**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 September 30, 2007**           |
|           |       |                                                            |
|           |       | **OR**                                                          |
| ** **     | ** ** | ** **                                                      |
| o              | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF**        |
|           | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                         |
|           |       |                                                            |
|           | ** ** | **For the transition period from ____________ to ____________** |

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

**Delaware**

**62-1698183**

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

* *

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

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

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

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

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

          There were 749,550 shares of common stock outstanding as of November 1, 2007 (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, 2007 and September 30, 2007 (unaudited)

 

3

Unaudited Condensed Consolidated Statements of Operations for the three months ended September 30, 2006 and 2007

 

4

Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended September 30, 2006 and 2007

 

5

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

6

 Item 2.

 

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

22

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

40

Item 4.

 

Controls and Procedures

40

**PART II. **

 

**OTHER INFORMATION**

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

41

Item 6.

 

Exhibits

 

41

 

 

Signature

 

42

 

Index to Exhibits

43

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Table of Contents

**PART IFINANCIAL INFORMATION**

**Item 1.    Financial Statements.**

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

 

 

**June 30, 2007**

 

 

 

**(Unaudited) September 30, 2007**

 

 

 

 

 

 

**ASSETS**

 

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

 

 

Current assets:

 

 

 

 

 

 

 

 

   Cash and cash equivalents

$

120.1

$

158.3

   Restricted cash

6.2

2.5

   Accounts receivable, net of allowance for doubtful accounts of       approximately $113.2 and $117.7 at June 30, 2007 and       September 30, 2007, respectively

287.3

288.3

 

   Inventories

46.8

47.2

 

   Prepaid expenses and other current assets

57.7

63.7

 

 

 

        Total current assets

518.1

560.0

 

Property, plant and equipment, net of accumulated depreciation

1,186.6

1,163.3

 

Goodwill

689.2

689.2

 

Intangible assets, net of accumulated amortization

68.0

68.7

 

Investments in and advances to affiliates

7.3

7.3

Other assets

62.2

61.5

 

 

 

        Total assets

$

2,531.4

$

2,550.0

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

Current liabilities:

 

   Accounts payable

$

144.1

$

147.9

 

   Accrued salaries and benefits

75.0

72.1

   Accrued health claims

61.4

60.5

 

   Accrued interest

13.4

26.5

 

   Other accrued expenses and current liabilities

59.8

63.0

 

   Current maturities of long-term debt

8.0

8.0

 

 

 

        Total current liabilities

361.7

378.0

 

Minority interests in equity of consolidated entities

9.3

9.3

 

Other liabilities

82.3

88.7

 

Long-term debt, less current maturities

1,520.7

1,520.4

 

Commitments and contingencies

Stockholders’ Equity:

Common Stock; $.01 par value, 1,000,000 shares authorized, 749,550 shares     issued and outstanding at June 30, 2007 and September 30, 2007

–

–

Additional paid-in capital

644.6

645.1

Retained deficit

(87.2

)

(91.5

)

 

        Total stockholders’ equity

557.4

553.6

 

 

        Total liabilities and stockholders’ equity

$

2,531.4

$

2,550.0

 

 

 

See accompanying notes.

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Table of Contents

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

**Three months ended September 30, 2006**

**Three months ended September 30, 2007**

 

 

 

 

 

 

 

*(In millions)*

Patient service revenues

$

521.3

 

 

 

$

556.8

 

Premium revenues

 

97.0

 

 

 

 

105.7

 

 

 

 

 

 

 

 

     Total revenues

 

618.3

 

 

 

 

662.5

 

 

 

 

 

 

 

 

 

 

Costs and Expenses:

 

 

 

 

 

 

 

 

   Salaries and benefits (includes stock compensation of       $0.3 and $0.5, respectively)

 

259.6

 

 

 

 

273.7

 

   Supplies

 

100.2

 

 

 

 

103.2

 

   Medical claims expense

 

71.7

 

 

 

 

76.0

 

   Purchased services

 

33.6

 

 

 

 

34.8

 

   Provision for doubtful accounts

 

40.5

 

 

 

 

53.9

 

   Other operating expenses

 

50.1

 

 

 

 

54.5

 

   Rents and leases

 

8.9

 

 

 

 

10.1

 

   Depreciation and amortization

 

28.9

 

 

 

 

32.5

 

   Interest, net

 

29.8

 

 

 

 

31.7

 

   Other

 

(0.8

)

 

 

 

2.0

 

 

 

 

 

 

 

Loss from continuing operations before income taxes

 

(4.2

)

 

 

 

(9.9

)

Income tax benefit

 

1.5

 

 

 

3.4

 

 

 

 

 

 

 

Loss from continuing operations

 

(2.7

)

 

 

(6.5

)

Loss from discontinued operations, net of taxes

 

(5.0

)

 

 

(0.4

)

 

 

 

 

 

 

 

Net loss

$

(7.7

)

 

 

$

(6.9

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

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Table of Contents

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

 

 

 

**Three months ended September 30, 2006**

** **

** **

 

**Three months ended September 30, 2007**

 

 

 

 

 

 

 

 

 

 

 

*(In millions)*

**Operating activities:**

 

 

 

 

 

 

 

 

Net loss

 

$

(7.7

) 

 

$

(6.9

)

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

 

 

 

 

 

 

 

 

   Loss from discontinued operations, net of taxes

5.0

0.4

   Depreciation and amortization

 

 

28.9

 

 

 

32.5

 

   Provision for doubtful accounts

 

 

40.5

 

 

 

53.9

 

   Deferred income taxes

 

(1.6

)

 

(4.2

)

   Amortization of loan costs

 

 

1.1

 

 

 

1.2

 

   Accretion of principal on senior discount notes

 

4.1

 

 

4.6

 

   Loss (gain) on sale of assets

 

 

(2.6

) 

 

 

0.1

   Stock compensation

 

 

0.3

 

 

 

0.5

 

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

 

 

 

 

 

 

 

 

      Accounts receivable

 

 

(65.4

)

 

 

(57.3

)

      Inventories

 

 

(1.2

)

 

 

(0.4

)

      Prepaid expenses and other current assets

 

 

(7.5

)

 

 

(1.9

)

      Accounts payable

 

 

(1.9

)

 

 

5.3

      Accrued expenses and other current liabilities

 

 

2.7

 

 

23.2

      Other liabilities

 

 

5.1

 

 

 

5.3

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities – continuing operations

 

 

(0.2

)

 

 

56.3

Net cash provided by operating activities – discontinued operations

0.6

0.8

 

 

 

 

 

Net cash provided by operating activities

0.4

57.1

 

 

 

 

 

 

 

 

 

**Investing activities:**

 

 

 

 

 

 

 

 

Capital expenditures

 

 

(36.9

)

 

 

(21.4

)

Purchases of short-term investments

 

 

(30.0

)

 

 

(30.0

)

Sales of short-term investments

30.0

 

30.0

 

Proceeds from asset dispositions

 

 

6.5

 

 

 

0.1

 

Other

 

 

2.1

 

 

1.3

 

 

 

 

 

 

 

Net cash used in investing activities – continuing operations

 

 

(28.3

)

 

 

(20.0

)

Net cash provided by (used in) investing activities – discontinued operations

(0.8

)

3.1

 

 

 

 

 

Net cash used in investing activities

(29.1

)

(16.9

)

 

 

 

 

 

 

 

 

 

**Financing activities:**

 

 

 

 

 

 

 

 

Payments of long-term debt and capital leases

 

 

(2.1

)

 

 

(2.0

)

Proceeds from stock option exercises

–

0.2

Payments to retire stock and stock options

–

(0.2

)

 

 

 

 

 

 

 

Net cash used in financing activities

 

 

(2.1

) 

 

 

(2.0

)

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

 

(30.8

)

 

 

38.2

Cash and cash equivalents, beginning of period

 

 

123.6

 

 

120.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

92.8

 

 

$

158.3

 

 

 

 

 

 

 

 

Net cash paid for interest

 

$

14.6

 

$

13.2

 

 

 

 

 

 

 

Net cash paid for income taxes

 

$

0.4

 

$

0.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2007(Unaudited)**

**1.             BUSINESS AND BASIS OF PRESENTATION**

**Business**

                Vanguard Health Systems, Inc. (“Vanguard”) is an investor-owned healthcare company whose affiliates own and operatehospitals and related healthcare businesses in urban and suburban areas.  As of September 30, 2007, Vanguard’s affiliates owned and managed 15 acute care hospitals with 4,143 licensed beds and related outpatient service locations complementary to thehospitals providing healthcare services in San Antonio, Texas; metropolitan Phoenix, Arizona; metropolitan Chicago, Illinois; and Massachusetts. Vanguard also owns managed health plans in Chicago, Illinois and Phoenix, Arizona and two surgery centers in OrangeCounty, California.

**Basis of Presentation**

                The accompanying unaudited condensed consolidated financial statements include the accounts of subsidiaries and affiliates controlledby Vanguard. Vanguard generally considers control to represent the majority of an entity’s voting interests. Vanguard also consolidates any entities for which it receives the majority of the entity’s expected returns or is at risk for the majority of theentity’s expected losses based upon its investment or financial interest in the entity. All material intercompany accounts and transactions have been eliminated. As none of Vanguard’s common shares are publicly held, no earnings per share information ispresented in the accompanying unaudited condensed consolidated financial statements. The majority of Vanguard’s expenses are “cost of revenue” items. Costs that could be classified as general and administrative include certain Vanguard corporateoffice costs, which approximated $7.5 million and $9.4 million for the three months ended September 30, 2006 and 2007, respectively.

                The unaudited condensed consolidated financial statements as of September 30, 2007 and for the three months ended September 30, 2006and 2007 have been prepared in conformity with accounting principles generally accepted in the United States for interim reporting and in accordance with Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and notes required byaccounting 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 normal recurring adjustments)necessary for a fair presentation of the financial position and the results of operations for the periods presented.  The results of operations for the periods presented are not necessarily indicative of the expected results for the fiscal year ending June 30,2008.  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, 2007 included in Vanguard’s Annual Report on Form 10-K(“10-K”) filed with the Securities and Exchange Commission on September 19, 2007. The balance sheet at June 30, 2007 has been derived from the audited consolidated financial statements included in Vanguard’s June 30, 2007 10-K.

                *Use of Estimates*

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

**Reclassifications**

                Vanguard adjusted its previously reported condensed consolidated statement of operations and condensed consolidated statement of cashflows for the three months ended September 30, 2006, to reflect the impact of the classification of the acute care operations of Phoenix Memorial Hospital (“PMH”) as discontinued operations.  See Note 2 for further discussion of discontinuedoperations. Certain other prior year amounts have been reclassified to conform to current year presentation.

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Table of Contents

**2.             DISCONTINUED OPERATIONS**

                On October 1, 2006, certain of Vanguard’s subsidiaries completed the sale of their three hospitals in Orange County, California(West Anaheim Medical Center, Huntington Beach Hospital and La Palma Intercommunity Hospital) to subsidiaries of Prime Healthcare, Inc. for net proceeds of $40.0 million, comprised of cash proceeds of $37.0 million and $3.0 million of proceeds placed in escrow thatwas distributed to a subsidiary of Vanguard on July 2, 2007. The operations of the California hospitals are included in discontinued operations, net of taxes in the accompanying statements of operations for both periods presented as set forth by SFAS 144,*Accounting for the Impairment or Disposal of Long-Lived Assets* (“SFAS 144”) and EITF 03-13, *Applying the Conditions of Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations* (“EITF03-13”).

                In June 2007, Vanguard ceased providing acute care services at PMH and began leasing certain floors of the building to various thirdparty healthcare providers. The leases are 5-year and 7-year leases with renewal options. When comparing the projected lease income to the historical total revenues of PMH, Vanguard determined that the expected cash inflows under the leases were insignificant anddeemed to be indirect cash flows. Thus, the acute care operations of PMH are included in discontinued operations, net of taxes in the accompanying statements of operations for both periods presented as set forth by SFAS 144 and EITF 03-13.

                Vanguard’s California medical office buildings, sold in March 2006, are also included in discontinued operations, net of taxes inthe accompanying statements of operations for both periods presented. The post-transaction direct cash flows that previously precluded these operations from being included in discontinued operations under EITF 03-13 were eliminated upon the sale of the Californiahospitals.

                The following table sets forth the components of loss from discontinued operations, net of taxes for the quarters ended September 30,2006 and 2007 (in millions).

**Quarter ended September 30,**
****
 

 

**2006**

 

    

** **

**2007**

 

 

 
****
 

 

** **
****
 

Total revenues

$

61.0

 

 

$

1.4

 

Operating expenses

67.0

2.0

Allocated interest

2.2

–

Income tax benefit

(3.2

)

(0.2

)
****
 

 

** **
****
Loss from discontinued operations,    net of taxes

$

5.0

 

$

0.4

                Vanguard allocated $2.2 million of interest expense to discontinued operations during the three months ended September 30, 2006. The allocation was based upon the ratio of net assets to be sold to the sum of Vanguard’s total net assets and Vanguard’s outstanding debt.  Discontinued operations included approximately $3.2 million and $0.2 million of income tax benefits duringthe three months ended September 30, 2006 and 2007, respectively, calculated using an effective tax rate of approximately 39.0% and 33.3%, respectively.

**3.             STOCK-BASED COMPENSATION**

                Vanguard accounts for stock-based employee compensation granted prior to July 1, 2006 under the provisions of Statement of FinancialAccounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”). Effective July 1, 2003, Vanguard adopted SFAS 123 on a prospective basis, an acceptable transition method set forth in SFAS No. 148, *Accounting for Stock-BasedCompensation Transition and Disclosure*. For grants dated July 1, 2006 and subsequent, Vanguard accounts for stock-based employee compensation under the provisions of Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment* (“SFAS123(R)”). Vanguard also adopted SFAS 123(R) on a prospective basis.

