payable

$

91.7

$

94.1

 

   Accrued health claims

33.5

42.2

 

   Accrued interest

16.1

14.4

 

   Other accrued expenses and current liabilities

111.5

95.8

 

   Current maturities of long-term debt

8.3

5.7

 

 

 

        Total current liabilities

261.1

252.2

 

Other liabilities

62.6

81.0

 

Long-term debt, less current maturities

471.1

487.0

 

Payable-In-Kind Preferred Stock; $.01 par value, 150,000 combined shares of     Preferred Stock and Payable-In-Kind Preferred Stock authorized, 25,194     shares of Payable-In-Kind Preferred Stock issued and outstanding at     June 30, 2003 and December 31, 2003, and 30,000 shares of Series B     Payable-in-Kind Preferred Stock issued and outstanding at June 30, 2003     and December 31, 2003, at redemption value

57.0

58.9

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

–

–

Common Stock; $.01 par value, 600,000 shares authorized, 232,713 and 232,800     shares issued and outstanding at June 30, 2003 and December 31, 2003, respectively

–

–

Additional paid-in capital

352.5

350.8

Accumulated other comprehensive loss

(0.6

)

(0.2

)

Retained earnings

23.2

39.3

 

        Total stockholders’ equity

375.1

389.9

 

 

        Total liabilities and stockholders’ equity

$

1,226.9

$

1,269.0

 

See accompanying notes.

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

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

 

**Three months ended December 31,**

** **

**Six months ended December 31,**

 

**2002**

** **

**2003**

** **

**2002**

** **

**2003**
******
*(In millions)*
******
 

Patient service revenues

 

$

213.9

 

$

364.0

 

$

427.3

 

$

715.0

 

Premium revenues

 

 

53.4

78.0

107.9

136.9

 

 

 

 

      Total revenues

 

 

267.3

442.0

535.2

851.9

 

 

 

 

 

Costs and Expenses:

 

 

 

   Salaries and benefits

 

 

113.0

182.8

227.0

359.0

 

   Supplies

 

 

34.8

68.5

71.4

133.8

 

   Medical claims expense

 

 

38.9

57.0

78.4

100.9

 

   Purchased services

 

 

18.0

22.1

35.1

44.7

 

   Provision for doubtful accounts

 

 

13.7

30.0

27.6

60.3

 

   Insurance

6.3

9.5

12.6

18.8

 

   Other operating expenses

 

 

17.1

25.3

34.0

47.0

 

   Rents and leases

 

 

3.7

5.7

7.5

11.1

 

   Depreciation and amortization

 

 

10.2

15.9

19.1

31.0

 

   Interest, net

 

 

7.3

10.9

14.5

21.3

 

   Other

 

 

(0.1

)

(1.8

)

(0.4

)

(2.6

)

 

 

 

 

 

Income before income taxes

 

 

4.4

16.1

8.4

26.6

 

Income tax expense

 

 

1.8

6.3

3.4

10.5

 

 

 

 

 

Net income

 

 

2.6

9.8

5.0

16.1

 

Preferred stock dividends

 

 

(0.5

)

(0.9

)

(1.0

)

(1.9

)

 

 

 

 

 

Net income attributable to common    stockholders

 

$

2.1

$

8.9

$

4.0

$

14.2

 

 

 

 

 

 

See accompanying notes.

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

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

** **

** **

**Six months ended December 31,**

** **

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

** **

**2002**

** **

**2003**

 

 

*(In millions)*

Operating activities:

 

 

 

 

 

Net income

 

$

5.0

 

$

16.1

 

Adjustments to reconcile net income to net cash     provided by operating activities:

 

 

 

    Depreciation and amortization

 

19.1

 

31.0

 

    Provision for doubtful accounts

 

27.6

 

60.3

 

    Amortization of loan costs

 

0.7

 

0.9

 

    (Gain) loss on sale of assets

 

(0.2

)

 

(0.8

)

 

    Changes in operating assets and liabilities, net of

 

 

 

        effects of acquisitions:

 

 

 

        Accounts receivable

 

(21.9

)

 

(74.6

)

 

        Supplies

 

(1.2

)

 

(0.4

)

 

        Prepaid expenses and other current assets

 

12.7

 

(6.1

)

 

        Accounts payable

 

(6.5

)

 

2.3

 

        Accrued expenses and other current liabilities

 

1.2

 

5.3

 

        Other liabilities

 

8.2

 

16.4

 

 

 

 

Net cash provided by operating activities

 

44.7

 

50.4

 

 

Investing activities:

 

 

 

Acquisitions including working capital settlement payments

 

(1.6

)

 

(12.3

)

 

Capital expenditures

 

(30.0

)

 

(70.9

)

 

Proceeds from asset dispositions

0.5

6.2

 

Other

 

1.4

 

0.3

 

 

 

 

Net cash used in investing activities

 

(29.7

)

 

(76.7

)

 

 

Financing activities:

 

 

 

Proceeds from long-term debt

 

–

 

104.0

 

Payments of long-term debt and capital leases

 

(1.9

)

 

(90.6

)

 

Proceeds from termination of swap agreement

 

5.5

 

–

 

Proceeds from joint venture contributions

–

2.0

 

Exercise of stock options

 

–

 

0.1

 

Proceeds from common stock and PIK preferred stock issuances

 

0.9

 

–

 

 

 

 

Net cash provided by financing activities

 

4.5

 

15.5

 

 

 

Net increase (decrease) in cash and cash equivalents

 

19.5

 

(10.8

)

 

Cash and cash equivalents, beginning of period

 

55.4

 

27.2

 

 

 

 

Cash and cash equivalents, end of period

 

$

74.9

 

$

16.4

 

 

 

Net cash paid for interest

$

13.0

$

22.3

 

 

 

Net cash paid (received) for income taxes

$

(0.1

)

$

1.3

 

 

 

 

See accompanying notes.

 

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

**VANGUARD HEALTH SYSTEMS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003(Unaudited)**

**1.             BASIS OF PRESENTATION AND ORGANIZATION**

****

                The unaudited condensed consolidated financial statements as of December 31, 2003 and for the three months and six months then endedinclude the accounts of Vanguard Health Systems, Inc. (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 inaccordance with Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements.

                In the opinion of management, the unaudited condensed consolidated financial statements reflect 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, 2004.  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, 2003 included in the Company’s Annual Report onForm 10-K filed with the Securities and Exchange Commission.

                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 December 31, 2003, the Company owned 16 hospitals with a total of 3,784 licensed beds and related outpatient service locationscomplementary to the hospitals providing health care services to the metropolitan Phoenix, Arizona; metropolitan Los Angeles/Orange County, California; metropolitan Chicago, Illinois; and metropolitan San Antonio, Texas markets.  The Company also owned twohealth plans:  a Medicaid managed health plan, Phoenix Health Plan, which served approximately 99,000 members in Arizona as of December 31, 2003; and MacNeal Health Providers, which had responsibility, under capitated contracts covering certain physician andoutpatient services, for approximately 50,000 member lives in metropolitan Chicago, Illinois as of December 31, 2003.

                Certain prior year amounts have been reclassified to conform to current year presentation.  The majority of the Company’sexpenses are “cost of revenue” items.

**2.             ADOPTION OF ACCOUNTING PRONOUNCEMENTS**

                The Company sponsors four stock option plans.  Prior to July 1, 2003, the Company accounted for stock-based employee compensationin accordance with the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*.  During the six months ended December 31, 2002, the Company recognized no compensation expense relatedto outstanding stock options as each of those stock options had an exercise price equal to the fair market value of the underlying common stock on the date of grant, were not exercisable until the occurrence of a future contingent event or had already been recognizedas compensation expense in a previous period.  Effective July 1, 2003, the Company adopted the fair value method of accounting for stock-based employee compensation set forth by Statement of Financial Accounting Standards No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”).  The Company elected to use the prospective transition method set forth by Statement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation – Transition and Disclosure*. This transition method requires that only stock options granted subsequent to the adoption of SFAS 123 be measured at fair value.  During the six months ended December 31, 2003, the Company recorded non-cash stock compensation of approximately $33,000 for stockoptions granted during the period.

-6-
****
**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, except for those whose number of exercisable shares is contingent upon a future event, for those periods presented.  For purposes of the pro forma disclosures, the estimated fair value of the stock options is amortized to expense over therespective vesting periods of the options.

**Three months ended December 31,**

**Six months ended December 31,**

 

 

 

**2002**

 

**2003**

 

 

 

**2002**

 

 

**2003**

 

Net income

 

$

2.6

$

9.8

 

$

5.0

 

$

16.1

 

Pro forma compensation expense from stock options, net of taxes

 

 

(0.4

)

(0.5

)

 

 

(0.9

)

 

(1.0

)

 

 

 

 

 

 

 

 

 

 

Pro forma net income

 

$

2.2

$

9.3

 

$

4.1

 

$

15.1

 

 

 

 

 

 

 

 

 

 

 

                The Company used the following weighted average assumptions to estimate the non-cash stock compensation expense for the three monthsand six months ended December 31, 2003:  risk-free interest rate of 4.1%; 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 forthe three months and six months ended December 31, 2002 and 2003, respectively:  risk-free interest rate of 5.5% and 5.2%, respectively; dividend yield of 0.0%; and expected option life of 10 years.

**3.             ACQUISITIONS**

****

**Fiscal 2003 Acquisition**

                On January 3, 2003, but effective January 1, 2003, the Company, through a majority-owned subsidiary, acquired substantially all of theassets of five acute care hospitals with a total of 1,537 beds and related health care businesses located in San Antonio, Texas, and surrounding areas of south Texas from Baptist Health System (“BHS”), a Texas not-for-profit corporation.  Thepurchase price of the net assets acquired was $306.1 million, comprised of cash of $258.5 million, $30.0 million of the Company’s Series B payable-in-kind redeemable convertible preferred stock and approximately $17.6 million of the Company’s convertiblesubordinated notes due 2013 bearing interest at 8.18% per annum.  The Company funded the cash portion of the purchase price with $150.0 million of term loan borrowings under the amended 2001 credit facility, $50.0 million from private sales of its common stockand cash on hand of $58.5 million.  The total purchase price included $12.3 million of payments made during the second quarter of fiscal 2004 to settle acquired working capital adjustments and other acquisition obligations.  The BHS acquisition wasaccounted for using the purchase method of accounting.  The results of operations of BHS are included in the accompanying condensed consolidated income statements for the three months and six months ended December 31, 2003.

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

                The purchase price for the fiscal 2003 acquisition was allocated as follows (in millions).

 

 

 

**BHS**

Fair value of assets acquired:

 

 

 

   Cash

 

$

–

   Accounts receivable, net

 

 

50.7

   Other current assets

 

 

18.6

   Property, plant and equipment

 

 

255.1

   Other assets

9.0

   Goodwill and intangible assets

 

 

30.5

 

 

 

   Assets acquired 

 

 

363.9

Liabilities assumed

 

 

57.8

   Purchase price of net assets acquired 

306.1

Payable-In-Kind Preferred Stock issued

 

 

30.0

Subordinated notes issued 

17.6

 

 

Cash paid for net assets acquired

 

$

258.5

 

 

 

**Pro Forma Results**

                The following table shows the unaudited pro forma results of consolidated operations as if the BHS acquisition had occurred at thebeginning of the period presented, after giving effect to certain adjustments, including the depreciation and amortization of the assets acquired based upon their fair values, changes in net interest expense resulting from changes in consolidated debt and changes inincome taxes and non-income taxes (in millions).

**Three months ended December 31,**

**Six months ended December 31,**

**2002**

 

 

 

**2003**

 

 

 

**2002**

 

 

 

**2003**

 

 

 

Revenues

 

$

393.5

$

442.0

 

$

770.0

 

$

851.9

 

Income (loss) before income taxes

1.7

16.1

(2.2

)

26.6

Income tax expense (benefit)

0.8

6.3

(0.7

)

10.5

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

0.9

$

9.8

 

$

(1.5

)

$

16.1

 

 

 

 

 

 

 

 

 

 

 

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

**4.             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, 2003 and December 31, 2003 (in millions).

 

 

** **

** **

**Gross Carrying Amount**

** **

**Accumulated Amortization**

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

 

** **

** **

**June 30, 2003**

** **

**December 31, 2003**

** **

**June 30, 2003**

** **

**December 31, 2003**

 

 

**Class of Intangible Asset**

** **

** **
****
 

Amortized intangible assets:

** **

** **

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Deferred loan costs

 

$

17.2

 

 

$

17.2

 

 

$

2.7

 

 

$

3.6

 

 

    Contracts

 

 

7.9

 

 

 

7.9

 

 

 

2.4

 

 

 

2.9

 

 

    Customer lists

 

 

2.3

 

 

 

2.3

 

 

 

2.3

 

 

 

2.3

 

 

    Other

 

 

3.8

 

 

 

3.8

 

 

 

1.5

 

 

 

1.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Subtotal

 

 

31.2

 

 

 

31.2

 

 

 

8.9

 

 

 

10.5

 

 

 Indefinite-lived intangible assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

    License and accreditation

 

 

9.8

 

 

 

9.8

 

 

 

–

 

 

 

–

 

 

    Other

 

 

6.5

 

 

 

6.5

 

 

 

–

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Subtotal

 

 

16.3

 

 

 

16.3

 

 

 

–

 

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

47.5

 

 

$

47.5

 

 

$

8.9

 

 

$

10.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                Changes in the carrying amount of goodwill from June 30, 2003 to December 31, 2003 follows (in millions).

 

 

 

**Acute Care Services**

 

**Health Plans**

 

 

**Total**

 

 

Balance as of June 30, 2003

 

$

91.5

 

$

8.7

 

$

100.2

Settlement of working capital and other acquired obligations

9.5

–

9.5

Adjustments to record net assets acquired to fair value               

 

 

(4.1

)

               

–

               

 

(4.1

)

 

 

 

 

 

 

 

Balance as of December 31, 2003

 

$

96.9

 

$

8.7

 

$

105.6

 

 

 

 

 

 

 

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

**5.             FINANCING ARRANGEMENTS**

                A summary of the Company’s long-term debt as of June 30, 2003 and December 31, 2003 follows (in millions):

 

 

 

**June 30, 2003**

 

     

**December 31, 2003**

 

 

 

 

9.75% Senior Subordinated Notes

 

$

300.0

 

$

300.0

 

Term loans payable under the amended 2001 credit facility

 

 

149.3

 

 

148.1

 

Revolving loans payable under the amended 2001 credit facility

 

 

–

 

 

19.0

 

8.18% Convertible Subordinated Notes

 

 

17.6

 

 

17.6

 

Capital leases

 

 

10.4

 

 

8.0

 

Other

 

 

2.1

 

 

–

 

 

 

 

 

 

 

 

 

 

479.4

 

 

492.7

 

Less: current maturities

 

 

(8.3

)

 

(5.7

)

 

 

 

 

 

 

 

 

$

471.1

 

$

487.0

 

 

 

 

 

 

 

**9.75% Senior Subordinated Notes**

                On July 30, 2001, the Company received gross proceeds of $300.0 million through the issuance of its 9.75% Senior Subordinated Notes(the “9.75% Notes”) which mature in August 2011.  Interest on the 9.75% Notes is payable semi-annually on February 1 and August 1.  The Company may redeem the 9.75% Notes, in whole or in part, at any time from August 1, 2006 to July 31, 2009 atredemption prices ranging from 104.875% to 101.625%, plus accrued and unpaid interest.  The Company may redeem the 9.75% Notes on or after August 1, 2009 at a 100% redemption price plus accrued and unpaid interest.  Additionally, at any time prior to August1, 2004, the Company may redeem up to 35% of the principal amount of the 9.75% Notes with the net cash proceeds of one or more sales of its capital stock at a redemption price of 109.75% plus accrued and unpaid interest to the redemption date; provided that at least65% of the aggregate principal amount of the 9.75% Notes originally issued on July 30, 2001 remains outstanding after each such redemption and notice of any such redemption is mailed within 90 days of each such sale of capital stock.

