<PAGE>   1
                       DOCUMENTS INCORPORATED BY REFERENCE

         Document incorporated by reference and the part of Form 10-K into which
the document is incorporated:

         Portions of the Registrant's Definitive
         Proxy Statement Relating to the Annual
         Meeting of Shareholders to be held on May 25, 1999             Part III

                           FORWARD-LOOKING STATEMENTS

         This report and other information that is provided by PhyCor, Inc.
("PhyCor" or the "Company") contain forward-looking statements, including those
regarding the status of existing clinic and IPA operations, the development of
additional IPAs, the adequacy of PhyCor's capital resources and other statements
regarding trends relating to various revenue and expense items. Many factors,
including PhyCor's ability to successfully restructure and maintain its
relationships with certain of its affiliated physician groups and IPAs and their
payors, could cause actual results to differ materially from those projected in
such forward-looking statements. In addition, factors including competition in
the health care industry, regulatory developments and changes, the nature of
capitated fee arrangements and other methods of payment for medical services,
the risk of professional liability claims, PhyCor's dependence on the revenue
generated by its affiliated clinics, the outcome of pending litigation, risks
associated with Year 2000 related failure and other uncertainties, could also
cause results to differ materially from those expressed or implied in the
forward-looking statements.

         For a more detailed discussion of the factors that could affect the
results of operations and financial condition of the Company, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations - Risk
Factors."

                                     PART I

ITEM 1. BUSINESS

COMPANY OVERVIEW

         We are a medical network management company that operates
multi-specialty medical clinics and develops and manages independent practice
associations ("IPAs"), which are networks of independent physicians who contract
together to provide medical services to individuals whose health care costs are
covered by health maintenance organizations, insurers, employers or other
third-party payors of health care services. In connection with our
multi-specialty clinic operations, we manage and operate two hospitals and four
health maintenance organizations ("HMOs"). We also provide health care
decision-support services, including demand management and disease management
services, to managed care organizations, health care providers, employers and
other group associations.

         As of December 31, 1998, we operated 56 clinics with 3,693 physicians
in 27 states. Our IPAs included approximately 22,900 physicians in 35 markets.
Our affiliated physicians provided capitated medical services to approximately
1,643,000 members, including approximately 304,000 Medicare and Medicaid
members. We also provided health care decision-support services to approximately
2.2 million individuals within the United States and approximately 500,000
additional individuals under foreign country license agreements.

         Our strategy is to position our affiliated multi-specialty medical
clinics and IPAs to be the physician component of organized health care systems.
We operate multi-specialty medical clinics with established market shares and
reputations for providing quality medical care. We focus our IPA development and
management efforts in markets that have characteristics indicating opportunities
for rapid enrollment growth and attractive fixed fees or capitation rates. The
Company helps to generate increased demand for the services and capabilities of
its affiliated physician organizations and to achieve growth through the
addition of physicians, the expansion of managed care relationships and the
addition and expansion of ancillary services.


                                       2
<PAGE>   2
         We believe that multi-specialty physician organizations are a critical
element of organized health care systems, because physician decisions determine
the cost and quality of care. PhyCor believes that physician-driven
organizations, including multi-specialty medical clinics, IPAs and the
combination of such organizations, present more attractive alternatives for
physician consolidation than hospital or insurer HMO controlled organizations.
Through the combination of our multi-specialty medical clinic and IPA management
capabilities, we offer management services to substantially all types of
physician organizations.

         We implement a number of programs and services at each clinic in order
to promote growth and efficiency. These programs include strategic planning and
budgeting, which focus on, among other things, cost containment and expense
reduction. PhyCor negotiates managed care contracts, enters into national
purchasing agreements, conducts productivity and procedure coding and charge
capturing studies and assists the clinics in physician recruitment efforts. We
maintain, for each clinic, information processing systems that have expanded our
accounting, billing, receivables management, scheduling and reporting systems
capabilities. We have also implemented a quality improvement initiative designed
to enhance the quality of patient service delivery systems at our affiliated
clinics through the maintenance and measurement of performance standards and
collection and review of patient evaluations.

         In response to events occurring in the market place, including a
reduction in health care reimbursement and the general difficulties being
experienced by many physicians and companies in the medical network management
industry (including PhyCor), we have modified our approach to structuring
arrangements with physician groups with which we might affiliate in the future.
We seek to acquire additional clinics through this modified affiliation
structure, which reduces significantly the capital investment made by PhyCor at
the initiation of a relationship. This reduced investment reduces the fees paid
by physician groups to PhyCor for management services and allows us to make
additional capital available to the groups during the term of the service
agreement. This capital will be used to assist the physician groups in the
expansion and improvement of their practices. We believe this new structure will
benefit both PhyCor and our affiliated physician organizations. We are also
seeking affiliations with physician organizations which have been created by
hospital systems. Hospital systems generally have experienced significant losses
from the ownership and operation of physician practices, and we believe that
management by PhyCor of these hospital-sponsored physician organizations will
benefit hospitals and hospital systems.

MULTI-SPECIALTY MEDICAL CLINICS

         A multi-specialty medical clinic provides a wide range of primary and
specialty physician care and ancillary services through an organized physician
group practice representing various medical specialties. Multi-specialty medical
clinics historically have been locally owned organizations managed by practicing
physicians. As of December 31, 1998, we operated 56 clinics with 3,693
physicians in 27 states. During 1998, we assisted affiliated clinics in
recruiting approximately 492 new physicians and in merging the practices of 58
additional physicians into their clinics.

         Clinic Operations

         We manage clinics pursuant to long-term service agreements with each of
the affiliated physician groups. Under the terms of the service agreement, we
typically provide each physician group with the equipment and facilities used in
its medical practice, manage clinic operations, employ the clinic's
non-physician personnel, other than certain diagnostic technicians, and receive
a service fee.

         During 1998, we acquired the assets of two multi-specialty clinics
located in New Britain, Connecticut and Huntington, New York, respectively, and
completed the purchase of certain assets of Lakeview Medical Center in Suffolk,
Virginia and numerous smaller medical practices. The Connecticut acquisition was
the Company's first clinic in that state. The principal assets acquired were
accounts receivable, property and equipment, prepaid expenses and service
agreement rights, an intangible asset. The consideration for the acquisitions
consisted of approximately 54% cash, 36% liabilities assumed and 10% convertible
notes. The cash portion of the aggregate purchase price was funded by a
combination of operating cash flow and borrowings under the Company's bank
credit facility. Property and equipment acquired consisted mostly of clinic
operating equipment. The Company is pursuing other possible clinic acquisitions
in both existing and new markets. There can be no assurance that additional
clinic acquisitions will be successfully completed.



                                       3
<PAGE>   3
         In May 1998, we acquired PrimeCare International, Inc. ("PrimeCare"), a
medical network management company serving southern California's Inland Empire
area. PrimeCare's network is comprised of an integrated campus, including the
Desert Valley Medical Group, Desert Valley Hospital and Apple Valley Surgery
Center, as well as the Inland Empire area IPA network. We issued approximately
4.0 million shares of common stock in connection with the PrimeCare transaction.
See "Item 3. Legal Proceedings."

         On July 24, 1998, we acquired First Physician Care, Inc. ("FPC"), an
Atlanta-based provider of practice management services. We issued approximately
2.9 million shares of common stock in connection with the FPC transaction. In
September 1998, we announced that certain of FPC's clinics were operating
significantly below expectations because of lower than expected revenues and
higher costs associated with FPC's core business. Additionally, in February
1999, we announced that because certain of FPC's clinics continued to experience
significant negative operating results which ultimately may require the sale of
certain clinic assets and discontinuation of some operations, a pre-tax charge
of $18.1 million was recorded in the fourth quarter of 1998 to recognize the
expected decline in future cash flows. In addition, we expect to record a
pre-tax charge of $1.8 million in the first quarter of 1999 related to severance
and other exit costs in connection with the restructuring of certain FPC
operations and may incur additional costs associated with restructuring or
terminating these or other FPC operations.

         In 1998, we recorded asset revaluation and restructuring charges
associated with clinic operations totaling $193.3 million related to the
disposition of assets of seven clinics and the revaluation of assets related to
certain underperforming clinics. As identified above, the Company expects to
record a pre-tax charge in the first quarter of 1999 totaling $8.0 million
related to severance and other transition costs resulting from the restructuring
and disposition of certain operations. These asset revaluation and restructuring
charges relate to certain group formation clinics and to certain traditional
clinics that were disposed of and certain clinics whose assets were written down
because of a variety of negative operating and market issues, including those
related to market position and clinic demographics, physician relations,
departure rates, declining physician incomes, physician productivity, operating
results and ongoing commitment and viability of the medical group. We
continually review our operations and trends impacting those operations to
determine the appropriate carrying value of our assets. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

         There can be no assurance that our efforts to strengthen and improve
each of our individual business operations will be successful, or that future
cash flows generated from our investments in each of our business operations
will be adequate to allow for full recovery of these investments. As a result,
there can be no assurance that future asset revaluation and restructuring
charges will not be necessary as business conditions and operating trends
continue to change.

         As of December 31, 1998, PhyCor operated the following medical clinics
in conjunction with the affiliated physician groups described below:

<TABLE>
<CAPTION>
                                                                                   PERCENTAGE
                                                                                       OF          NUMBER
                                                                                     PRIMARY         OF           PHYCOR
                                                        YEAR         NUMBER OF        CARE         MEDICAL      OPERATIONS
CLINIC                        LOCATION                 FOUNDED      PHYSICIANS     PHYSICIANS    SPECIALTIES     COMMENCED
------                        --------                 -------      ----------     ----------    -----------     ---------
<S>                           <C>                      <C>          <C>            <C>           <C>           <C>
Green Clinic                  Ruston, LA                1948            34             44%            15        Oct. 1988
Doctors' Clinic               Vero Beach, FL            1969            35             43             19        Jan. 1989
Nalle Clinic                  Charlotte, NC             1921           140             58             24        Feb. 1990
Greeley Medical Clinic        Greeley, CO               1933            43             54             16        Oct. 1990
Pueblo Physicians             Pueblo, CO                1970            37             57             13       Sept. 1991
Sadler Clinic                 Conroe, TX                1955            49             55             16        Jan. 1992
Diagnostic Clinic             San Antonio, TX           1972            42             52             16        Jan. 1992
Virginia Physicians           Richmond, VA              1923            70             66             15        Feb. 1992
Laconia Clinic                Laconia, NH               1938            22             50             14       Sept. 1992
Olean Medical                 Group Olean, NY           1937            33             36             20        Nov. 1992
Holston Medical Group         Kingsport, TN             1975            49             76             11        Jan. 1993
The Medical & Surgical        Irving, TX                1961            35             77             10        Mar. 1993
</TABLE>


                                       4
<PAGE>   4
<TABLE>
<CAPTION>
                                                                                   PERCENTAGE
                                                                                       OF          NUMBER
                                                                                     PRIMARY         OF           PHYCOR
                                                        YEAR         NUMBER OF        CARE         MEDICAL      OPERATIONS
CLINIC                        LOCATION                 FOUNDED      PHYSICIANS     PHYSICIANS    SPECIALTIES     COMMENCED
------                        --------                 -------      ----------     ----------    -----------     ---------
<S>                           <C>                      <C>          <C>            <C>           <C>           <C>