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                Vanguard has one stock-based compensation plan, the 2004 Stock Incentive Plan (“the 2004 Option Plan”). As of September 30,2007, the 2004 Option Plan, as amended, allows for the issuance of up to 101,117 options to purchase common stock of Vanguard to its employees. The stock options may be granted as Liquidity Event Options, Time Options or Performance Options at the discretion of theBoard. The Liquidity Event Options vest 100% at the eighth anniversary of the date of grant and have an exercise price per share as determined by the Board or a committee thereof.  The Time Options vest 20% at each of the first five anniversaries of the date ofgrant and have an exercise price per share as determined by the Board or a committee thereof.  The Performance Options vest 20% at each of the first five anniversaries of the date of grant and have an exercise price equal to $3,000 per share or as determined bythe Board. The Time Options and Performance Options immediately vest upon a change of control, while the Liquidity Event Options immediately vest only upon a qualifying Liquidity Event, as defined in the Plan Document. As of September 30, 2007, 65,754 options wereoutstanding under the 2004 Option Plan. Vanguard recognized salaries and benefits expense related to the 2004 Option Plan of $0.3 million and $0.5 million during the three months ended September 30, 2006 and 2007, respectively.

**4.             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, 2007 and September 30, 2007 (in millions).

 

 

**Gross Carrying Amount**

**Accumulated Amortization**

 

 

**Class of Intangible Asset** 

 

**June 30, 2007**

**September 30, 2007**

**June 30, 2007**

**September 30, 2007**

**            **

Amortized intangible assets:

 

 

 

 

   Deferred loan costs

   $          43.8

   $          43.8

   $          11.2

   $          12.4

   Contracts

               31.4

               31.4

                 8.6

                 9.4

   Physician income and other guarantees

               13.8

               18.8

                 5.4

                 7.7

   Other

                 1.3

                 1.3

                 0.3

                 0.3

 

   Subtotal

               90.3

               95.3

               25.5

               29.8

Indefinite-lived intangible assets:

 

 

 

 

   License and accreditation

                 3.2

                 3.2

                   –

                   –

 

Total

   $          93.5

   $          98.5

   $          25.5

   $          29.8

 

                Amortization expense for contracts for the three months ended September 30, 2006 and 2007 was $0.8 million. The other intangible assetsnoted above were amortized to either net interest, purchased services or other operating expenses.

**5.             IMPAIRMENT OF GOODWILL AND LONG-LIVED ASSETS**

                In recent periods, Vanguard experienced gradual changes to the business climate at its Chicago hospitals, the most significant beingpayer mix shifts, which have resulted in weaker than expected operating results at those hospitals. Vanguard believes that these trends may not be temporary in nature and may not be sufficiently offset by various initiatives to improve operating results. Accordingly,Vanguard performed an impairment test of the long-lived assets of these hospitals under SFAS 144 and SFAS 142, *Goodwill and Other Intangible Assets*, effective December 31, 2006 and recorded a $123.8 million ($110.5 million, net of tax benefit) impairmentcharge at that time to write down the carrying value of these hospitals to fair value. Fair value was estimated using a discounted net cash flows approach and two market-based approaches. As a result of the impairment charge, Vanguard reduced goodwill for its acutecare services segment $123.8 million during December 2006. Further deterioration in the operating results of the Chicago hospitals could result in additional future impairment charges.

                Vanguard completed its annual goodwill impairment test required by SFAS 142 during the fourth quarter of fiscal 2007 noting noimpairment. However, the previously discussed Chicago market and one other reporting unit, with combined goodwill of $140.0 million as of September 30, 2007, will require continual monitoring during fiscal year 2008 due to the sensitivity of the projected operatingresults of these reporting units to the goodwill impairment analysis. If projected future

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cash flows become less favorable than those projected by management, impairments may become necessary that could have a material adverse impact on Vanguard’s financial position and results of operations.

**6.             LONG-TERM DEBT**

                A summary of Vanguard’s long-term debt at June 30, 2007 and September 30, 2007 follows (in millions).

** **

** **

** **

**June 30, 2007**

**    **

** **

**September 30, 2007**

 

 

 

 

 

9.0% Senior Subordinated Notes

 

$

575.0 

 

$

575.0 

11.25% Senior Discount Notes

 

 

168.9 

 

 

173.5 

Term loans payable under credit facility

781.9 

779.9 

Other

 

 

2.9 

 

–

 

 

 

 

 

 

1,528.7 

1,528.4 

Less: current maturities

(8.0)

(8.0)

 

 

 

 

 

 

$

1,520.7 

$

1,520.4 

 

**9.0% Notes**

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

                Prior to October 1, 2009, the issuers may redeem the 9.0% Notes, in whole or in part, at a price equal to 100% of the principal amountthereof plus a make-whole premium. On or after October 1, 2009, the Issuers may redeem all or part of the 9.0% Notes at various redemption prices given the date of redemption as set forth in the indenture governing the 9.0% Notes.  The initial redemption pricefor the 9.0% Notes is equal to 104.50% of their principal amount, plus accrued and unpaid interest.  The redemption price declines each year after 2009.  The redemption price will be 100% of the principal amount, plus accrued and unpaid interest, beginningon October 1, 2012.

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

**11.25% Notes**

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

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                Prior to October 1, 2009, the issuers may redeem the 11.25% Notes, in whole or in part, at a price equal to 100% of the accreted valuethereof, plus accrued and unpaid interest, plus a make-whole premium. On or after October 1, 2009, the Discount Issuers may redeem all or a part of the 11.25% Notes at various redemption prices given the date of redemption as set forth in the indenture governing the11.25% Notes. The initial redemption price for the 11.25% Notes on October 1, 2009 is equal to 105.625% of their principal amount, plus accrued and unpaid interest. The redemption price declines each year after 2009. The redemption price will be 100% of the principalamount, plus accrued and unpaid interest, beginning on October 1, 2012.

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

**Credit Facility Debt**

                In connection with the Merger on September 23, 2004, two of Vanguard’s wholly owned subsidiaries, Vanguard Health Holding CompanyII, LLC and Vanguard Health Company II, Inc. (the “Co-borrowers”), entered into new senior secured credit facilities (the “merger credit facilities”) with various lenders and Bank of America, N.A. as administrative agent and Citicorp NorthAmerica, Inc. as syndication agent, and repaid all amounts outstanding under its previous credit facility. The merger credit facilities include a seven-year term loan facility in the aggregate principal amount of $800.0 million (of which $475.0 million was funded atclosing) and a six-year $250.0 million revolving credit facility (of which $27.7 million of capacity was utilized at closing for letters of credit related to certain performance guarantees). Of the $325.0 million unfunded term loans, $150.0 million was made availableto finance the acquisition of hospitals and related businesses provided that the acquisition occurred on or prior to February 20, 2005, and to fund capital expenditures and other corporate needs.  Also, $175.0 million was made available for working capital,capital expenditures and other general corporate purposes until September 23, 2005.  Vanguard borrowed all $325.0 million delayed draw term loans at various times during its fiscal years 2005 and 2006.

                On September 26, 2005, the Co-borrowers refinanced and repriced all $795.7 million of the then outstanding term loans under the mergercredit facilities by borrowing $795.7 million of replacement term loans that also mature on September 23, 2011 (the “2005 term loan facility”).  In addition, upon the occurrence of certain events, the Co-borrowers may request an incremental term loanfacility to be added to the 2005 term loan facility in an amount not to exceed $300.0 million in the aggregate, subject to receipt of commitments by existing lenders or other financing institutions and to the satisfaction of certain other conditions.  Therevolving loan facility under the merger credit facilities did not change in connection with the term loan refinancing. As of September 30, 2007, $779.9 million was outstanding under the 2005 term loan facility. The total remaining capacity of the revolving creditfacility, net of letters of credit, was $221.5 million as of September 30, 2007.

                The 2005 term loan facility borrowings bear interest at a rate equal to, at Vanguard’s option, LIBOR plus 2.25% per annum or abase rate plus 1.25% per annum. These interest rates reflect a savings of 1.00% per annum over the interest rate options for term loan borrowings under the merger credit facilities. Borrowings under the revolving credit facility currently bear interest at a rateequal to, at Vanguard’s option, LIBOR plus 2.25% per annum or a base rate plus 1.25% per annum, subject to an increase of up to 0.25% per annum should Vanguard’s leverage ratio increase over certain designated levels. Vanguard also pays a commitment feeto the lenders under the revolving credit facility in respect of unutilized commitments thereunder at a rate equal to 0.50% per annum. Vanguard pays customary letter of credit fees.

                Vanguard is subject to certain restrictive and financial covenants under the credit agreement governing the 2005 term loan facility andthe revolving credit facility including a total leverage ratio, senior leverage ratio, interest coverage ratio and capital expenditure restrictions. Vanguard was in compliance with each of these financial covenants as of September 30, 2007. Obligations under thecredit agreement are unconditionally guaranteed by Vanguard and Vanguard Health Holding Company I, LLC (“VHS Holdco I”) and, subject to certain exceptions, each of VHS Holdco I’s wholly-owned domestic subsidiaries (the “U.S.Guarantors”). Obligations under the credit agreement are also secured by substantially all of the assets of Vanguard Health Holding Company II, LLC (“VHS Holdco II”) and the U.S. Guarantors including a pledge of 100% of the membership interests ofVHS Holdco II, 100% of the capital stock of substantially all U.S. Guarantors (other than VHS Holdco I) and 65% of the capital stock of each of VHS Holdco II’s non-U.S. subsidiaries that are directly owned by VHS Holdco II or one of the U.S. Guarantors and asecurity interest in substantially all tangible and intangible assets of VHS Holdco II and each U.S. Guarantor.

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**7.             INCOME TAXES**

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

 

 

**Three months ended**

 

 

 

 

 

**September 30, 2006**

 

 

**September 30, 2007**

 

Current:

 

 

   Federal

 

$

(0.4

)

$

0.1

   State

 

 

0.5

 

0.7

 

Total current

 

 

0.1

 

 

0.8

 

 

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

 

 

   Federal

 

 

(1.4

)

 

(3.7

)

   State

 

 

(1.6

)

 

(1.7

)

 

 

 

(3.0

)

 

(5.4

)

Increase in valuation allowance

 

 

1.4

 

 

1.2

 

 

 

   Total income tax benefit

 

$

(1.5

)

$

(3.4

)

 

 

 

 

 

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

 

 

**Three months ended**

 

 

 

 

**September 30, 2006**

 

 

**September 30, 2007**

 

 

 

 

Income tax at federal statutory rate

 

35.0 %

 

    

35.0 %

 

Income tax at state statutory rate

(10.8)%

 

13.3 %

 

Nondeductible expenses and other

 

0.3 %

 

 

(1.6)%

 

Change in valuation allowance

10.8 %

(12.9)%

 

 

 

 

 

Effective income tax rate

 

35.3 %

 

 

33.8 %

 

 

 

 

 

 

                Net non-current deferred tax assets of $52.7 million and $53.4 million are included in other assets in the accompanying condensedconsolidated balance sheets as of June 30, 2007 and September 30, 2007, respectively.  Net current deferred tax assets were $8.9 million and $15.3 million as of June 30, 2007 and September 30, 2007, respectively.

                As of September 30, 2007, Vanguard had generated net operating loss (“NOL”) carryforwards for federal income tax and stateincome tax purposes of approximately $155.0 million and $504.0 million, respectively. The federal and state NOL carryforwards expire from 2022 to 2028 and 2008 to 2028, respectively.  Approximately $3.6 million of these NOLs are subject to annual limitation forfederal purposes.  These limitations are not expected to significantly affect Vanguard’s ability to ultimately recognize the benefit of these NOLs in future years.

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Table of Contents

                Effective July 1, 2007, Vanguard adopted the provisions of FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes– An Interpretation of FASB Statement No. 109* (“FIN 48”). In connection with the adoption of FIN 48, Vanguard recorded a $0.4 million net liability for unrecognized tax benefits, accrued interest and penalties, which was comprised of thefollowing (in millions).

Reclassification from  income taxes payable

$

0.3

Increase to non-current deferred tax assets

 

2.7

Cumulative impact of change recorded to retained earnings

 

(2.6

)

 

$

0.4

 

                The provisions of FIN 48 allow for the classification election of interest on an underpayment of income taxes, when the tax lawrequires interest to be paid, and penalties, when a tax position does not meet the minimum statutory threshold to avoid payment of penalties, in income taxes, interest expense or another appropriate expense classification based on the accounting policy election ofthe entity. Vanguard has elected to continue its historical practice of classifying interest and penalties as a component of income tax expense.

                Approximately $0.3 million of the $0.4 million of unrecognized tax benefits, if recognized, would impact the effective tax rate, whilethe remaining $0.1 million of unrecognized tax benefits, if recognized, would increase goodwill. The unrecognized tax benefits remained at $0.4 million as of September 30, 2007.

                Vanguard’s U.S. federal income tax returns for tax years 2005 and beyond remain subject to examination by the Internal RevenueService.

                On May 18, 2006, Texas repealed its current income tax and replaced it with a gross margins tax to be accounted for as an incometax.  Vanguard became subject to the Texas margins tax on July 1, 2006.

**8.             RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**

                In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No.159, *The Fair Value Option for Financial Assets and Financial Liabilities* (“SFAS 159”). SFAS 159 gives entities the option to voluntarily choose, at certain election dates, to measure many financial assets and liabilities at fair value. Electionsare made on an instrument by instrument basis and are irrevocable once made. Subsequent changes to the fair value of any instrument for which an election is made are reflected through earnings. SFAS 159 is effective for Vanguard as of July 1, 2008 with early adoptionpermitted. Vanguard does not expect SFAS 159 to significantly impact its future financial position, results of operations or cash flows.