                Payment of the principal and interest of the 9.75% Notes is subordinate to amounts owed for existing and future senior indebtedness ofthe Company and is guaranteed, jointly and severally, on an unsecured senior subordinated basis by most of the Company’s subsidiaries.  The Company is subject to certain restrictive covenants under the Indenture governing the 9.75% Notes.

**Credit facility debt**

                Concurrent with the issuance of the 9.75% Notes, the Company entered into a new senior secured credit facility (the “2001 creditfacility”) with a syndicate of lenders with Banc of America Securities LLC and Morgan Stanley Senior Funding, Inc. serving as joint lead arrangers and book managers and Bank of America, N.A. as administrative agent.  The 2001 credit facility initiallyprovided for up to $125.0 million of outstanding loans and letters of credit on a revolving basis and contemplated, but the lenders did not commit to, additional term loans of up to $250.0 million.  The Company would have been required to obtain commitments fromits existing or new lenders to obtain the term loans, but no approval of the existing lenders was necessary for such term loans.  The applicable interest rate under the 2001 credit facility was based upon either: 1) LIBOR plus a margin ranging from 2.25% to3.25% depending on the Company’s leverage ratio calculated using the most recent four quarters or 2) a base rate plus a margin ranging from 1.25% to 2.25% depending on the Company’s leverage ratio calculated using the most recent four quarters.  TheCompany was subject to certain restrictive and financial covenants under the 2001 credit facility.  Obligations under the 2001 credit facility were guaranteed by most of the Company’s wholly owned domestic subsidiaries and were secured by liens onsubstantially all of the assets of the Company and its subsidiaries and by pledges of the stock of the Company’s subsidiaries.

                Upon the acquisition of BHS in January 2003, the Company expanded its 2001 credit facility by adding a $150.0 million term loanfacility to its existing $125.0 million revolving loan facility (the “amended 2001 credit facility”).  The

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

Company utilized proceeds from the $150.0 million in term loans to fund a portion of the cash purchase price of the BHS acquisition.  The interest rate of the term loans is either: 1) LIBOR plus a margin of 4.25% or 2) abase rate plus a margin of 3.25%.  The outstanding term loans mature on January 3, 2010, and principal repayments of $375,000 are due at the end of each quarter starting on March 31, 2003 through December 31, 2008, after which four quarterly repayments of$35,250,000 are due starting on March 31, 2009 up to the maturity date.  The amended 2001 credit facility no longer contemplates any specified amount of additional term loans to the Company under the facility and, in addition, the facility now requires theapproval of the existing lenders representing two-thirds of the then outstanding term loans and revolving loan commitments for the issuance of additional term loans under this facility.  As of December 31, 2003, the Company had $19.0 million of outstandingrevolving loans under its amended 2001 credit facility primarily to fund its capital expenditure projects.  The interest rate applicable to the outstanding revolving loans was 5.75% (4.0% prime rate plus 1.75% margin based on the Company’s most recentleverage ratio) as of December 31, 2003.  The Company also had outstanding letters of credit of $20.8 million.  A portion of the outstanding letters of credit related to a performance guaranty required by the contract between AHCCCS and Phoenix Health Plan,which is owned by a subsidiary of the Company, while the remainder is related to the Company’s workers’ compensation program.  The Company is subject to certain restrictive and financial covenants under the amended 2001 credit facility.  TheCompany was in compliance with all such covenants as of December 31, 2003.

                The Company incurred offering costs and loan costs of approximately $11.5 million, $3.5 million and $2.3 million for the 9.75% Notes,the 2001 credit facility and the amended 2001 credit facility, respectively.  The Company capitalized the costs associated with the offering of the 9.75% Notes and the procurement of the 2001 credit facility and amended 2001 credit facility and is amortizingsuch costs to interest expense over the 10-year life of the 9.75% Notes, the 5-year life of the 2001 credit facility and the 7-year life of the amended 2001 credit facility.

**8.18% Convertible Subordinated Notes**

**

                Upon the acquisition of BHS in January 2003, the Company issued to the seller approximately $17.6 million of its convertiblesubordinated notes that provide for annual interest payments at 8.18% until maturity on January 3, 2013.  The notes are convertible at any time into the Company’s common stock at a $3,500 per share conversion price.  The Company may not redeem thenotes prior to January 1, 2008, and must pay redemption prices of 102% for redemptions during the first year subsequent to January 1, 2008, and 101% for redemptions during the second year subsequent to January 1, 2008, with redemptions thereafter available atpar.  Payment of the principal and interest of the 8.18% Convertible Subordinated Notes is subordinate to amounts owed for existing and future senior indebtedness of the Company.

****

**Derivatives**

                On February 15, 2002, the Company entered into an interest rate swap agreement with Bank of America, N.A., to swap its 9.75% fixedinterest rate on a notional amount of $100.0 million of the 9.75% Notes for a floating rate designated at the 6-month LIBOR rate (the benchmark interest rate) plus a fixed percentage of 3.63%.  The swap agreement was scheduled to mature upon the maturity orredemption of the 9.75% Notes but was terminable by either party at any time.  The floating interest rate was determined for the six-month period in arrears on semi-annual settlement dates of February 1 and August 1.  The swap qualified as a fair valuehedge under SFAS 133, and the Company elected the shortcut method of accounting due to the highly effective nature of the swap.  On August 13, 2002, the Company terminated the swap agreement resulting in a cash payment to the Company from Bank of America, N.A.of $5.5 million.  Approximately $5.3 million of the cash received represented the fair value of the swap as of the termination date, net of interest accrued since the previous settlement date.  The $5.3 million portion of the payment was recorded as adeferred gain and will be amortized as an offset to interest expense using the effective interest method over the remaining life of the 9.75% Notes.  The unamortized deferred gain is included in other liabilities on the accompanying condensed consolidatedbalance sheets as of June 30, 2003 and December 31, 2003.

                On January 17, 2003, the Company entered into an agreement with Bank of America, N.A. to swap the variable 90-day LIBOR rate applicableto a notional amount of $147.0 million of its $150.0 million of term loans under the amended 2001 credit facility for a fixed LIBOR rate of 1.77% for the one-year period commencing July 3, 2003 and ending July 3, 2004.  The swap agreement qualifies as a cashflow hedge under SFAS 133, and the Company has elected the shortcut method of accounting due to the highly effective nature of the swap.  The fair market value of the swap agreement as of December 31, 2003, was a liability of $0.2 million, net of taxes, and isincluded in other accrued expenses and current liabilities with an offsetting adjustment to accumulated other comprehensive loss on the accompanying condensed consolidated balance sheet as of December 31, 2003.

-11-
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**Table of Contents**

**6.             RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**

                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 theclassification of its outstanding preferred stock instruments.

                In May 2003, the FASB issued Statement of Financial Accounting Standards No. 149, *Amendment of Statement 133 on DerivativeInstruments and Hedging Activities* (“SFAS 149”).  SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments and for hedging activities.  SFAS 149 is effective for contracts entered into or modified afterJune 30, 2003.  The Company does not expect SFAS 149 to have a significant impact on its future results of operations or cash flows.

                In January 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities*.  This interpretationof ARB No. 51, *Consolidated Financial Statements*, sets forth criteria under which a company must consolidate certain variable interest entities.  Interpretation No. 46 places increased emphasis on controlling financial interests when determining if acompany should consolidate a variable interest entity.  Application of Interpretation No. 46 is required for periods ending after December 15, 2003, for public entities with interests in variable interest entities or potential variable interest entities commonlyreferred to as special-purpose entities.  Application by public entities for all other types of variable interest entities is required for periods ending after March 15, 2004.  Application by non-public entities to all types of variable interest entities isrequired at various dates in 2004 and 2005.  The Company does not expect Interpretation No. 46 to have a significant impact on its future results of operations or cash flows.

                In November 2002, the FASB issued Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirements for Guarantors,Including Indirect Guarantees of Indebtedness of Others*.  Interpretation No. 45 requires that certain guarantees be recorded at fair value at inception and requires additional disclosures on existing guarantees even if the likelihood of future liabilityunder the guarantees is deemed remote.  The provisions of Interpretation No. 45 are effective for financial statements of interim or annual periods ending after December 15, 2002.  The Company does not expect Interpretation No. 45 to have a significantimpact on its future results of operations or cash flows.

                In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, *Accounting for Costs Associated with Exit orDisposal Activities* (“SFAS 146”), which supersedes the provisions of EITF No. 94-3, *Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity*.  SFAS 146 requires companies to establish liabilitiesfor costs to exit an activity when the costs are incurred as opposed to the date when the companies commit to the exit plan.  Exit costs covered by SFAS 146 include, but are not limited to, certain employee severance and relocation costs, lease termination costsand other costs related to restructuring or discontinuing operations.  SFAS 146 is effective for exit activities initiated after December 31, 2002.  The Company does not expect SFAS 146 to have a significant impact on its future results of operations orcash flows.

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

**7.             SEGMENT INFORMATION**

                The Company’s acute care hospitals and related health care 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 health care businesses, collectively, and 2) health plans consisting of MacNeal HealthProviders, a contracting entity for MacNeal Hospital and Weiss Memorial Hospital in Chicago, 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 and six months ended December 31,2002 and 2003, respectively, including a reconciliation of Segment EBITDA to income before income taxes (in millions).

**Three months ended December 31, 2002**

**Three months ended December 31, 2003**
********
**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**

**Health Plans**

**Acute Care Services**

**Eliminations**

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

$

–

$

213.9

$

–

$

213.9

$

–

$

364.0

$

–

$

364.0

 

Premium revenues

53.4

–

–

53.4

78.0

–

–

78.0

 

Inter-segment revenues

–

6.6

(6.6

)

–

–

6.9

(6.9

)

–

 

 

      Total revenues

53.4

220.5

(6.6

)

267.3

78.0

370.9

(6.9

)

442.0

 

 

Operating expenses - external

43.2

202.1

–

245.3

64.1

337.8

–

401.9

 

Operating expenses - inter-segment

6.6

–

(6.6

)

–

6.9

–

(6.9

)

–

 

 

      Total operating expenses

49.8

202.1

(6.6

)

245.3

71.0

337.8

(6.9

)

401.9

 

 

      Segment EBITDA(1)

3.6

18.4

–

22.0

7.0

33.1

–

40.1

 

 

Less:

 

Depreciation and amortization

0.4

9.8

–

10.2

0.5

15.4

–

15.9

 

Interest, net

(0.5

)

7.8

–

7.3

0.5

10.4

–

10.9

 

Minority interests

–

0.2

–

0.2

–

(1.0

)

–

(1.0

)

 

Equity method loss (income)

–

(0.1

)

–

(0.1

)

–

(1.0

)

(1.0

)

 

Loss (gain) on sale of assets

–

–

–

–

–

(0.8

)

–

(0.8

)

 

 

      Income before income taxes

$

3.7

$

0.7

$

–

$

4.4

$

6.0

$

10.1

$

–

$

16.1

 

 

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

**Six months ended December 31, 2002**

**Six  months ended December 31, 2003**
********
**Health Plans**

**Acute Care Services**

**Eliminations**

**Consolidated**

**Health Plans**

**Acute Care Services**

**Eliminations**

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

$

–

$

427.3

$

–

$

427.3

$

–

$

715.0

$

–

$

715.0

 

Premium revenues

107.9

–

–

107.9

136.9

–

–

136.9

 

Inter-segment revenues

–

13.4

(13.4

)

–

–

13.4

(13.4

)

–

 

 

      Total revenues

107.9

440.7

(13.4

)

535.2

136.9

728.4

(13.4

)

851.9

 

 

Operating expenses - external

87.2

405.9

–

493.1

113.3

664.2

–

777.5

 

Operating expenses - inter-segment

13.4

–

(13.4

)

–

13.4

–

(13.4

)

–

 

 

      Total operating expenses

100.6

405.9

(13.4

)

493.1

126.7

664.2

(13.4

)

777.5

 

 

      Segment EBITDA(1)

7.3

34.8

–

42.1

10.2

64.2

–

74.4

 

 

Less:

 

Depreciation and amortization

0.8

18.3

–

19.1

1.0

30.0

–

31.0

 

Interest, net

(0.8

)

15.3

–

14.5

1.1

20.2

–

21.3

 

Minority interests

–

0.5

–

0.5

–

(1.9

)

–

(1.9

)

 

Equity method loss (income)

–

(0.2

)

–

(0.2

)

–

(1.8

)

–

(1.8

)

 

Loss (gain) on sale of assets

–

(0.2

)

–

(0.2

)

–

(0.8

)

–

(0.8

)

 

 

      Income before income taxes

$

7.3

$

1.1

$

–

$

8.4

$

8.1

$

18.5

$

–

$

26.6

 

 

Segment assets

$

49.8

$

811.6

$

861.4

$

28.6

$

1,240.4

$

1,269.0

 

 

Capital expenditures

$

–

$

30.0

$

30.0

$

0.4

$

70.5

$

70.9

 

 

____________________(1) Segment EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation, amortization, minority interests, gain or loss on sale of assets and equity method income or loss.  Management uses Segment EBITDA to measureperformance for the Company’s segments and to develop strategic objectives and operating plans for those segments.  Segment EBITDA eliminates the uneven effect of non-cash depreciation of tangible assets and amortization of intangible assets, much of whichresults from acquisitions accounted for under the purchase method of accounting.  Segment EBITDA also eliminates the effects of changes in interest rates which management believes relate to general trends in global capital markets, but are not necessarilyindicative of the operating performance of the Company’s segments.  Management believes that Segment EBITDA provides useful information about the financial performance of the Company’s segments to investors, lenders, financial analysts and ratingagencies.  Additionally, management believes that investors and lenders view Segment EBITDA as an important factor in making investment decisions and assessing the value of the Company.  Segment EBITDA is not a substitute for net income, operating cashflows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States.  Segment EBITDA, as presented, may not be comparable to similarly titled measures of other companies.

**8.             COMMITMENTS AND CONTINGENCIES**

****

                In certain of its acquisitions, the Company has committed to meet certain minimum post-acquisition capital expenditure requirements andcertain construction and facility expansion obligations.  Management continually monitors compliance with these commitments.  In addition, management evaluates contingencies based upon the best available information and believes that adequate provision forpotential losses associated with contingencies has been made.  In management’s opinion, based on current available information, these commitments described below will not have a material effect on the Company’s results of operations or financialposition, but the capital expenditure commitments could have an effect on the timing of the Company’s cash flows, including its need to borrow additional amounts under its revolving credit facility.

**Capital Expenditure Commitments**

****

                The Company has committed to make capital expenditures of $200.0 million in the acquisition agreement related to its purchase of theBHS assets and $50.0 million in the acquisition agreement related to its purchase of Phoenix Baptist Hospital and Arrowhead Community Hospital.  As of December 31, 2003, the remaining commitment under the BHS purchase agreement was $144.4 million while theremaining aggregate commitment under the Phoenix Baptist Hospital and Arrowhead Community Hospital agreement was approximately $8.1 million.  The commitments may be satisfied by third parties on behalf of the Company, including construction of medical officebuildings by unrelated developers.  Aside from

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

commitments under acquisition agreements, the Company also estimates a remaining commitment of $5.1 million related to the construction of West Valley Hospital in metropolitan Phoenix, Arizona and $36.0 million to completein-process capital projects at other hospitals.