Clinic of Irving
Simon-Williamson Clinic       Birmingham, AL            1935            36             61             15        July 1993
Medical Arts Clinic           Corsicana, TX             1952            40             43             18        Jan. 1994
Lexington Clinic              Lexington, KY             1920           170             49             25        Feb. 1994
Southern Plains Medical       Chickasha, OK             1946            22             64             11        Aug. 1994
Center
Holt-Krock Clinic             Fort Smith, AR            1921            79             43             20       Sept. 1994(1)
Burns Clinic Medical          Petoskey, MI              1931           100             45             25        Oct. 1994(2)
Center
Boulder Medical Center        Boulder, CO               1949            52             46             22        Oct. 1994
Northeast Arkansas            Jonesboro, AR             1977            74             62             15        Mar. 1995
Clinic
PAPP Clinic                   Newnan, GA                1939            45             58             11         May 1995
Ogden Clinic                  Ogden, UT                 1968            38             42             18        June 1995
Arnett Clinic                 Lafayette, IN             1922           129             40             24        Aug. 1995
Casa Blanca Clinic            Mesa, AZ                  1969            83             69             18       Sept. 1995
South Texas Medical           Wharton, TX               1985            65             60             19        Nov. 1995
Clinics
South Bend Clinic             South Bend, IN            1916            64             64             18        Nov. 1995(3)
Guthrie Clinic                Sayre, PA                 1910           235             43             29        Nov. 1995(4)
Clinics of North Texas        Wichita Falls, TX         1995            84             46             22        Mar. 1996
Houston Metropolitan          Houston, TX               1975            26            100             21        Mar. 1996
Medical Associates            Rome, GA                  1948           105             31             21         May 1996
Harbin Clinic
Focus Health Services         Denver, CO                1989            55             86              8        July 1996
Clark-Holder Clinic           LaGrange, GA              1936            42             38             17        July 1996
Medical Arts Clinic           Minot, ND                 1958            33             58             15        Aug. 1996
Wilmington Health             Wilmington, NC            1971            60             47             14        Aug. 1996
Associates
Gulf Coast Medical Group      Galveston, TX             1996            24             79              8        Aug. 1996(5)
Hattiesburg Clinic            Hattiesburg, MS           1963           123             46             21        Oct. 1996
Toledo Clinic                 Toledo, OH                1926            85             25             19        Nov. 1996
Lewis-Gale Clinic             Roanoke, VA               1909           137             47             25        Nov. 1996
Straub Clinic & Hospital      Honolulu, HI              1921           178             56             25        Jan. 1997(6)
The Vancouver Clinic          Vancouver, WA             1936            80             56             15        Jan. 1997
First Physicians              Palm Springs, CA          1997            21             62              7        Feb. 1997
Medical Group
St. Petersburg-Suncoast       St. Petersburg, FL        1997            83             30             22        Feb. 1997(7)
Medical Group
White Wilson Medical          Ft. Walton, FL            1946            58             50             17        July 1997
Center
Welborn Clinic                Evansville, IN            1947            85             53             21        Aug. 1997
The Maui Medical Group        Maui, HI                  1961            35             60             14       Sept. 1997
Murfreesboro Medical          Murfreesboro, TN          1949            45             62             11        Oct. 1997
Clinic
West Florida Medical          Pensacola, FL             1938           160             34             27        Oct. 1997
Center Clinic
Northern California           Santa Rosa, CA            1975            35             54              5        Dec. 1997
Medical Associates
Lakeview Medical Center       Suffolk, VA               1905            33             55             13        Jan. 1998(8)
Grove Hill Medical            New Britain, CT           1947            73             47             15        Mar. 1998
Center
Desert Valley Medical         Victorville, CA           1985            56             75             16         May 1998
Group
Riverbend Physicians &        Alton, IL                 1955            16             69              7        July 1998(9)
Surgeons
</TABLE>


                                       5
<PAGE>   5
<TABLE>
<CAPTION>
                                                                                   PERCENTAGE
                                                                                       OF          NUMBER
                                                                                     PRIMARY         OF           PHYCOR
                                                        YEAR         NUMBER OF        CARE         MEDICAL      OPERATIONS
CLINIC                        LOCATION                 FOUNDED      PHYSICIANS     PHYSICIANS    SPECIALTIES     COMMENCED
------                        --------                 -------      ----------     ----------    -----------     ---------
<S>                           <C>                      <C>          <C>            <C>           <C>           <C>

Health Partners Medical       Bedford, TX               1993            48            100              4        July 1998(9)
Group
Doctors Walk-In               Tampa Bay, FL             1958            25            100              4        July 1998(9)
Clinics, Inc.
Palm Beach Medical Group      Palm Beach, FL            1953            29             72              7        July 1998(9)
Georgia Internal Lithia       Springs, GA               1976             4            100              1        July 1998(9)
Medicine
Huntington Medical Group      Huntington, NY            1945            34             50             14        Oct. 1998
</TABLE>

(1)      In January 1999, we agreed to sell certain assets to Sparks Regional
         Medical Center and Sparks Regional Medical Center Foundation
         (collectively, "Sparks"). Sparks is expected to enter into a long-term
         agreement with PhyCor to maintain access to certain key physician
         practice management resources. There is no assurance this transaction
         will be completed or completed as contemplated.

(2)      In February 1999, we announced an agreement to sell assets to
         Healthshare Group ("HSG"). There is no assurance this transaction will
         be completed or completed as contemplated.

(3)      Entered into an interim management agreement, effective November 1,
         1995, and consummated the acquisition of certain assets and entered
         into a long-term service agreement effective January 1, 1996.

(4)      Entered into a series of agreements whereby PhyCor agreed to provide
         management services for up to five years and agreed to acquire certain
         assets of the clinic upon the occurrence of certain conditions. These
         conditions were not met as of March 26, 1999. The Clinic has the option
         to renew or terminate the management agreement and purchase the clinic
         assets at the end of 1999.

(5)      In March 1999, we terminated our affiliation with this group.

(6)      Entered into an administrative services agreement, effective October 1,
         1996, and consummated the merger with Straub and entered into a
         long-term service agreement effective January 17, 1997.

(7)      Acquired all of the capital stock of two clinics, combined their
         operations and entered into a long-term service agreement with the
         newly formed group effective February 28, 1997.

(8)      Entered into an interim management agreement, effective December 1,
         1997, and consummated the acquisition of certain assets and entered
         into a long-term service agreement effective January 1, 1998.

(9)      Each of these clinics was acquired in the FPC transaction in July 1998.

         In connection with our multi-specialty clinic operations, we manage and
operate two hospitals and four HMOs. In addition to the 3,693 physicians
affiliated with the Company at December 31, 1998, the PhyCor-affiliated
physician groups employ approximately 617 physician extenders, which include
physician assistants, nurse practitioners and other mid-level providers. We
believe physician extenders comprise an important component of our integrated
network strategy by efficiently expanding the level of services offered in our
clinics.

         The physician groups offer a wide range of primary and specialty
physician care and ancillary services. Approximately 52% of PhyCor's affiliated
physicians are primary care providers, and approximately 48% practice various
medical and surgical specialties. The primary care physicians are those in
family practice, general internal medicine, obstetrics and gynecology,
occupational medicine, pediatrics and emergency and urgent care. Medical
specialties include allergy, cardiology, dermatology, endocrinology,
gastroenterology, infectious diseases, nephrology,


                                       6
<PAGE>   6
neurology, oncology, pulmonology, radiology and rheumatology. Surgical
specialties include general surgery, ophthalmology, orthopedics, otolaryngology,
thoracic surgery and urology. The clinics vary in the number and types of
specialties offered. Substantially all of the physicians practicing in the
clinics are certified or eligible to be certified by the applicable medical
specialty boards.

         The clinics also offer a wide array of ancillary services. Most clinics
provide a range of imaging services, which may include CAT scanning,
mammography, nuclear medicine, ultrasound and x-ray. In addition, many of the
clinics have clinical laboratories and pharmacies. Ambulatory surgery units and
rehabilitation services are in place or being planned in many clinics, in some
cases through joint ventures. Several of the clinics have diabetes centers,
pharmaceutical clinical trial programs and weight management programs. Some
offer renal dialysis and participate, usually by joint venture, in home infusion
therapy. Ancillary revenue, including both technical and professional fee
components, accounted for approximately 24.4% of gross clinic revenue for the
year ended December 31, 1998 compared to 26.7% for the year ended December 31,
1997.

         In connection with an acquisition of assets and execution of a service
agreement, we investigate the history and general reputation of each physician
group. We obtain representations and covenants from the physician group with
respect to historical financial performance and the employment and licensure of
individual physicians. PhyCor does not undertake an independent investigation of
the backgrounds of each physician member of the clinics. As part of its services
performed under the service agreement, PhyCor personnel undertake administrative
tasks in connection with obtaining and maintaining liability insurance for the
physician group, including maintaining and reviewing files relating to physician
licensure and certification. PhyCor does not control the practice of medicine by
physicians or compliance by them with licensure or certification requirements.
Only the FPC entities in Florida and Georgia employ physicians. The substantial
majority of PhyCor's relationships in those states are with separate physician
groups that employ the physicians and to which PhyCor provides management
services. PhyCor's affiliated physicians maintain full professional control over
their medical practices, determine which physicians to hire or terminate and set
their own standards of practice in order to promote high quality health care.

         PhyCor Operations

         Pursuant to our service agreements, we manage all aspects of the
affiliated clinics other than the provision of medical services, which is
controlled solely by the physician groups. The clinic's joint policy board,
equally represented by physicians and PhyCor personnel, focuses on strategic and
operational planning, marketing, managed care arrangements and other major
issues facing the clinic. The joint policy board involves experienced health
care managers in the decision making process and brings increased discipline and
accountability to clinic operations.

         We enhance clinic growth by expanding managed care arrangements,
assisting in the recruitment and merger of physicians and expanding and adding
ancillary services. We help the physician groups recruit physicians from outside
the community and merge physicians in sole practices or single specialty groups
from within the community into the clinics' physician groups.

         We believe our clinics have the opportunity, in conjunction with
managed care organizations, insurance companies and hospitals, to create
high-quality, cost-effective health care delivery systems. We align our
affiliated clinics with low-cost, high-quality hospitals and related providers
in each of their markets and through various relationships seek to more closely
coordinate the overall delivery of health care to patients. These plans may
include participation by affiliated physicians in physician networks which we
developed and managed. See "IPA and Physician Networks." Certain of our
relationships with managed care organizations and insurance companies require
the physician networks being developed by the clinics to assume responsibility
for physician services, hospital utilization and overall medical management. We
believe that medical management performed within physician organizations can
yield the greatest value in quality-driven, cost-effective health care and that
premiums collected from purchasers of health care will be allocated based upon
the value of the services performed by the health care provider members of
organized health care systems.

         We sponsor the PhyCor Institute for Healthcare Management, which
provides practical managed care and medical management training for physicians
affiliated or considering affiliation with PhyCor. Through the Institute's


                                       7
<PAGE>   7
efforts, physicians in many locations work together to achieve "economies of
intellect" and best practice performance through shared data and experience. We
believe that, in the future, our ability to differentiate our physician
organizations based upon quality clinical performance will positively impact
financial performance.

         We try to focus the attention of the physician groups on practice
patterns. This effort emphasizes outcomes measurement and management in order to
attain the desired clinical results while controlling the use of health
resources. Similarly, our quality service initiatives seek to improve the
patient's overall experience with the health care delivered within PhyCor's
affiliated clinics and networks.

         We provide support for the selection and implementation of information
systems at our clinics. We have selected certain practice management and other
systems considered to be most effective for capitated risk management, provider
profiling and outcomes analysis for implementation at our clinics. These systems
are designed to allow physician organizations to successfully capture
information that will enable them to more effectively manage the risk associated
with capitated arrangements.

         We negotiate national arrangements that provide cost savings to our
clinics through economies of scale in malpractice insurance, supplies and
equipment. We also provide operational support through a better practice
resource group, which focuses on assisting clinics or departments within clinics
in defining and executing patient services and revenue and expense savings
opportunities. These better practice initiatives may also include organizational
staffing and budget assistance for clinical research. We provide measurement
capabilities for medical outcomes in specific therapeutic areas and compile and
utilize physician productivity information. We also offer a staffing management
system that aligns staffing with the volume and service needs of our clinics. We
launched the PhyCor Online intranet service in 1998, which facilitates
communication between affiliated physicians, provides outcomes information and
supports physician discussion groups for medical and business practices.

         Service Agreements - Clinic Operations

         Our long-term service agreements are for terms of up to 40 years.
Long-term agreements entered into prior to 1994 are generally for terms of 30
years. The termination provisions of the service agreements provide that the
agreements may not be terminated by PhyCor or the physician groups without
cause, which includes material default or bankruptcy. Upon the expiration of the
term of a service agreement or in the event of termination, the physician group
is obligated to purchase all of the related tangible and intangible assets owned
by our subsidiary that is a party to the service agreement, generally at then
current book value. In the event of a termination, we expect the terminating
group to fulfill its repurchase obligation in accordance with the service
agreement at the effective time of termination and would actively pursue
compliance with such repurchase obligation. The physician group agrees not to
compete with us during the term of the service agreement, and substantially all
of the physicians agree not to compete with their physician group for a period
of time or agree to pay liquidated damages if they compete. We agree not to
affiliate with other multi-specialty groups in the clinic's service area during
the term of the service agreement. Two clinics have recently challenged the
enforceability of the percentage-based management fee structure contained in
their service agreements. While we are defending the enforceability of these
service agreements and would defend the enforceability of other service
agreements, if challenged, there can be no assurance that successful challenges
of the service agreements will not have a material adverse effect on our
operations. See "Item 3. Legal Proceedings."

         Under substantially all of our service agreements, we receive a service
fee equal to the clinic expenses incurred plus a percentage of operating income
of the clinic (net clinic revenue less certain clinic expenses before physician
distributions) and, under all other service agreements except one described
below, we receive a percentage of net clinic revenue. In 1998, our service
agreement revenue was derived from contracts with the following service fee
structures: (i) 92.1% of revenue was derived from contracts in which the service
fee was based on a percentage, ranging from 11% to 18%, of clinic operating
income plus reimbursement of clinic expenses; (ii) .8% of revenue was derived
from a contract in which the service fee was based on 51.7% of net clinic
revenue; (iii) 5.9% of revenue was derived from contracts in which the service
fee was based upon a combination of (a) 10% of clinic operating income, plus (b)
a percentage, ranging from 2.75% to 3.5%, of net clinic revenue and plus (c)
reimbursement of clinic expenses; and (iv) 1.2% of revenue was derived from a
flat fee contract.