                On September 15, 2006, the FASB issued Statement of Financial Accounting Standards No. 157, *Fair Value Measurement* (“SFAS157”).  SFAS 157 sets forth comprehensive guidance for measuring fair value of assets and liabilities.  Under the provisions of SFAS 157, fair value should be based on the assumptions market participants would use to complete the sale of an asset ortransfer of a liability.  SFAS 157 provides a hierarchy of information to be used to determine the applicable market assumptions, and fair value measurements would be separately disclosed under each applicable layer of the hierarchy.  SFAS 157 does notexpand or restrict the use of fair value for measuring assets and liabilities but provides a single methodology to be used when fair value accounting is applied.  SFAS 157 is effective for Vanguard’s fiscal year beginning July 1, 2008 with early adoptionpermitted.  Vanguard does not expect the adoption of SFAS 157 to significantly impact its future financial position, results of operations or cash flows.

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Table of Contents

**9.             SEGMENT INFORMATION**

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

                The following table provides unaudited condensed financial information by business segment for the three months ended September 30,2006 and 2007, including a reconciliation of Segment EBITDA to income (loss) from continuing operations before income taxes (in millions).

 

 

**Three months ended September 30, 2006**

** **

**Three months ended September 30, 2007**

 

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

 

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

**Consolidated**

** **

**Health Plans**

** **

**Acute Care Services**

** **

**Eliminations**

** **

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

$

–

$

521.3

$

–

$

521.3

$

–

$

556.8

$

–

$

556.8

 

Premium revenues

97.0

–

–

97.0

105.7

–

–

105.7

 

Inter-segment revenues

–

9.1

(9.1

)

–

–

8.4

(8.4

)

–

 

 

      Total revenues

97.0

530.4

(9.1

)

618.3

105.7

565.2

(8.4

)

662.5

 

 

Operating expenses - external

80.6

483.7

–

564.3

87.4

518.3

–

605.7

 

Operating expenses - inter-segment

9.1

–

(9.1

)

–

8.4

–

(8.4

)

–

 

 

      Total operating expenses

89.7

483.7

(9.1

)

564.3

95.8

518.3

(8.4

)

605.7

 

 

      Segment EBITDA(1)

7.3

46.7

–

54.0

9.9

46.9

–

56.8

 

 

Less:

 

Interest, net

0.2

29.6

–

29.8

(0.1

)

31.8

–

31.7

 

Depreciation and amortization

1.0

27.9

–

28.9

1.0

31.5

–

32.5

 

Minority interests

–

0.7

–

0.7

–

0.9

–

0.9

 

Equity method income

–

(0.2

)

(0.2

)

–

(0.9

)

(0.9

)

 

Stock compensation

–

0.3

–

0.3

–

0.5

–

0.5

 

Loss (gain) on sale of assets

–

(2.6

)

–

(2.6

)

–

0.1

–

0.1

 

Monitoring fees and expenses

–

1.3

–

1.3

–

1.9

–

1.9

 

 

      Income (loss) from continuing             operations before income taxes

$

6.1

$

(10.3

)

$

–

$

(4.2

)

$

9.0

$

(18.9

)

$

–

$

(9.9

)

 

 

Capital expenditures – continuing             operations

$

–

$

36.9

$

–

$

36.9

$

–

$

21.4

$

–

$

21.4

 

 

Segment assets

$

151.9

$

2,398.1

$

–

$

2,550.0

 

 

____________________(1) Segment EBITDA is defined as income before interest expense (net of interest income), income taxes, depreciation and amortization, minority interests, equity method income or loss, stock compensation, debt extinguishment costs, gain or loss on sale of assets,monitoring fees and expenses, impairment loss and discontinued operations.  Management uses Segment EBITDA to measure performance for Vanguard’s segments and to develop strategic objectives and operating plans for those segments.  Segment EBITDAeliminates the uneven effect of non-cash depreciation of tangible assets and amortization of intangible assets, much of which results from acquisitions accounted for under the purchase method of accounting.  Segment EBITDA also eliminates the effects of changesin interest rates which management believes relate to general trends in global capital markets, but are not necessarily indicative of the operating performance of Vanguard’s segments.  Management believes that Segment EBITDA provides useful informationabout the financial performance of Vanguard’s segments to investors, lenders, financial analysts and rating agencies.  Additionally, management believes that investors and lenders view Segment EBITDA as an important factor in making investment decisionsand assessing the value of Vanguard.  Segment EBITDA is not a substitute for net income, operating cash flows or other cash flow statement data determined in accordance with accounting principles generally accepted in the United States.  Segment EBITDA, aspresented, may not be comparable to similarly titled measures of other companies.

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Table of Contents

**10.          COMMITMENTS AND CONTINGENCIES**

                Management evaluates contingencies based upon the best available information and believes that adequate provision for potential lossesassociated 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 Vanguard’s results of operations or financial position, but thecapital obligations could have an effect on the timing of Vanguard’s cash flows, including its need to borrow available amounts under its revolving credit facility.

**Capital Expenditure Commitments**

                Vanguard currently has multiple capital projects underway including significant advanced clinical system upgrades.  As ofSeptember 30, 2007, Vanguard estimated its remaining commitments to complete capital projects in process to be approximately $55.4 million.

**Patient Service Revenues**

                Final determinations of amounts earned under the Medicare and Medicaid programs often occur in subsequent years because of audits bythe programs, rights of appeal and the application of numerous technical provisions.  Differences between original estimates and subsequent revisions (including final settlements) are included in the condensed consolidated statements of operations in the periodin which the revisions are made.  Management believes that adequate provision has been made for adjustments that may result from final determination of amounts earned under the Medicare and Medicaid programs.  Net adjustments for final third partysettlements positively impacted Vanguard’s loss from continuing operations before income taxes by $0.5 million and $2.6 million for the three months ended September 30, 2006 and 2007, respectively. Vanguard recorded $22.8 million and $17.3 million of charitycare deductions from continuing operations during the three months ended September 30, 2006 and 2007, respectively.

**Governmental Regulation**

                Laws and regulations governing the Medicare, Medicaid and other federal healthcare programs are complex and subject tointerpretation.  Vanguard’s management believes that it is in compliance with all applicable laws and regulations in all material respects. However, compliance with such laws and regulations can be subject to future government review and interpretation aswell as significant regulatory action including fines, penalties, and exclusion from the Medicare, Medicaid and other federal healthcare programs. Vanguard is not aware of any material regulatory proceeding or investigation underway or threatened involvingallegations of potential wrongdoing.

**Acquisitions**

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

**Guarantees**

                *Physician Guarantees*

                Vanguard entered into physician relocation agreements and service agreements under which it guarantees minimum monthly income, revenuesor collections to physicians during a specified period of time (typically 12 months to 24 months). In return for the minimum guarantee payments, the physicians are required to practice in the community or to provide emergency room or specialty program coverage atVanguard’s hospitals for a stated period of time (typically 3 to 5 years) or else return the payments to Vanguard. In January 2006, Vanguard adopted Financial Accounting Standards Board Staff

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Table of Contents

Position No. FIN 45-3, *Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners* (“FSP 45-3”).  FSP 45-3 requires that a liability be recorded at fairvalue for all guarantees entered into on or after January 1, 2006. Vanguard determines this liability and an offsetting intangible asset by calculating an estimate of expected payments to be made over the guarantee period. Vanguard reduces the liability as it makesguarantee payments and amortizes the intangible asset over the term of the physicians’ relocation or service agreements. As of September 30, 2007, Vanguard had a net intangible asset of $10.6 million and a remaining liability of $7.7 million related to thesephysician guarantees. The maximum amount of Vanguard’s unpaid physician income guarantees under FSP 45-3 as of September 30, 2007 was approximately $16.8 million.

                *Other Guarantees*

                As part of its contract with the Arizona Health Care Cost Containment System (“AHCCCS”), one of Vanguard’s healthplans, Phoenix Health Plan, is required to maintain a performance guarantee, the amount of which is based upon Plan membership and capitation premiums received.  As of September 30, 2007, Vanguardmaintained this performance guarantee in the form of $19.0 millionof surety bonds with independent third party insurers collateralized by letters of credit of approximately $2.9 million.  In October 2007, upon the expiration of these surety bonds, Vanguard purchased $22.0 million of replacement surety bonds that expire onSeptember 30, 2008.

**Variable Interest Entities**

                Vanguard is a party to two contractual agreements whereby it may be required to make monthly payments to the developers and managers oftwo medical office buildings located on its hospital campuses through minimum rent revenue guarantees.  Vanguard entered into these agreements to provide an incentive to the developers to fund the construction of the medical office buildings and manage thebuildings upon their completion in order to make physician office space available near its hospital campuses.  One contract commenced in April 2005 for a period of 12 years.  Vanguard deemed this contract a variable interest entity in which Vanguard is notthe primary beneficiary. The maximum annual amount Vanguard would pay under the contract assuming zero occupancy would be approximately $1.5 million. For the second contract, Vanguard expects the medical office building to achieve specified occupancy levels thatwould permanently release Vanguard from its minimum rent guarantee during fiscal 2008 and deems the developer landlord to be the primary beneficiary. Vanguard currently expects to make no rental shortfall payments during fiscal 2008 under either of these contractsgiven current and expected future occupancy levels.

                As of June 30, 2007, Vanguard had a third minimum rent guarantee arrangement with a medical office building entity. Due to thesignificance of Vanguard’s historical minimum rent revenue payments to the operations of the medical office building, Vanguard consolidated this entity for financial reporting purposes. During the quarter ended September 30, 2007, the partnership that owned themedical office building sold the building to a third party, which terminated Vanguard’s minimum rent guarantee obligation. Thus, Vanguard no longer included this entity in its consolidated financial statements as of September 30, 2007.

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

                Vanguard conducts substantially all of its business through its subsidiaries. Most of Vanguard’s subsidiaries jointly andseverally guarantee the 9.0% Notes on an unsecured senior subordinated basis. Certain of Vanguard’s other consolidated wholly-owned and non wholly-owned entities do not guarantee the 9.0% Notes in conformity with the provisions of the indenture governing the9.0% Notes and do not guarantee Vanguard’s senior secured credit facilities in conformity with the provisions thereof. The condensed consolidating financial information for the parent company, the issuers of the 9.0% Notes, the issuers of the 11.25% Notes, thesubsidiary guarantors, the non-guarantor subsidiaries, certain eliminations and consolidated Vanguard as of June 30, 2007 and September 30, 2007 and for the three months ended September 30, 2006 and 2007 follows.

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSJune 30, 2007**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

Current assets:

Cash and cash equivalents

$           –

$              –

$              –

$       11.7

$    108.4

$              –

$      120.1

Restricted cash

             –

                –

                –

           4.4

          1.8

                –

            6.2

Accounts receivable, net

             –

                –

                –

       260.0

        27.3

                –

        287.3

Inventories

             –

                –

                –

         41.8

          5.0

                –

          46.8

Prepaid expenses and other current assets

            0.1

                –

                –

         37.8

        22.4

            (2.6)

          57.7

 

    Total current assets

            0.1

                –

                –

       355.7

      164.9

            (2.6)

        518.1

             

Property, plant and equipment, net

             –

                –

                –

    1,112.1

        74.5

                –

     1,186.6

Goodwill

             –

                –

                –

       605.6

        83.6

                –

        689.2

Intangible assets, net

             –

            29.2

              3.4

         11.1

        24.3

                –

          68.0

Investments in consolidated subsidiaries

        608.8

                –

                –

              –

        26.6

        (635.4)

              –

Other assets

             –

                –

                –

         69.4

          0.1

                –

          69.5

    Total assets

$      608.9

$          29.2

$            3.4

$  2,153.9

$    374.0

$      (638.0)

$   2,531.4

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

Current liabilities:

Accounts payable

$           –

$              –

$              –

$     132.8

$      11.3

$             –

$      144.1

Accrued expenses and other current liabilities

             –

            13.4

                –

       123.8

        87.9

          (15.5)

        209.6

Current maturities of long-term debt

              –

              8.0

                –

          (0.2)

          0.2

                –

            8.0

    Total current liabilities

             –

            21.4

                –

       256.4

        99.4

          (15.5)

        361.7

Other liabilities

             –

                –

                –

         50.6

        45.3

            (4.3)

          91.6

Long-term debt, less current maturities

             –

       1,348.9

          168.9

           2.9

             –

                –

     1,520.7

Intercompany

         51.5

     (1,013.2)

        (120.9)

    1,368.3

        51.8

        (337.5)

              –

Stockholders’ equity

        557.4

        (327.9)

          (44.6)

       475.7

      177.5

        (280.7)

        557.4

 

    Total liabilities and stockholders’ equity

$      608.9

$          29.2

$            3.4

$  2,153.9

$    374.0

$      (638.0)

$   2,531.4

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING BALANCE SHEETSSeptember 30, 2007(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

Current assets:

Cash and cash equivalents

$         –

$              –

$              –

$       89.1

$      69.2

$              –

$      158.3

Restricted cash

           –

                –

                –

           0.7

          1.8

               –

            2.5

Accounts receivable, net

           –

                –

                –

       264.5

        23.8

                 –

        288.3

Inventories

           –

                –

                –

         42.0

          5.2

                 –

          47.2

Prepaid expenses and other current assets

         0.1

                –

                –

         47.1

        19.0

           (2.5)

          63.7

 

    Total current assets

         0.1

                –

                –

       443.4

      119.0

           (2.5)

        560.0

             

Property, plant and equipment, net

           –

                –

                –

    1,093.0

        70.3

                 –

     1,163.3

Goodwill

           –

                –

                –

       605.6

        83.6

                 –

        689.2

Intangible assets, net

           –

          28.1

              3.4

         13.8

        23.4

                 –

          68.7

Investments in consolidated subsidiaries

     608.8

                –

                –

              –

        25.6

       (634.4)