**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 program, 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 income statements in the period in whichthe 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.  As of December 31, 2003, the Company had 6 unfiledMedicare cost reports relating to Medicare fiscal year-end 2003.  Net adjustments to third party settlements resulted in increases to income before income taxes of $1.0 million and $0 for the three months ended December 31, 2002 and 2003, respectively, and $2.5million and $4.4 million for the six months ended December 31, 2002 and 2003, respectively.  The Company recorded $3.3 million and $9.2 million of charity care revenue deductions during the three months ended December 31, 2002 and 2003, respectively, and $6.7million and $17.0 million of charity care revenue deductions during the six months ended December 31, 2002 and 2003, respectively.

**Governmental Regulation**

****

                Laws and regulations governing the Medicare and Medicaid and other federal health care 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 investigation involving allegations of potentialwrongdoing.  While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from theMedicare, Medicaid and other federal health care 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 health care laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-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 generally seeks to obtain indemnification from prospective sellers covering such matters, there can be no assurance that anysuch matter will be covered by indemnification, or if covered, that such indemnification will be adequate to cover potential losses and fines.

**Professional and General Liability Risks**

****

                As is typical in the health care industry, the Company is subject to potential claims and legal actions in the ordinary course ofbusiness including patient care.  Through May 31, 2002, the Company maintained third-party insurance coverage on a claims-made basis for individual malpractice claims exceeding $1.0 million and annual aggregate claims exceeding $13.6 million.  Due to thelimited availability of carriers willing to underwrite professional and general liability coverage and unfavorable premium quotes received, effective June 1, 2002, the Company established a wholly owned captive subsidiary to insure its professional and generalliability risks at a $10.0 million retention level.  The Company maintains excess coverage with third party insurers for individual claims exceeding $10.0 million per occurrence up to $100.0 million in the aggregate.  The captive insurance subsidiaryintends to fund claims costs from proceeds of premium payments received from the

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

Company.  The current industry environment appears to indicate an increase in the quantity and severity of professional liability claims.  This environment has led to increased costs for professional liabilitypremiums, including reinsurance premiums, which the Company expects to continue for the foreseeable future.  Also, the Company is exposed to increased payments to malpractice claimants in the event physicians practicing at the Company’s hospitals areunable to obtain adequate malpractice insurance.  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 $15.0 million, an amount determined based upon Plan membership and capitation premiums received.  As of December 31, 2003, the Company maintained this performanceguarantee in the form of surety bonds totaling $10.0 million with independent third party insurers that expire on September 30, 2004 and a letter of credit issued to AHCCCS in the amount of $5.0 million.  The Company also was required to arrange for a $1.0million letter of credit to collateralize its $10.0 million in surety bonds with the third party insurers.

**9.             COMPREHENSIVE INCOME**

                The components of comprehensive income, net of related taxes, are as follows (in millions).

 

 

**Six months ended December 31,**

 

 

 

 

**2002**

 

 

 

**2003**

 

 

 
****
 

Net income

 

$

5.0

 

 

$

16.1

 

 

 

 

 

 

 

 

Other comprehensive loss related to fair value    of interest rate swap

 

 

–

(0.2

)

 

 

Comprehensive income

 

$

5.0

$

15.9

**10.          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 jointlyand severally guarantee the 9.75% Notes on an unsecured senior subordinated basis.  Certain other consolidated entities that are not wholly owned by the Company have not guaranteed the 9.75% Notes in conformity with the provisions of the indenture governing the9.75% Notes and have also not guaranteed the amended 2001 credit facility in conformity with the provisions thereof.  The condensed consolidating financial information for the parent company, the subsidiary guarantors, the non-guarantor subsidiaries, certaineliminations and the consolidated Company as of June 30, 2003 and December 31, 2003 and for the three months and six months ended December 31, 2002 and 2003, follows.

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSJune 30, 2003(Unaudited)**

 

 

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

 
**
 

 

 

*(in millions)*

 

**ASSETS**

Current assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

–

 

 

$

21.2

 

$

6.0

 

 

$

–

 

$

 

27.2

 

Accounts receivable, net

 

 

–

 

 

 

189.2

 

24.7

 

 

 

–

 

 

 

213.9

 

Supplies

 

 

–

 

 

 

29.7

 

2.4

 

 

 

–

 

 

 

32.1

 

Prepaid expenses and other current assets

 

 

–

 

 

 

5.3

 

20.8

 

 

 

(1.1

)

 

 

25.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current assets

 

 

–

 

 

 

245.4

 

53.9

 

 

 

(1.1

)

 

 

298.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property, plant and equipment, net

 

 

–

 

 

 

721.8

 

55.4

 

 

 

–

 

 

 

777.2

 

Goodwill

 

 

–

 

 

 

100.2

 

–

 

 

 

–

 

 

 

100.2

 

Intangible assets, net

 

 

–

 

 

 

37.0

 

1.6

 

 

 

–

 

 

 

38.6

 

Investments in subsidiaries

 

 

408.8

 

 

 

–

 

–

 

 

 

(408.8

)

 

 

–

 

Other assets

 

 

–

 

 

 

12.7

 

10.2

 

 

 

(10.2

)

 

 

12.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total assets

 

$

408.8

 

 

$

1,117.1

 

$

121.1

 

 

$

(420.1

)

 

$

1,226.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

 

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

–

 

 

 

85.5

 

$

6.2

 

 

 

–

 

 

$

91.7

 

Accrued expenses and other current liabilities

 

 

–

 

 

 

148.6

 

14.1

 

 

 

(1.6

)

 

 

161.1

 

Current maturities of long-term debt

 

 

–

 

 

 

7.5

 

0.8

 

 

 

–

 

 

 

8.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current liabilities

 

 

–

 

 

 

241.6

 

21.1

 

 

 

(1.6

)

 

 

261.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other liabilities

 

 

13.6

 

 

 

32.5

 

34.2

 

 

 

(17.7

)

 

 

62.6

 

Long-term debt, less current maturities

 

 

–

 

 

 

467.6

 

3.5

 

 

 

–

 

 

 

471.1

 

Intercompany

 

 

(36.9

)

 

 

(40.4

)

 

37.5

 

 

 

39.8

 

 

 

–

 

Payable-In-Kind Preferred Stock

 

 

57.0

 

 

 

–

 

–

 

 

 

–

 

 

 

57.0

 

Stockholders’ equity

 

 

375.1

 

 

 

415.8

 

24.8

 

 

 

(440.6

)

 

 

375.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total liabilities and stockholders’ equity

 

$

408.8

 

 

$

1,117.1

 

$

121.1

 

 

$

(420.1

)

 

$

1,226.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSDecember 31, 2003(Unaudited)**

 

** **

**Parent**
** **
**Guarantor Subsidiaries**

** **

**Combined Non-Guarantors**

** **

**Eliminations**

** **

**Total Consolidated**

 

 

** **

 

 

** **

*(in millions)*

 

**ASSETS**

** **

 

Current assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

–

 

 

$

(1.2

)

 

$

17.6

 

 

$

–

 

 

$

16.4

 

Accounts receivable, net

 

 

–

 

 

 

205.4

 

 

 

22.8

 

 

 

–

 

 

 

228.2

 

Supplies

 

 

–

 

 

 

28.9

 

 

 

3.6

 

 

 

–

 

 

 

32.5

 

Prepaid expenses and other current assets

 

 

8.0

 

 

 

12.7

 

 

 

11.0

 

 

 

(1.8

)

 

 

29.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current assets

 

 

8.0

 

 

 

245.8

 

 

 

55.0

 

 

 

(1.8

)

 

 

307.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property, plant and equipment, net

 

 

–

 

 

 

745.9

 

 

 

61.4

 

 

 

–

 

 

 

807.3

 

Goodwill

 

 

–

 

 

 

105.3

 

 

 

0.3

 

 

 

–

 

 

 

105.6

 

Intangible assets, net

 

 

–

 

 

 

35.7

 

 

 

1.3

 

 

 

–

 

 

 

37.0

 

Investments in subsidiaries

 

 

408.8

 

 

 

–

 

 

 

–

 

 

 

(408.8

)

 

 

–

 

Other assets

 

 

–

 

 

 

12.1

 

 

 

14.5

 

 

 

(14.5

)

 

12.1

 

 

 

 

 

 

 

 

 

 

 

 

    Total assets

 

$

416.8

 

 

$

1,144.8

 

 

$

132.5

 

 

$

(425.1

)

 

$

1,269.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

–

 

$

87.2

 

$

6.9

 

 

$

–

 

 

$

94.1

Accrued expenses and other current liabilities

 

 

0.4

 

 

143.6

 

 

10.9

 

 

(2.5

)

 

 

152.4

Current maturities of long-term debt

 

 

–

 

 

4.5

 

 

1.2

 

 

 

–

 

 

 

5.7

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total current liabilities

 

 

0.4

 

 

235.3

 

 

19.0

 

 

 

(2.5

)

 

 

252.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other liabilities

 

 

28.0

 

 

 

24.3

 

 

36.7

 

 

 

(8.0

)

 

 

81.0

Long-term debt, less current maturities

 

 

–

 

 

 

485.6

 

 

1.4

 

 

 

–

 

 

 

487.0

Intercompany

 

 

(60.4

)

 

 

(48.1

)

 

 

52.1

 

 

 

56.4

 

 

 

–

Payable-In-Kind Preferred Stock

 

 

58.9

 

 

 

–

 

 

–

 

 

 

–

 

 

 

58.9

Stockholders’ equity

 

 

389.9

 

 

 

447.7

 

 

23.3

 

 

 

(471.0

)

 

 

389.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total liabilities and stockholders’ equity

 

$

416.8

 

 

$

1,144.8

 

 

$

132.5

 

 

$

(425.1

)

 

$

1,269.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING INCOME STATEMENTSFor the three months ended December 31, 2002(Unaudited)**

 

 

**Parent**
** **
**Guarantor Subsidiaries**

** **

**Combined Non-Guarantors**

** **

**Eliminations**

** **

**Total Consolidated**

 

 

 

 

 

 

*(in millions)*

 

** **

 

 

Patient service revenues

 

$

–

 

 

$

185.1

 

 

$

28.8

 

 

$

–

 

 

$

213.9

 

Premium revenues

 

 

–

 

 

 

53.4

 

 

 

3.7

 

 

 

(3.7

)

 

 

53.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Total revenues

 

 

–

 

 

 

238.5

 

 

 

32.5

 

 

 

(3.7

)

 

 

267.3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits

 

 

–

 

 

 

99.7

 

 

 

13.3

 

 

 

–

 

 

 

113.0

 

Supplies

 

 

–

 

 

 

29.5

 

 

 

5.3

 

 

 

–

 

 

 

34.8

 

Medical claims expense

 

 

–

 

 

 

38.9

 

 

 

–

 

 

 

–

 

 

 

38.9

 

Purchased services

 

 

–

 

 

 

16.0

 

 

 

2.0

 

 

 

–

 

 

 

18.0

 

Provision for doubtful accounts

 

 

–

 

 

 

11.7

 

 

 

2.0

 

 

 

–

 

 

 

13.7

 

Insurance

 

 

–

 

 

 

5.1

 

 

 

4.9

 

 

 

(3.7

)

 

 

6.3

 

Other operating expenses

 

 

–

 

 

 

15.2

 

 

 

1.9

 

 

 

–

 

 

 

17.1

 

Rents and leases

 

 

–

 

 

 

3.3

 

 

 

0.4

 

 

 

–

 

 

 

3.7

 

Depreciation and amortization

 

 

–

 

 

 

9.6

 

 

 

0.6

 

 

 

–

 

 

 

10.2

 

Interest, net

 

 

–

 

 

 

6.4

 

 

 

0.9

 

 

–

 

 

 

7.3

 

Management fees

 

 

–

 

 

 

(0.1

) 

 

 

0.1

 

 

 

–

 

 

 

–

 

Other

 

 

–

 

 

 

(0.1

)

 

 

–

 

 

 

–

 

 

 

(0.1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

        Total costs and expenses

 

 

–

 

 

 

235.2

 

 

 

31.4

 

 

 

(3.7

)

 

 

262.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

–

 

 

 

3.3

 

 

 

1.1

 

 

 

–

 

 

 

4.4

 

Income tax expense

 

 

1.8

 

 

 

–

 

 

 

–

 

 

 

–

 

 

 

1.8

 

Equity in earnings of subsidiaries

 

 

4.4

 

 

 

–

 

 

 

–

 

 

 

(4.4

)

 

 

–

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

2.6

 

 

$

3.3

 

 

$

1.1

 

 

 

(4.4

)

 

$

2.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING INCOME STATEMENTSFor the three months ended December 31, 2003(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Patient service revenues

$

–

$

327.9

$

36.1

$

–

$

364.0

Premium revenues

–

78.0

4.8

(4.8

)

78.0

        Total revenues

–

405.9

40.9

(4.8

)

442.0

Salaries and benefits

–

165.5

17.3

–

182.8

Supplies

–

62.8

5.7

–

68.5

Medical claims expense

–

57.0

–

–

57.0

Purchased services

–

18.5

3.6

–

22.1

Provision for doubtful accounts

–

26.8

3.2

–

30.0

Insurance

–

7.6

6.7

(4.8

)

9.5

Other operating expenses

–

22.0

3.3

–

25.3

Rents and leases

–

4.9

0.8

–

5.7

Depreciation and amortization

–

14.7

1.2

–

15.9

Interest, net

–

10.2

0.7

–

10.9

Management fees

–

(0.8

)

0.8

–

–

Other

–

(1.8

)

–

–

(1.8

)

        Total costs and expenses

–

387.4

43.3

(4.8

)

425.9

Income (loss) before income taxes

–

18.5

(2.4

)

–

16.1

Income tax expense

6.3

–

–

–

6.3

Equity in earnings of subsidiaries

16.1

–

–

(16.1

)

–

Net income (loss)

$

9.8

$

18.5

$

(2.4

)

$

(16.1

)

$

9.8

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the six months ended December 31, 2002(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Patient service revenues

$

–

$

369.0

$

58.3

$

–

$

427.3

Premium revenues

–

107.9

7.6

(7.6

)

107.9

        Total revenues

–

476.9

65.9

(7.6

)

535.2

Salaries and benefits

–

199.7

27.3

–

227.0

Supplies

–

60.7

10.7

–

71.4

Medical claims expense

–

78.4

–

–

78.4

Purchased services

–

31.4

3.7

–

35.1

Provision for doubtful accounts

–

23.9

3.7

–

27.6

Other operating expenses

–

8.7

3.9

–

12.6

Insurance

–

31.8

9.8

(7.6

)

34.0

Rents and leases

–

6.6

0.9

–

7.5

Depreciation and amortization

–

17.8

1.3

–

19.1

Interest, net

–

13.6

0.9

–

14.5

Management fees

–

(1.2

)

1.2

–

–

Other

–

(0.4

)

–

–

(0.4

)

        Total costs and expenses

–

471.0

63.4

(7.6

)

526.8

Income before income taxes

–

5.9

2.5

–

8.4

Income tax expense

3.4

–

–

–

3.4

Equity in earnings of subsidiaries

8.4

–

–

(8.4

)

–

Net income

$

5.0

$

5.9

$

2.5

$

(8.4

)

$

5.0

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the six months ended December 31, 2003(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(in millions)*

 

** **

 

Patient service revenues

$

–

$

642.1

$

72.9

$

–

$

715.0

Premium revenues

–

136.5

9.6

(9.2

)

136.9

        Total revenues

–

778.6

82.5

(9.2

)

851.9

Salaries and benefits

–

324.0

35.0

–

359.0

Supplies

–

122.1

11.7

–

133.8

Medical claims expense

–

100.9

–

–

100.9

Purchased services

–

37.7

7.0

–

44.7

Provision for doubtful accounts

–

53.5

6.8

–

60.3

Insurance

–

14.6

13.4

(9.2

)

18.8

Other operating expenses

–

39.9

7.1

–

47.0

Rents and leases

–

9.7

1.4

–

11.1

Depreciation and amortization

–

28.7

2.3

–

31.0

Interest, net

–

19.3

2.0

–

21.3

Management fees

–

(1.5

)