                                       8
<PAGE>   8
         The service agreements allow the affiliated physician group to
terminate the service agreement in the event of the bankruptcy or similar event
of PhyCor's subsidiary that is a party to the service agreement or in the event
of a material breach of the service agreement by the Company or its subsidiary,
provided (i) such breach is not cured generally within 90 days following written
notice and (ii) such termination is approved by the affirmative vote of
generally no less than 75% of the physician shareholders. Many of the service
agreements allow the physician group to terminate the service agreement if any
person or persons acquire the right to vote 50% or more of PhyCor's common
stock, unless the transaction was approved by PhyCor's Board of Directors or
subsequently approved by two-thirds of PhyCor's directors who are not members of
management or affiliates of the acquiring person. The physician group in
Lexington, Kentucky may also terminate its service agreement if an entity named
therein acquires 15% or more of the Company's outstanding common stock. Other
groups may terminate their service agreement in the event of a merger where
PhyCor does not survive or a takeover or sale of substantially all the assets of
PhyCor or in the event of a sale of all or substantially all of the assets or
capital stock of the PhyCor subsidiary that is a party to the service agreement.
Some physician groups have rights of first refusal to purchase the clinic assets
owned by PhyCor if PhyCor determines to sell such assets. The above provisions
could have an adverse effect on any efforts to take control of PhyCor without
the consent of the Board of Directors and the physician groups having these
rights. In addition, the Company may terminate a service agreement (a) in the
event of the bankruptcy or similar event of the affiliated physician group, or
(b) a material breach of the service agreement by the affiliated physician group
which is not cured within 90 days following written notice. In any event of
termination, the affiliated physician group is required by the terms of the
service agreement to repurchase all of the tangible and intangible assets of the
Company related to the physician group generally at the then current net book
value.

IPA AND PHYSICIAN NETWORKS

         We believe that the health care industry will continue to be driven by
local market factors and that organized providers of health care, like IPAs,
will play a significant role in delivering cost-effective, quality medical care.
IPAs offer physicians an opportunity to participate in expanding organized
health care systems and assistance in contracting with insurance companies,
HMOs, employers and other large purchasers of health care services. IPAs
consolidate independent physicians by providing general organizational structure
and management to the physician network. IPAs provide or contract for medical
management services to assist physician networks in obtaining and servicing
managed care contracts and enable previously unaffiliated physicians to assume
and more effectively manage capitated risk. In certain instances we are required
to underwrite letters of credit to the managed care payor to help ensure payment
of health care costs for which our affiliated IPAs assume responsibility. As of
March 24, 1999, we had issued to managed care payors letters of credit through
our credit facility totaling approximately $14.6 million. We would seek
reimbursement from an IPA if there was a draw on a letter of credit. While no
draws on any of these letters of credit have occurred, there can be no assurance
that draws will not occur on the letters of credit in the future.

         As of December 31, 1998, we managed IPAs with approximately 22,900
physicians in 35 markets. The IPA segment of our business accounted for
approximately 16% of our 1998 revenues. We typically establish management
companies for IPAs through which all health plan contracts are negotiated. Each
of these management companies provides information and operating systems,
actuarial and financial analysis, medical management and provider contract
services to the IPAs. In some cases, physicians have an equity interest in the
management company. We assist physicians in forming networks to develop a
managed care delivery system in which the IPA accepts fiscal responsibility for
providing a wide range of medical services. We intend to continue to develop
health care delivery systems in certain markets that do not have established
managed care networks.

         We are developing physician networks around our physician groups to
enhance managed care contracting and to expand our role as a significant
physician component of organized health care systems. Physicians in affiliated
physician groups may participate, in conjunction with unaffiliated physicians,
in IPAs we develop and manage. Substantially all of our IPAs are developed and
managed by North American Medical Management, Inc. ("NAMM"). PhyCor purchased a
minority interest in PhyCor Management Corporation ("PMC") in 1995 and completed
the acquisition of the remaining interests in PMC on March 31, 1998. PMC, which
also provided management services to physician networks, was fully integrated
into NAMM during 1998. Additionally, through our acquisition of PrimeCare, we
operate PrimeCare's IPAs in California.



                                       9
<PAGE>   9
         In July 1998, we acquired The Morgan Health Group, Inc. ("MHG"), an
Atlanta-based IPA whose network at such time included approximately 400 primary
care physicians and 1,800 specialists who provided care to approximately 57,000
managed care members under capitated contracts (the "MHG Acquisition"). In
September 1998, we announced that the earnings of MHG were significantly below
target because of higher than expected costs from MHG's managed care contracts.
In February 1999, we announced that because MHG's costs significantly exceeded
revenues under its principal payor contract which accounted for approximately
90% of its revenue (the "Payor Contract"), we were going to record a pre-tax
asset revaluation charge of approximately $31.6 million in the fourth quarter of
1998 to write-off goodwill that was recorded in connection with the MHG
Acquisition. In addition, the Company expects to record a $0.7 million pre-tax
charge in the first quarter of 1999 related to the termination of the Payor
Contract. The Payor Contract will terminate by mutual agreement on April 30,
1999. On February 19, 1999, we notified the former owners of MHG of our
rescission offer of all consideration we received in the MHG Acquisition and
demand for rescission of the transactions contemplated by the MHG Acquisition.
The former owners of MHG have rejected our demand for rescission. The former
owners have since requested certain financial information regarding MHG. We are
currently responding to that request and continuing discussions with the former
MHG shareholders as well as considering other available options.

         In October 1998, we formed a joint venture with Physician Partners
Company, L.L.C., a physician organization created by physicians to develop an
IPA, to operate an IPA management business and to develop and manage a regional
managed care contracting network, which is anticipated to include IPAs in New
York City, northern New Jersey, southern Connecticut and Long Island.

         Subsequent to year end, we completed agreements with two IPA
organizations to provide managed care services. We entered into an agreement
with the Southern Nevada Healthcare Network in Las Vegas, Nevada, on January 1,
1999, which provided management of capitated health care services contracts for
54,000 HMO enrollees through approximately 300 physicians. On March 1, 1999, we
also began managing the New Century Physicians IPA in the Kansas City
metropolitan area with approximately 10,000 enrollees and 120 physicians.

OTHER OPERATIONS

         We provide health care decision-support services, including demand
management and disease management services, to managed care organizations,
health care providers, employers and other group associations through CareWise,
Inc. ("CareWise"). We acquired CareWise on July 1, 1998 in exchange for
approximately 3.1 million shares of common stock. CareWise is a nationally
recognized leader in the health care decision-support industry. At December 31,
1998, through CareWise, we provided healthcare decision-support services to
approximately 2.2 million individuals within the United States and approximately
500,000 additional individuals under foreign country license agreements.

         We are also seeking to affiliate with physician organizations which
have been created by hospital systems. Hospital systems generally have
experienced significant losses from the ownership and operation of physician
practices. We believe that our management of these hospital-sponsored
organizations will benefit hospitals and hospital systems.

REGULATION

         General

         The health care industry is highly regulated, and the regulatory
environment in which the Company operates may change significantly in the
future. In general, regulation of health care companies is increasing.

         Every state imposes licensing requirements on individual physicians and
on facilities and services operated by physicians. In addition, federal and
state laws regulate HMOs and other managed care organizations. Many states
require regulatory approval, including certificates of need, before establishing
certain types of health care facilities, offering certain services or making
expenditures in excess of statutory thresholds for health care equipment,
facilities or programs. To date, none of our clinics nor our managed IPAs have
been required to obtain certificates of need for their activities.



                                       10
<PAGE>   10
         In connection with the expansion of existing operations and the entry
into new markets and managed care arrangements, PhyCor and its affiliated
practice groups and managed IPAs may become subject to compliance with
additional regulation.

         The Company and its clinics and managed IPAs are also subject to
federal, state and local laws dealing with issues such as occupational safety,
employment, medical leave, insurance regulations, civil rights and
discrimination, and medical waste and other environmental issues. At an
increasing rate, federal, state and local governments are expanding the
regulatory requirements on businesses, including medical practices. The
imposition of these regulatory requirements may have the effect of increasing
operating costs and reducing the profitability of the Company's operations.

         PhyCor's managed IPAs and affiliated physician groups enter into
contracts and joint ventures with licensed insurance companies, such as HMOs,
whereby the IPAs and affiliated physician groups may be paid on a capitated fee
basis. Under capitation arrangements, health care providers bear the risk,
subject to certain loss limits, that the total costs of providing medical
services to members will exceed the premiums received. To the extent that the
IPAs and affiliated physician groups subcontract with physicians or other
providers for their services on a fee-for-service basis, the managed IPAs and
affiliated physician groups may be deemed to be in the business of insurance. If
deemed to be an insurer they will be subject to a variety of regulatory and
licensing requirements applicable to insurance companies or HMOs resulting in
increased costs to the managed IPAs and affiliated physician groups, and
corresponding lower revenue to PhyCor. The Company or its managed IPAs and
affiliated physician groups may be adversely affected by such regulations.

         In connection with two multi-specialty medical clinic acquisitions, the
Company owns HMOs previously affiliated with the clinics and in another
multi-specialty medical clinic acquisition, the Company agreed to provide
management services to the physician group and the HMO owned by the physician
group. The Company also owns a 50% interest in another HMO affiliated with a
physician group and provides management services to that HMO. The HMO industry
is highly regulated at the state level and is highly competitive. Additionally,
the HMO industry has been subject to numerous legislative initiatives within the
past several years that would increase potential HMO liability to patients,
resulting in increased costs to HMOs and correspondingly reduced revenue to
PhyCor. Certain aspects of health care reform legislation being considered at
the federal level have direct and indirect consequences for the HMO industry.
There can be no assurance that developments in any of these areas will not have
an adverse effect on the Company's wholly-owned HMOs or on HMOs in which the
Company has a partial ownership interest or other financial involvement.

         Many of the PhyCor-managed IPA contracts with third party payors are
based on fixed or capitated fee arrangements. Under these capitation
arrangements, health care providers receive a fixed fee per plan member per
month and providers bear the risk, generally subject to certain loss limits,
that the total costs of providing medical services to the members will exceed
the fixed fee. The IPA management fees are based, in part, upon a share of the
portion, if any, of the fixed fee that exceeds actual costs incurred. Some
agreements with payors also contain "shared risk" provisions under which PhyCor,
through the IPA, can share additional fees or can share in additional costs,
depending on the utilization rates of the members and the success of the IPAs.
Any significant costs could have a material adverse effect on the Company.

         The health care providers' ability to effectively manage the patient's
use of medical services and the costs of such services determines the
profitability of a capitated fee. The management fees are also based upon a
percentage of revenue collected by the IPA. Any loss of revenue by the IPAs
because of the loss of affiliated physicians, the termination of third party
payor contracts or other changes in plan membership or capitated fees may reduce
our management fees. We, like other managed care management entities, are often
subject to liability claims arising from activities such as utilization
management and compensation arrangements, designed to control costs by reducing
services. A successful claim on this basis against us, an affiliated clinic or
IPA could have a material adverse effect on us.


                                       11
<PAGE>   11

         Federal and state antitrust laws also prohibit agreements in restraint
of trade, the exercise of monopoly power and other practices that are considered
to be anti-competitive. We believe that we are in material compliance with
federal and state antitrust laws in connection with the operation of our clinics
and our IPAs and physician networks.

         We believe our operations are in material compliance with applicable
law and expect to modify our agreements and operations to conform in all
material respects to future regulatory changes. Our ability to be profitable
will depend in part upon our affiliated physician groups and managed IPAs
obtaining and maintaining all necessary licenses, certificates of need and other
approvals and operating in compliance with applicable health care regulations.
We are unable to determine what additional government regulations, if any,
affecting our business may be enacted in the future or how existing or future
laws and regulations might be interpreted by the relevant regulatory
authorities. The failure of the Company or any of our affiliated physician
groups or managed IPAs to comply with applicable law could have a material
adverse effect on the Company.

         State Legislation

         At the state level, all state laws restrict the unlicensed practice of
medicine, and many states also prohibit the splitting or sharing of fees with
non-physician entities and the enforcement of noncompetition agreements against
physicians. Many states also prohibit the corporate practice of medicine by an
unlicensed corporation or other non-physician entity and prohibit referrals to
facilities in which physicians have a financial interest. Additionally, the
Florida Board of Medicine has interpreted the Florida fee-splitting law very
broadly. This interpretation may prohibit the payment of any percentage-based
management fee, even to a management company that does not refer patients to a
managed group. The Florida Board of Medicine stayed its own decision pending a
judicial determination of its decision. We have filed a friend of the court
brief advocating that the court not uphold the decision of the Florida Board of
Medicine. Oral argument before the court has been set for May 1999, and it is
possible that the court will announce its ruling by late 1999. Two of our
affiliated physician groups have filed suit seeking a declaratory judgment
regarding the enforceability of the fee arrangements under their service
agreements with PhyCor in light of the OIG Advisory Opinion 98-4, described
below. One of the groups located in Florida, also challenged the fee arrangement
under the Florida Board of Medicine opinion. See "Item 3. Legal Proceedings." Of
our six affiliated physician groups in Florida, we manage four groups under
service agreements for which we are paid a percentage-based management fee, and
we own and operate the other two Florida groups. Our service agreements provide
that any changes in laws shall result in agreed upon modifications to the
applicable service agreements to comply with laws. Future interpretations of, or
changes in, state laws may require structural and organizational modifications
of our existing relationships with our clinics. Changes in the laws may also
necessitate modifications in our relationships with our affiliated IPAs. There
can be no assurance that we would be able to appropriately modify our
relationships with our physician groups and IPAs to ensure that the Company and
its operations would not be adversely affected by such changes in the laws.
Statutes in some states could restrict expansion of the operations of the
Company to the applicable jurisdictions. In addition, one of our subsidiaries
holds a limited Knox-Keene license in the state of California, and as a result
is subject to an increased level of state oversight by the California Department
of Corporations.