              –

Other assets

           –

                –

                –

         68.7

          0.1

                 –

          68.8

    Total assets

$   608.9

$        28.1

$            3.4

$  2,224.5

$    322.0

$     (636.9)

$   2,550.0

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

Current liabilities:

Accounts payable

$         –

$              –

$              –

$     135.8

$      12.1

$              –

$      147.9

Accrued expenses and other current liabilities

           –

          26.5

                –

       126.9

        84.5

         (15.8)

        222.1

Current maturities of long-term debt

            –

            8.0

                –

              –

            –

                 –

            8.0

    Total current liabilities

           –

          34.5

                –

       262.7

        96.6

         (15.8)

        378.0

Other liabilities

           –

                –

                –

         58.8

        42.3

           (3.1)

          98.0

Long-term debt, less current maturities

           –

     1,346.9

          173.5

              –

            –

                 –

     1,520.4

Intercompany

       55.3

      (995.7)

        (120.9)

    1,411.5

         (2.8)

       (347.4)

              –

Stockholders’ equity

     553.6

      (357.6)

          (49.2)

       491.5

      185.9

       (270.6)

        553.6

 

    Total liabilities and stockholders’ equity

$   608.9

$        28.1

$            3.4

$  2,224.5

$    322.0

$     (636.9)

$   2,550.0

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the three months ended September 30, 2006(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

** **

** **

Patient service revenues

$         –

    $     –

    $      –

   $  491.7

   $    36.4

    $  (6.8)

   $   521.3

Premium revenues

           –

           –

            –

         12.6

        84.5

          (0.1)

          97.0

 

    Total revenues

           –

           –

            –

       504.3

      120.9

          (6.9)

        618.3

Salaries and benefits

         0.3

           –

            –

       240.0

        19.3

            –

        259.6

Supplies

           –

           –

            –

         93.3

          6.9

            –

        100.2

Medical claims expense

           –

           –

            –

           8.8

        69.7

          (6.8)

          71.7

Purchased services

           –

           –

            –

         29.8

          3.8

            –

          33.6

Provision for doubtful accounts

           –

           –

            –

         39.3

          1.2

            –

          40.5

Other operating expenses

         0.1

           –

            –

         43.2

          6.9

          (0.1)

          50.1

Rents and leases

           –

           –

            –

           7.3

          1.6

            –

            8.9

Depreciation and amortization

           –

           –

            –

         25.1

          3.8

            –

          28.9

Interest, net

           –

       30.3

           4.2

          (4.6)

         (0.1)

            –

          29.8

Management fees

           –

           –

            –

          (2.2)

          2.2

            –

             –

Other

           –

           –

            –

          (0.9)

          0.1

            –

           (0.8)

 

    Total costs and expenses

         0.4

       30.3

           4.2

       479.1

      115.4

          (6.9)

        622.5

 

Income (loss) from continuing    operations before income taxes

      (0.4)

      (30.3)

          (4.2)

         25.2

          5.5

            –

           (4.2)

Income tax expense (benefit)

      (1.5)

           –

            –

            –

          0.5

          (0.5)

           (1.5)

Equity in earnings of subsidiaries

      (8.8)

           –

            –

            –

            –

           8.8

             –

 

Income (loss) from continuing    operations

      (7.7)

      (30.3)

          (4.2)

         25.2

          5.0

           9.3

           (2.7)

Loss from discontinued operations,    net of taxes

           –

           –

            –

          (3.5)

        (1.5)

            –

           (5.0)

 

Net income (loss)

$   (7.7)

    $ (30.3)

    $    (4.2)

   $    21.7

   $      3.5

    $     9.3

   $     (7.7)

 

-18-

Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONSFor the three months ended September 30, 2007(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

** **

** **

Patient service revenues

$         –

  $       –

    $      –

   $  526.8

   $    36.2

    $  (6.2)

   $   556.8

Premium revenues

           –

           –

            –

         14.4

        91.4

          (0.1)

        105.7

 

    Total revenues

           –

           –

            –

       541.2

      127.6

          (6.3)

        662.5

Salaries and benefits

         0.5

           –

            –

       254.2

        19.0

            –

        273.7

Supplies

           –

           –

            –

         96.4

          6.8

            –

        103.2

Medical claims expense

           –

           –

            –

           9.1

        73.1

          (6.2)

          76.0

Purchased services

           –

           –

            –

         31.5

          3.3

            –

          34.8

Provision for doubtful accounts

           –

           –

            –

         52.2

          1.7

            –

          53.9

Other operating expenses

         0.1

           –

            –

         47.4

          7.1

          (0.1)

          54.5

Rents and leases

           –

           –

            –

           8.5

          1.6

            –

          10.1

Depreciation and amortization

           –

           –

            –

         28.8

          3.7

            –

          32.5

Interest, net

           –

       29.7

           4.6

          (1.5)

         (1.1)

            –

          31.7

Management fees

           –

           –

            –

          (2.1)

          2.1

            –

             –

Other

           –

           –

            –

           2.0

            –

            –

            2.0

 

    Total costs and expenses

         0.6

       29.7

           4.6

       526.5

      117.3

          (6.3)

        672.4

 

Income (loss) from continuing    operations before income taxes

      (0.6)

      (29.7)

          (4.6)

         14.7

        10.3

            –

           (9.9)

Income tax expense (benefit)

      (3.4)

           –

            –

            –

          0.4

          (0.4)

           (3.4)

Equity in earnings of subsidiaries

      (9.7)

           –

            –

            –

            –

           9.7

             –

 

Income (loss) from continuing    operations

      (6.9)

      (29.7)

          (4.6)

         14.7

          9.9

         10.1

           (6.5)

Income (loss) from discontinued    operations, net of taxes

           –

           –

            –

           1.1

        (1.5)

            –

           (0.4)

 

Net income (loss)

$   (6.9)

  $  (29.7)

    $    (4.6)

   $    15.8

   $      8.4

    $   10.1

   $     (6.9)

 

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the three months ended September 30, 2006(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

**Operating activities:**

 

 

 

 

 

 

 

Net income (loss)

$       (7.7)

$    (30.3)

$        (4.2)

$       21.7

$        3.5

$         9.3

$          (7.7)

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

 

 

 

 

 

 

 

Loss from discontinued operations

           –

           –

             –

           3.5

          1.5

            –

             5.0

Depreciation and amortization

           –

           –

             –

         25.1

          3.8

            –

           28.9

Provision for doubtful accounts

           –

           –

             –

         39.3

          1.2

            –

           40.5

Deferred income taxes

         (1.6)

           –

             –

            –

           –

            –

            (1.6)

Amortization of loan costs

           –

          1.0

           0.1

            –

           –

            –

             1.1

Accretion of principal on senior discount notes

           –

           –

           4.1

            –

           –

            –

             4.1

(Gain) loss on sale of assets

           –

           –

             –

         (2.7)

          0.1

            –

            (2.6)

Stock compensation

          0.3

           –

             –

            –

           –

            –

             0.3

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

               

              

                

               

              

               

                 

    Equity in earnings of subsidiaries

          8.8

           –

             –

            –

           –

          (8.8)

              –

    Accounts receivable

           –

           –

             –

       (55.8)

         (9.6)

            –

          (65.4)

    Inventories

           –

           –

             –

         (1.2)

           –

            –

            (1.2)

    Prepaid expenses and other current assets

           –

           –

             –

         (9.0)

          1.5

            –

            (7.5)

    Accounts payable

           –

           –

             –

         (3.2)

          1.3

            –

            (1.9)

    Accrued expenses and other liabilities

          0.2

        13.1

              –

         (3.6)

         (1.4)

          (0.5)

             7.8

Net cash provided by (used in) operating activities –        continuing operations

           –

       (16.2)

             –

         14.1

          1.9

            –

            (0.2)

Net cash provided by (used in) operating activities –        discontinued operations

            –

            –

              –

           1.5

         (0.9)

             –

             0.6

Net cash provided by (used in) operating activities

           –

       (16.2)

             –

         15.6

          1.0

            –

             0.4

**Investing activities:**

               

              

                

               

              

            –

                 

Acquisitions

           –

           –

             –

            –

           –

            –

              –

Capital expenditures

           –

           –

             –

       (36.1)

         (0.8)

            –

          (36.9)

Proceeds from short-term investments

           –

           –

             –

            –

       (30.0)

            –

          (30.0)

Sales of short-term investments

           –

           –

             –

            –

        30.0

            –

           30.0

Proceeds from asset dispositions

           –

           –

             –

           6.5

           –

            –

             6.5

Other

            –

            –

              –

           2.1

            –

             –

             2.1

Net cash used in investing activities –        continuing operations

           –

           –

             –

       (27.5)

         (0.8)

            –

          (28.3)

Net cash used in investing activities –        discontinued operations

            –

            –

              –

         (0.4)

         (0.4)

             –

            (0.8)

Net cash used in investing activities

           –

           –

             –

       (27.9)

         (1.2)

            –

          (29.1)

**Financing activities:**

               

              

                

               

              

               

                 

Payments of long-term debt and capital leases

           –

         (2.0)

             –

            –

         (0.1)

            –

            (2.1)

Cash provided by (used in) intercompany activity

            –

        18.2

              –

         17.8

       (36.0)

             –

               –

Net cash provided by (used in) financing activities

            –

        16.2

              –

         17.8

       (36.1)

             –

            (2.1)

Net increase (decrease) in cash and cash equivalents

           –

           –

             –

           5.5

       (36.3)

            –

          (30.8)

Cash and cash equivalents, beginning of period

            –

            –

              –

         38.5

        85.1

             –

         123.6

Cash and cash equivalents, end of period

$          –

$          –

$            –

$       44.0

$      48.8

$           –

$         92.8

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Table of Contents

**VANGUARD HEALTH SYSTEMS, INC.CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWSFor the three months ended September 30, 2007(Unaudited)**

** **

**Parent**

**Issuers of 9.0% Notes**

**Issuers of 11.25% Notes**

**Guarantor Subsidiaries**

**Combined Non- Guarantors**

**Eliminations**

**Total Consolidated**

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

*(In millions)*

**Operating activities:**

 

 

 

 

 

 

 

Net income (loss)

$     (6.9)

$     (29.7)

$        (4.6)

$       15.8

$        8.4

$       10.1

$          (6.9)

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

 

 

 

 

 

 

 

Loss (income) from discontinued operations

           –

            –

             –

         (1.1)

          1.5

             –

             0.4

Depreciation and amortization

           –

            –

             –

         28.8

          3.7

             –

           32.5

Provision for doubtful accounts

           –

            –

             –

         52.2

          1.7

             –

           53.9

Deferred income taxes

       (4.2)

            –

             –

             –

            –

             –

            (4.2)

Amortization of loan costs

           –

          1.2

             –

             –

            –

             –

             1.2

Accretion of principal on senior discount notes

           –

            –

           4.6

             –

            –

             –

             4.6

(Gain) loss on sale of assets

           –

            –

             –

           0.7

         (0.6)

             –

             0.1

Stock compensation

          0.5

            –

             –

             –

            –

             –

             0.5

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

              

            –

                

               

              

               

                 

    Equity in earnings of subsidiaries

          9.7

            –

             –

             –

            –

          (9.7)

               –

    Accounts receivable

           –

            –

             –

       (57.0)

         (0.3)

             –

          (57.3)

    Inventories

           –

            –

             –

         (0.2)

         (0.2)

             –

            (0.4)

    Prepaid expenses and other current assets

           –

            –

             –

         (4.8)

          2.9

             –

            (1.9)

    Accounts payable

           –

            –

             –

           3.2

          2.1

             –

             5.3

    Accrued expenses and other liabilities

          0.9

        13.1

              –

         21.4

         (6.5)

          (0.4)

           28.5

Net cash provided by (used in) operating activities –        continuing operations

           –

       (15.4)

             –

         59.0

        12.7

             –

           56.3

Net cash provided by (used in) operating activities –        discontinued operations

            –

             –

              –

           1.2

         (0.4)

              –

             0.8

Net cash provided by (used in) operating activities

           –

       (15.4)

             –

         60.2

        12.3

             –

           57.1

**Investing activities:**

              

              

                

               

              

             –

                 

Capital expenditures

           –

            –

             –

       (19.6)

         (1.8)

             –

          (21.4)

Proceeds from short-term investments

           –

            –

             –

             –

       (30.0)

             –

          (30.0)

Sales of short-term investments

           –

            –

             –

             –

        30.0

             –

           30.0

Proceeds from asset dispositions

           –

            –

             –

           0.1

            –

             –

             0.1

Other

            –

             –

              –

           0.3

          1.0

              –

             1.3

Net cash used in investing activities –        continuing operations

           –

            –

             –

       (19.2)

         (0.8)

             –

          (20.0)

Net cash provided by investing activities –        discontinued operations

            –

             –

              –

           3.1

            –

              –

             3.1

Net cash used in investing activities

           –

            –

             –

       (16.1)

         (0.8)

             –

          (16.9)

**Financing activities:**

              

              

                

               

              

               

                 

Payments of long-term debt and capital leases

           –

         (2.0)

             –

             –

            –

             –

            (2.0)

Proceeds from stock option exercises

           –

            –

             –

           0.2

            –

             –

             0.2

Payments to retire stock and stock options

           –

            –

             –

         (0.2)

            –

             –

            (0.2)

Cash provided by (used in) intercompany activity

            –

        17.4

              –

         33.3

       (50.7)

              –

                –

Net cash provided by (used in) financing activities

            –

        15.4

              –

         33.3

       (50.7)

              –

            (2.0)

Net increase (decrease) in cash and cash equivalents

           –

            –

             –

         77.4

       (39.2)

             –

           38.2

Cash and cash equivalents, beginning of period

            –

             –

              –

         11.7

      108.4

              –

         120.1

Cash and cash equivalents, end of period

$          –

$           –

$            –

$       89.1

$      69.2

$            –

$       158.3

-21-

Table of Contents

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

**Forward Looking Statements**

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

                •  Our high degree of leverage and interest rate risk

                •  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

                •  Conflicts of interest that may arise as a result of our control by a small number of stockholders

                •  The highly competitive nature of the healthcare industry

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

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

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

                •  Potential federal or state reform of healthcare

                •  Future governmental investigations

                •  The availability of capital to fund our corporate growth strategy

                •  Potential lawsuits or other claims asserted against us

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

                •  Changes in general economic conditions

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

                •  Dependence on our senior management team and local management personnel

                •  Volatility of professional and general liability insurance for us and the physicians who practice at ourhospitals                    and increases in the quantity and severity of professional liability claims

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Table of Contents

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

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

                •  The geographic concentration of our operations

                •  Technological and pharmaceutical improvements that increase the cost of providing, or reduce the demand for,                   healthcare services and shift demand for inpatient services to outpatient settings

                •  Costs and compliance risks associated with Section 404 of the Sarbanes-Oxley Act

                •  Material non-cash charges to earnings from impairment of goodwill associated with declines in the fair market                   values of our reporting units

                •  Volatility of materials and labor costs for potential construction projects that may be necessary for futuregrowth

                Our forward-looking statements speak only as of the date made.  Except as required by law, we undertake no obligation to publiclyupdate or revise any forward-looking statements contained herein, whether as a result of new information, future events or otherwise.  We advise you, however, to consult any additional disclosures we make in our other filings with the Securities and ExchangeCommission, including, without limitation, the discussion of risks and other uncertainties under the caption “Item 1A. Risk Factors” contained in our Annual Report on Form 10-K (“10-K”) for the fiscal year ended June 30, 2007. You arecautioned to not rely on such forward-looking statements when evaluating the information contained in this report.  In light of the significant uncertainties inherent in the forward-looking statements included in this report, you should not regard the inclusionof such information as a representation by us that our objectives and plans anticipated by the forward-looking statements will occur or be achieved, or if any of them do, what impact they will have on our results of operations and financial condition.