1.5

–

–

Other

–

(2.6

)

–

–

(2.6

)

        Total costs and expenses

–

746.3

88.2

(9.2

)

825.3

Income (loss) before income taxes

–

32.3

(5.7

)

–

26.6

Income tax expense

10.5

–

–

–

10.5

Equity in earnings of subsidiaries

26.6

–

–

(26.6

)

–

Net income (loss)

$

16.1

$

32.3

$

(5.7

)

$

(26.6

)

$

16.1

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the six months ended December 31, 2002(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(In millions)*

 

** **

 

Operating activities:

Net income

$

5.0

$

5.9

$

2.5

$

(8.4

)

$

5.0

Adjustments to reconcile net income to net cash     provided by operating activities:

    Depreciation and amortization

–

17.8

1.3

–

19.1

    Provision for doubtful accounts

–

23.9

3.7

–

27.6

    Amortization of loan costs

–

0.7

–

–

0.7

    Loss (gain) on sale of assets

–

(0.2

)

–

–

(0.2

)

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

    Equity in earnings of subsidiaries

(8.4

)

–

–

8.4

–

    Accounts receivable

–

(23.0

)

1.1

–

(21.9

)

    Supplies

–

(1.0

)

(0.2

)

–

(1.2

)

    Prepaid expenses and other current assets

–

11.6

 

1.1

–

12.7

 

    Accounts payable

–

(1.2

)

(5.3

)

–

(6.5

)

    Accrued expenses and other current liabilities

1.0

 

(5.1

)

5.3

–

1.2

    Other liabilities

4.5

3.9

(0.2

)

–

8.2

Net cash provided by operating activities

2.1

 

33.3

9.3

–

44.7

Investing activities:

Acquisitions, including working capital settlement     payments

–

(1.6

)

–

–

(1.6

)

Capital expenditures

–

(23.5

)

(6.5

)

–

(30.0

)

Proceeds from asset sales

–

0.5

–

–

0.5

Other

–

1.4

 

–

 

–

1.4

 

Net cash used in investing activities

–

(23.2

)

(6.5

)

–

(29.7

)

Financing activities:

Proceeds from long-term debt

–

–

–

–

–

Payments of long-term debt and capital leases

–

(1.5

)

(0.4

)

–

(1.9

)

Cash provided by intercompany activity

(2.1

)

1.2

0.9

–

–

Proceeds from termination of swap agreement

–

5.5

–

–

5.5

Proceeds from common stock and PIK preferred     stock issuances

–

0.9

–

–

0.9

Net cash provided by (used in) financing activities

(2.1

)

6.1

0.5

–

4.5

Net increase in cash and cash equivalents

–

16.2

3.3

–

19.5

Cash and cash equivalents, beginning of period

–

56.3

(0.9

)

–

55.4

Cash and cash equivalents, end of period

$

–

$

72.5

$

2.4

$

–

$

74.9

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

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the six months ended December 31, 2003(Unaudited)**

**Parent**

**Guarantor Subsidiaries**

**Combined Non-Guarantors**

**Eliminations**

**Total Consolidated**

 

 

*(In millions)*

 

** **

 

Operating activities:

Net income (loss)

$

16.1

$

32.3

$

(5.7

)

$

(26.6

)

$

16.1

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

    Depreciation and amortization

–

28.7

2.3

–

31.0

    Provision for doubtful accounts

–

53.5

6.8

–

60.3

    Amortization of loan costs

–

0.9

–

–

0.9

    Loss (gain) on sale of assets

–

(0.8

)

–

–

(0.8

)

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

    Equity in earnings of subsidiaries

(26.6

)

–

–

26.6

–

    Accounts receivable

–

(73.6

)

(1.0

)

–

(74.6

)

    Supplies

–

(0.1

)

(0.3

)

–

(0.4

)

    Prepaid expenses and other current assets

(8.0

)

(8.2

)

10.1

–

(6.1

)

    Accounts payable

–

4.4

(2.1

)

–

2.3

    Accrued expenses and other current liabilities

(2.8

)

12.3

(4.2

)

–

5.3

    Other liabilities

17.8

(3.8

)

2.4

–

16.4

Net cash provided by (used in) operating activities

(3.5

)

45.6

8.3

–

50.4

Investing activities:

Acquisitions, including working capital settlement     payments

–

(12.3

)

–

–

(12.3

)

Capital expenditures

–

(66.9

)

(4.0

)

–

(70.9

)

Proceeds from asset dispositions

–

6.2

–

–

6.2

Other

–

4.6

(4.3

)

–

0.3

Net cash used in investing activities

–

(68.4

)

(8.3

)

–

(76.7

)

Financing activities:

Proceeds from long-term debt

–

104.0

–

–

104.0

Payments of long-term debt and capital leases

–

(87.8

)

(2.8

)

–

(90.6

)

Proceeds from joint venture partner contributions

–

2.0

–

–

2.0

Exercise of stock options

–

0.1

–

–

0.1

Cash provided by (used in) intercompany activity

3.5

(17.9

)

14.4

–

–

Net cash provided by financing activities

3.5

0.4

11.6

–

15.5

Net increase (decrease) in cash and cash equivalents

–

(22.4

)

11.6

–

(10.8

)

Cash and cash equivalents, beginning of period

–

21.2

6.0

–

27.2

Cash and cash equivalents, end of period

$

–

$

(1.2

)

$

17.6

$

–

$

16.4

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

**11.          Subsequent Events**

                During January 2004, the Company repaid all $19.0 million in outstanding revolving loans under the amended 2001 credit facility. Subsequent to this repayment, the Company borrowed $25.0 million, net of repayments, under the revolving loan facility of the amended 2001 credit facility.

****

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

****

                You should read this discussion together with our unaudited condensed consolidated financial statements and related notes includedwithin 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 health care 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 health care professionals, including physicians                    and nurses

                •  Potential federal or state reform of health care

                •  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 health care plans

                •  Changes in general economic conditions

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

                •  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,                   health care 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

                Except as required by law, we undertake no obligation to publicly update any forward-looking statements, whether as a result of newinformation, future events or otherwise.  We advise you, however, to consult any additional disclosures we make in our other filings with the Securities and Exchange Commission, including, without limitation, the discussion of risks and other uncertainties underthe caption “Risk Factors” contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.  You are cautioned to not rely on such forward-looking statements when evaluating the information contained in thisreport.  In light of the significant uncertainties inherent 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 theforward-looking statements will occur or be achieved, or if any of them do, what impact they will have on the Company’s results of operations and financial condition.

**Overview**

****

                As of December 31, 2003, we owned and operated 16 hospitals with a total of 3,784 licensed beds, and related outpatient servicelocations complementary to the hospitals providing health care services to the metropolitan Phoenix, Arizona, Chicago, Illinois, San Antonio, Texas, and Los Angeles/Orange County, California markets.  We also owned two health plans: a Medicaid managed healthplan, Phoenix Health Plan, which serves approximately 99,000 members in Arizona; and MacNeal Health Providers, which has responsibility, under capitated contracts covering certain physician and outpatient services, for approximately 50,000 member lives inmetropolitan Chicago, Illinois.  Our objective is to provide high-quality, cost-effective health care services in the communities we serve.  We focus our operations and business development in urban and suburban markets, specifically on those facilitieswhere we identify an opportunity to improve operating performance and profitability and increase market share, either through a network of hospitals and other health care facilities or a single well-positioned facility.  We were incorporated in July 1997 andacquired 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 health careservices in the communities we serve.  These strategies include quality control, expansion of services, partnering with physicians and health care professionals and identifying growing geographic areas in need of our services for expansion or acquisitionopportunities.  If we achieve these strategies, we will 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 increased bad debts arising from an increase in self-pay accounts receivable, newly enacted Medicareregulations, expanded charity care programs, potential state Medicaid funding cuts, rising professional liability costs, nurse staffing issues and potential impairment issues related to one of our Phoenix hospitals.  The following paragraphs more fully describethe strategies, risks and trends mentioned above.

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

**Operating Strategies and Related Risks**

****

                In order to increase revenues and enhance operating margins, we have implemented several operating initiatives, including thefollowing:

               •

   

Implementing programs and procedures to improve the quality of health care 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 health care 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 health care services provided by our facilities.  We believe that a key factor in increasing patient volume is to provide the communities we serve a comprehensive medical solution.  Thisstrategy requires effective recruiting and retention programs for general practitioners and specialists and maintaining quality nursing support as well as a commitment to capital projects to maintain and upgrade our existing facility framework and to expandfacilities and services where necessary to meet the health care needs of the communities we serve.  Also, we believe completing strategic acquisitions to achieve in-market and new market growth will allow us to better serve our patients while improving ouroperating performance.  Our facility expansion strategies include constructing new facilities in underserved areas of our markets, as demonstrated by our construction of West Valley Hospital in western metropolitan Phoenix.

 

 

 

               •

   

Fostering a partnership culture with physicians and health care professionals.  We believe that the key to providing the most effective and efficient health care services lies in both effective recruiting and retentionprograms and continual training and education support.  Our relationships with the University of Chicago at our MacNeal and Weiss hospitals in metropolitan Chicago, Illinois, demonstrate one of our many commitments to professional development for physicians andhealth care professionals.  Our comprehensive recruiting and retention strategy serves as a cornerstone to build partnering relationships with employees and physicians to ensure we have the expertise necessary to carry out our mission in all areas of our healthcare facilities.  We also intend to increase our participation, consistent with applicable laws, in the development of joint venture partnerships 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 activities inmarkets 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 today, comprisingapproximately 13% of the total U.S. population.  By the year 2030 the number of these elderly persons is expected to climb to 69 million, or 20% of the total population.  We believe our initiatives will position us to capitalize on this demographictrend.  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 third party payersand strengthen recruiting initiatives.

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

               •

   

Managed care, Medicare and Medicaid revenues are significant to our business and are all subject to pricing pressures.  For the six months ended December 31, 2003, managed care (including Medicare and Medicaid managedcare plans), Medicare and Medicaid payers accounted for 46%, 30% and 7% of patient service revenues, respectively.  We continue to aggressively renegotiate managed care contracts in order to improve pricing for the health care services we provide.  Managedcare payers are subject to

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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 continually reviews its portfolio of managed care relationships and attempts to balance pricing and volume issues; however, as long as strong competition remains in the markets we serve, these challenges will continue.  Our future operating resultsand cash flows could be materially adversely affected to the extent we are unable to achieve increased reimbursement arrangements while maintaining patient volume.  We are also at risk for highly acute cases reimbursed by payers under pre-determined, fixed ratessuch as Medicare DRG payments. 

 

 

 

               •

   

Many procedures once performed exclusively on an inpatient basis at hospitals are now being provided on an outpatient basis.  Advances in technology and the focus of payers on treating lower acuity patients in a lessexpensive setting have driven the increase in outpatient utilization.  For the six months ended December 31, 2003, 63% of total surgeries performed in our facilities were outpatient surgeries.  Outpatient revenues as a percentage of total gross patientrevenues were 33% and 35% for the six months ended December 31, 2002 and 2003, respectively.  The significance of outpatient utilization is offset somewhat by the aging of the baby boomer population, which supports increased inpatient days and surgeries. 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 number of outpatientsurgery centers and specialty hospitals that have commenced operations in the past few years.  We anticipate that competition for outpatient services will remain intense during the foreseeable future.

 

 

 

               •

   

Intense market competition may limit our ability to enter choice markets or to recruit and retain quality health care 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 health care services, recruiting and retaining qualified health care 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, we own a relatively small number of hospitals that can cause anindividual acquisition to 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 may also 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 January 3, 2003, but effective January 1, 2003, we acquired substantially all of the assets of five acute care hospitals with atotal of 1,537 beds and related health care businesses located in and around San Antonio, Texas, from Baptist Health System (“BHS”).  The BHS acquisition purchase price was $306.1 million, comprised of cash of $258.5 million, $30.0 million of ourSeries B payable-in-kind preferred redeemable preferred stock and approximately $17.6 million of our convertible subordinated notes due 2013 bearing interest at 8.18% per annum.  The total purchase price included $12.3 million of payments made during the secondquarter of fiscal 2004 to settle acquired working capital adjustments and other acquisition obligations.  We funded the cash portion of the purchase price with $150.0 million of term loan borrowings under our amended 2001 credit facility, $50.0 million fromprivate sales of our common stock and $58.5 million of cash on hand.  The operations of BHS are included in the condensed consolidated income statement for the six months ended December 31, 2003.

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**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 first half of fiscal 2004, we experienced a 68.0% increase in discharges and a63.8% increase in hospital adjusted discharges compared to the same period in fiscal 2003, primarily due to the acquisition of BHS in January 2003.  On a same hospital basis, discharges and adjusted discharges-hospitals increased 1.1% and 4.1%, respectively,during the first half of fiscal 2004 compared to the same period in fiscal 2003.  The same hospital comparisons include the effects of the opening of West Valley Hospital in Goodyear, Arizona, during September 2003, as this hospital replaced our freestandingemergency center in that geographic area.  The following table provides details of discharges by payer for the three months and six months ended December 31, 2003 compared to the same periods ended December 31, 2002.

**Three months ended December 31,**

**Six months ended December 31,**

 

 

**2002**

 

**2003**

 

 

 

**2002**

 

 

**2003**

 

Medicare

5,711

11,264

 

11,280

 

21,840

 

Medicaid

3,027

3,895

5,966

8,179

Managed care

12,139

19,933

24,427

39,323

Self pay

315

1,296

644

2,328

Other

412

465

864

892

 

 

 

 

 

 

 

 

    Total

21,604

36,853

 

43,181

72,562

 

 

 

 

 

 

 

 

 

 

                We attribute the same hospital volume improvements to expanded service offerings, new contracts negotiated with certain managed careproviders, increased influenza admissions and our market-driven management strategies.  We expect our volume growth trend to continue.  However, restoring the community’s confidence in hospitals we have acquired from previous owners and staying aheadof our competition in the markets we serve require continuous long-term focus.

                The majority of our revenues are based on negotiated, per diem or pre-determined payment structures that are far less than the amountswe would otherwise charge for our services.  In addition to volume factors described above, patient mix, acuity factors and pricing trends affect our revenues.  Our revenue per adjusted hospital discharge increased 3.2% from $6,129 to $6,323 during thefirst half of fiscal 2004 compared to the same period in fiscal 2003.  This increase reflects improved reimbursement for services provided under negotiated managed care contracts and improved Medicare reimbursements.  Additionally, the ability of ourhospitals 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 discounts also impact this statistic byincreasing revenue deductions and decreasing the provision for doubtful accounts.  There is no guarantee that future reimbursement rates, even if improved, will sufficiently cover potential increases in the cost of providing health care services to ourpatients.

                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 DRG payments.  To achieve this mandate, in recent years CMS has periodically increased the cost threshold used to determineeligibility 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 rules for determiningoutlier 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.  CMS recentlyadopted a final rule that modified the outlier formula in an effort to more accurately distribute outlier payments from the outlier pool to claiming hospitals and to ensure that hospitals cannot inappropriately manipulate outlier payments.  Once the rule wasadjusted, CMS actually decreased the outlier threshold for federal fiscal year 2004 to $31,000 from $33,560 in federal fiscal year 2003.  Other modifications made by CMS include allowing fiscal intermediaries to utilize more recent tentative cost reportinformation to determine outlier payments, requiring the use of hospital-specific cost to charge ratios in most cases and establishing a mechanism of recoupment of previous

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overpayments.  Based on the guidelines set forth in the final rule, we do not believe that our current level of outlier payments will be materially affected.