         Medicare Payment System

         Our affiliated physician groups and IPAs derived approximately 19% of
their net revenue in 1998 from payments for services provided to patients
enrolled in the federal Medicare program, including patients covered by risk
contracts. Clinics and IPAs managed by the Company provide medical services
under risk contracts to approximately 258,000 Medicare members. The prior system
of Medicare payments, other than for risk contracts, was based on customary,
prevailing and reasonable physician charges and was phased out from 1992 through
1996 and replaced with an annually-adjusted resource-based relative value scale
("RBRVS").

         Medicare Fraud and Abuse and Anti-Referral Provisions

         There are many provisions in the Social Security Act that are intended
to address fraud and abuse among providers and other health care companies. One
of the fraud and abuse provisions (the "anti-kickback statute") prohibits
providers and others from soliciting, receiving, offering or paying, directly or
indirectly, any form of remuneration in return for the referral of, or the
arranging for the referral of, Medicare and other federal or state health care
program


                                       12
<PAGE>   12
patients or patient care opportunities. It also prohibits payments in return for
the purchase, lease, arrangement, or order of any item or service that is
covered by Medicare, certain other federal health care programs, or a state
health program.

         In July 1991, the federal government published regulations that provide
exceptions, or "safe harbors", for business transactions that will be deemed not
to violate the anti-kickback statute. In September 1993, additional safe harbors
were proposed for eight activities, including referrals within group practices
consisting of active investors. In April 1998, the HHS Office of the Inspector
General released Advisory Opinion 98-4, which states that a percentage-based
management fee paid to a medical network management company does not fit within
any safe harbor. The opinion concludes that, because a percentage-based fee does
not fit within a safe harbor, such a fee could implicate the Anti-Kickback Law
if any part of the management fee is intended to compensate the manager for its
efforts in arranging for referrals to the managed group. The opinion
acknowledges, however, that a management fee that does not fit within a safe
harbor is not necessarily illegal. Both the opinion and the preamble to the
government's published safe harbors state that arrangements that do not fall
within safe harbors are nevertheless legal as long as there is no intent on the
part of either party to pay for or accept payment for referrals. Although many
of our management fees are percentage-based fees, and many of our other
arrangements, including the arrangements between NAMM and providers and provider
groups, do not in all instances fall within the protection offered by these safe
harbors or the proposed safe harbors, we believe our operations are in material
compliance with applicable Medicare fraud and abuse laws. As discussed above,
two of our affiliated physician groups filed lawsuits seeking declaratory
judgments regarding the enforceability of the fee arrangement contained in their
service agreements with PhyCor in light of OIG Advisory Opinion 98-4.

         We believe our operations are in material compliance with the
anti-kickback law. Although we are receiving remuneration under our service
agreements and management agreements for the services we provide to our
affiliated clinics and IPAs, we are not in a position to make or influence
referrals of federal or state health care program patients or services to the
physician groups or networks. Moreover, we believe that the fees we receive
represent fair value for our services. No part of the fees we receive are
intended to be remuneration for improper activities. Consequently, we do not
believe that the service fees and management fees that we receive from our
affiliated groups and IPAs could be viewed as remuneration for referring or
influencing referrals of patients or services covered by federal or state health
care programs as prohibited by the anti-kickback statute. We are a separate
provider of Medicare and state health program reimbursed services on a limited
basis in the states of Florida and Georgia because we own certain groups in
those states that employ physicians. To the extent that we are deemed to be a
separate provider of medical services under our service agreement or management
agreement arrangements and to receive referrals from physicians, our financial
arrangements could be subject to greater scrutiny under the anti-kickback
statute. The Company also operates one pharmacy under a provider number that is
separate from the clinic. We do not believe that our operation of this pharmacy
or our operation of providers in Florida and Georgia creates a material risk
under the anti-kickback statute because all of our operations are structured to
fit as closely as possible within an applicable safe harbor.

         In connection with the transaction with Straub Clinic & Hospital,
Incorporated ("Straub"), we provide certain management services to both the
physician group practice and a hospital owned by the group. In addition, in
connection with the PrimeCare transaction, the Company acquired a hospital in
California. Because hospitals are subject to extensive regulation and because
hospital management companies have, in some instances, been viewed as referral
sources by federal regulatory agencies, the relationship between PhyCor and the
Straub physician group, and the relationship between PhyCor and its California
hospital and affiliated California medical groups, could come under increased
scrutiny under the anti-kickback statute.

         If any of our arrangements were found to be in violation of the
anti-kickback law, the Company, the physician groups and/or the individual
physicians would be subject to civil and criminal penalties, including possible
exclusion from participation in government health care. These penalties could
have a materially adverse affect on the Company.

         Under legislation known as the Stark Law, physicians who have an
ownership interest or a compensation arrangement with certain providers of
"designated health services" are prohibited from referring Medicare and Medicaid
patients to those providers, unless an exception exists. The "designated health
services" covered by the Stark Law include physical therapy services;
occupational therapy services; radiology services, including MRI, CT and
ultrasound; radiation therapy services; durable medical equipment; parenteral
and enteral nutrients, equipment


                                       13
<PAGE>   13
and supplies; prosthetics, orthotics and prosthetic devices; home health
services; outpatient prescription drugs; and inpatient and outpatient hospital
services. We believe that our clinics are operating in compliance with the
statutory exceptions to the Stark Law, including, but not limited to, the
exceptions for referrals to in-office ancillary services within a group
practice. As a result, we believe that physicians who are members of our
affiliated clinics may make referrals of designated health services to the
clinics. If any of the affiliated clinics or their physicians are found to be in
violation of the Stark Law, they could be subject to significant penalties,
including possible exclusion from further participation in the Medicare or
Medicaid programs. Such penalties could have a material adverse effect on the
Company.

         Impact of Health Care Regulatory Changes

         Congress and many state legislatures routinely consider proposals to
control health care spending. Government efforts to reduce health care expenses
through the use of managed care or the reduction of Medicare and Medicaid
reimbursement may adversely affect our cost of doing business and contractual
relationships. For example, recent developments that affect the Company's
activities include: (a) federal legislation requiring a health plan to continue
coverage for individuals who are no longer eligible for group health benefits
and prohibiting the use of "pre-existing condition" exclusions that limit the
scope of coverage; (b) a Health Care Financing Administration policy prohibiting
restrictions in Medicare risk HMO plans on a physician's recommendation of other
health plans and treatment options to patients; and (c) regulations imposing
restrictions on physician incentive provisions in physician provider agreements.
These types of legislation, programs and other regulatory changes may have a
material adverse effect on PhyCor.

COMPETITION

         Managing medical networks is a highly competitive business. Many
businesses compete with the Company to acquire medical clinics, manage such
clinics, employ clinic physicians or provide services to IPAs. These competitors
include other medical network management companies, large hospitals, other
multi-specialty clinics and health care companies, HMOs and insurance companies.
Although many of the medical network management companies formerly competing
with the Company have exited or are exiting the market, several of the remaining
competitors have longer operating histories and significantly greater resources
than the Company. We may not be able to compete effectively with existing or new
competitors. Additional competition may make it more difficult to acquire the
assets of medical clinics or develop or manage IPAs on beneficial terms. To the
extent that health care industry reforms make prepaid medical care more
attractive and provide incentives to form organized health care systems, the
Company anticipates facing greater competition. PhyCor's revenues are dependent
upon the continued stability and economic viability of the medical groups with
which it has long-term service agreements and IPAs that it manages. These
organizations face competition from several sources, including sole
practitioners, single and multi-specialty groups and staff model HMOs.

INSURANCE

         The Company maintains medical professional liability insurance on a
claims made basis for all of its operations. Insurance coverage under such
policies is contingent upon a policy being in effect when a claim is made,
regardless of when the events which caused the claim occurred. The Company also
maintains general liability and umbrella coverage on an occurrence basis. The
cost and availability of such coverage has varied widely in recent years. While
the Company believes its insurance policies are adequate in amount and coverage
for its current operations, there can be no assurance that the coverage
maintained by the Company is sufficient to cover all future claims or will
continue to be available in adequate amounts or at a reasonable cost. PhyCor and
its subsidiary operating each affiliated physician group are named as additional
insureds on the various policies maintained by each affiliated physician group,
including the professional liability insurance policies carried by the physician
group.

EMPLOYEES

         As of December 31, 1998, the Company employed approximately 21,700
people, including 145 in the corporate office. None of the Company's employees
is a member of a labor union, and the Company considers its relations with its
employees to be very good.



                                       14
<PAGE>   14
ITEM 2. PROPERTIES

         The Company leases approximately 52,000 square feet of rentable space
at 30 Burton Hills Boulevard in Nashville, Tennessee, where the Company's
headquarters are located. The Company pays approximately $83,000 per month in
rent, which rental amount increases over the term of the lease to approximately
$93,000 per month in the final year. The lease expires in 2003. The Company
believes these arrangements and other available space are adequate for its
current needs. The Company has a $60 million synthetic lease facility on which
the total drawn cost is .50% to 1.25% above the applicable eurodollar rate. The
Company has also leased through its synthetic lease facility, and has an option
to acquire, an adjacent, unimproved parcel of land which the Company could use
for additional or replacement facilities in the future. The Company has no
current plans to build such facilities. Of the $60 million available under the
synthetic lease facility, $26.0 million has been committed to lease properties
associated with two of PhyCor's affiliated clinics. The remaining synthetic
lease facility is expected to be used for, among other projects, the
construction or acquisition of medical office buildings related to our
operations.

         The Company leases, subleases or occupies facilities pursuant to its
service agreements with each of our clinics. In many cases, facilities are
leased from the physician groups with the lease cost generally included in the
service fees paid to PhyCor. In connection with the acquisition of the Company's
affiliated clinic in Lexington, Kentucky, the Company acquired the real estate
used by the physician group, including the clinic's main clinic facility in
Lexington and other satellite facilities in Lexington and the surrounding
communities. In connection with the Company's acquisitions of its affiliated
clinics in Lafayette, Indiana, and St. Petersburg, Florida, the Company acquired
the real estate used by each of the physician groups. At the time of such
acquisitions, certain of the properties were subject to a mortgage, which
indebtedness was assumed by PhyCor as a result of the transactions and repaid in
full. The Company makes these facilities available to the physician groups
pursuant to the long-term service agreements with Lexington Clinic, Arnett
Clinic and St. Petersburg-Suncoast Medical Clinic, respectively.

         In conjunction with the acquisition of PrimeCare, the Company assumed
leases for the real estate related to PrimeCare's operations and has an option
to purchase in 1999 the primary facilities used by PrimeCare. Certain of these
properties are subject to mortgages with an aggregate outstanding principal
balance as of February 28, 1999 of $7.9 million and bearing interest at rates
ranging from 8.25% to 10.5%.

         The Company may from time to time acquire real estate in connection
with the acquisition of clinic assets. The Company anticipates that as the
clinics continue to grow and add new services, expanded facilities will be
required. Such transactions may require PhyCor's assistance in obtaining
financing of the property on behalf of the physician groups.

ITEM 3. LEGAL PROCEEDINGS

         The Company and certain of its current and former officers and
directors, Joseph C. Hutts, Derril W. Reeves, Richard D. Wright (who is no
longer with the Company), Thompson S. Dent, and John K. Crawford have been named
defendants in nine securities fraud class actions filed between September 8 and
October 23, 1998. The factual allegations of the complaints in all nine actions
are substantially identical and assert that during various periods between April
22, 1997 and September 22, 1998, the defendants issued false and misleading
statements which materially misrepresented the earnings and financial condition
of the Company and its clinic operations and misrepresented and failed to
disclose various other matters concerning the Company's operations in order to
conceal the alleged failure of the Company's business model. Plaintiffs further
assert that the alleged misrepresentations caused the Company's securities to
trade at inflated levels while the individual defendants sold shares of the
Company's stock at such levels. In each of the nine actions, the plaintiff seeks
to be certified as the representative of a class of all persons similarly
situated who were allegedly damaged by the defendants' alleged violations during
the "class period." Each of the actions seeks damages in an indeterminate
amount, interest, attorneys' fees and equitable relief, including the imposition
of a trust upon the profits from the individual defendants' trades. The federal
court actions have been consolidated in the U.S. District Court for the Middle
District of Tennessee. Defendants' motion to dismiss is pending before that
court. The state court actions have been consolidated in Davidson County,
Tennessee. The Company believes that it has meritorious defenses to all of the
claims, and intends to vigorously defend against these actions. There can be no
assurance, however, that such defenses will be successful or that the lawsuits
will not have a material adverse effect on


                                       15
<PAGE>   15
the Company. The Company's Restated Charter provides that the Company shall
indemnify the officers and directors for any liability arising from these suits
unless a final judgment establishes liability (a) for a breach of the duty of
loyalty to the Company or its shareholders, (b) for acts or omissions not in
good faith or which involve intentional misconduct or a knowing violation of law
or (c) for an unlawful distribution.