**Executive Overview**

                As of September 30, 2007, we owned and operated 15 hospitals with a total of 4,143 licensed beds, and related outpatient servicefacilities complementary to the hospitals in San Antonio, Texas, metropolitan Phoenix, Arizona, metropolitan Chicago, Illinois, and Massachusetts, and two surgery centers in Orange County, California. On March 8, 2006, we sold our medical office buildings inCalifornia to a third-party buyer for approximately $28.7 million. On October 1, 2006, we sold our three California hospitals with combined 491 licensed beds to subsidiaries of Prime Healthcare, Inc. for net proceeds of $40.0 million. The operating results of theCalifornia hospitals and medical office buildings are classified as discontinued operations in our condensed consolidated statements of operations for all periods presented. In June 2007, we ceased providing acute care services at Phoenix Memorial Hospital(“PMH”) and began leasing certain floors of the building to various third party healthcare providers. As a result, the acute care operating results of PMH are also classified as discontinued operations in our condensed consolidated statements ofoperations for all periods presented.

                As of September 30, 2007, we also owned three health plans as set forth in the following table.

**Health Plan**

    

 

**   Location   **

      

**September 30, 2007 Membership**

 

Phoenix Health Plan (“PHP”) – managed Medicaid

 

Arizona

 

100,600

Abrazo Advantage Health Plan (“AAHP”) – managed Medicare and Dual Eligible

 

Arizona

 

    3,400

MacNeal Health Providers (“MHP”) – capitated outpatient and physician services

 

Illinois

 

  43,500

 

 

 

 

 

147,500

 

 

                Our objective is to provide high-quality, cost-effective healthcare services through an integrated delivery platform serving the needsof the communities in which we operate.  We focus our business development efforts and operations on

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Table of Contents

hospital and other related healthcare facilities where we see an opportunity to improve operating performance and profitability and increase market share.

**Operating Environment**

                The operating environment for hospital management companies is undergoing a significant change that presents both challenges andopportunities for us.  In order to remain competitive in the markets we serve, we must adapt our operating strategies to not only accommodate changing environmental factors but to make them operating advantages for us relative to our peers.  These factorswill require continued focus on quality of care initiatives.  As consumers become more involved in their healthcare decisions, perceived quality of care will become an even greater factor in determining where physicians choose to practice and where patientschoose to receive care.  The following paragraphs discuss some of the new challenges that we currently face and that we expect to become more prominent during the foreseeable future.

                *Pay for Performance Reimbursement*

                Many payers, including Medicare and several large managed care organizations, currently require providers to report certain qualitymeasures in order to receive the full amount of payment increases that were awarded automatically in the past.  For federal fiscal year 2008, Medicare expanded the number of quality measures to be reported to 27 from 21 during 2007 and from 10 during 2006. Thesemeasures include risk-adjusted outcomes measures such as 30-day mortality measures for patients who suffered a heart attack, heart failure or pneumonia; additional measures related to patients who undergo surgical procedures such as hospital-acquired infections data;and several patient satisfaction indicators.  Many large managed care organizations have developed quality measurement criteria that are similar to or even more stringent than the Medicare requirements.  We have invested and will continue to investsignificant capital to upgrade our clinical information systems to enable us to report these quality measures.

                While current payer guidelines are based upon the reporting of quality measures, we believe it is only a matter of time until thequality measures themselves determine reimbursement rates for hospital services. For example, on April 13, 2007, CMS proposed reforms in the hospital inpatient prospective payment system that would implement a provision of the Deficit Reduction Act of 2005(“DRA”) that takes the first steps toward preventing Medicare from giving hospitals higher payment for the additional costs of treating a patient that acquires a condition (including an infection) during a hospital stay. The DRA required CMS to select atleast two conditions that are (1) high cost, high volume or both; (2) assigned to a higher rate of reimbursement when present as a secondary diagnosis; and (3) are reasonably preventable through application of evidence-based guidelines. These rules were adopted inAugust 2007. Under the rules, beginning in federal fiscal year 2009 (which commences October 1, 2008) cases with these conditions would not be paid at a higher reimbursement rate unless they were present on admission. The rules identify eight conditions, includingthree serious preventable events (sometimes called “never events”) that meet the statutory criteria. Thus, our ability to demonstrate quality of care in our hospitals could significantly impact our future operating results.

                *Physician Integration*

                Our ability to attract skilled physicians to our hospitals is critical to our success. We have significant physician recruitment goalsin place with primary emphasis on family practice and internal medicine, hospitalists, obstetrics and gynecology, cardiology, neurology and orthopedics. Similar to previous strategies, physician employment and relocation incentives remain important. However, theperceived quality of care at our hospitals will become even more important to physicians. Similar to hospital reimbursement, plans are being developed to transform physician reimbursement to a pay for performance basis. In a hospital setting, many of the qualitymeasures that apply to nursing care also apply to physician care. This interdependence aligns the quality of care focus of physicians and hospitals in order that both can receive equitable compensation for services provided.

                We also face the risk of heightened physician reimbursement pressures that could cause physicians to seek to increase revenues bycompeting with hospitals for inpatient business. Additional competition from physician-owned specialty hospitals could adversely impact our future operating results. Again, we expect to mitigate this risk by achieving a competitive advantage with our quality of careinitiatives that new specialty hospitals might not be equipped to implement. These pressures may also result in our employing more physicians or pursuing additional opportunities to partner with physicians to provide healthcare services to the communities weserve.

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                *Nursing Salaries Pressures*

                In order to demonstrate high quality services, we must hire and retain nurses who share our ideals and beliefs and who have access tothe training necessary to implement our quality of care initiatives. Given the nationwide nursing shortage and the particular limited nursing availability in the Phoenix area, we expect continued pressures on nursing salaries and benefits. These pressures includehigher than normal base wage increases, flexible working hours and other benefits and higher nurse to patient ratios necessary to improve quality of care. Quality of care initiatives also require additional nurse training programs that increase salaries and benefitscosts. We will incur significant training costs as nurses learn to utilize our new information technology tools that allow us to monitor and report quality performance indicators. Becoming the employer of choice for nurses requires upfront human resource investmentsthat could negatively affect operating results in the short-term. We may also be limited in our ability to adjust staffing levels in periods of lower than expected volumes. However, we expect that reducing turnover and improving the skill sets of our nurses willreduce our reliance on contract labor and result in improved quality of care and increased revenues in the long-term.

                We expect to supplement our base of trained nursing professionals by expanding our comprehensive nurse recruiting and retentionprogram. This program includes the following key components, among others:

               •

Nursing schools in San Antonio andPhoenix                                                                                               

               •

 

Foreign nurse recruiting initiatives

               •

 

Tuition reimbursement and internal training to promote career advancement opportunities, including specialization qualifications

               •

 

Extern programs and campus events to network with students

               •

 

Preceptor and other mentoring programs

               •

 

Expansion of orientation programs and employee involvement initiatives

               •

 

Performance leadership training for managers and directors

               •

 

Flexible work hours for nurses

               •

 

Employee safety initiatives

               •

 

Competitive pay and benefits and nursing recognition programs

                We operate the Baptist Health System School of Health Professions (“SHP”) in San Antonio, which offers eight differentprograms with the greatest enrollment in the professional nursing program. The SHP trains approximately 450 students each year, the majority of which have historically chosen permanent employment with us. SHP experienced a slight enrollment growth in fall 2007compared to fall 2006. Plans are underway to transition SHP’s current diploma program to a degree granting program that will be more attractive to potential students. SHP enrollment includes approximately 80 students in our metropolitan Phoenix market that aretrained using state of the art distance learning technology maximizing utilization of SHP instructors. Students are provided with company-funded scholarships that cover tuition, books and fees in return for a commitment to work at one of our hospitals for a definedperiod of time. Should we be unsuccessful in our attempts to maintain adequate nursing staff for our present and future needs, our future operating results could be materially adversely impacted.

                *Competition for Outpatient Services*

                With advances in medical technologies and pharmaceuticals, many services once provided in an inpatient setting are now available in anoutpatient setting. The redirection of services to outpatient settings is also influenced by pressures from payers to reduce costs and by patients who seek convenience. Our hospitals and many other acute hospitals have struggled to retain or grow outpatient businessresulting from this inpatient to outpatient shift. Competition for outpatient services has increased significantly with the proliferation of surgery centers, outpatient imaging centers and outpatient laboratories that are often viewed as more convenient to physiciansand patients. While we remain at risk for further migration of outpatient services to non-hospital settings or to other hospitals, we expect to mitigate these risks with our quality of care initiatives, physician integration strategies and capital projects to improvethe design of and access to outpatient service areas in our hospitals.

                *Implementation of our Quality Initiatives*

**

                The previous paragraphs discuss the industry trends that are integral to our future success and how quality of care is the mostimportant component in achieving success in those areas. While we are in the early stages of implementing our

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expanded quality of care initiatives, we believe that the following programs currently in place represent key building blocks to a successful strategy.

               •

Monthly review of the 21 quality indicators prescribed by CMS for federal fiscal year 2007 with plans to expand to 27 during our fiscal 2008

               •

 

Rapid response teams in place at all of our hospitals to provide more timely and efficient care

               •

 

Hourly nursing rounds in place at most of our hospitals

               •

 

Engagement of an external group to conduct unannounced mock JCAHO surveys

               •

 

Alignment of hospital management incentive compensation with quality performance indicators

               •

 

Additional staffing to collect and report quality information and to facilitate action plans to address areas for improvement

               •

 

Common information system in place at all hospitals to report quality indicators

               •

 

Common information system at departmental level to achieve efficiencies in delivering care and to feed data to the common reporting system (partially implemented, with all modules to be operational by the end of fiscal2009)

**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 payment rates for these services with third party payers.

                *Sources of Revenues*

                The primary sources of our revenues include various managed care payers including managed Medicare and Medicaid programs, thetraditional Medicare program, various state Medicaid programs, commercial health plans and the patients themselves. We are typically paid much less than our gross charges regardless of the payer source. Revenues from governmental programs are based upon complexreimbursement methodologies that require us to extensively monitor compliance with regulations including billing, coding and cost reimbursement items. These regulations change frequently and require us to adjust our processes, procedures and information systems inorder to ensure that we bill these programs correctly and record related revenues appropriately. Revenues from managed care programs are typically based on contractually-stated rates or discounts we have negotiated with the various managed care plans. The contractsoften contain exclusions, carve-outs, performance criteria and other guidelines that also require our constant focus and attention. Private patients who are members of managed care plans are not required to pay us for their healthcare services other than thecoinsurance and deductible portions of their plan coverage calculated after managed care discounts have been applied. A more detailed description of these revenue sources is set forth in Part I, Item I, “Business”, “Reimbursement” of our June30, 2007 10-K.

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                The following table sets forth the percentages of net patient revenues by payer for the quarters ended September 30, 2006 and2007.

**Quarter ended September 30,**

 

 
****
 

**2006**

**2007**
********
Medicare

 

25.4%

 

25.3%

 

Medicaid

 

9.0%

 

8.6%

 

Managed care(1)

 

51.9%

 

55.1%

 

Self pay

 

9.4%

 

9.7%

 

Other

4.3%

1.3%

 

 

 

 

Total

 

100.0%

 

100.0%

 

 

 

 

 

____________________

(1)

 

Includes revenues from managed Medicare, managed Medicaid and other governmental managed plans in addition to commercial managed care plans.

                *Volumes by Payer*

                During the quarter ended September 30, 2007, we experienced a 1.1% increase in discharges from continuing operations and a 1.2%increase in hospital adjusted discharges from continuing operations compared to the prior year quarter. The following table provides details of discharges from continuing operations by payer for the quarters ended September 30, 2006 and 2007.