                We also recognize premium revenues from our Medicaid managed health plan in Phoenix, Arizona, Phoenix Health Plan and from MacNealHealth Providers in Chicago, Illinois, which is a payer for certain physician and outpatient services for certain capitated member lives.  Premium revenues increased by $29.0 million or 26.9% during the first half of fiscal 2004 compared to the same period infiscal 2003.  The primary driver of this revenue increase is the period over period increase in Phoenix Health Plan membership from approximately 74,000 covered lives to approximately 99,000 covered lives.  A portion of this increase relates to a greaternumber of patients qualifying for coverage under the state Medicaid program, Arizona Health Care Cost Containment System or “AHCCCS”, after the passage of Proposition 204.  Also, Phoenix Health Plan’s membership increased due to the withdrawalof one competing plan from the AHCCCS program in October 2003.  Our contract with AHCCCS was recently renewed for the three-year period ending September 30, 2006, with an option for AHCCCS to renew the contract for two additional one-year periodsthereafter.  Should our contract with AHCCCS terminate, our future operating results and cash flows could be materially reduced.

**General Trends**

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

                *Accounts Receivable Collection Risks Leading to Increased Bad Debts*

                Similar to others in the hospital industry, the collectibility of our accounts receivable has deteriorated primarily due to an increasein self-pay accounts receivable.  The increase in self-pay accounts receivable has led to increased write-offs and older accounts receivable outstanding, resulting in the need for an increased allowance for doubtful accounts.  The increase in self-payaccounts receivable results from a combination of factors including general economic weakness, higher levels of patient deductibles and co-insurance and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay forescalating health care costs.  We have implemented policies and procedures designed to expedite upfront cash collections and promote repayment plans from our patients.  However, we believe that increased bad debts will remain a prevalent trend in thehospital industry during the foreseeable future.

                *Effects of the Recently Enacted 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 publicized prescription drug benefit that will provide direct relief to Medicare beneficiaries starting in 2006, the 2003 Act provides a number of direct benefitsto our hospitals including, but not limited to: a provision confirming current law that the update factor for inpatients for federal fiscal year 2004 will be the full market basket of 3.40%; a provision effective October 1, 2004 setting a lower threshold fordetermining when CMS is required to provide additional reimbursement for new technologies that would receive inadequate payment if assigned to a standard DRG; provisions basically providing hospitals with more reimbursement for outpatient drugs; a provisionincreasing 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 2005 and 2006, but decreasing such amount slightly infederal 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; a provision giving hospitals relief during calendar year 2004 making it easier for them to obtainpayments related to their residents in family practice programs; a provision eliminating the requirement  that hospitals must obtain secondary payment information from all Medicare beneficiaries receiving reference laboratory services; and a provision mandatingthat CMS pay the routine costs associated with category A (experimental/investigational) clinical trials beginning January 1, 2005; among others. The 2003 Act also decreases hospital reimbursement in a few areas, including, but not limited to, a provision denyingupdates to hospitals 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 nowconditions such update amounts upon a hospital providing CMS with specific quality data relating to the quality of services provided.

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Those hospitals failing to provide CMS with the required data will receive an update equal to the market basket minus 0.4%. We intend to have our hospitals comply with this reporting requirement.  Onbalance,****however,****we believe that the 2003 Act will 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 2007 for those hospitalscomplying with the new reporting requirement.

                *Expansion of Charity Care*

                We currently record revenue deductions for patient accounts that meet our guidelines for charity care.  Certain other hospitalcompanies have recently proposed policies to provide discounts from gross charges to certain patients without qualifying insurance who would not qualify for charity care under historical charity care policies.  CMS has granted preliminary approval to at leastone of these proposals pending final approval from other federal regulators.  If final approval for these discount policies is granted, we intend to adopt similar policies in addition to our current charity care policies.  Implementation of such policiescould result in decreased revenues with a lesser offsetting impact to the provision for doubtful accounts.

                *State 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.  Two of the states in which we operate, California and Texas, have already reduced, or announced plans to reduce, state Medicaid funding.  We are unable to assess the financial impact of enacted or proposed statefunding cuts at this time.  We remain at risk for additional funding decreases by the other states in which we operate, which could materially reduce our operating results and cash flows.

*                Rising Professional Liability Costs*

                Effective June 1, 2002, we established a wholly owned captive insurance subsidiary to insure our professional and general liabilityrisks for individual claims up to $10.0 million.  We maintain excess insurance coverage with independent third party carriers for aggregate claims up to $100.0 million.  Prior to June 1, 2002, we maintained third-party insurance coverage on a claims-madebasis for individual malpractice claims exceeding $1.0 million and annual aggregate claims exceeding $13.6 million.  The cost of insurance has negatively affected operating results and cash flows throughout the health care industry due to pricing pressures oninsurers and fewer carriers willing to underwrite professional and general liability insurance.  Also, many physicians practicing in our hospitals have encountered difficulty in obtaining malpractice insurance.  In the event these physicians are unable toobtain adequate malpractice insurance coverage, our hospitals are likely to incur a greater percentage of the amounts paid to claimants, which would adversely affect our future operating results and cash flows.  We last renewed our third party coverage with thesame $100.0 million limit for the period June 1, 2003 to May 31, 2004, resulting in excess coverage premiums increases of 15-20%.  The current industry environment appears to indicate an increase in the quantity and severity of malpractice claims.  However,some states, including Texas, have recently passed tort reform legislation or are considering such legislation to place limits on non-economic damages.  Absent significant additional legislation to curb the size of malpractice judgments in the other states, weexpect our recent trend of increased insurance costs to continue for the foreseeable future.

*                Nursing Shortage and Nursing Ratio Requirements*

                The hospital industry continues to face a nationwide shortage of nurses.  We have experienced particular difficulty in retainingand recruiting nurses in our Phoenix, Arizona, and Los Angeles/Orange County, California markets.  Recent reports forecast this shortage to continue for the foreseeable future.  We have begun a comprehensive recruiting and retention plan for nurses thatfocuses on competitive salaries and benefits as well as employee satisfaction, best practices, tuition assistance, effective training programs and workplace environment.  However, should we be unsuccessful in our attempts to maintain nursing coverage adequatefor our present and future needs, our future operating results could be adversely impacted.

                Effective January 1, 2004, minimum nursing 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 nurse staffing strategies.  We estimate that our additional staffing costs from

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this regulation could exceed $2.0 million on an annual basis in California.  If similar regulations were adopted in other states in which we operate, our future operating results and cash flows could be furtherreduced.

                *Potential Impairment Concerns*

                We continue to experience operating results that do not meet our expectations at one of our Phoenix hospitals.  Since thereopening of the hospital’s emergency department in July 2003 and the purchase of a minority interest in the hospital by a large multi-specialty physician group in August 2003, this hospital has not achieved the patient volume growth and cash flow growth thatwe anticipated.  We continue to believe that the hospital’s operating results will improve gradually over the next few months.  However, should the hospital continue to perform below our expectations, we may realize an impairment of long-lived assetsthat could have a material adverse affect on our future operating results.

**Results of Operations**

                The following tables present summaries of our operating results for the three months and six months ended December 31, 2002 and2003.

 

 

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

 

 

 

 

 

 

**2002**

 

 

 

 

 

**2003**

 

 

 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 
****
Patient service revenues

 

$

213.9

 

 

 

80.0

%

 

$

364.0

 

 

 

82.4

%

Premium revenues

 

 

53.4

 

 

 

20.0

%

 

 

78.0

 

 

 

17.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

267.3

 

 

 

100.0 

%

 

442.0

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits

 

 

113.0

 

 

 

42.3

%

 

 

182.8

 

 

 

41.4

%

Supplies

 

 

34.8

 

 

 

13.0

%

 

 

68.5

 

 

 

15.4

%

Medical claims expense

 

 

38.9

 

 

 

14.6

%

 

 

57.0

 

 

 

12.9

%

Provision for doubtful accounts

 

 

13.7

 

 

 

5.1

%

 

 

30.0

 

 

 

6.8

%

Insurance

 

 

6.3

 

 

 

2.4

%

 

 

9.5

 

 

 

2.2

%

Other operating expenses

 

 

38.6

 

 

 

14.4

%

 

 

54.1

 

 

 

12.2

%

Depreciation and amortization

 

 

10.2

 

 

 

3.8

%

 

 

15.9

 

 

 

3.6

%

Interest, net

 

 

7.3

 

 

 

2.7

%

 

 

10.9

 

 

 

2.5

%

Minority interests and other expenses

 

 

0.1

 

 

 

0.0

%

 

 

(2.8

)

 

 

(0.6)

%

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

4.4

 

 

 

1.7

%

 

 

16.1

 

 

 

3.6

%

Provision for income taxes

 

 

1.8

 

 

 

0.7

%

 

 

6.3

 

 

 

1.4

%

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

2.6

 

 

 

1.0

%

 

$

9.8

 

 

 

2.2

%

 

 

 

 

 

 

 

 

 

 

 

 

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**Table of Contents**

 

 

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

 

 

 

 

 

 

**2002**

 

 

 

 

 

**2003**

 

 

 

 

**Amount**

 

**%**

 

 

**Amount**

 

 

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 
****
Patient service revenues

 

$

427.3

 

 

 

79.8

%

 

$

715.0

 

 

 

83.9

%

Premium revenues

 

 

107.9

 

 

 

20.2

%

 

 

136.9

 

 

 

16.1

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

535.2

 

 

 

100.0 

%

 

851.9

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits

 

 

227.0

 

 

 

42.4

%

 

 

359.0

 

 

 

42.1

%

Supplies

 

 

71.4

 

 

 

13.3

%

 

 

133.8

 

 

 

15.7

%

Medical claims expense

 

 

78.4

 

 

 

14.6

%

 

 

100.9

 

 

 

11.9

%

Provision for doubtful accounts

 

 

27.6

 

 

 

5.2

%

 

 

60.3

 

 

 

7.1

%

Insurance

 

 

12.6

 

 

 

2.4

%

 

 

18.8

 

 

 

2.2

%

Other operating expenses

 

 

76.2

 

 

 

14.2

%

 

 

104.7

 

 

 

12.3

%

Depreciation and amortization

 

 

19.1

 

 

 

3.6

%

 

 

31.0

 

 

 

3.6

%

Interest, net

 

 

14.5

 

 

 

2.7

%

 

 

21.3

 

 

 

2.5

%

Minority interests and other expenses

 

 

–

 

 

 

0.0

%

 

 

(4.5

)

 

 

(0.5)

%

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

8.4

 

 

 

1.6

%

 

 

26.6

 

 

 

3.1

%

Provision for income taxes

 

 

3.4

 

 

 

0.7

%

 

 

10.5

 

 

 

1.2

%

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

5.0

 

 

 

0.9

%

 

$

16.1

 

 

 

1.9

%

 

 

 

 

 

 

 

 

 

 

 

 

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**Table of Contents**

**Selected Operating Statistics**

The following table sets forth certain operating statistics for each of the periods presented.  For the same hospital indicators presented below, our newly opened West Valley Hospital is included for the three months andsix months ended December 31, 2003, for same hospital comparison purposes.

 

 

 

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

 

 

 

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

 

**2002**

**2003**

**2002**

**2003**

Number of hospitals at the end of period

 

 

10

 

 

16

 

 

 

10

 

 

16

Licensed beds

 

 

2,129

 

 

3,784

 

 

 

2,129

 

 

3,784

Discharges (a)

 

 

21,604

 

 

36,853

 

 

 

43,181

 

 

72,562

Adjusted discharges - hospitals (b)

 

 

32,461

 

 

53,893

 

 

 

64,828

 

 

106,158

Average length of stay (c)

 

 

3.94

 

 

4.18

 

 

 

3.98

 

 

4.18

Patient days (d)

 

 

85,165

 

 

154,105

 

 

 

171,658

 

 

303,572

Adjusted patient days - hospitals (e)

 

 

127,167

 

 

222,005

 

 

 

256,036

 

 

437,709

Net revenue per adjusted discharge - hospitals (f)

 

$

6,129

 

$

6,305

 

 

$

6,129

 

$

6,323

Outpatient surgeries (g)

 

 

10,079

 

 

14,838

 

 

 

20,039

 

 

29,430

Emergency room visits (h)

 

 

77,053

 

 

133,653

 

 

 

157,184

 

 

255,701

Gross revenue payer mix:

  Medicare

27.5

%

30.8

%

27.6

%

30.4

%

  Medicaid

8.4

%

8.1

%

8.4

%

8.4

%

  Managed Care

57.2

%

54.0

%

56.9

%

54.3

%

  Commercial

2.5

%

2.1

%

2.7

%

2.0

%

  Self pay

4.4

%

5.0

%

4.4

%

4.9

%

100.0

%

100.0

%

100.0

%

100.0 %

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Same hospital indicators:

 

 

 

 

 

 

 

 

 

 

 

 

 

  Number of hospitals

10

11

10

11

  Total revenues (in millions) (i)

$

267.3

$

310.8

$

535.2

$

594.0

  Patient service revenues (in millions) (j)

$

213.9

$

232.8

 

 

$

427.3

$

457.2

  Discharges (k)

 

 

21,604

 

 

22,381

 

 

 

43,181

 

 

43,675

  Adjusted discharges - hospitals (l)

 

 

32,449

 

 

34,575

 

 

 

64,817

 

 

67,482

  Average length of stay (m)

 

 

3.94

 

 

4.03

 

 

 

3.98

 

 

4.05

  Patient days (n)

 

 

85,165

 

 

90,096

 

 

 

171,658

 

 

176,957

  Adjusted patient days - hospitals (o)

 

 

127,167

 

 

137,739

 

 

256,036

 

 

270,314

  Net revenue per adjusted discharge – hospitals (p)

$

6,092

 

$

6,191

 

 

$

6,111

 

$

6,307

  Outpatient surgeries (q)

 

 

10,079

 

 

10,789

 

 

 

20,039

 

 

21,240

  Emergency room visits (r)

 

 

77,053

 

 

92,093

 

 

 

157,184

 

 

176,402

____________________

(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)

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

(d)

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

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**Table of Contents**

(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)

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

(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)

Same hospital total revenues represent revenues from entities owned (including health plans) for the entire three month or six month periods of both years presented, except that West Valley Hospital isincluded for the 2003 periods.

(j)

Same hospital patient service revenues represent patient service revenues (excluding health plan premium revenues) from entities owned for the entire three month or six month periods of both years presented, except that WestValley Hospital is included for the 2003 periods.

(k)

Same hospital discharges represent discharges for hospitals owned for the entire three month or six month periods of both years presented, except that West Valley Hospital is included for the 2003 periods.

(l)

Same hospital adjusted discharges-hospitals is calculated by multiplying discharges by the sum of gross hospital inpatient and outpatient patient revenues and then dividing the result by gross hospital inpatient revenues forall hospitals owned for the entire three month or six month periods of both years presented, except that West Valley Hospital is included for the 2003 periods.

(m)

Same hospital average length of stay represents average length of stay for hospitals owned for the entire three month or six month periods of both years presented, except that West Valley Hospital is included for the 2003periods.

(n)

Same hospital patient days represent patient days for hospitals owned for the entire three month or six month periods of both years presented, except that West Valley Hospital is included for the 2003 periods.

(o)

Same hospital 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 for allhospitals owned for the entire three month or six month periods of both years presented, except that West Valley Hospital is included for the 2003 periods.

(p)

Same hospital net revenue per adjusted discharge-hospitals is calculated by dividing net hospital patient revenues by adjusted discharges-hospitals for those hospitals owned for the entire three month or six month periods ofboth years presented, except that West Valley Hospital is included for the 2003 periods.  This statistic measures the average net payment expected to be received for a patient’s stay in the those hospitals.

(q)

Same hospital outpatient surgeries represent the number of surgeries performed on an outpatient basis (patient overnight stays not necessary) at hospitals or ambulatory surgery centers owned for the entire three month or sixmonth periods for both years presented, except that West Valley Hospital is included for the 2003 periods.