         On January 23, 1999, the Company and Holt-Krock Clinic, P.L.C.
("Holt-Krock") entered into a settlement agreement with Sparks Regional Medical
Center and Sparks Regional Medical Center Foundation (collectively, "Sparks") to
resolve their lawsuits and all related claims between the parties and certain
former Holt-Krock physicians. As a result, Sparks is expected to acquire certain
assets from PhyCor, offer employment to a substantial number of Holt-Krock
physicians and enter into a long-term agreement whereby PhyCor will provide
physician practice management resources to Sparks. These transactions are
expected to be completed on or before May 31, 1999, upon execution of definitive
agreements, however, there can be no assurance that the transaction will be
completed or that it will be completed on the terms described above. See Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Results of Operations -- 1998 Compared to 1997."

         On February 2, 1999, Prem Reddy, M.D., the former majority shareholder
of PrimeCare, a medical network management company acquired by the Company in
May 1998, filed suit against the Company and certain of its current and former
executive officers in United States District Court for the Central District of
California. The complaint asserts fraudulent inducement relating to the
PrimeCare transaction and that the defendants issued false and misleading
statements which materially misrepresented the earnings and financial condition
of the Company and its clinic operations and misrepresented and failed to
disclose various other matters concerning the Company's operations in order to
conceal the alleged failure of the Company's business model. The Company
believes that it has meritorious defenses to all of the claims and intends to
vigorously defend this suit, however, there can be no assurance that if the
Company is not successful in litigation, that this suit will not have a material
adverse effect on the Company.

         On February 6, 1999, White-Wilson Medical Center, P.A. ("White -
Wilson") filed suit against PhyCor of Fort Walton Beach, Inc., the PhyCor
subsidiary with which it is a party to a service agreement, in the United States
District Court for the Northern District of Florida. White-Wilson is seeking a
declaratory judgment regarding the enforceability of the fee arrangement in
light of the Florida Board of Medicine opinion discussed above (See "Item 1.
Regulation - State Legislation") and OIG Advisory Opinion 98-4. Additionally, on
March 17, 1999, the Clark-Holder Clinic, P.A. filed suit against PhyCor of
LaGrange, Inc., the PhyCor subsidiary with which it is a party to a service
agreement, in Georgia Superior Court for Troup County, Georgia similarly
questioning the enforceability of the fee arrangement in light of OIG Advisory
Opinion 98-4. The terms of the service agreements provide that the agreements
shall be modified if the laws are changed, modified or interpreted in a way that
requires a change in the agreements. PhyCor intends to vigorously defend the
enforceability of the structure of the management fee against these suits,
however, there can be no assurance that if the Company is not successful in such
litigation, that these suits will not have a material adverse effect on the
Company.

         Certain litigation is pending against the physician groups affiliated
with the Company and IPAs managed by the Company. The Company has not assumed
any liability in connection with such litigation. Claims against the physician
groups and IPAs could result in substantial damage awards to the claimants which
may exceed applicable insurance coverage limits. While there can be no assurance
that the physician groups and IPAs will be successful in any such litigation,
the Company does not believe any such litigation will have a material adverse
effect on the Company. Certain other litigation is pending against the Company
and certain subsidiaries of the Company, none of which management believes would
have a material adverse effect on the Company's financial position or results of
operations on a consolidated basis.

         The U.S. Department of Labor (the "Department") is conducting an
investigation of the administration of the PhyCor, Inc. Savings and Profit
Sharing Plan (the "Plan"). The Department has not completed its investigation,
but has raised questions involving certain administrative practices in early
1998. The Department has not recommended enforcement action against PhyCor, nor
has it identified an amount of liability or penalty that could be assessed
against PhyCor. Based on the nature of the investigation, PhyCor believes that
its financial exposure is not material. PhyCor intends to cooperate with the
Department's investigation. There can be no assurance, however, that PhyCor will
not have a monetary penalty imposed against it.



                                       16
<PAGE>   16
         The Company's forward-looking statements relating to the
above-described litigation reflect management's best judgment based on the
status of the litigation to date and facts currently known to the Company and
its management and, as a result, involve a number of risks and uncertainties,
including the possible disclosure of new facts and information adverse to the
Company in the discovery process and the inherent uncertainties associated with
litigation.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         Not applicable.




                                       17
<PAGE>   17
                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The Company's common stock is traded on the Nasdaq Stock Market under
the symbol PHYC. The Company's 4.5% convertible subordinated debentures due
2003, are traded on the Nasdaq Stock Market under the symbol PHYCH.
The Company's initial public offering took place on January 22, 1992.

<TABLE>
<CAPTION>
          1997                                                   HIGH            LOW
          ----                                                   ----            ---
<S>                                                            <C>             <C>
          First Quarter                                        $ 35.38         $ 26.50
          Second Quarter                                         35.50           22.88
          Third Quarter                                          34.75           27.63
          Fourth Quarter                                         33.25           22.75
</TABLE>
<TABLE>
<CAPTION>
          1998                                                   HIGH            LOW
          ----                                                   ----            ---
<S>                                                              <C>             <C>
          First Quarter                                          28.50           18.88
          Second Quarter                                         23.81           14.13
          Third Quarter                                          17.38            4.50
          Fourth Quarter                                          7.69            3.94
</TABLE>
<TABLE>
<CAPTION>
          1999                                                   HIGH            LOW
          ----                                                   ----            ---

<S>                                                             <C>              <C>
          First Quarter (through March 26, 1999)                $ 8.38           $4.50
</TABLE>

         As of March 26, 1999, the Company had approximately 29,742
shareholders, including 3,842 shareholders of record and approximately 25,900
persons or entities holding common stock in nominee name.

         The Company has never declared or paid a dividend on its common stock,
except in the form of three-for-two stock splits effected in December 1994,
September 1995 and June 1996, each of which was paid in the form of a 50% stock
dividend. The Company intends to retain its earnings to finance the growth of
its businesses. The declaration of other dividends is currently prohibited by
the Company's bank credit facility and its synthetic lease facility, and it is
anticipated that other loan agreements and leases which the Company may enter
into in the future will also contain restrictions on the payment of dividends by
the Company.




                                       18
<PAGE>   18
ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,                       1998              1997              1996           1995           1994
-----------------------                       ----              ----              ----           ----           ----
<S>                                       <C>               <C>               <C>            <C>            <C>
Statement of Operations Data:
Net revenue                               $ 1,512,499       $ 1,119,594       $   766,325    $   441,596    $   242,485
Operating expenses:
    Cost of provider services                 134,302                --                --             --             --
    Salaries, wages and benefits              513,646           421,716           291,361        166,031         88,443
    Supplies                                  227,440           181,565           119,081         67,596         37,136
    Purchased medical services                 37,774            31,171            21,330         17,572         11,778
    Other expenses                            218,359           171,480           125,947         71,877         40,939
    General corporate expenses                 29,698            26,360            21,115         14,191          9,417
    Rents and lease expense                   126,453           100,170            65,577         36,740         23,413
    Depreciation and amortization              90,238            62,522            40,182         21,445         12,229
    Provision for asset revaluation and
        clinic restructuring(1)               224,900            83,445                --             --             --
    Merger expenses                            14,196                --                --             --             --
                                          -----------       -----------       -----------    -----------    -----------
        Net operating expenses              1,617,006         1,078,429           684,593        395,452        223,355
                                          -----------       -----------       -----------    -----------    -----------
     Earnings (loss) from operations         (104,507)           41,165            81,732         46,144         19,130
    Interest income                            (3,032)           (3,323)           (3,867)        (1,816)        (1,334)
    Interest expense                           36,266            23,507            15,981          5,230          3,963
                                          -----------       -----------       -----------    -----------    -----------
        Earnings (loss) before income
            taxes and minority interest      (137,741)           20,981            69,618         42,730         16,501
    Income tax expense (benefit)              (39,890)            6,098            22,775         13,923          4,826
    Minority interest                          13,596            11,674            10,463          6,933             --
                                          -----------       -----------       -----------    -----------    -----------
        Net earnings (loss)               $  (111,447)(2)   $     3,209(2)    $    36,380    $    21,874    $    11,675(3)
                                          ===========       ===========       ===========    ===========    ===========
Net earnings (loss) per share(4)
    Basic                                 $     (1.55)(2)   $       .05(2)    $       .67    $       .45    $       .35(3)
    Diluted                               $     (1.55)(2)   $       .05(2)    $       .60    $       .41    $       .32(3)
Weighted average shares outstanding(4)
    Basic                                      71,822            62,899            54,608         48,817         33,240
    Diluted                                    71,822            66,934            61,096         53,662         42,988
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,                                  1998            1997           1996            1995            1994
------------                                  ----            ----           ----            ----            ----
<S>                                        <C>              <C>            <C>            <C>               <C>
Balance Sheet Data:
Working capital                            $ 187,854        $ 203,301      $ 182,553      $ 111,420         $ 80,533
Total assets                               1,846,539        1,562,776      1,118,581        643,586          351,385
Long-term debt                               651,209          501,107        444,207        140,633           94,653
Total shareholders' equity                   804,410          710,488        451,703        388,822          184,125
</TABLE>

1         Provision for asset revaluation and clinic restructuring relates to
          revaluation of assets of certain of the Company's affiliated clinics
          and MHG.
2         Excluding the effect of the asset revaluation, clinic restructuring
          and merger charges in 1997 and 1998, the Company's net earnings, net
          earnings per share - basic and net earnings per share - diluted would
          have been approximately $57.0 million, or $.91 per share - basic, and
          $.85 per share - diluted, and $54.7 million, or $.76 per share-basic
          and $.74 per share-diluted, respectively, in such years.
3         Excluding the effect of the utilization of a net operating loss carry
          forward to reduce income taxes in 1994, net earnings, net earnings per
          share-basic and net earnings per share-diluted would have been $10.2
          million, or $.31 per share-basic and $.28 per share-diluted.
4         Per share amounts and weighted average shares outstanding have been
          adjusted for the three-for-two stock splits effected December 1994,
          September 1995 and June 1996.


                                       19
<PAGE>   19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

OVERVIEW

         The Company operates multi-specialty medical clinics, develops and
manages IPAs and provides health care decision-support services, including
demand management and disease management services to managed care organizations,
health care providers, employers and other group associations. In connection
with the Company's multi-specialty clinic operations, we manage and operate two
hospitals and four HMOs. A substantial majority of the Company's revenue in 1997
and 1998 was earned under service agreements with multi-specialty clinics.
Revenue earned under substantially all of the service agreements is equal to the
net revenue of the clinics, less amounts retained by physician groups.

         When PhyCor acquires a clinic's operating assets, it simultaneously
enters into a long-term service agreement with the affiliated physician group.
Under the service agreement, PhyCor provides the physician group with the
equipment and facilities used in its medical practice, manages clinic
operations, employs the clinic's non-physician personnel, other than certain
diagnostic technicians, and receives a service fee.

         The affiliated physicians maintain full professional control over their
medical practices, determine which physicians to hire or terminate and set their
own standards of practice in order to promote high quality health care. Pursuant
to its service agreements with physician groups, PhyCor manages all aspects of
the clinic other than the provision of medical services, which is controlled by
the physician groups. At each clinic, a joint policy board equally represented
by physicians and PhyCor personnel focuses on strategic and operational
planning, marketing, managed care arrangements and other major issues facing the
clinic.

         To increase clinic revenue, the Company works with the affiliated
physician groups to recruit additional physicians, merge other physicians
practicing in the area into the affiliated physician groups, negotiate contracts
with managed care organizations and provide additional ancillary services. To
reduce or control expenses, among other things, PhyCor utilizes national
purchasing contracts for key items, reviews staffing levels to make sure they
are appropriate and assists the physicians in developing more cost-effective
clinical practice patterns.

         Under substantially all of its service agreements, the Company receives
a service fee equal to the clinic expenses it has incurred plus a percentage of
operating income of the clinic (net clinic revenue less certain contractually
agreed upon clinic expenses before physician distributions) and, under all other
service agreements except one described below, the Company receives a percentage
of net clinic revenue. In 1998, the Company's service agreement revenue was
derived from contracts with the following service fee structures: (i) 92.1% of
revenue was derived from contracts in which the service fee was based on a
percentage, ranging from 11% to 18%, of clinic operating income plus
reimbursement of clinic expenses; (ii) 0.8% of revenue was derived from a
contract in which the service fee was based on 51.7% of net clinic revenue;
(iii) 5.9% of revenue was derived from contracts in which the service fee was
based upon a combination of (a) 10% of clinic operating income, (b) a
percentage, ranging from 2.75% to 3.5%, of net clinic revenue and (c)
reimbursement of clinic expenses; and (iv) 1.2% of revenue was derived from a
flat fee contract.