 

 

**Quarter ended September 30,**

 

 

 

 

**2006**

 

**2007**

 

 

 

Medicare

 

11,086

 

26.9%

 

11,153

 

26.8%

Medicaid

 

5,796

 

14.1%

 

5,290

 

12.7%

Managed care(1)

 

22,443

 

54.5%

 

23,545

 

56.5%

Self pay

 

1,476

 

3.6%

 

1,466

 

3.5%

Other

392

0.9%

211

0.5%

 

 

 

 

 

Total

 

41,193

 

100.0%

 

41,665

 

100.0%

 

 

 

 

 

____________________

(1)

 

Includes discharges under managed Medicare, managed Medicaid and other governmental managed plans in addition to commercial managed care plans.

                We continue to experience limited volume growth due to stagnant demand for inpatient healthcare services and increased competition foravailable patients. Additionally, decreases in certain subacute services as a result of regulatory changes and reduced demand for elective procedures as a result of changes in patient insurance coverage continue to weaken inpatient and outpatient volumes. We expectour volumes to improve more significantly over the long-term as a result of quality of care and service expansion initiatives and other market-specific strategies. We have experienced improved volumes from our recently completed expansion projects in San Antonio andPhoenix, but full utilization of these services has not yet occurred.

                While Medicare and self-pay discharges are basically flat quarter over quarter, our self-pay volumes have generally increased duringthe past twelve months and traditional Medicare volumes have shifted to managed Medicare volumes (included in the Managed care category in the table above) during the past twelve months. These shifts have resulted in

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increased bad debts and increased exposure to collection risks for patient co-insurance and deductible amounts, which are subject to cost reimbursement under the traditional Medicare program but not under managed Medicareplans.

                *Payer Reimbursement Trends*

                In addition to volume factors described above, patient mix, acuity factors and pricing trends affect our patient service revenues. Netpatient revenues per adjusted hospital discharge from continuing operations increased 5.6% from $7,436 during the quarter ended September 30, 2006 to $7,849 during the quarter ended September 30, 2007.  This increase reflects improved reimbursement for servicesprovided under negotiated managed care contracts and improved Medicare reimbursements. However, due to consolidation of managed care plans and federal and state efforts to decrease Medicare and Medicaid spending, our ability to recognize improved reimbursement aboveor equal to rates recognized in previous periods is becoming more difficult.

                Increases in levels of charity care and negotiated self-pay discounts also impact net patient revenues per adjusted hospital dischargeby decreasing revenues and decreasing the provision for doubtful accounts. We cannot assure you that future reimbursement rates, even if improved, will sufficiently cover potential increases in the cost of providing healthcare services to our patients.

                During fiscal 2007 we began receiving payments under the Bexar County, Texas upper payment limit (“UPL”) Medicaid program.The UPL program allows private hospitals to enter into indigent care affiliation agreements with governmental entities. Within the parameters of these programs, private hospitals expand charity care services to indigent patients and alleviate expenses for thegovernmental entity. The governmental entity is then able to utilize its tax revenue to fund the Medicaid program for private hospitals. Since the beginning of our participation with the UPL program, we have recognized $22.3 million of revenues and $12.3 million ofincome from continuing operations before income taxes directly related to the program. CMS began reviewing the operations of the private hospital UPL programs after the state of Texas made the first payments in April 2007. It is customary for CMS to review Medicaidpayment programs, and it is our understanding that all private hospital UPL programs in Texas are now under CMS review. In October 2007, the state halted all funding of the private hospital UPL programs due to the deferral by CMS of certain federal Medicaid payments.We believe the state will continue to withhold payments until CMS completes its review and delineates any concerns. CMS has only indicated to us that it might require some changes in the program documentation, however there can be no assurance at this time whetherthe final results of the CMS review will be limited to merely changes in our program documentation. While the current suspension and the possible termination of future benefits of our UPL program are not material to our financial statements, should the federal, stateor county governments require recoupment of the previous matching funds paid to us, our results of operations and cash flows could be materially adversely impacted.

                *Premium Revenues*

                We recognize premium revenues from our three health plans, PHP, AAHP and MHP. AAHP commenced operations on January 1, 2006 primarily toprovide healthcare services (including Medicare Part D) to those individuals eligible for both Medicare and Medicaid benefits based on age and income levels. As of September 30, 2007, approximately 3,400 members were enrolled in this program, most of whom werepreviously enrolled in PHP. PHP’s membership increased to approximately 100,600 at September 30, 2007 compared to approximately 94,600 at September 30, 2006. Premium revenues from these three plans increased by $8.7 million or 9.0% during the quarter endedSeptember 30, 2007 compared to the prior year quarter. This increase resulted primarily from the increased number of enrollees quarter over quarter. PHP also experienced period over period increased per member per month reimbursement as a result of a rate increasethat went into effect on October 1, 2006. In September 2007, the Arizona Health Care Cost Containment System (“AHCCCS”) exercised its final one-year renewal option under its contract with PHP that commenced on October 1, 2003, which extends the currentcontract through September 30, 2008. The Centers for Medicare and Medicaid Services (“CMS”) renewed its contract with AAHP for a one-year period effective January 1, 2007.  Should the PHP contract terminate, our future operating results and cashflows 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. While these trends may involve certain factors that are outside of our control, the extent to

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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, if any, will have onus.

                *Accounts Receivable Collection Risks Leading to Increased Bad Debts*

                Similar to others in the hospital industry, the collectibility of our accounts receivable has deteriorated primarily due to an increasein self-pay receivables. The following table provides a summary of our accounts receivable payer class mix as of each respective period presented.

**September 30, 2006**

**0-90 days**

**91-180 days**

**Over 180 days**

**Total**

Medicare

 

 

18.0%

 

 

 

0.8%

 

 

0.6%

 

 

19.4%

Medicaid

8.0%

1.2%

1.0%

10.2%

Managed Care

38.3%

3.9%

2.3%

44.5%

Self Pay(1)

10.9%

8.9%

2.0%

21.8%

Other

2.7%

0.9%

0.5%

4.1%

 

    Total

 

77.9%

 

15.7%

 

6.4%

 

100.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**June 30, 2007**

**0-90 days**

**91-180 days**

**Over 180 days**

**Total**

Medicare

 

 

15.0%

 

 

 

0.6%

 

 

0.6%

 

 

16.2%

Medicaid

7.5%

2.0%

1.0%

10.5%

Managed Care

38.0%

4.0%

2.9%

44.9%

Self Pay(1)

12.0%

10.8%

2.8%

25.6%

Other

1.8%

0.6%

0.4%

2.8%

 

    Total

 

74.3%

 

18.0%

 

7.7%

 

100.0%

 

 

 

 

 

 

 

 

 

 

 

**September 30, 2007**

**0-90 days**

**91-180 days**

**Over 180 days**

**Total**

Medicare

 

 

16.9%

 

 

 

0.5%

 

 

0.5%

 

 

17.9%

Medicaid

7.5%

1.0%

0.8%

9.3%

Managed Care

42.1%

3.1%

2.8%

48.0%

Self Pay(1)

10.9%

9.5%

2.2%

22.6%

Other

1.5%

0.4%

0.3%

2.2%

 

    Total

 

78.9%

 

14.5%

 

6.6%

 

100.0%

 

                ____________________(1)           Includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the                primary payer. If primary payment has not been received for an account, the patient co-insurance and deductible amounts remain                classified in the primary payer category.

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                Our combined allowance for doubtful accounts and allowance for charity care on a consolidated basis covered 91.4% of self-pay accountsreceivable as of June 30, 2007 and September 30, 2007. Our combined allowance for doubtful accounts and allowance for charity care from continuing operations covered 87.5% and 86.9% of self-pay accounts receivable from continuing operations as of June 30, 2007 andSeptember 30, 2007, respectively.

                The increase in self-pay accounts receivable has led to increased write-offs and older accounts receivable outstanding, resulting inthe need for an increased allowance for doubtful accounts and charity care. The increase in self-pay accounts receivable results from a combination of factors including price increases, increased patient volumes, higher levels of patient deductibles and co-insuranceunder managed care programs and the increased difficulties of uninsured patients who do not qualify for charity care programs to pay for escalating healthcare costs. We have implemented policies and procedures designed to expedite upfront cash collections and promoterepayment plans from our patients. Our upfront cash collections from continuing operations increased 12.7% during the quarter ended September 30, 2007 compared to the prior year quarter.  However, we believe bad debts will remain sensitive to changes in payermix, pricing and general economic conditions for the hospital industry during the foreseeable future.

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

We do not pursue collection of amounts due from uninsured patients that qualify for charity care under our guidelines (currently those uninsured patients whose incomes are equal to or less than 200% of the current federalpoverty guidelines set forth by the Department of Health and Human Services). We exclude charity care accounts from revenues when we determine that the account meets our charity care guidelines. We deducted $22.8 million and $17.3 million of charity care from totalrevenues during the quarters ended September 30, 2006 and 2007, respectively. Healthcare services provided to undocumented aliens that qualify for border funding reimbursement represented $5.8 million and $4.8 million of the charity care deductions during thequarters ended September 30, 2006 and 2007, respectively.

                *Medicaid Funding Cuts*

                Many states, including certain states in which we operate, have periodically reported budget deficits as a result of increased costsand lower than expected 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 theseprograms and other states may make similar funding cuts. These cuts may include tightened participant eligibility standards, reduction of benefits, enrollment caps or payment reductions. Additionally, pressure exists at the federal level to reduce Medicaid matchingfunds provided to states. Federal legislation enacted in 2006 requires federal Medicaid funding cuts of $4.8 billion over five years. CMS also issued a final rule in May 2007 that, if implemented, would require additional federal Medicaid funding reductions. We areunable to assess the financial impact on our business of enacted or proposed state or federal funding cuts at this time.

                *Volatility of Professional Liability Costs*

                We maintained professional and general liability insurance coverage through a wholly owned captive insurance subsidiary for individualclaims incurred through May 31, 2006 up to $10.0 million. For claims incurred subsequent to May 31, 2006, we self-insure the first $9.0 million per occurrence, and the captive subsidiary insures the next $1.0 million per occurrence. We maintain excess insurancecoverage with independent third party carriers on a claims-made basis for individual claims exceeding $10.0 million up to $75.0 million, but limited to total annual payments of $65.0 million in the aggregate. The total cost of our professional and general liabilityinsurance is sensitive to the volume and severity of cases reported. Malpractice premiums have adversely affected the ability of physicians to obtain malpractice insurance at reasonable rates in certain markets, particularly in metropolitan Chicago, resulting inphysicians relocating to different geographic areas. In the event physicians practicing in our hospitals are unable to obtain adequate malpractice insurance coverage, our hospitals are likely to incur a greater percentage of the amounts paid to claimants.  Ourprofessional liability exposures also increase when we employ physicians. On the other hand, some states, including Texas and Illinois, have passed tort reform legislation to place limits on non-economic damages. While we have taken multiple steps at our facilitiesto reduce our professional liability exposures, absent significant additional legislation to curb the size of malpractice judgments in other states in which we operate, our insurance costs may increase in the future.

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                *Increased Cost of Compliance in a Heavily Regulated Industry*

                We conduct business in a heavily regulated industry. Accordingly, we maintain a comprehensive, company-wide compliance program toaddress healthcare regulatory and other compliance requirements. This compliance program includes, among other things, initial and periodic ethics and compliance training, a toll-free reporting hotline for employees, annual fraud and abuse audits and annual codingaudits. The organizational structure of our compliance program includes oversight by our board of directors and a high-level corporate management compliance committee. Our Senior Vice President of Compliance and Ethics reports jointly to our Chairman and ChiefExecutive Officer and to our board of directors, serves as Chief Compliance Officer and is charged with direct responsibility for the day-to-day management of our compliance program.  During fiscal 2006, we established regional compliance officers in our marketsand staffed the new positions with compliance professionals 100% dedicated to compliance duties. The financial resources necessary for program oversight, enforcement and periodic improvements to our program continue to grow, especially when we add new features to ourprogram or engage external resources to assist with these highly complex matters.

**Update of Critical Accounting Policies and Estimates**

                The unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generallyaccepted in the United States. In preparing these financial statements, we make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses included in the financial statements. Management bases its estimates on historicalexperience and other available information, the results of which form the basis of the estimates and assumptions. We consider the following accounting policies to be critical accounting policies because they involve the most subjective and complex assumptions andassessments, are subject to a great degree of fluctuation period over period and are the most critical to our operating performance:  revenues and revenue deductions, allowance for doubtful accounts and provision for doubtful accounts, insurance reserves,medical claims reserves, income taxes and impairment of long-lived assets and goodwill.

                Other than the update provided below, there have been no changes in the nature or application of our critical accounting policies andestimates as discussed in Note 2 to our consolidated financial statements included in our 10-K for the fiscal year ended June 30, 2007.

*                Allowance for Doubtful Accounts and Provision for Doubtful Accounts*

                Our ability to collect the self-pay portions of receivables is critical to our operating performance and cash flows. The allowance fordoubtful accounts was approximately 28.3% and 29.0% of accounts receivable, net of contractual discounts, as of June 30, 2007 and September 30, 2007, respectively. The primary collection risk relates to uninsured patient accounts and patient accounts for whichprimary insurance has paid but patient deductibles or co-insurance portions remain outstanding.

                Effective July 1, 2007, we began estimating the allowance for doubtful accounts using a standard policy that reserves 100% of allaccounts aged greater than 365 days subsequent to discharge date plus 85% of uninsured accounts less than 365 days old plus 40% of self pay after insurance/Medicare less than 365 days old. Our previous policy reserved all accounts greater than 180 days plus amarket-specific percentage of uninsured and self pay after insurance/Medicare balances. The change in policy negatively impacted our provision for doubtful accounts during the quarter ended September 30, 2007. However, we believe our new policy will adjust morequickly to payer mix shifts over time. We test our allowance for doubtful accounts policy quarterly using a hindsight calculation that utilizes write-off data for all payer classes during**the previous twelve-month period to estimate the allowance for doubtfulaccounts at a point in time. We also supplement our analysis by monitoring cash collections and self-pay utilization. Significant changes in payer mix, business office operations, general economic conditions and healthcare coverage provided by federal or stategovernments or private insurers may have a significant impact on our estimates and significantly affect our operations and cash flows.