(r)

Same hospital emergency room visits represent the number of patient visits to receive treatment at a hospital or freestanding emergency room owned for the entire three month or six month periods for both years presented,except that West Valley Hospital is included for the 2003 periods, regardless of whether an overnight stay is subsequently required.

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**Table of Contents**

**Quarter ended December 31, 2003 compared to Quarter ended December 31, 2002**

                *Revenues*.  The $174.7 million increase in revenues during the quarter ended December 31, 2003, was attributable to revenuesfrom the BHS acquisition of $131.2 million and same hospital revenue improvement of $43.5 million.  On a same hospital basis, discharges increased by 3.6% during the quarter ended December 31, 2003, while adjusted discharges-hospitals (which includes a factorfor outpatient volume) increased by 6.6%.  Our service expansion initiatives and increased influenza admissions played significant roles in inpatient volume improvements.  We experienced significant increases in emergency room visits during the current yearquarter due to the influenza breakout during December and the growing populations served by our hospitals.  Outpatient volumes were also positively impacted by increased outpatient surgeries, primarily resulting from our physician retention and service expansionstrategies.

                Revenues, exclusive of health plan premium and other non-hospital revenues, per adjusted discharge increased 1.6% on a same hospitalbasis during the quarter ended December 31, 2003, as a result of our successful negotiations of managed care contracts with improved reimbursement rates in certain markets and also improved Medicare reimbursement rates.  However, during negotiations in prioryears with certain of our managed care payers, higher negotiated reimbursement rates resulted in volume declines.  We expect discharges and revenues on a same hospital basis to improve as we continue renegotiation efforts and recover volumes from certain managedcare payers.

                We continue to develop and implement strategies to increase volumes at our hospitals including physician recruitment, expansion ofemergency departments, surgery units and specialty services and resource sharing within geographic markets.  Current capital projects underway, or initiatives expected to begin during the next 12 months, include expansions and upgraded technology for obstetrics,emergency room, psychiatric, rehabilitation, cardiac, radiology and surgery units as well as real estate projects to support hospital buildouts and construction of medical office buildings.  We will continue our physician recruiting and retention initiatives toincrease hospital volumes and provide the services needed in the communities we serve.

                *Salaries and benefits*.  The $69.8 million increase in salaries and benefits is primarily attributable to the BHSacquisition, which accounts for $55.1 million of the increase.  Salaries and benefits as a percentage of revenues decreased to 41.4% during the quarter ended December 31, 2003, from 42.3% during the prior year period.  The decrease resulted from a $24.6million increase in premium revenues, which do not result in a significant increase in related salaries and benefits.  Absent the effect of the increased premium revenues, we experienced rising employee benefits costs and increased nursing wages due to thenursing shortage described below.

                Despite improved labor productivity and care management strategies, we continue to experience increased salaries and benefits relatedto the nursing shortage.  We have experienced particular difficulty in retaining and recruiting nurses in our Phoenix, Arizona and Los Angeles/Orange County, California markets.  Recent reports forecast this shortage to continue for the foreseeable future,especially in California where state mandated increased nurse-staffing ratios began to go into effect on January 1, 2004.  These factors typically require that we hire additional nurses and utilize more costly outsourced nursing personnel.  Ourcomprehensive recruiting and retention plans for nurses that focus on competitive salaries and benefits as well as employee satisfaction, best practices, tuition assistance, effective training programs and workplace environment has mitigated some of the effects ofthe nursing shortage.  However, should we be unsuccessful in our attempts to maintain nursing coverage adequate for our present and future needs, and especially if additional states in which we operate enact new laws regarding nurse-staffing ratios, our futureoperating results could be adversely impacted by increased salaries and benefits.

                *Supplies*.  Acquisitions accounted for $29.3 million of the $33.7 million increase in supplies during the quarter endedDecember 31, 2003.  Supplies expense as a percentage of revenues increased to 15.4% for the quarter ended December 31, 2003, from 13.0% during the prior year period.  This increase is due to the BHS acquisition.  Supplies as a percentage of revenuesare much higher at the BHS hospitals compared to our other hospitals.  On a same hospital basis, after considering the increased health plan premium revenues, supplies as a percentage of revenues were comparable period over period.  We expect this ratio toimprove as we continue to transition supplies contracts at the BHS hospitals to our purchasing group contract rates and fully implement materials management strategies.  These improvements may be offset, however, by continued price increases for pharmaceuticalsand medical supplies, including the impact of increased use of drug eluting stents.

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                *Medical claims*.  The $18.1 million increase in medical claims is due to the significant increase in enrollees at PhoenixHealth Plan.  Medical claims expense as a percentage of premium revenues remained comparable period over period.  Medical claims expense represents the amounts paid by the health plans for health care services provided to their members, including anestimate 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 of approximately $6.9 million, or10.8% of gross health plan medical claims expense, were eliminated in consolidation during the quarter ended December 31, 2003.

                *Insurance*.  The BHS acquisition accounted for $2.2 million of the $3.2 million increase in insurance expense during thequarter ended December 31, 2003.  Insurance expense on a same hospital basis increased slightly during the current year quarter.  The same hospital increase is primarily due to increased premiums for professional and general liability coverage above ourcaptive insurance subsidiary’s retention.  We anticipate continued increases in insurance costs in the near future since the professional and general liability market remains depressed.

                *Other operating expenses*.  Other operating expenses include costs such as rents and leases, professional fees, purchasedservices, marketing, repairs, utilities, licenses and non-income taxes.  The BHS acquisition accounted for $12.9 million of the increase in other operating expenses during the quarter ended December 31, 2003.  On a same hospital basis, other operatingexpenses increased by $2.6 million during the quarter ended December 31, 2003, primarily due to an increase in property taxes.  Other operating expenses as a percentage of revenues decreased to 12.2% from 14.4% quarter over quarter.  We expect these costsas a percentage of revenues to continue to decrease as we increase revenues.

                *Provision for doubtful accounts*.  The BHS acquisition accounted for $11.9 million of the $16.3 million increase in theprovision for doubtful accounts.  During the quarter ended December 31, 2003, the provision for doubtful accounts as a percentage of patient service revenues increased to 8.2% from 6.4% during the prior year period.  During the current year quarter, weexperienced a slight increase in self-pay revenues as a percentage of total revenues.  Due to general economic conditions, collecting outstanding self-pay accounts has become increasingly difficult.  Additionally, our provision for doubtful accounts hasbeen reduced in historical periods by the effects of greater than expected collections of accounts receivable included with hospital acquisitions.  Our provision for doubtful accounts as a percentage of patient service revenues is reduced by our policy ofdeducting charity accounts from revenues at the time in which those accounts meet our charity care guidelines.  For the quarters ended December 31, 2002 and 2003, we recorded $3.3 million and $9.2 million of charity care revenue deductions, respectively. Also, the implementation of Proposition 204 in Arizona, which expanded Medicaid coverage to include many previously uninsured patients, countered the increasing rate of self-pay revenues to total revenues.

                *Depreciation and amortization*.  During the quarter ended December 31, 2003, depreciation and amortization related to theBHS acquisition was $4.9 million, while same hospital depreciation and amortization increased by $0.8 million.  As part of our commitment to expand and improve our capital infrastructure, we spent approximately $98.5 million for capital improvements duringfiscal 2003, and we have spent an additional $70.9 million since June 30, 2003.  These capital purchases resulted in increased depreciation and amortization during the quarter ended December 31, 2003, compared to the prior year period.

                *Interest*.  The $3.6 million increase in net interest expense during the quarter ended December 31, 2003 primarily relatesto $150.0 million of new term loan borrowings and related loan costs under the amended 2001 credit facility and the issuance of $17.6 million of convertible subordinated notes to fund the BHS acquisition in January 2003.

                *Minority interests and other*.  Minority interests and other expenses decreased $2.9 million during the quarter endedDecember 31, 2003, compared to the prior year period.  Minority interests represent the third party portion of earnings of certain of our non-wholly owned affiliates included in our consolidated income statements.  Minority interests decreased by $1.2million during the quarter ended December 31, 2003, as a result of the start-up of the joint venture arrangement at one of our Phoenix hospitals with a large physician group.  This hospital incurred a net loss during the current year quarter.  Equity methodincome increased by $0.9 million during the quarter ended December 31, 2003, while gains on asset sales increased by $0.8 million.

                *Income taxes.*  The provision for income taxes increased from $1.8 million during the quarter ended December 31, 2002 to$6.3 million for the quarter ended December 31, 2003.  The slight decrease in the effective tax rate during the current year quarter is due to the effect of the BHS acquisition.

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                *Net income*.  The $7.2 million increase to net income results from the increased revenues as described above in excess ofincreased expenses.  Net income during the quarter ended December 31, 2003, was adversely affected by increases in depreciation and amortization, net interest and income taxes of $5.7 million, $3.6 million and $4.5 million, respectively.  We view thesecosts as products of our strategic growth initiative.

**Six months ended December 31, 2003 compared to six months ended December 31, 2002**

                *Revenues*.  The $316.7 million increase in revenues during the six months ended December 31, 2003, was attributable torevenues from the BHS acquisition of $257.9 million and same hospital revenue improvement of $58.8 million.  On a same hospital basis, discharges increased by 1.1% during the six months ended December 31, 2003, while adjusted discharges-hospitals (which includesa factor for outpatient volume) increased by 4.1%.  As previously discussed in the “Revenue/Volume Trends” section, our expansion strategies and increased influenza treatments and admissions were the primary drivers of these increases.  Samehospital discharges were unfavorably impacted during the current year period by our termination of a Phoenix hospital’s relationship with a large cardiology practice during the fourth quarter of fiscal 2003 in preparation for the July 2003 reopening of theemergency department and the expansion of other acute services at this Phoenix hospital.  In August 2003, a large multi-specialty physician group in Phoenix purchased a minority interest in this Phoenix hospital.  We expect volumes at this hospital torecover in the future as the start-up of these operations and expansion of service offerings are completed; however, should volumes not improve, we could realize an impairment on these assets.  Same hospital discharges were favorably impacted by the opening ofWest Valley Hospital during September 2003.

                We continue to develop and implement strategies to increase volumes at our hospitals including physician recruitment, expansion ofspecialty services and resource sharing within geographic markets.  Current capital projects underway, or initiatives expected to begin during the next 12 months, include expansions and upgraded technology for obstetrics, emergency room, psychiatric,rehabilitation, cardiac, radiology and surgery units as well as real estate projects to support hospital buildouts and construction of medical office buildings.  We will continue our physician recruiting and retention initiatives to increase hospital volumes andprovide the services needed in the communities we serve.

                *Salaries and benefits*.  The $132.0 million increase in salaries and benefits is primarily attributable to the BHSacquisition, which accounts for $108.7 million of the increase.  Same hospital salaries and benefits as a percentage of patient service revenues increased year over year due to the nursing shortage and increased employee benefits costs previouslydiscussed.  We expect our nursing recruiting and retention program to positively impact our future salaries and benefits costs; however, this improvement may not fully absorb the effects of the nursing shortage as exacerbated by existing and potential furtherminimum nursing ratio regulations.

                *Supplies*.  The BHS acquisition accounted for $57.9 million of the $62.4 million increase in supplies during the currentyear period.  Supplies as a percentage of revenues are much higher at the BHS hospitals compared to our other hospitals.  On a same hospital basis, supplies as a percentage of patient service revenues remained comparable year over year.  We expect thisratio to improve as we continue to transition supplies contracts at the BHS hospitals to our purchasing group contract rates and fully implement materials management strategies.  These improvements may be offset, however, by continued price increases forpharmaceuticals and medical supplies, including the impact of increased use of drug eluting stents.

                *Medical claims*.  The $22.5 million increase in medical claims is due to the significant increase in enrollees at PhoenixHealth Plan, as previously discussed.  Medical claims expense as a percentage of health plan premium revenues increased slightly year over year due to changes in the mix of enrollees and case severity.  Medical claims expense represents the amounts paid bythe health plans for health care 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 $13.4 million, or 11.7% of gross health plan medical claims expense, were eliminated in consolidation during the six months ended December 31, 2003.

                *Insurance*.  The BHS acquisition accounted for $4.4 million of the $6.2 million increase in insurance expense during thecurrent year period.  Insurance expense on a same hospital basis increased slightly during the current year period.  The same hospital increase is primarily due to increased premiums for professional and general liability coverage above our captiveinsurance subsidiary’s retention.  We anticipate continued increases in insurance costs in the near future since the professional and general liability market remains depressed.

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                *Other operating expenses*.  Other operating expenses include costs such as rents and leases, professional fees, purchasedservices, marketing, repairs, utilities, licenses and non-income taxes.  The BHS acquisition accounted for $28.5 million of the increase in other operating expenses during the current year period.  On a same hospital basis, other operating expenses werecomparable year over year.  Other operating expenses as a percentage of revenues decreased to 12.3% from 14.2% year over year.  We expect these costs as a percentage of revenues to continue to decrease as we increase revenues.

                *Provision for doubtful accounts*.  The BHS acquisition accounted for $21.9 million of the $32.7 million increase in theprovision for doubtful accounts.  During the six months ended December 31, 2003, the provision for doubtful accounts as a percentage of patient service revenues increased to 8.4% from 6.5% during the prior year period.  The year over year increase is due tothe collection risks previously discussed.  Our provision for doubtful accounts as a percentage of patient service revenues is positively impacted by our policy of deducting charity accounts from revenues at the time in which those accounts meet our charity careguidelines.  For the six months ended December 31, 2002 and 2003, we recorded $6.7 million and $17.0 million of charity care revenue deductions, respectively.  Also, the implementation of Proposition 204 in Arizona, which expanded Medicaid coverage toinclude many previously uninsured patients, countered the increasing rate of self-pay revenues to total revenues.

                *Depreciation and amortization*.  During the six months ended December 31, 2003, depreciation and amortization related to theBHS acquisition was $9.7 million, while same hospital depreciation and amortization increased by $2.2 million.  The year over year increase relates to our significant capital expenditures during the past 18 months, as previously discussed.

                *Interest*.  The $6.8 million increase in net interest expense during the current year period primarily relates to $150.0million of new term loan borrowings and related loan costs under the amended 2001 credit facility and the issuance of $17.6 million of convertible subordinated notes to fund the BHS acquisition in January 2003.

                *Minority interests and other*.  Minority interests and other expenses decreased $4.5 million during the current yearperiod.  Minority interests represent the third party portion of earnings of certain of our non-wholly owned affiliates included in our consolidated income statements.  Minority interests decreased by $2.3 million during the current year period, as a resultof the start-up of the joint venture arrangement at one of our Phoenix hospitals with a large physician group.  This hospital incurred a net loss during the current year period.  Equity method income increased by $1.6 million during the current year period,while gains on asset sales increased by $0.6 million.

                *Income taxes.*  The provision for income taxes increased from $3.4 million during the six months ended December 31, 2002 to$10.5 million for the six months ended December 31, 2003.  The slight decrease in the effective tax rate year over year relates to the effect of the BHS acquisition.

                *Net income*.  The $11.1 million year over year increase in net income relates to increased revenues, as described above, inexcess of increased expenses.  Net income during the current year period was adversely affected by increases in depreciation and amortization, net interest and income taxes of $11.9 million, $6.8 million and $7.1 million, respectively.  We view these costsas products of our strategic growth initiative.

**Liquidity and Capital Resources**

****

                At December 31, 2003, we had working capital of $54.8 million, including cash and cash equivalents of $16.4 million.  Workingcapital at June 30, 2003 was $37.1 million.  Cash provided by operating activities increased from $44.7 million during the six months ended December 31, 2002 to $50.4 million during the six months ended December 31, 2003.  The $11.1 million increase in netincome and the timing of payments of accounts payable, accrued expenses and other liabilities primarily accounted for the period over period increase in cash from operating activities.