         The Company has historically amortized goodwill and other intangible
assets related to its service agreements over the periods during which the
agreements are expected to be effective, ranging from 25 to 40 years. Effective
April 1, 1998, the Company adopted a maximum of 25 years as the useful life for
amortization of its intangible assets, including those acquired in prior years.
Had this policy been in effect for 1997, amortization expense would have
increased by approximately $11.2 million for the year. Applying the Company's
historical tax rate, diluted earnings per share would have been reduced by $.10
for 1997. On the same basis, for the first quarter of 1998, amortization expense
would have increased by approximately $3.3 million, resulting in an increase in
diluted loss per share of $0.03.

         Each of the service agreements with the Company's affiliated physician
groups provides the affiliated physician group the right to terminate the
service agreement in the event of the bankruptcy or similar event of the
Company's subsidiary that is a party to the service agreement or in the event of
a material breach of the service


                                       20
<PAGE>   20
agreement by the Company or its subsidiary (i) which is not cured within 90
days, generally, following written notice and (ii) which termination is approved
by the affirmative vote of no less than 75%, generally, of the physician
shareholders. Many of the service agreements provide that if any person or
persons acquire the right to vote 50% or more of PhyCor's common stock, the
physician group may terminate the service agreement, unless the transaction was
approved by PhyCor's Board of Directors or subsequently approved by two-thirds
of PhyCor's directors who are not members of management or affiliates of the
acquiring person. The physician group in Lexington, Kentucky may also terminate
its service agreement if an entity named therein acquires 15% or more of the
Company's outstanding common stock. Other groups may terminate their service
agreement in the event of a merger where PhyCor does not survive or a takeover
or sale of substantially all the assets of PhyCor or in the event of a sale of
all or substantially all of the assets or capital stock of the PhyCor subsidiary
with whom the service agreement was entered into. Some physician groups have
rights of first refusal to purchase the clinic assets owned by PhyCor if PhyCor
determines to sell such assets. The above provisions could have an adverse
effect on any efforts to take control of PhyCor without the consent of the Board
of Directors and the physician groups having these rights. In addition, the
Company may terminate a service agreement (i) in the event of the bankruptcy or
similar event of the affiliated physician group, or (ii) a material breach of
the service agreement by the affiliated physician group which is not cured
within 90 days, generally, following written notice. In any event of
termination, the affiliated physician group is obligated to repurchase all of
the tangible and intangible assets of the Company related to the physician group
generally at the then current net book value.

         Pursuant to the Company's service agreements with its affiliated
clinics, the physician groups affiliated with the clinics are obligated to
repurchase at book value all of the assets associated with the clinic, including
intangible assets, upon termination of the service agreement. The Company's
ability to recover the net book value associated with a terminated service
agreement is largely dependent upon the circumstances of the termination, the
willingness of the physicians to honor their agreement with the Company and the
financial position of the physicians affiliated with the clinic. In the event of
a termination of a service agreement, PhyCor expects the terminating group to
fulfill its repurchase obligation at the effective time of termination. The
Company owns substantially all of the tangible assets related to the operations
of its affiliated clinics, which assets provide collateral for a portion of the
purchase requirement in the event of termination. Tangible assets associated
with clinics represented approximately 51% of the Company's total assets
associated with the clinics. The intangible assets of the Company related to the
affiliated clinics totaled $696.8 million as of December 31, 1998. In connection
with the disposal of certain clinic operations, the Company determined that a
sale of assets below book value provided a more cost-effective means to
terminate its relationship with certain clinics rather than attempting to
collect the full net book value of the assets through the enforcement of its
contractual rights under the service agreement with the clinic. See "Asset
Revaluation and Clinic Restructuring-Assets Held for Sale." The Company has
evaluated, on an individual basis, the appropriate course of action for each of
its terminated service agreements and expects to pursue the most appropriate and
effective course, given the facts and circumstances of any termination, to
recover the amounts owed as a result of any such termination.

         In November 1997, the Emerging Issues Task Force reached a consensus on
EITF 97-2, "Application of APB Opinion No. 16 and FASB Statement No. 94 to
Physician Practice Entities", which was adopted in November 1997, and relates
primarily to the consolidation of physician practices controlled by a company.
The Company has not consolidated the physician practices it manages as it does
not have operating control of these practices as defined in EITF 97-2. Physician
practices and IPAs which are owned and operated by the Company are consolidated
for such purposes.

         The Company has increased its focus on the development of IPAs to
enable the Company to provide services to a broader range of physician
organizations, to enhance the operating performance of existing clinics and to
further develop physician relationships. The Company develops IPAs that include
affiliated clinic physicians to enhance the clinics' attractiveness as providers
to managed care organizations. Fees earned from managing the IPAs are based upon
a percentage of revenue collected by the IPAs and also upon a share of surplus,
if any, of capitated revenue of the IPAs. In 1998, approximately 16% of the
Company's revenue was earned under IPA management agreements. The Company is not
a party to the capitated contracts entered into by the IPAs not owned by the
Company, but is exposed to losses to the extent of its share of the excess of
costs, if any, over the capitated revenue of the IPAs. The Company is a party to
capitated contracts entered into by the PrimeCare and MHG IPAs.


                                       21
<PAGE>   21
         The table below indicates the number of clinics and physicians
affiliated with the Company and provides certain information with respect to the
Company's IPA operations at the end of the years indicated:

<TABLE>
<CAPTION>
                                              1998           1997            1996            1995           1994
                                              ----           ----            ----            ----           ----
<S>                                         <C>            <C>             <C>             <C>           <C>
Clinic operations:
    Number of affiliated clinics                  56             55              44              31            22
    Number of affiliated physicians            3,693          3,863           3,050           1,955         1,143
IPA operations:
    Number of markets                             35             28              17              13             7(1)
    Number of physicians                      22,900         19,000           8,700           5,300         3,600(1)
    Number of commercial members             730,000        420,000         306,000         180,000       105,000(1)
    Number of Medicare members               171,000         99,000          69,000          38,000        24,000(1)
</TABLE>

(1)      Information is as of January 1, 1995.

         The table below indicates the payor mix of the aggregate net clinic
revenue earned by the physician groups and IPAS currently affiliated with the
Company.

<TABLE>
<CAPTION>
                                             1998            1997           1996            1995            1994
                                             ----            ----           ----            ----            ----
<S>                                          <C>            <C>            <C>            <C>              <C>
Medicare                                        19%            22%            20%            20%              29%
Medicaid                                         3              4              3              3                3
Managed care(1)                                 51             41             42             37               25
Private payor and insurance                     27             33             35             40               43
                                             -----          -----          -----          -----            -----
                                               100%           100%           100%           100%             100%
</TABLE>

(1)      Includes HMO, PPO, Medicare risk contracts and direct employer
         contracts, of which approximately 70% of 1998 managed care revenue was
         attributable to capitated contracts.

         The payor mix varies from clinic to clinic and changes as acquisitions
are made. Since 1993, managed care revenue as a percentage of all revenue has
increased significantly primarily as a result of the Company's management of
IPAs for which all revenue is derived from managed care contracts. PhyCor
believes that this trend will continue as a greater portion of the population in
the Company's markets joins managed care plans. Other changes in payor mix have
resulted from the acquisition of clinics with payor mixes different from
historical payor mixes experienced by the Company's affiliated groups.

         Many of the payor contracts entered into on behalf of PhyCor-managed
IPAs are based on capitated fee arrangements. Under capitation arrangements,
health care providers bear the risk, subject to certain loss limits, that the
aggregate costs of providing medical services to members will exceed the
payments received. The IPA management fees are based, in part, upon a share of
the remaining portion, if any, of capitated amounts of revenues after payment of
expenses. Agreements with payors also contain shared risk provisions under which
the Company and the IPA can earn additional compensation based on utilization of
hospital services by members and may be required to bear a portion of any loss
in connection with such shared risk provisions. The profitability of the managed
IPAs is dependent upon the ability of the providers to effectively manage the
per patient costs of providing medical services and the level of utilization of
medical services. The management fees are also based upon a percentage of
revenue collected by the IPAs. Through its service fees, the Company also shares
indirectly in capitation risk assumed by its affiliated physician groups.

         In May 1998, the Company acquired PrimeCare, a medical network
management company serving southern California's Inland Empire area. PrimeCare's
network is comprised of an integrated campus, including the Desert Valley
Medical Group, Desert Valley Hospital and Apple Valley Surgery Center, as well
as the Inland Empire area IPA


                                       22
<PAGE>   22
network. The total consideration for PrimeCare was approximately $170.0 million,
consisting of approximately 4.0 million shares of common stock, assumed
liabilities and cash. See Item 3. "Legal Proceedings."

         On July 1, 1998, the Company acquired Seattle-based CareWise, a
nationally recognized leader in the health care decision-support industry, which
as of December 31, 1998, provided health care decision-support services to
approximately 2.7 million individuals worldwide. The total consideration for
CareWise was approximately $67.5 million, consisting of approximately 3.1
million shares of common stock and assumed liabilities.

         In July 1998, the Company acquired MHG, an Atlanta-based IPA whose
network at such time included approximately 400 primary care physicians and
1,800 specialists who provided care to approximately 57,000 managed care members
under capitated contracts. The total consideration for MHG was approximately
$33.1 million, consisting of 500,000 shares of common stock and assumed
liabilities. See Item 1. "Business - Physician Networks."

         On July 24, 1998, the Company acquired FPC, an Atlanta-based provider
of practice management services. The total consideration for FPC was
approximately $60.4 million, consisting of 2.9 million shares of common stock
and assumed liabilities.

         In addition, in 1998 the Company purchased certain assets of two
multi-specialty clinics, numerous smaller medical practices and completed its
purchase of certain operating assets of Lakeview Medical Center located in
Suffolk, Virginia, which was operated under a management agreement during
December 1997.

         In October 1998, the Company formed a joint venture with Physician
Partners Company, L.L.C., a physician organization created by physicians to
develop an IPA management business and to develop and manage a regional managed
care contracting network, which is anticipated to include IPAs in New York City,
northern New Jersey, southern Connecticut and Long Island.

         As a result of 1998 transactions, the Company acquired total assets of
$459.7 million. The principal assets acquired were accounts receivable, property
and equipment, prepaid expenses, goodwill and service agreement rights, an
intangible asset. The consideration for the acquisitions consisted of
approximately 21% cash, 38% liabilities assumed, 39% common stock and 2%
convertible notes. The cash portion of the aggregate purchase price was funded
by a combination of operating cash flow and borrowings under the Company's bank
credit facility. Property and equipment acquired consists mostly of clinic and
hospital operating equipment.

         In September 1998, PhyCor adopted a common stock repurchase program
pursuant to which it may repurchase up to $50.0 million of PhyCor common stock.
In October 1998, PhyCor expanded the program into a securities repurchase
program to include its 4.5% convertible subordinated debentures and other
securities, the economic terms of which are derived from the common stock or
debentures. In conjunction with the securities repurchase program, PhyCor has
repurchased approximately 2.6 million shares of common stock for approximately
$12.6 million, 2.2 million shares of which were repurchased in the fourth
quarter. Recent changes to the Company's bank credit facility limit the amount
of the Company's securities the Company may repurchase. See "Liquidity and
Capital Resources."





                                       23
<PAGE>   23
RESULTS OF OPERATIONS

         The following table shows the percentage of net revenue represented by
various expense categories reflected in the Company's Consolidated Statements of
Operation.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,                                              1998                1997              1996
-----------------------                                              ----                ----              ----
<S>                                                                 <C>                 <C>                <C>
Net revenue                                                         100.0%              100.0%             100.0%
Operating expenses:
    Cost of provider services                                         8.9                 -.-                -.-
    Salaries, wages and benefits                                     33.9                37.7               38.0
    Supplies                                                         15.0                16.2               15.5
    Purchased medical services                                        2.5                 2.8                2.8
    Other expenses                                                   14.4                15.3               16.4
    General corporate expenses                                        2.0                 2.4                2.8
    Rents and lease expense                                           8.4                 8.9                8.6
    Depreciation and amortization                                     6.0                 5.6                5.2
    Provision for asset revaluation and clinic restructuring         14.9                 7.4                -.-
    Merger expenses                                                   0.9                 -.-                -.-
                                                                    -----               -----              -----
Net operating expenses                                              106.9(1)             96.3(1)            89.3
    Earnings (loss) from operations                                  (6.9)(1)             3.7(1)            10.7
Interest income                                                      (0.2)               (0.3)              (0.5)
Interest expense                                                      2.4                 2.1                2.1
                                                                    -----               -----              -----
    Earnings (loss) before income taxes and minority                 (9.1)(1)             1.9(1)             9.1
interest
Income tax expense (benefit)                                         (2.6)(1)             0.5(1)             3.0
Minority interest                                                     0.9                 1.1                1.4
                                                                    -----               -----              -----
    Net earnings (loss)                                              (7.4)%(1)            0.3%(1)            4.7%
                                                                    =====               =====              =====
</TABLE>

(1)       Excluding the effect of the provision for asset revaluation and clinic
          restructuring and merger expenses in 1997 and 1998, net operating
          expenses, earnings from operations, earnings before income taxes and
          minority interest, income tax expense and net earnings, as a percent
          of net revenue, would have been 88.9%, 11.1%, 9.3%, 3.2% and 5.1%,
          respectively, for 1997, and 91.1%, 8.9%, 6.7%, 2.2%, and 3.6%,
          respectively, for 1998.