                We classify accounts pending Medicaid approval as Medicaid accounts in our accounts receivable aging report and record a manualcontractual allowance for these accounts equal to the average Medicaid reimbursement rate for that specific state. We have historically been successful in qualifying approximately 50% of submitted accounts for Medicaid coverage. As of September 30, 2007, we hadapproximately $12.0 million of Medicaid pending accounts receivable from continuing operations ($4.9 million of which was stated at gross charges with a manual contractual allowance and $7.1 million of which was stated net of contractual discounts). In the event anaccount is not successfully qualified for Medicaid coverage and does not meet our charity guidelines, the previously recorded Medicaid contractual adjustment remains a revenue deduction

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(similar to a self-pay discount), and the remaining net account balance is reclassified to self-pay status and subjected to our allowance for doubtful accounts policy. During the quarters ended September 30, 2006 and 2007,approximately $2.4 million and $4.2 million of net accounts receivable from continuing operations was reclassified from Medicaid pending status to self-pay status, respectively. If the account does not qualify for Medicaid coverage but does qualify as charity care,the contractual adjustment is reversed and the gross account balance is recorded as a charity deduction. During the quarters ended September 30, 2006 and 2007, we recorded approximately $1.4 million and $1.3 million of charity deductions from continuing operationsfor the net balances of accounts previously classified as Medicaid pending that did not meet Medicaid eligibility requirements.

                Because we require patient verification of coverage at the time of admission or service, reclassifications of Medicare or managed careaccounts to self-pay, other than patient coinsurance or deductible amounts, occur infrequently and are not material to our financial statements.  Additionally, the impact of these classification changes is further limited by our ability to identify any necessaryclassification changes prior to patient discharge or soon thereafter. Due to information system limitations and timing of claims or benefits adjudication, we are unable to quantify patient deductible and co-insurance receivables that are included in the primary payerclassification in the accounts receivable aging report at any given point in time. Our self-pay financial class includes uninsured patients and those patient co-insurance and deductible amounts for which payment has been received from the primary payer. If primarypayment has not been received for an account, the patient co-insurance and deductible amounts remain classified in the primary payer category. When classification changes occur, the account balance remains aged from the patient discharge date.

                *Income Taxes*

                We believe that our tax return provisions are accurate and supportable, but certain tax matters require interpretations of tax law thatmay be subject to future challenge and may not be upheld under tax audit. To reflect the possibility that all of our tax positions may not be sustained, we maintain tax reserves that are subject to adjustment as updated information becomes available or ascircumstances change. We record the impact of tax reserve changes to our income tax provision in the period in which the additional information, including the progress of tax audits, is obtained.

                We assess the realization of our deferred tax assets to determine whether an income tax valuation allowance is required. Based on allavailable evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, we determine whether it is more likely than not that all or a portion of the deferred tax assets will be realized. The factorsused in this determination include the following:

                •  Cumulative losses in recent years                •  Income/losses expected in future years                •  Unsettled circumstances that, if favorably resolved, would adversely affect future operations                •  Availability, or lack thereof, of taxable income in prior carryback periods that would limit realization of                    tax benefits                •  Carryforward period associated with the deferred tax assets and liabilities                •  Prudent and feasible tax planning strategies

In addition, financial forecasts used in determining the need for or amount of federal and state valuation allowances are subject to changes in underlying assumptions and fluctuations in market conditions that couldsignificantly alter our recoverability analysis and thus have a material adverse impact on our consolidated financial condition, results of operations or cash flows.

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                Effective July 1, 2007, we adopted the provisions of FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes –An Interpretation of FASB Statement No. 109* (“FIN 48”). In connection with the adoption of FIN 48, we recorded a $0.4 million net liability for unrecognized tax benefits, accrued interest and penalties, which was comprised of the following (inmillions).

Reclassification from  income taxes payable

$

0.3

Increase to non-current deferred tax assets

 

2.7

Cumulative impact of change recorded to retained earnings

 

(2.6

)

 

 

 

$

0.4

 

 

                The provisions of FIN 48 allow for the classification election of interest on an underpayment of income taxes, when the tax lawrequires interest to be paid, and penalties, when a tax position does not meet the minimum statutory threshold to avoid payment of penalties, in income taxes, interest expense or another appropriate expense classification based on the accounting policy election ofthe entity. We elected to continue our historical practice of classifying interest and penalties as a component of income tax expense.

                Approximately $0.3 million of the $0.4 million of unrecognized tax benefits, if recognized, would impact the effective tax rate, whilethe remaining $0.1 million of unrecognized tax benefits, if recognized, would increase goodwill. The unrecognized tax benefits remained at $0.4 million as of September 30, 2007.

**Selected Operating Statistics**

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

 

 

 

 

**(Unaudited) Quarter ended September 30,**

 

 

 

 

 

**2006**

 

 

**2007**

 

Number of hospitals at end of period

 

 

 

15

 

15

Number of licensed beds at end of period

 

 

 

4,124

 

4,143

Discharges (a)

 

 

 

41,193

 

41,665

Adjusted discharges - hospitals (a)

 

 

 

66,072

 

66,844

Net revenue per adjusted discharge - hospitals (a)

 

 

$

7,436

$

7,849

Patient days (a)

 

 

 

175,306

 

178,542

Adjusted patient days - hospitals (a)

 

 

 

281,182

 

286,440

Average length of stay (days) (a)

 

 

 

4.26

 

4.29

Outpatient surgeries (a)

 

 

 

19,248

 

18,129

Emergency room visits (a)

 

 

 

139,760

 

144,743

Occupancy rate (a)

47.6

%

46.8

%

Average daily census (a)

1,906.0

1,941.0

Member lives (a)

144,000

147,500

Medical claims percentage (a)

73.9

%

71.9

%

____________________

(a)

 

The definitions for the statistics included above are set forth in Part 2, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Selected OperatingStatistics” in our June 30, 2007 10-K.

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

                The following table presents summaries of our operating results for the quarters ended September 30, 2006 and 2007.

 

 

**(Unaudited) Quarter ended September 30,**

 

 

 

 

**2006**

 

**2007**

 

 
****
 
****
 

 

**Amount**

 

**%**

** **

** **

**Amount**

** **

** **

**%**

 

 

 
****
 
****
 

 

*(In millions)*

 

 

** **

Patient service revenues

 

$

521.3

 

 

 

84.3

%

 

$

556.8

 

 

 

84.0

%

Premium revenues

 

 

97.0

 

 

 

15.7

%

 

 

105.7

 

 

 

16.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

618.3

 

 

 

100.0

%

 

662.5

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Salaries and benefits (includes stock compensation of $0.3    and $0.5, respectively)

 

 

259.6

 

 

 

42.0

%

 

 

273.7

 

 

 

41.3

%

Supplies

 

 

100.2

 

 

 

16.2

%

 

 

103.2

 

 

 

15.6

%

Medical claims expense

 

 

71.7

 

 

 

11.6

%

 

 

76.0

 

 

 

11.5

%

Provision for doubtful accounts

 

 

40.5

 

 

 

6.5

%

 

 

53.9

 

 

 

8.1

%

Other operating expenses

 

 

92.6

 

 

 

15.0

%

 

 

99.4

 

 

 

15.0

%

Depreciation and amortization

 

 

28.9

 

 

 

4.7

%

 

 

32.5

 

 

 

4.9

%

Interest, net

 

 

29.8

 

 

 

4.8

%

 

 

31.7

 

 

 

4.8

%

Minority interests and other expenses

 

 

(0.8

)

 

 

(0.1

)%

 

 

2.0

 

 

0.3

%

 

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations before income taxes

 

 

(4.2

) 

 

 

(0.7

)%

 

 

(9.9

)

 

 

(1.5

)%

Income tax benefit

 

 

1.5

 

 

 

0.3

%

 

 

3.4

 

 

0.5

%

 

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

(2.7

) 

 

 

(0.4

)%

(6.5

)

(1.0

)%

Loss from discontinued operations, net of taxes

(5.0

)

(0.8

)%

(0.4

)

(0.1

)%

Net loss

 

$

(7.7

) 

 

 

(1.2

)%

 

$

(6.9

)

 

 

(1.1

)%

 

 

 

 

 

 

 

 

 

 

 

 

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Table of Contents

**Quarter ended September 30, 2007 compared to Quarter ended September 30, 2006**

                *Revenues*.  Revenues increased $44.2 million during the quarter ended September 30, 2007 compared to the prior year quarterdue to improved reimbursement for services provided and increased patient volumes. Net revenue per adjusted hospital discharge from continuing operations increased 5.6% quarter over quarter.  Our service expansion initiatives and managed care contractingstrategies played significant roles in our rate improvements. Hospital adjusted discharges from continuing operations increased 1.2% during the current year quarter. While overall patient volumes have increased slightly, we continue to face competitive pressures fromother hospitals in recruiting and retaining quality physicians and reduced elective outpatient procedures resulting from an increase in the number of uninsured patients and those insured patients with higher coinsurance and deductibles limits. Emergency room visitsfrom continuing operations increased 3.6% quarter over quarter, while outpatient surgery volumes decreased 5.8% quarter over quarter. Outpatient surgeries were adversely impacted by the opening of a physician-owned surgery center on the campus of one of our SanAntonio hospitals in October 2006 and general increased competition for outpatient services in our other markets. We expect revenue growth to continue during the remainder of our current fiscal year, although factors outside our control including patient demand forhealthcare services and increased competition could limit such growth.

                Premium revenues increased 9.0% during the current year quarter as a result of a quarter over quarter increase in health planenrollees.  Also, per member per month reimbursement for PHP increased quarter over quarter as a result of an AHCCCS rate increase effective October 1, 2006.

                We continue to focus on implementing our quality of care initiatives and developing an optimal service line mix that both meets theneeds of our patients and improves our operating results.  The success of these strategies depends on our ability to retain our nurses, our physician recruitment and retention initiatives, our capital improvement projects including advanced clinical systems andour primary care development initiatives. We believe that these initiatives and the favorable demographic trends in most of our markets will position us to recapture patient volumes once demand for healthcare services recovers.

                *Costs and Expenses*.  Total costs and expenses, exclusive of income taxes and discontinued operations, were $672.4 millionor 101.5% of total revenues during the current year quarter, compared to 100.7% during the prior year quarter.  Salaries and benefits, supplies, medical claims and provision for doubtful accounts represent the most significant of our normal costs and expenses orthose subject to the greatest level of fluctuation period over period.

               •

  

**Salaries and benefits. Salaries and benefits as a percentage of total revenues decreased to 41.3% during the current year quarter from 42.0% during the prior year quarter. We attribute this improvement to ourstaff management initiatives, our ability to reduce contract labor utilization and our premium revenue growth. Our contract labor expense decreased by 20.5% quarter over quarter. The national nursing shortage continues to hinder our ability to fully manage salariesand benefits. Adjusting staffing levels during periods of weakened demand for healthcare services is more difficult when nursing resources are constrained limiting our ability to re-adjust staffing levels when demand recovers. We expect the nursing shortage tocontinue during the foreseeable future, although we intend to mitigate these pressures by continuing to improve our comprehensive nurse recruiting and retention program. We also expect that salaries and benefits may increase in the future as a result of our need toemploy more physicians at our hospitals. Maintaining a stable nurse workforce and access to quality physicians is vital to our quality initiatives and places even more importance on increasing revenues in order to realize a lower percentage of salaries and benefitsto total revenues.
 

 

** **

               •

**Supplies. Supplies as a percentage of total revenues decreased to 15.6% during the current year quarter from 16.2% during the prior year quarter.  We are beginning to realize the benefits of our increasedcorporate focus on supply chain strategies including charge master and pharmacy formulary refinements, better utilization of our group purchasing organization and reductions in the variation of physician preference items.  Because our growth strategies includeexpansion of high acuity services, we do not expect to realize significant future decreases in this ratio. Price increases for pharmaceuticals and medical supplies could have a significant adverse impact on future supplies costs.
 

 

** **

               •

**Medical claims. Medical claims expense as a percentage of premium revenues decreased from 73.9% to 71.9% during the current year quarter compared to the prior year quarter primarily as a result of decreasedmedical claims expense at AAHP. AAHP began operations on January 1, 2006. During the prior year quarter, we had
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limited historical data upon which to rely for estimating medical claims for AAHP. As further information has since become available, we have refined our AAHP medical claims expense estimates to better reflect actualutilization. Medical claims expense represents the amounts paid by the health plans for healthcare services provided to their members, including an estimate of incurred but not yet reported claims that is determined based upon lag data and other actuarialassumptions. Revenues and expenses between the health plans and our hospitals and related outpatient service providers of approximately $8.4 million, or 10.0% of gross health plan medical claims expense, were eliminated in consolidation during the current yearquarter.

 

 

 

               •

**Provision for doubtful accounts. During the current year quarter, the provision for doubtful accounts as a percentage of patient service revenues increased to 9.7% from 7.8% during the prior year quarter. Weadjusted our allowance for doubtful accounts policy effective July 1, 2007 to more quickly recognize uncollectible accounts associated with uninsured or underinsured patients. The quarter over quarter increase was primarily attributable to this policy change and aquarter over quarter increase in self-pay net revenue payer mix. Also, patient co-insurance and deductible amounts have become more difficult to collect due to managed care plans’ efforts to shift a greater portion of healthcare costs to their enrollees.
During the quarters ended September 30, 2006 and 2007, we recorded $22.8 million and $17.3 million of charity care revenue deductions from continuing operations, respectively. On a combined basis, the provision for doubtfulaccounts and charity care deductions as a percentage of patient service revenues increased to 12.8% during the current year quarter compared to 12.1% during the prior year quarter.  Collecting outstanding self-pay accounts remains difficult; however, we haveexperienced improved upfront cash collections and success in qualifying patients for coverage under Medicaid or similar programs.