                Cash used in investing activities increased from $29.7 million for the six months ended December 31, 2002 to $76.7 million for the sixmonths ended December 31, 2003.  We increased capital expenditures from $30.0 million for the six months ended December 31, 2002 to $70.9 million for the six months ended December 31, 2003.  The primary reasons for this increase are the capital expendituresrelated to the BHS hospitals and West Valley Hospital and our expansion initiatives at certain of our other hospitals.  We spent approximately $7.8 million related to our construction of West Valley Hospital in metropolitan Phoenix, Arizona during the six monthsended December 31, 2003.  We also spent $9.3 million related to other significant hospital expansion projects during the six months ended December 31, 2003.  The funding of our capital expenditures is in part subject to the timing of capital expenditures atthe BHS hospitals and Arrowhead Community Hospital

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and Phoenix Baptist Hospital required as part of the respective purchase agreements for these facilities.  As of December 31, 2003, the Company has funded or committed to fund approximately $97.5 million of its $250.0million contractual commitment for these hospitals, and the Company expects to fulfill these commitments within the next five years.  The commitments can be satisfied by third party capital expenditures arranged by us.  For example, if we arranged for anunrelated developer to construct a medical office building in the market, such costs would satisfy a portion of our commitment.  We believe our capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our qualityobjectives.

                Cash provided by financing activities increased from $4.5 million for the six months ended December 31, 2002 to $15.5 million for thesix months ended December 31, 2003.  The increase was primarily attributable to our revolving credit borrowings of $19.0 million under the amended 2001 credit facility primarily for the purpose of funding our capital expenditure projects, as describedbelow.

                On January 3, 2003, in connection with our purchase of the health care assets of Baptist Health System in San Antonio, Texas(“BHS”), we expanded our 2001 credit facility by adding a $150.0 million term loan facility to our existing revolving loan facility (“the amended 2001 credit facility”).  We utilized the proceeds of the $150.0 million in term loans tofund a portion of the purchase price paid to BHS.  The revolving loan facility capacity remains at $125.0 million under the amended 2001 credit facility.  Additionally, as part of the BHS purchase price, we issued approximately $17.6 million of ourconvertible subordinated notes, which provide for annual interest payments at 8.18% until maturity on January 3, 2013.  The notes are convertible at any time into our common stock at a $3,500 per share conversion price.  We may not redeem the notes prior toJanuary 1, 2008, and must pay redemption prices of 102% and 101% for redemptions during the two years subsequent to January 1, 2008, respectively, with redemptions thereafter being available at par.  During the six months ended December 31, 2003, we borrowed$19.0 million, net of repayments, of revolving loans under the amended 2001 credit facility.  As of the date of this report, we have $25.0 million in outstanding revolving loans under the amended 2001 credit facility.

                As of December 31, 2003, we had 55,194 shares of two series of Payable-In-Kind Convertible Redeemable Preferred Stock (“PIKPreferred Stock”) outstanding with a liquidation value of $1,000 per share.  We issued 20,000 shares of our first series of PIK Preferred Stock (“Series A”) on February 1, 2000 in connection with the acquisition of MacNeal Hospital.  Wecurrently intend to issue and record paid-in-kind dividends annually at 8% of the liquidation value of the Series A PIK Preferred Stock until January 31, 2007 and to pay cash dividends annually thereafter until the January 31, 2015 redemption date applicable to suchshares.  The Series A PIK Preferred Stock will automatically convert to common stock upon an initial public offering of our common stock with gross proceeds to us of at least $50.0 million at a conversion price equal to the initial public offering price. In connection with our purchase of the health care assets of BHS on January 3, 2003, we issued 30,000 shares of our Series B PIK Preferred Stock with a liquidation value of $1,000 per share.  We currently intend to issue and record paid-in-kind dividendsannually at 6.25% of the liquidation value of the Series B PIK Preferred Stock until the dividend period ended December 31, 2010, and to pay cash dividends annually thereafter until the January 31, 2015 redemption date applicable to such shares.  The Series BPIK Preferred Stock is convertible to our common stock at any time at a $3,500 per share conversion price.

                On January 9, 2003, subsequent to our purchase of the health care assets of BHS and expansion of the 2001 credit facility, Standard andPoor’s 1) lowered our corporate credit rating from “B+” to “B”; 2) lowered the credit rating on the 9.75% Notes from “B-” to “CCC+”; and 3) affirmed the “B+” credit rating on our amended 2001 creditfacility.  Standard and Poor’s stated that it made the downgrades due to its concerns about the size of the BHS acquisition and our ability to generate sufficient returns in relation to our indebtedness.  On December 2, 2002, Moody’s affirmedits existing rating of “Ba3” for the $125.0 million revolving loan facility under the existing 2001 credit facility, affirmed its existing rating of “B3” for the 9.75% Notes and assigned a “Ba3” rating to the $150.0 million termloans under the amended 2001 credit facility.

                Including the remaining construction costs of West Valley Hospital, we anticipate spending up to $94.5 million on facilities expansionand renovation projects and medical technologies upgrades and replacements during the remainder of fiscal 2004, subject to the timing of the facilities expansion projects.  We believe that working capital on hand, future operating cash flows and the availabilityof revolving borrowings under our amended 2001 credit facility are sufficient to meet our operating needs for the foreseeable future and to fund the routine expenditures noted above and preliminary costs associated with the expansion projects.  However, if weinitiate the expansion projects noted above or other significant

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expansion projects deemed important to our long-term strategic plan, we would need to obtain additional debt or equity funding during the next 12 months to complete such projects.

                We also intend to seek acquisitions that fit our corporate growth strategy.  These acquisitions may require debt or equity fundingin addition to working capital on hand, future cash flows from operations and amounts available under our revolving loan facility.  Management continually assesses its capital needs and may seek to adjust its capitalization as considered necessary to achieve itsoperations strategies.

                Certain funds controlled by Morgan Stanley Capital Partners (“MSCP”) have previously entered into a subscription agreementwith us to purchase an additional $273.4 million of our common stock to fund future acquisitions and other cash flow needs.  However, common stock purchases by the MSCP funds are subject to several conditions outside the control of the Company, including theapproval of MSCP’s internal Investment Committee.  No assurance can be given that any or all of such conditions to additional common stock purchases will be met.   

                We are subject to certain restrictive and financial covenants under the amended 2001 credit facility including an interest coverageratio, a total leverage ratio, a senior leverage ratio and capital expenditure restrictions.  The following table sets forth limits and requirements under these financial covenants and our ratio calculations used to determine compliance with the covenants as ofDecember 31, 2003.

 

**Debt covenant**

 

**Actual Ratio**

 

 

Interest coverage ratio requirement

            2.15x

 

           3.57x

 

 

 

 

Leverage ratio limit

            5.25x

 

           2.95x

 

 

 

 

Senior leverage ratio limit

            2.75x

 

           0.70x

As of the date of this report, letters of credit aggregating $20.8 million are outstanding under the amended 2001 credit facility.  These letters of credit utilize borrowing capacity in like amount under our $125.0million revolving loan facility.

                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.

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                The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portionsof long-term debt and capital leases, with payment dates as of December 31, 2003.

 

**Payments due by period**

 

 

 
****
 

 

 

**Less than 1 year**

**1-3 years**

**4-5 years**

**After 5 years**

**Total**

 

 

 
**
 

**Contractual Cash Obligations:**

 

*(In millions)*

 

Long-term debt

 

$

39.2

 

 

$

84.8

 

 

$ 

84.4

 

 

$

578.8

 

$

 

787.2

 

Capital lease obligations

 

4.5

 

 

4.3

 

0.1

 

 

–

 

 

8.9

 

Operating leases

 

 

17.2

 

 

 

23.9

 

14.7

 

 

 

25.7

 

 

 

81.5

 

Purchase obligations

 

 

23.6

 

 

 

–

 

–

 

 

 

–

 

 

 

23.6

 

    Subtotal

 

$

84.5

 

 

$

113.0

 

$

99.2

 

 

$

604.5

 

 

$

901.2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Amount of commitment expiration per period**

 

 

 
****
 

 

 

**Less than 1 year**

**1-3 years**

**4-5 years**

**After 5 years**

**Total**

 

 

 
**
 

**Other Commitments:**

 

*(In  millions)*

 

Construction and improvement commitments

$

30.6

 

 

$

0.1

$

0.5

 

 

$

10.6

 

$

 

41.8

 

Guarantees of surety bonds

 

10.0

 

 

–

 

 

–

 

 

–

 

 

10.0

 

Letters of credit

 

–

 

 

–

 

–

 

 

20.8

 

 

20.8

 

Capital expenditure commitments

 

 

21.8

 

 

 

54.6

 

76.2

 

 

 

–

 

 

 

152.6

 

Physician commitments

 

 

5.3

 

 

 

–

 

–

 

 

 

–

 

 

 

5.3

 

Minimum rent revenue commitments

–

0.1

–

0.2

0.3

    Subtotal

 

$

67.7

 

 

$

54.8

 

$

76.7

 

 

$

31.6

 

 

$

230.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total obligations and commitments

$

152.2

$

167.8

$

175.9

 

 

$

636.1

$

1,132.0

 

 

 

 

 

 

 

 

 

 

 

 

 

                The health care industry is typically not impacted as significantly as most other industries by periods of recession, erosions ofconsumer confidence or other general economic trends as most health care services are not considered a component of discretionary spending.  However, our hospitals and related outpatient service providers may be negatively impacted to the extent such economicconditions result in decreased elective procedures performed, decreased reimbursements to us by federal or state governments or managed care payers or increased collection risk of private pay accounts receivable.  Management is not aware of any economic trendsthat would lead us to believe that we will not be able to remain in compliance with all of our debt covenants and meet all of our required obligations and commitments in the near future.

**Critical Accounting Policies**

                Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in theUnited States.  In preparing our financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements.  We base our estimates onhistorical experience and other information currently available, the results of which form the basis of our estimates and assumptions.  While we believe our estimation processes are reasonable, actual results could differ from those estimates.  Thefollowing represent the estimates that we consider most critical to our operating performance and involve the most subjective and complex assumptions and assessments.

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                *Allowance for Doubtful Accounts*.  Our ability to collect outstanding receivables from third party payers and patients iscritical to our operating performance and cash flows.  As of December 31, 2003, the allowance for doubtful accounts is approximately 19.9% of the accounts receivable balance net of contractual discounts.  The primary collection risk lies with uninsuredpatient accounts or patient accounts for which the primary insurance carrier has paid but a patient portion remains outstanding.  We estimate the allowance for doubtful accounts using a standard policy that considers the age of the accounts since patientdischarge date and the volume of self-pay accounts receivable outstanding.  We continually monitor our accounts receivable balances and use multiple tools to ensure that our allowance for doubtful accounts policy provides a reasonable basis for ourestimate.  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 collections analyses and other key ratios that considerpayer mix and other relevant data.  We believe our standard policy is flexible to adapt to changing collection trends and our procedures for testing our standard policy provide timely and accurate information.  However, many factors including generaleconomic factors, federal and state regulatory factors and patient-specific factors affect the collectibility of accounts receivable, and our estimates could be materially affected by changes in these factors.  We do not pursue collection of amounts related topatients that qualify for charity care under our guidelines.  Charity care accounts are deducted from revenues and do not affect the provision for doubtful accounts.  During the quarters ended December 31, 2002 and 2003, we deducted $3.3 million and $9.2million of charity care from revenues, respectively.  During the six months ended December 31, 2002 and 2003, we deducted $6.7 million and $17.0 million of charity care from revenues, respectively.  Significant changes in payer mix or business officeoperations could have a significant impact on our operating results and cash flows.

                *Contractual Discounts and Settlement Estimates*.  We continue to experience heavy utilization from Medicare and managed carepatients.  For the six months ended December 31, 2003, Medicare and managed care revenues accounted for 85% of total gross patient revenues.  The Medicare regulations and various managed care contracts are often complex and may include multiplereimbursement mechanisms for different types of services provided in our health care facilities and cost report settlement provisions requiring complex calculations and assumptions that are subject to interpretation.  For the majority of our revenues,contractual adjustments are automatically recorded at the time of billing by the accounts receivable systems based upon the terms of the specific payer contract.  Certain of our Medicare business requires that we submit annual cost reports and record estimatesof amounts owed to or receivable from Medicare.  These cost reports include complex calculations and estimates as the services authorized and provided and related reimbursement are often subject to interpretation that could result in payments that differ fromour estimates.  Additionally, updated regulations and contract renegotiations occur frequently necessitating continual review and assessment of the estimation process by management.

                *Insurance Reserves*.  Given the nature of our operating environment, we are subject to medical malpractice or workerscompensation claims or lawsuits in the ordinary course of business.  Through May 31, 2002, we maintained third-party insurance coverage for individual malpractice claims exceeding $1.0 million and workers compensation claims exceeding $250,000 to mitigate aportion of this risk.  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 purchase from third party insurers excess coverage for claimsexceeding $10.0 million per occurrence up to $100.0 million in the aggregate.  We estimate our reserve for self-insured professional and general liability and workers compensation risks using historical claims data, demographic factors, severity factors, currentincident logs and other actuarial data.  As of December 31, 2003, our professional and general liability accrual for asserted and unasserted claims was approximately $35.1 million and is included within accrued expenses and other current liabilities and otherliabilities on the accompanying condensed consolidated balance sheets.  For the six months ended December 31, 2003, our total premiums and self-insured retention cost for professional and general liability insurance was approximately $17.8 million, and we paidapproximately $1.4 million in professional liability claims and expenses.  The estimated accrual for malpractice and workers compensation claims could be significantly affected should current and future occurrences differ from historical claims trends.  Theestimation process is also complicated by the relatively short period of time in which we have owned our health care facilities as occurrence data under previous ownership may not necessarily reflect occurrence data under our ownership.  While managementmonitors current claims closely and considers outcomes when estimating its reserve, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in the estimates.

                *Medical Claims Reserves*.  Medical claims expense as a percentage of revenues decreased to 11.9% for the six months endedDecember 31, 2003, compared to 14.6% for the prior year period, given the increase in acute services revenues as a result of the BHS acquisition.  As a result of the increased patient enrollment of our health plans, the medical claims reserve has continuallyincreased.  We estimate the medical claims reserve using historical claims experience (including severity and payment lag time) and other actuarial data including number of enrollees, age of enrollees and certain enrollee

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health indicators to predict the cost of health care services provided to enrollees during any given period.  While management believes that its estimation methodology effectively captures trends in medical claims costs,actual payments could differ significantly from our estimates given changes in the health care cost structure or adverse experience.  For the six months ended December 31, 2003, approximately $13.4 million of health plan payments made to hospitals and otherhealth care entities owned by us for services provided to our enrollees were eliminated in consolidation.  Our operating results and cash flows could be materially affected by increased or decreased utilization of our owned health care facilities by enrollees ofour health plans.

**Contingencies and Health Care Regulation**

                *Effects of Inflation and Changing Prices*.  The health care industry is labor intensive.  Wages and other expensesincrease during periods of inflation and when labor shortages occur in the marketplace.  Various federal, state and local laws have been enacted that, in certain cases, limit our ability to increase prices.  Revenues for acute care hospital servicesrendered to Medicare patients are established under the federal government’s prospective payment system.  We believe that hospital industry operating margins have been, and may continue to be, under significant pressure because of deterioration ininpatient volumes, changes in payer mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare program.

                *Health Care Reform*.  In recent years, an increasing number of legislative proposals have been introduced or proposedto Congress and in some state legislatures that would significantly affect the services provided by and reimbursement to health care providers in our markets.  The cost of certain proposals would be funded in significant part by reductions in payments bygovernment programs, including Medicare and Medicaid, to health care providers or by taxes levied on hospitals or other providers.  We are unable to predict which, if any, proposals for health care reform will be adopted and we can not assure you that proposalsadverse to our business will not be adopted.