1998 COMPARED TO 1997

         Net revenue increased $392.9 million, or 35.1%, from $1.12 billion for
1997 to $1.51 billion for 1998. Net revenue from multi-specialty and group
formation clinics ("Clinic Net Revenue") increased in 1998 from 1997 by $182.0
million, comprised of (i) a $161.4 million increase in service fees for
reimbursement of clinic expenses incurred by the Company and (ii) a $20.6
million increase in the Company's fees from clinic operating income and net
physician group revenue. The increases in Clinic Net Revenue, excluding same
clinic revenue increases discussed below, were comprised of $177.2 million from
newly acquired clinics in 1998 or the timing of entering into new service
agreements in 1997, reduced by $49.5 million from clinic operations disposed of
in 1998. Included in the changes in Clinic Net Revenue is the impact of
declining reimbursement for services rendered by the physician groups.
Specifically, the provision for doubtful accounts and contractual adjustments on
gross physician group, hospital and other revenue increased to 40.5% for 1998
from 38.3% for 1997. Net revenue from the service agreements (excluding clinics
whose related assets have been sold) in effect for all of 1998 and 1997
increased by $54.3 million in 1998 compared with 1997. Same market service
agreement net revenue growth resulted from the addition of new physicians, the
expansion of ancillary services and increases in patient volume and fees.

         Net revenue from IPAs increased $168.8 million, or 241.1%, from $70.0
million for 1997 to $238.8 million for 1998. This increase resulted primarily
from increases in net revenues from the acquisitions of PrimeCare and MHG in
1998 of an aggregate of approximately $137.2 million and the addition of ten IPA
markets subsequent to the first


                                       24
<PAGE>   24
quarter of 1997 of approximately $10.6 million. (The Company expects to commence
closing MHG operations effective April 30, 1999. See "Asset Revaluation and
Clinic Restructuring.") Net revenue from the IPA markets in effect for all of
1998 and 1997 increased by $21.0 million, or 31.9%, in 1998 compared to 1997.
Same market IPA growth resulted from the addition of new physicians, increases
in IPA enrollment and increases in patient volume and fees.

         During 1998, most categories of operating expenses changed as a
percentage of net revenue when compared to 1997. The addition of cost of
provider services is a result of the acquisitions of PrimeCare and MHG in 1998.
PrimeCare and MHG own and manage IPAs, and each are a party to certain managed
care contracts, resulting in the Company presenting revenue from these
operations on a "grossed-up basis." Under this method, unlike the majority of
the Company's IPAs, the cost of provider services (payments to physicians and
other providers under compensation, sub-capitation and other reimbursement
contracts) is not included as a deduction to net revenue of the Company, but is
reported as an operating expense. This revenue reporting resulted in a new cost
of provider services expense line item and in general would cause other expense
line items to decrease as a percentage of net revenue when compared to periods
prior to the acquisitions of Primecare and MHG. As a result, during 1998 most
categories of operating expenses decreased as a percentage of net revenue when
compared to 1997. Excluding the impact of PrimeCare's and MHG's revenue
reporting, there were no significant variances in the operating expenses as a
percentage of net revenue compared to 1997. Excluding the impact of PrimeCare's
and MHG's revenue reporting, supplies expense, other expenses, rents and lease
expense and depreciation and amortization marginally increased as a percentage
of net revenue. The increase in supplies expense is a result of continued
increases in costs of drugs and medications, the addition of pharmacies at
certain existing clinics and recent affiliations with clinics that operate
pharmacies. Other expenses and rents and lease expense increased as a result of
the reduction of physicians in certain of the Company's group formation clinics
which resulted in these clinics not operating at full capacity but still being
responsible for certain fixed costs obligations. The increase in depreciation
and amortization expense resulted from the change in amortization policy with
respect to intangible assets and the impact of recent acquisitions. Excluding
the impact of PrimeCare's and MHG's revenue reporting, salaries, wages and
benefits marginally decreased as a percentage of net revenue. This decrease is a
result of the Company's continuing efforts to control overhead costs. While
general corporate expenses decreased as a percentage of net revenue, the dollar
amount increased as a result of the Company's response to increasing physician
group needs for practice management services, including managed care
negotiations, information system implementations and clinical outcomes
management programs.

         PhyCor's managed IPAs and affiliated physician groups enter into
contracts with third party payors, many of which are based on fixed or capitated
fee arrangements. Under these capitation arrangements, health care providers
receive a fixed fee per plan member per month and providers bear the risk,
generally subject to certain loss limits, that the total costs of providing
medical services to the members will exceed the fixed fee. The IPA management
fees are based, in part, upon a share of the portion, if any, of the fixed fee
that exceeds actual costs incurred. Some agreements with payors also contain
"shared risk" provisions under which PhyCor, through the IPA, can share
additional fees or can share in additional costs, depending on the utilization
rates of the members and the success of the IPAs. Through calculation of its
service fees, the Company also shares indirectly in capitation risk assumed by
its affiliated physician groups. In addition, the Company owns two HMOs which
were affiliated with the multi-specialty clinics prior to affiliation with
PhyCor. The Company also owns a 50% interest in another such HMO. Incurred but
not reported claims payable ("IBNR claims payable") represent the liability for
covered services that have been performed by physicians for enrollees of various
medical plans. The estimated claims incurred but not reported are based on the
Company's historical claims data, current enrollment, health service utilization
statistics and other related information. There were no material adjustments in
the current year to prior year IBNR claims payable. In connection with the July,
1998 MHG IPA acquisition, the Company assumed IBNR claims payable of
approximately $7.0 million. Subsequently, the MHG IBNR claims payable liability
as of the acquisition date was increased by approximately $8.3 million. See
"Asset Revaluation and Clinic Restructuring - Assets Held for Sale."

         On behalf of certain of the Company's affiliated IPAs, the Company has
been required to underwrite letters of credit to managed care payors to help
ensure payment of health care costs for which the affiliated IPAs have assumed
responsibility. As of December 31, 1998, letters of credit aggregating $7.0
million were outstanding under the bank credit facility for the benefit of
managed care payors. The Company would seek reimbursement from an IPA if there
was a draw on a letter of credit. No draws on any of these letters of credit
have occurred to date.



                                       25
<PAGE>   25
         The total provision for asset revaluation and clinic restructuring for
the year ended December 31, 1998 totaled $224.9 million, consisting of $22.0
million in the first quarter of 1998, a net $92.5 million in the third quarter
of 1998 and $110.4 million in the fourth quarter of 1998. The provision for
clinic restructuring of $22.0 million in the first quarter of 1998 related to
seven of the Company's clinics that were being restructured or disposed of and
included facility and lease termination costs, severance and other exit costs.
In the fourth quarter of 1997, the Company recorded a pre-tax charge of $83.4
million related to asset revaluation at these same clinics. The charges
addressed operating issues that developed in four of the Company's
multi-specialty clinics that represent the Company's earliest developments of
such clinics through the formation of new groups. Three other clinics included
in the 1997 charge represent clinics disposed of during 1998 because of a
variety of negative operating and market-specific issues. See discussion of
these charges in "Asset Revaluation and Clinic Restructuring" below. At December
31, 1998, the Company had a total of five group formation clinics and two FPC
clinics that have characteristics similar to group formation clinics. These
remaining clinics include two clinics associated with the charges discussed
above, one of which was disposed of in March 1999. The total assets and
intangible assets of the remaining five group formation clinics and similar FPC
clinics totaled $56.8 million and $21.0 million, respectively, at December 31,
1998. Net revenue and pre-tax income (loss) for the group formation and similar
FPC clinics for 1998 were $63.7 million and ($1.0) million, respectively, and
for 1997 were $44.4 million and $519,000, respectively.

         The Company also recorded a pre-tax charge to earnings of approximately
$14.2 million in the first quarter of 1998 relating to the termination of its
merger agreement with MedPartners, Inc. This charge represented PhyCor's share
of investment banking, legal, travel, accounting and other expenses incurred
during the merger negotiation process.

         The Company expects an effective tax rate of approximately 37.6% in
1998 before the tax benefit of the provision for clinic restructuring and merger
expenses discussed above as compared to a rate of 38.5% in 1997.

1997 COMPARED TO 1996

         Net revenue increased $353.3 million from $766.3 million for 1996 to
$1.12 billion for 1997, an increase of 46.2%. The increase in clinic net
revenues in 1997 as compared to 1996 of $333.1 million included $278.5 million
in service fees resulting from newly acquired clinics in 1997 or the timing of
entering into new service agreements in 1996 and was comprised of (i) a $294.2
million increase in service fees for reimbursement of clinic expenses incurred
by the Company and (ii) a $38.9 million increase in the Company's share of
clinic operating income and net physician group revenue. Net revenue from the 31
service agreements and 13 IPA markets in effect for both years increased $75.3
million, or 12.8%, in 1997 compared with 1996. Same market growth resulted from
the addition of new physicians, the expansion of ancillary services, and
increases in patient volume and fees. The remaining increase results from the
addition of new clinic service agreements in 1997 and the timing of entering
into new service agreements in 1996.

         During 1997, most categories of operating expenses were relatively
stable as a percentage of net revenue when compared to 1996, despite the large
increase in the dollar amounts resulting from acquisitions and clinic growth.
The decrease in salaries, wages and benefits and other expenses as a percentage
of net revenue resulted from the acquisition of clinics with lower levels of
these expenses compared to the existing base of clinics. The increase in
supplies and rents and lease expense as a percentage of net revenue resulted
from the acquisition of clinics with higher levels of these expenses compared to
the existing base of clinics. The addition of pharmacies at certain existing
clinics and new clinics which operate pharmacies also resulted in increased
clinic supplies expense as a percentage of net revenue. While general corporate
expenses decreased as a percentage of net revenue, the dollar amount of general
corporate expenses increased as a result of the addition of corporate personnel
to accommodate increased acquisition activity and to respond to increasing
physician group needs for support in managed care negotiations, information
systems implementation and clinical outcomes management programs.

         The asset revaluation charge of $83.4 million in 1997 related to the
asset revaluation of seven of the Company's multi-specialty clinics, and
included current assets, property and equipment, other assets and intangible
assets of $6.4 million, $4.9 million, $5.3 million and $66.8 million,
respectively. This charge addressed issues which developed in four of the
Company's multi-specialty clinics which represented the Company's earliest
developments of such clinics through the formation of new groups. The clinics
were considered to have an impairment of certain current assets, property and
equipment, other assets and, primarily, intangible assets because of certain
groups of physicians


                                       26
<PAGE>   26
within a larger clinic terminating their relationship with the medical group
affiliated with the Company and therefore affecting future cash flows. Net
revenue and pre-tax income (loss) for the four clinics that were part of new
group formations included in the charge were $88.4 million and ($2.9) million in
1997 and $78.7 million and $188,000 in 1996, respectively. Net revenue and total
assets of other new group formations not included in the asset revaluation
charge totaled $38.7 million and $61.4 million, respectively, in 1997, and $13.0
million and $37.2 million, respectively, in 1996. Three other clinics included
in the charge represented clinics being disposed of because of a variety of
negative operating and market issues, including those related to market position
and clinic demographics, physician relations, operating results and ongoing
viability of the existing medical group. Net revenue and pre-tax income (loss)
for the three clinics to be disposed of were $25.5 million and ($1.0 million) in
1997 and $26.5 million and $772,000 in 1996, respectively.

         The Company's effective tax rate was approximately 38.5% in 1997 and
1996.

SUMMARY OF OPERATIONS BY QUARTER

         The following table presents unaudited quarterly operating results for
1998 and 1997. The Company believes that all necessary adjustments have been
included in the amounts stated below to present fairly the quarterly results
when read in conjunction with the Consolidated Financial Statements. Results of
operations for any particular quarter are not necessarily indicative of results
of operations for a full year or predictive of future periods.