                *Income taxes*. Our effective tax rate decreased from approximately 35% during the prior year quarter to approximately 34% duringthe current year quarter primarily as a result of an increase in the valuation allowance for certain deferred tax assets during the current year quarter that reduced our tax benefit.

                *Net loss*.  The $0.8 million quarter over quarter decrease in net loss resulted primarily from the decrease in loss fromdiscontinued operations, net of taxes, during the current year quarter. The prior year quarter included the operating losses of the California hospitals prior to their sale on October 1, 2006.

**Liquidity and Capital Resources**

                *Operating Activities. * At September 30, 2007, we had working capital of $182.0 million, including cash and cash equivalentsof $158.3 million.  Working capital at June 30, 2007 was $156.4 million. Cash provided by operating activities increased $56.7 million quarter over quarter.  The increase in operating cash flows was primarily due to improved net cash collections of accountsreceivable and a decrease in payments of accounts payable and other liabilities during the current year quarter. Net accounts receivable days improved by approximately 2 days quarter over quarter.

                *Investing Activities*.  Cash used in investing activities decreased from $29.1 million during the prior year quarter to$16.9 million during the current year quarter, primarily as a result of a $15.5 million quarter over quarter decrease in capital expenditures. We have now paid substantially all amounts related to our significant expansion projects in Phoenix and San Antonio, themajority of which were still in process during the prior year quarter.

                We anticipate spending a total of $140.0 million to $160.0 million in capital expenditures during fiscal 2008 including the $21.4million spent through September 30, 2007. Our fiscal 2008 estimate includes approximately $29.3 million of information technology upgrades to support our quality initiatives at our facilities. We expect to fund our capital expenditures with cash on hand, cash flowsfrom operations and availability under our revolving credit facility. We believe our capital expenditure program is sufficient to service, expand and improve our existing facilities to meet our quality objectives.

                *Financing Activities*.  Cash flows from financing activities was flat quarter over quarter. As of September 30, 2007, we hadoutstanding $1,528.4 million in aggregate indebtedness, with an additional $221.5 million of available borrowing capacity under our revolving credit facility ($250.0 million net of outstanding letters of credit of $28.5 million). Our liquidity requirements aresignificant, primarily due to debt service requirements. The 9.0% Notes require semi-annual interest

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payments. Prior to October 1, 2009, our interest expense on the 11.25% Notes will consist solely of non-cash accretions of principal.

                Our previous senior secured credit facilities executed in September 2004 consisted of a revolving credit facility and the initial termloan facility. Our revolving credit facility provides for loans in a total principal amount of up to $250.0 million, and matures in September 2010. The initial term loan facility, which was scheduled to mature in September 2011, provided for loans in a totalprincipal amount of up to $800.0 million as follows: (1) $475.0 million borrowed on September 23, 2004 to finance the Blackstone merger, to refinance our then existing indebtedness and to pay fees and expenses relating thereto; (2) $150.0 million borrowed on December31, 2004 and February 18, 2005 to finance the acquisition of our Massachusetts hospitals and for other general corporate purposes and (3) $175.0 million borrowed in September 2005 to fund capital expenditures and for other general corporate purposes.

                On September 26, 2005, we refinanced and repriced all $795.7 million of the outstanding term loans under the initial term loan facilityby borrowing $795.7 million of replacement term loans (the “2005 term loan facility”).

                The 2005 term loan facility borrowings bear interest at a rate equal to, at our option, a base rate plus 1.25% per annum or LIBOR plus2.25% per annum. These rates reflect a savings of 1.0% per annum over the interest rate options for our previous initial term loan facility. The borrowings under the revolving credit facility currently bear interest at a rate equal to, at our option, a base rate plus1.00% per annum or LIBOR plus 2.00% per annum. These rates are subject to increase by up to 0.25% per annum should our leverage ratio exceed certain designated levels.

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

                The 2005 term loan facility and the revolving credit facility contain a number of covenants that, among other things, restrict, subjectto certain exceptions, our ability, and the ability of our subsidiaries, to sell assets, incur additional indebtedness or issue preferred stock, repay other indebtedness (including the 9.0% Notes and 11.25% Notes), pay dividends and distributions or repurchase ourcapital stock, create liens on assets, make investments, loans or advances, make certain acquisitions, engage in mergers or consolidations, enter into sale and leaseback transactions, engage in certain transactions with affiliates, amend certain material agreementsgoverning our indebtedness, including the 9.0% Notes and 11.25% Notes, change the business conducted by our subsidiaries and enter into hedging agreements. In addition, the senior credit facilities require us to maintain the following financial covenants: a maximumtotal leverage ratio, a maximum senior leverage ratio, a minimum interest coverage ratio and a maximum capital expenditures limitation.

                As of September 30, 2007, our capital expenditures, as defined in the senior secured credit agreement, were below the maximum covenantamount, and we were in compliance with the other debt covenant ratios as defined in our senior secured credit agreement, as follows.

 

 

**Debt Covenant Ratio**

           

**Actual Ratio**

 

 

Interest coverage ratio requirement

 

2.00x

 

2.45x

Total leverage ratio limit

 

5.75x

 

4.59x

Senior leverage ratio limit

 

3.75x

 

2.26x

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

              •  incur additional indebtedness or issue preferred stock;

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

              •  make investments;

              •  enter into certain transactions with affiliates;

              •  pay dividends or other similar payments by our subsidiaries;

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

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

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

**Standard & Poor’s**

               

**Moody’s**

 

 

Corporate credit rating

B

 

B2

9% Senior Subordinated Notes            

CCC+

 

Caa1

111⁄4% Senior Discount Notes

CCC+

 

Caa1

Senior credit facilities

B+

 

Ba3

                *Capital Resources*.  We expect that cash generated from our operations and cash available to us under our revolving creditfacility will be sufficient to meet our working capital needs, debt service requirements and planned capital expenditure programs during the next twelve months and into the foreseeable future prior to the maturity dates of our outstanding debt. However, we cannotassure you that our operations will generate sufficient cash or that future borrowings under our refinanced senior credit facilities will be available to enable us to meet these requirements and needs.

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

**Guarantees and Off Balance Sheet Arrangements**

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

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**Obligations and Commitments**

                The following table reflects a summary of obligations and commitments outstanding, including both the principal and interest portionsof long-term debt and capital leases, with payment dates as of September 30, 2007.

 

 

**Payments due by period**

** **

** **

 

 

 
****
** **

** **

 

 

 

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

** **

**During Years 4-5**

** **

**After 5 years**

** **

**Total**

 

 

 
**
 

**Contractual Cash Obligations:**

 

*(In millions)*

 

Long-term debt (1)

 

$

117.6

 

 

$

245.6

 

 

$

964.3

 

 

$

1,005.4

 

$

 

2,332.9

 

Operating leases (2)

 

 

28.5

 

 

 

43.2

 

28.1

 

 

 

39.4

 

 

 

139.2

 

Purchase obligations (2)

 

 

30.9

 

 

 

–

 

–

 

 

 

–

 

 

 

30.9

 

Health claims payable (3)

60.5

–

–

–

60.5

Estimated self-insurance liabilities (4)      

 

 

22.1

 

 

 

40.7

 

20.4

 

 

 

6.8

 

 

 

90.0

 

 

 

 

 

 

 

 

 

 

 

    Subtotal

 

$

259.6

 

 

$

329.5

 

$

1,012.8

 

 

$

1,051.6

 

 

$

2,653.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

** **

** **

** **

 

 

 
****
** **

** **

 

 

 

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

** **

**During Years 4-5**

** **

**After 5 years**

** **

**Total**

 

 

 
**
 

**Other Commitments:**

 

*(In  millions)*

 

Construction and capital improvements (5)         

$

41.3

 

 

$

14.1

$

–

 

 

$

–

 

 

$

55.4

 

Guarantees of surety bonds (6)

 

19.0

 

 

–

 

 

–

 

 

–

 

 

19.0

 

Letters of credit (7)

 

–

 

 

–

 

28.5

 

 

–

 

 

28.5

 

Physician commitments (8)

 

 

9.2

 

 

 

–

 

–

 

 

 

–

 

 

 

9.2

 

FIN 48 net liability (9)

0.4

–

–

–

0.4

 

    Subtotal

 

$

69.9

 

 

$

14.1

 

$

28.5

 

 

$

–

 

 

$

112.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Total obligations and commitments

$

329.5

$

343.6

$

1,041.3

 

 

$

1,051.6

$

2,766.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

____________________

(1)

 

Includes both principal and interest portions of outstanding debt. The interest portion of our variable rate debt assumes that the 7.45% rate as of September 30, 2007 remains stable over the remaining term of thedebt.

 

 

 

(2)

These obligations are not reflected in our consolidated balance sheet.

 

 

 

(3)

 

Represents estimated payments to be made in future periods for healthcare costs incurred by enrollees in PHP, AAHP and MHP and is separately stated on our consolidated balance sheet.

 

 

 

(4)

 

Includes the current and long-term portions of our professional and general liability, workers’ compensation and employee health reserves.

 

 

 

(5)

 

Represents our estimate of amounts we are committed to fund in future periods through executed agreements to complete projects included as construction in progress on our consolidated balance sheet.

 

 

 

(6)

 

Represents performance bonds we have purchased related to medical claims liabilities of PHP.

 

 

 

(7)

 

Amounts relate primarily to instances in which we have letters of credit outstanding with the third party administrator of our self-insured workers’ compensation program.

(8)

 

Includes physician guarantee liabilities recognized in our consolidated balance sheet under the provisions of FSP 45-3, *Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or ItsOwners*, and liabilities for other fixed expenses under physician relocation agreements not yet paid.

(9)

 

Represents expected future liabilities determined under the provisions of FIN 48 (See critical accounting policy update for further discussion).

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Table of Contents

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

                    We are subject to market risk from exposure to changes in interest rates based on our financing, investing, andcash management activities. As of September 30, 2007, we had in place $1,029.9 million of senior credit facilities bearing interest at variable rates at specified margins above either the agent bank’s alternate base rate or its LIBOR rate. The senior creditfacilities consist of $779.9 million in term loans maturing in September 2011 and a $250.0 million revolving credit facility maturing in September 2010 (of which $28.5 million of capacity was utilized by outstanding letters of credit as of September 30, 2007).Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates would not be material to our results of operations or cashflows. Holding other variables constant, including levels of indebtedness, a 0.125% increase in interest rates would have an annual estimated impact on income from continuing operations before income taxes and cash flows of approximately $1.0 million.

                    The $250.0 million revolving credit facility bears interest at the alternate base rate plus a margin of 1.25%per annum or the LIBOR rate plus a margin of 2.25% per annum, in each case subject to an increase of up to 0.25% in the event our leverage ratio exceed certain designated levels. The revolving credit facility matures in September 2010. The $779.9 million inoutstanding term loans bear interest at the alternate base rate plus a margin of 1.25% per annum or the LIBOR rate plus a margin of 2.25% per annum and mature in September 2011.  The interest rate for the term loans was approximately 7.45% as of September 30,2007.

                    From time to time, we use derivatives such as interest rate swaps to manage our market risk associated withvariable rate debt or similar derivatives for fixed rate debt. We do not hold or issue derivative instruments for trading purposes and are not a party to any instruments with leverage features.

**Item 4.    Controls and Procedures.**

**                Evaluation of Disclosure Controls and Procedures**

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

**                Changes in Internal Control Over Financial Reporting**

                There were no changes in our internal control over financial reporting during our fiscal quarter ended September 30, 2007, that hasmaterially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Table of Contents

**PART IIOTHER INFORMATION**

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

                (a)           During the quarterly period ended September 30, 2007, we issued thesecurities described below that were not registered under the Securities Act of 1933. The transaction described below was conducted in reliance upon the exemption from registration provided in Rule 701 of the Securities Act for a sale of securities under a writtencompensatory benefit plan established by the issuer for the participation of its current and former employees. This sale was made without the use of an underwriter, and the certificate evidencing the securities issued in connection with this transaction bears arestrictive legend permitting transfer of the securities only upon registration under the Securities Act or pursuant to an exemption from registration.

                On August 1, 2007, for an aggregate purchase price of $174,465.91, we issued 168 shares of our common stock to a former employee uponhis exercise of vested options which would have otherwise expired 90 days after his termination of employment.

**Item 6.    Exhibits.**

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

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**SIGNATURE**

****

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

DATE:     November 13,2007                                                                            VANGUARD HEALTH SYSTEMS, INC.

                                                                                                               BY:          /s/ Phillip W.Roe                                                                                                                                                                               *Phillip W. Roe                                                                                                                               Executive Vice President, Chief Financial Officer,                                                                                                                               Chief Accounting Officer & Treasurer*                                                                                                                               (Authorized Officer, Principal Financial Officer                                                                                                                               and Chief Accounting Officer)

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Table of Contents

**INDEX TO EXHIBITS**

**Exhibit No.     **

  

**Description**

 

 

 

4.1

Sixth Supplemental Indenture, dated as of October 2, 2007, among Vanguard Health Holding Company II, LLC, Vanguard Holding Company II, Inc., the Guarantors party thereto and the Trustee

 

 

 

10.1

 

Contract Amendment Number 17, executed on September 6, 2006, but effective as of  October 1, 2007, to the Arizona Health Care Cost Containment System Administration Contract No. YH04-0001-06 between Phoenix Health Planand the Arizona Health Care Cost Containment System. (Incorporated by reference from Exhibit 10.1 to the Company’s Current Report on Form 8-K dated September 7, 2007, File No. 333-71934.)

 

 

 

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.

-43-********