                *Federal and State Regulation and Investigations*.  The health care industry is subject to extensive federal, state andlocal laws and regulations relating to licensing, conduct of operations, ownership of facilities, addition of facilities and services, confidentiality and security issues associated with medical records, billing for services and prices for services.  These lawsand regulations are extremely complex.  In many instances, the industry does not have the benefit of significant regulatory or judicial interpretation of these laws and regulations.  As a result of these laws and regulations, some of our activities couldbecome the subject of governmental investigations or inquiries.  Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of hospital companies.  In theevent of a determination that we are in violation of any of these laws, rules or regulations, or if further changes in the regulatory framework occur, our results of operations could be significantly harmed.

                *Acquisitions*.  We have acquired and plan to continue acquiring businesses with prior operating histories. Acquired companies may have unknown or contingent liabilities, including liabilities for failure to comply with health care laws and regulations, such as billing and reimbursement, fraud and abuse and similar anti-referral laws.  Although we attempt to structureour acquisitions as asset acquisitions in which we do not assume liability for seller wrongful actions and institute policies and procedures designed to conform practices to our standards following completion of acquisitions, we may become liable for such pastactions of acquired entities deemed improper by private plaintiffs or government agencies.  We generally obtain indemnification from prospective sellers covering such matters; however, such indemnification may not cover such actions or may not be adequate tocover potential losses and fines.

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

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                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.  During February 2002, we entered into an interest rate swap agreement on a notional amount of $100.0million of our 9.75% Notes.  The swap agreement effectively converted the 9.75% fixed rate of the notional amount to a variable rate, calculated as the 6-month LIBOR rate in effect on each semi-annual settlement date plus a fixed margin of 3.63%.  EffectiveAugust 13, 2002, we terminated the interest rate swap agreement resulting in a net cash payment to us from the counter-party of $5.5 million.  Upon the termination of the interest rate swap agreement, all $300.0 million of such notes bore interest at the 9.75%fixed rate.  The fair value of the 9.75% Notes was approximately $329.3 million as of December 31, 2003, based upon quoted market prices.

                In order to fund a portion of the purchase price of the BHS acquisition, we entered into the amended 2001 credit facility with a new$150.0 million term loan facility.  The $150.0 million in term loans borrowed under the amended 2001 credit facility bear interest at a variable interest rate based upon the LIBOR rate in effect on certain interest reset dates plus an applicable fixedmargin.  To mitigate a portion of the interest rate risk for our variable rate debt, in January 2003 we entered into an agreement with Bank of America, N.A. to swap the variable LIBOR rate for a notional amount of $147.0 million of our $150.0 million of termloans under the amended 2001 credit facility for a fixed LIBOR rate of 1.77% for the one-year period commencing on July 3, 2003 and ending on July 3, 2004.  During December 2003, we borrowed $19.0 million in revolving loans under the amended 2001 credit facilitybearing interest at an initial rate or 5.75% equal to the prime rate of 4.0% plus a margin of 1.75% based on our most recent leverage ratio.  As of the date of this report, we have $25.0 million of outstanding revolving loans.

                Based upon a hypothetical 1% increase to the current interest rate applicable to the outstanding term loans under our credit facilitydebt, annualized interest expense for the term loan borrowings would increase by $1.5 million beginning after the termination of our interest rate swap on July 3, 2004.  A hypothetical 1% change in interest rates would not have a material impact on the fairvalue of our fixed rate convertible subordinated notes.  As of the date of this report, we also have $20.8 million in letters of credit outstanding under the amended 2001 credit facility.

**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 was no change in our internal control over financial reporting during our fiscal quarter ended December 31, 2003, that hasmaterially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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**PART IIOTHER INFORMATION**

**Item 1.    Legal Proceedings.**

                In November 2003 we settled on favorable terms the proceeding in the U.S.  Patent and Trademark Office described in “Item 3.Legal Proceedings” in our Form 10-K for the fiscal year ended June 30, 2003.  In that proceeding (Opposition No. 155,388) we objected to the registration of the mark “VANGUARD HEALTHCARE” by Vanguard Healthcare Management Services, LLC(“VHMS”), a company not affiliated with us.  In accordance with the settlement, we have amended our service mark application for the mark “VANGUARD” so that it relates solely to hospital and health care services, excluding nursing home,rehabilitation hospitals and assisted living center services, and VHMS has consented to this amendment. Additionally, we have consented to the amendment of VHMS’s service mark application for the mark “VANGUARD HEALTHCARE” so that it relates solelyto the ownership, operation and/or management of nursing homes, rehabilitation hospitals and assisted living centers. The opposition proceeding has been formally dismissed with prejudice and both we and VHMS have otherwise agreed that the other party may use its ownservice mark for its respective amended services described above.  We do not expect the formal entry by the Patent and Trademark Office of our amendment to our service mark application until the second half of calendar 2004.   Thereafter, the VANGUARDmark which we seek will be published in the U.S. Patent and Trademark Office Official Gazette for potential opposition to registration by third parties.

**Item 2.    Changes in Securities and Use of Proceeds.**

                During the quarterly period ended December 31, 2003, we issued the following securities that were not registered under the SecuritiesAct of 1933. Each of the transactions 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 public offering. Each of these sales was made without the use of anunderwriter, and the certificates and other documentation evidencing the securities issued in connection with these transactions bear a restrictive legend permitting transfer of the securities only upon registration under the Securities Act or pursuant to anexemption from registration. Each share of common stock issued was issued for cash consideration at a purchase price of $1,701.18 per share.

                On October 2, 2003, we issued to Rosemary Perkins, a former employee, 2 shares of our common stock, for an aggregate purchase price of$3,402.36, upon her exercise of stock options previously issued to her under our 2000 Stock Option Plan.

                On October 6, 2003, we issued to Luke McGuinness, a former member of management, 75 shares of our common stock, for an aggregatepurchase price of $127,588.50, upon his exercise of stock options previously issued to him under our 1998 Stock Option Plan.

                On November 13, 2003, we issued to Teresa Tardy, a former employee, 10 shares of our common stock, for an aggregate purchase price of$17,011.80, upon her exercise of stock options previously issued to her under our 1998 and 2000 Stock Option Plans.

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

                The following persons were elected to our board of directors by the holders of 100% of our outstanding common stock by action takenpursuant to the written consent dated November 6, 2003 of such holders in lieu of an annual stockholders’ meeting:

Karen H. BechtelEric T. FryHoward I. HoffenW. Lawrence HoughCharles N. Martin, Jr.Joseph D. MooreKeith B. PittsRonald P. Soltman

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**Item 6.    Exhibits And Reports On Form 8-K.**

                (a)           Exhibits

                               3.1           Certificate of Incorporation. (Incorporated by reference from Exhibit 3 to Vanguard’s Current                                               Report on Form 8-K dated January 14, 2003.)

                               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, dated as of July 30, 2001 between Vanguard Health Systems, Inc., other Guarantors and                                               the Trustee.  (Incorporated by reference from Exhibit 4.1 to the Company’s Registration Statement                                               on Form S-1 having Registration No. 333-71934.)

                               4.2           First Supplemental Indenture, dated as of September 21, 2001 between Vanguard Health Systems,                                               Inc., other Guarantors and the Trustee.  (Incorporated by reference from Exhibit 4.2 to the                                               Company’s Registration Statement on Form S-1 having Registration No. 333-71934.)

                               4.3           Second Supplemental Indenture, dated as of October 2, 2001 between Vanguard Health Systems,                                               Inc., other Guarantors and the Trustee.  (Incorporated by reference from Exhibit 4.3 to the                                               Company’s Registration Statement on Form S-1 having Registration No. 333-71934.)

                               4.4           Amended and Restated Subscription Agreement dated June 1, 2000 between Vanguard Health                                               Systems, Inc., funds controlled by Morgan Stanley Capital Partners and certain investors.                                               (Incorporated by reference from Exhibit 4.4 to the Company’s Registration Statement on                                               Form S-1 having Registration No. 333-71934.)

                               4.5           Voting Proxy Agreement dated as of June 1, 1998, among certain holders and Vanguard Health                                               Systems, Inc. (Incorporated by reference from Exhibit 4.5 to the Company’s Registration                                               Statement on Form S-1 having Registration No. 333-71934.)

                               4.6           Amended and Restated Shareholders Agreement, dated as of June 1, 2000 among Vanguard                                               Health Systems, Inc., funds controlled by Morgan Stanley Capital Partners and certain holders.                                               (Incorporated by reference from Exhibit 4.6 to the Company’s Registration Statement on                                               Form S-1 having Registration No. 333-71934.)

                               4.7           Surviving Shareholders Agreement dated as of June 1, 1998 among Vanguard Health Systems,                                               Inc., funds controlled by Morgan Stanley Capital Partners and certain holders.  (Incorporated by                                               reference from Exhibit 4.7 to the Company’s Registration Statement on Form S-1 having                                               Registration No. 333-71934.)

                               4.8           Letter Agreement dated as of June 1, 1998 among Vanguard Health Systems, Inc., funds                                               controlled by Morgan Stanley Capital Partners and certain investors.  (Incorporated by reference                                               from Exhibit 3.2 to the Company’s Registration Statement on Form S-1 having Registration No.                                               333-71934.)

                               4.9           8.18% Convertible Subordinated Notes due 2013 of Vanguard Health Systems, Inc. dated January                                               1, 2003.  (Incorporated by reference from Exhibit 4 to the Company’s Current Report on                                               Form 8-K dated January 14, 2003.)

                               4.10         Third Supplemental Indenture, dated as of October 31, 2002, among Vanguard, other                                               Guarantors and the Trustee.  (Incorporated by reference from Exhibit 4.2 to the Company’s                                               Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2002.)

                               10.1         Contract Amendment Number 06, executed on November 10, 2003, but effective as of                                               October 1, 2003, to the Arizona Health Care Cost Containment System Administration

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                                               Contract No. YH04-0001-06 between VHS Phoenix Health Plan and the Arizona Health                                               Care Cost Containment System.

                               10.2         Amendment No. 2 to Employment Agreement between Vanguard Health Systems, Inc.                                               and Charles N. Martin, Jr., dated as of January 1, 2004.

                               10.3         Amendment No. 2 to Employment Agreement between Vanguard Health Systems, Inc.                                               and W. Lawrence Hough, dated as of January 1, 2004.

                               10.4         Amendment No. 2 to Employment Agreement between Vanguard Health Systems, Inc.                                               and Joseph D. Moore, dated as of January 1, 2004.

                               10.5         Amendment No. 2 to Employment Agreement between Vanguard Health Systems, Inc.                                               and Ronald P. Soltman, dated as of January 1, 2004.

                               10.6         Amendment No. 2 to Employment Agreement between Vanguard Health Systems, Inc.                                               and Keith B. Pitts, dated as of January 1, 2004.

                               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.

                (b)           Reports on Form 8-K

                                During the quarter ended December 31,2003, the Company filed one report on Form 8-K.  On                                November 10, 2003, the Company filed a Current Report on Form 8-K reporting,pursuant to                                Items 9 and 12, that the Company had issued a press release announcing its firstquarter                                operating results and gave certain information about its use of a non-GAAPfinancial measure,                                Adjusted EBITDA, in such earnings release and for other purposes; and theCompany also                                furnished as exhibits to such Current Report a copy of such press release aswell as some                                supplementary financial disclosures relating to Regulation G.

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**SIGNATURE**

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

DATE:     February 10,2004                                                                               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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**INDEX TO EXHIBITS**

**Exhibit No.**        **Description**

3.1                           Certificate of Incorporation. (Incorporated by reference fromExhibit 3 to Vanguard’s Current                                Report on Form 8-K dated January 14, 2003.)

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

4.1                           Indenture, dated as of July 30, 2001 between Vanguard HealthSystems, Inc., other Guarantors and                                the Trustee.  (Incorporated by reference from Exhibit 4.1 to theCompany’s Registration Statement                                on Form S-1 having Registration No. 333-71934.)

4.2                           First Supplemental Indenture, dated as of September 21, 2001between Vanguard Health Systems,                                Inc., other Guarantors and the Trustee.  (Incorporated by reference fromExhibit 4.2 to the                                Company’s Registration Statement on Form S-1 having Registration No.333-71934.)

4.3                           Second Supplemental Indenture, dated as of October 2, 2001 betweenVanguard Health Systems,                                Inc., other Guarantors and the Trustee.  (Incorporated by reference fromExhibit 4.3 to the                                Company’s Registration Statement on Form S-1 having Registration No.333-71934.)

4.4                           Amended and Restated Subscription Agreement dated June 1, 2000between Vanguard Health                                Systems, Inc., funds controlled by Morgan Stanley Capital Partners and certaininvestors.                                (Incorporated by reference from Exhibit 4.4 to the Company’s RegistrationStatement on                                Form S-1 having Registration No. 333-71934.)

4.5                           Voting Proxy Agreement dated as of June 1, 1998, among certainholders and Vanguard Health                                Systems, Inc. (Incorporated by reference from Exhibit 4.5 to the Company’sRegistration                                Statement on Form S-1 having Registration No. 333-71934.)

4.6                           Amended and Restated Shareholders Agreement, dated as of June 1,2000 among Vanguard                                Health Systems, Inc., funds controlled by Morgan Stanley Capital Partners andcertain holders.                                (Incorporated by reference from Exhibit 4.6 to the Company’s RegistrationStatement on                                Form S-1 having Registration No. 333-71934.)

4.7                           Surviving Shareholders Agreement dated as of June 1, 1998 amongVanguard Health Systems,                                Inc., funds controlled by Morgan Stanley Capital Partners and certainholders.  (Incorporated by                                reference from Exhibit 4.7 to the Company’s Registration Statement on FormS-1 having                                Registration No. 333-71934.)

4.8                           Letter Agreement dated as of June 1, 1998 among Vanguard HealthSystems, Inc., funds                                controlled by Morgan Stanley Capital Partners and certain investors. (Incorporated by reference                                from Exhibit 3.2 to the Company’s Registration Statement on Form S-1 havingRegistration No.                                333-71934.)

4.9                           8.18% Convertible Subordinated Notes due 2013 of Vanguard HealthSystems, Inc. dated January                                1, 2003.  (Incorporated by reference from Exhibit 4 to the Company’sCurrent Report on                                Form 8-K dated January 14, 2003.)

4.10                         Third Supplemental Indenture, dated as of October 31, 2002, among Vanguard,other                                Guarantors and the Trustee.  (Incorporated by reference from Exhibit 4.2 tothe Company’s                                Quarterly Report on Form 10-Q for the quarterly period ended December 31,2002.)

10.1                         Contract Amendment Number 06, executed on November 10, 2003, but effective asof                                October 1, 2003, to the Arizona Health Care Cost Containment SystemAdministration

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                                Contract No. YH04-0001-06 between VHSPhoenix Health Plan and the Arizona Health                                Care Cost Containment System.

10.2                         Amendment No. 2 to Employment Agreement between Vanguard Health Systems,Inc.                                and Charles N. Martin, Jr., dated as of January 1, 2004.

10.3                         Amendment No. 2 to Employment Agreement between Vanguard Health Systems,Inc.                                and W. Lawrence Hough, dated as of January 1, 2004.

10.4                         Amendment No. 2 to Employment Agreement between Vanguard Health Systems,Inc.                                and Joseph D. Moore, dated as of January 1, 2004.

10.5                         Amendment No. 2 to Employment Agreement between Vanguard Health Systems,Inc.                                and Ronald P. Soltman, dated as of January 1, 2004.

10.6                         Amendment No. 2 to Employment Agreement between Vanguard Health Systems,Inc.                                and Keith B. Pitts, dated as of January 1, 2004.

31.1                         Certification of CEO pursuant to Rule 13a-14(a)/15d-14(a), as adoptedpursuant 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 adoptedpursuant 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 pursuantto Section                                906 of the Sarbanes-Oxley Act of 2002.

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

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