<TABLE>
<CAPTION>
                                                                   1998 QUARTER ENDED
                                                                   ------------------
                                            MAR 31              JUNE 30          SEPT 30              DEC 31
                                            ------              -------          -------              ------
<S>                                       <C>                  <C>              <C>                  <C>
Net revenue                                 322,695            $ 371,450        $ 408,487            $ 409,867
Earnings (loss) before taxes                (10,753)(1)           24,306          (73,019)(2)          (91,871)(3)
Net earnings (loss)                          (7,498)(1)           15,313          (50,843)(2)          (68,419)(3)
Earnings (loss) per share--diluted        $    (.12)(1)        $     .22        $    (.66)(2)        $    (.90)(3)
</TABLE>

<TABLE>
<CAPTION>
                                                                1997 QUARTER ENDED
                                                                ------------------
                                            MAR 31           JUNE 30          SEPT 30          DEC 31
                                            ------           -------          -------          ------
<S>                                       <C>              <C>              <C>              <C>
Net revenue                               $ 250,652        $ 267,354        $ 284,291        $ 317,297
Earnings (loss) before taxes                 20,011           22,395           24,576          (57,675)(4)
Net earnings (loss)                          12,307           13,706           15,040          (37,844)(4)
Earnings (loss) per share--diluted        $     .19        $     .20        $     .22        $    (.56)(4)
</TABLE>

(1)       Excluding the effects of asset revaluation and clinic restructuring
          charges and merger expenses, the Company's earnings before taxes, net
          earnings and net earnings per share-diluted for the first quarter of
          1998 would have been approximately $25.4 million, $16.0 million and
          $.24, respectively.

(2)       Excluding the effects of asset revaluation and clinic restructuring
          charges, the Company's earnings before taxes, net earnings and net
          earnings per share-diluted for the third quarter of 1998 would have
          been approximately $19.5 million, $12.0 million and $.15,
          respectively.

(3)       Excluding the effects of asset revaluation and clinic restructuring
          charges, the Company's earnings before taxes, net earnings and net
          earnings per share-diluted for the fourth quarter of 1998 would have
          been approximately $18.5 million, $11.4 million and $.15,
          respectively.

(4)       Excluding the effects of asset revaluation and clinic restructuring
          charges, the Company's earnings before taxes, net earnings and net
          earnings per share-diluted for the fourth quarter of 1997 would have
          been approximately $25.8 million, $16.0 million and $.24,
          respectively.



                                       27
<PAGE>   27
ASSET REVALUATION AND CLINIC RESTRUCTURING

         Assets Held for Sale

         During 1998, the health care industry has undergone rapid changes that
have significantly affected physicians and other health care providers.
Declining reimbursement from Medicare and commercial payors has negatively
impacted physician revenues and incomes. The Company and its physicians have
attempted to react to this development by devising and implementing plans to
reduce overhead, increase patient volume, increase physician productivity and
change payor mixes. In some clinics, physicians have been slow to engage in
necessary changes because of medical group culture or other market factors and,
as a result, these strategies have been only marginally successful or in some
cases not successful. Physician groups that have weak governance structures and
marginal market presence, among other factors, have experienced difficulty
dealing with the impact of these financial pressures. This difficulty has
affected the relationships among physicians within the groups and between the
physician groups and the Company. As a result, during 1998 the Company sold
clinic operating assets and terminated the related service agreements, or is in
the process of doing so, with a number of clinics affiliated with the Company.

         In the fourth quarter of 1998, the Company recorded pre-tax asset
revaluation charges totaling $110.4 million, consisting of $75.7 million related
to assets to be sold and $34.7 million related to asset impairments. The fourth
quarter 1998 asset revaluation charge related to assets held for sale included
current assets, property and equipment, other assets and intangible assets of
$2.4 million, $2.9 million, $1.4 million and $69.0 million, respectively.

         $26.0 million of the fourth quarter 1998 charge related to adjustments
of the carrying value of the Company's assets at Holt-Krock and Burns Clinic
Medical Center ("Burns") as a result of agreements to sell certain assets
associated with these service agreements. These clinics represent
multi-specialty clinics that are being disposed because of a variety of negative
operating and market issues, including those related to declining reimbursement
for Medicare and commercial patient services, market position and clinic
demographics, physician relations, physician turnover rates, declining physician
incomes, physician productivity, operating results and ongoing viability of the
existing medical group. Although these factors have been present individually
from time to time in various affiliated clinics and could occur in future clinic
operations, the combined effect of these factors at the clinics held for sale
resulted in clinic operations that were difficult to effectively manage.
Therefore, the Company determined in the fourth quarter of 1998 to sell the
clinic operating assets and terminate the agreements related to these clinics.
The net assets held for sale for these two clinics at December 31, 1998 was
approximately $33.7 million and consisted primarily of accounts receivable,
property and equipment, other assets and intangible assets less certain current
liabilities. For the year ended December 31, 1998, net revenues and pre-tax
income from these two clinics was $75.4 million and $1.0 million, respectively,
compared to $76.9 million and $4.4 million, respectively, for the year ended
December 31, 1997.

         In addition, the fourth quarter 1998 charge provided for the write-off
of $31.6 million of goodwill recorded in connection with the July 1998 MHG
acquisition. MHG was an Atlanta-based IPA whose network at such time included
approximately 400 primary care physicians and 1,800 specialists who provided
care to approximately 57,000 managed care members under capitated contracts. In
September 1998, PhyCor announced that the earnings of MHG were significantly
below target because of higher than expected costs from MHG's managed care
contracts. Subsequent to the closing of this acquisition, the claims received
from its principal payor for costs arising before the acquisition revealed that
MHG's costs significantly exceeded its revenues under the payor contract prior
to the date of acquisition. PhyCor continued to fund the premium deficiency
under this principal payor contract, which accounted for approximately 90% of
MHG's revenues, while attempting to renegotiate payment terms with the payor to
allow for this principal payor contract to be economically viable. In January of
1999, a mutually beneficial agreement could not be reached. The payor contract
is expected to terminate by mutual agreement on April 30, 1999 and the Company
expects to commence closing its MHG operation at that time. The Company is
attempting to recover its investment in MHG from the sellers of MHG, but there
can be no assurance of a recovery. For the year ended December 31, 1998, net
revenue and pre-tax income from MHG was $30.4 million and $300,000,
respectively.

         Also included in the fourth quarter 1998 pre-tax charge is $18.1
million related to one of the clinics included in the acquisition of First
Physician Care ("FPC") in July 1998 that was experiencing significant problems
similar to those the Company had previously experienced with group formation
clinics. PhyCor recorded the asset revaluation


                                       28
<PAGE>   28
charge primarily to write down goodwill from the FPC acquisition to recognize
the expected decline in future cash flows of the investment. The net assets held
for sale for this FPC clinic at December 31, 1998 was approximately $3.0 million
and consisted primarily of property and equipment. For the year ended December
31, 1998, net revenue and pre-tax income from this FPC clinic was $9.5 million
and $600,000, respectively.

         At December 31, 1998, net assets currently expected to be sold during
the next 12 months totaled approximately $41.2 million after taking into account
the charges discussed above relating to clinics with which the Company intends
to terminate its affiliation. These net assets consisted of current assets,
property and equipment, intangible assets and other assets less liabilities
which are expected to be assumed by purchasers. The Company intends to recover
these amounts during the next 12 months as the asset sales occur. However, there
can be no assurance that the Company will recover this entire amount. As of
March 31, 1999, the Company had completed the sale of one clinic and received
approximately $4.8 million of proceeds on those assets held for sale in form of
notes receivable, with the purchasers assuming certain liabilities.

         In the third quarter of 1998, the Company recorded a net pre-tax asset
revaluation charge of $92.5 million, comprised of a $103.3 million charge less
the reversal of restructuring charges recorded in the first quarter of 1998. Of
this charge, $75.9 million related to assets to be sold for operations that the
Company considered "group formation clinics" and included current assets,
property and equipment, other assets and intangible assets of $3.4 million, $3.6
million, $6.7 million and $62.2 million, respectively. Group formation clinics
represented the Company's attempt to create multi-specialty groups by combining
the operations of several small physician groups or individual physician
practices. The Company has not been able to successfully consolidate the
operations of these clinics as a result of a variety of factors including lack
of medical group governance or leadership, inability of the Company and the
clinics to agree on income distribution plans, separate information systems,
redundant overhead structures and lack of group cohesiveness. The Company has
therefore determined to sell the clinic operating assets and terminate the
agreements related to these clinics. For the year ended December 31, 1998, net
revenues and pre-tax losses from these group formation clinics included in the
third quarter 1998 charge were $52.7 million and $3.7 million, respectively,
compared to $83.9 million and $1.9 million, respectively, for the year ended
December 31, 1997.

         A portion of the third quarter 1998 charge related to deteriorating
negative operating trends for three group formation clinic operations which were
included in the fourth quarter 1997 asset revaluation charge and the
corresponding decision to dispose of those assets when the restructuring plan
was unsuccessful. Prior to this charge, the carrying value of these assets and
liabilities was $84.8 million and $17.8 million, respectively. The third quarter
1998 asset revaluation charge related to assets held for sale for these three
group formation clinics included current assets, property and equipment, other
assets and intangible assets of approximately $2.2 million, $2.8 million, $6.7
million and $50.5 million, respectively. The Company completed the termination
of its agreements with two of these clinics in the third quarter of 1998 and one
clinic in the first quarter of 1999. The net assets held for sale for the one
remaining clinic at December 31, 1998 were approximately $4.5 million and
consisted primarily of accounts receivable and property and equipment. Total
consideration received from these terminations consisted of approximately $3.8
million in cash and $5.3 million in notes receivable, in addition to certain
liabilities being assumed by the purchasers.

         Additionally, the third quarter 1998 charge provided for the
disposition of assets of two group formation clinics that were not included in
the fourth quarter 1997 asset revaluation charge. The third quarter 1998 asset
revaluation charge related to assets held for sale for these two group formation
clinics included current assets, property and equipment and intangible assets of
approximately $1.2 million, $800,000 and $11.7 million, respectively. The
Company completed the termination of its agreements with one of these clinics in
the third quarter of 1998 and the other clinic in the fourth quarter of 1998.
Total consideration received from these terminations consisted of approximately
$7.5 million in cash and $5.1 million in notes receivable, in addition to
certain liabilities being assumed by the purchasers.

         In the fourth quarter of 1997, the Company recorded pre-tax asset
revaluation charges totaling approximately $83.4 million, consisting of $29.2
million related to assets to be sold and $54.2 million related to restructuring
of clinic operations. The fourth quarter 1997 asset revaluation charge related
to assets held for sale included current assets, property and equipment, other
assets and intangible assets of $5.8 million, $2.9 million, $4.5 million and
$16.0 million, respectively, related to three clinics. The factors impacting the
decision to sell these assets and terminate the agreements


                                       29
<PAGE>   29
with the affiliated physician groups is consistent with the factors described in
the discussion of the fourth quarter of 1998 asset revaluation charge above. The
Company determined in the fourth quarter of 1997 that its position in each of
these markets was untenable under current circumstances as the cash flow,
although positive, did not provide sufficient return to the Company. Therefore,
the Company determined to sell the clinic operating assets and terminate the
agreements related to these clinics. The Company completed the termination of
its agreements with one of these clinics in the first quarter of 1998, one
clinic in the second quarter of 1998 and one clinic in the third quarter of
1998. Total consideration received from these terminations consisted of
approximately $4.7 million in cash, in addition to certain liabilities being
assumed by the purchasers. Losses on the clinics divested approximated the
amounts accrued. These clinics were sold below book value because of the reasons
noted above, and given such facts, a sale at a discount to carrying value was
considered more cost effective that a closure which would have subjected the
Company to additional costs. For the year ended December 31, 1998, net revenues
and pre-tax losses from these clinics was $7.4 million and $300,000,
respectively, compared to $25.5 million and $1.0 million, respectively, for the
year ended December 31, 1997.

         In summary, net revenues and pre-tax income (losses) from operations
disposed of as of December 31, 1998 were $54.0 million and ($3.1 million),
respectively, for the year ended December 31, 1998, compared to $103.5 million
and ($2.5 million), respectively, for the year ended December 31, 1997. Net
revenues and pre-tax income from operations held for sale as of December 31,
1998 were $121.4 million and $1.0 million, respectively, for the year ended
December 31, 1998, compared to $82.8 million and $4.0 million, respectively, for
the year ended December 31, 1997.

         There can be no assurance that in the future a similar combination of
negative characteristics will not develop at a clinic affiliated with the
Company and result in the termination of the service agreement or that in the
future additional clinics will not terminate relationships with the Company in a
manner that may adversely affect the Company.

         Asset Impairments

         As previously discussed in "Asset Revaluation and Clinic Restructuring
- Assets Held for Sale," 1998 has been a period of rapid change for physicians
and physician groups. Factors such as unexpected physician departures, declining
Medicare and commercial reimbursement, changing market conditions, demographics,
group governance and leadership, and continued increasing pressure on operating
costs contribute to stagnant and, in some cases, expected declining physician
incomes and operating results of these clinic operations. The Company and its
physicians have continued to attempt to react to this development by devising
and implementing plans to reduce overhead, increase patient volume, increase
physician productivity, and change payor mixes. In some clinics, physicians have
been slow to engage in necessary changes because of medical group culture or
other market factors, therefore making these strategies only marginally
successful.

         In the fourth quarter of 1998, the Company recorded $34.7 million of
asset revaluation charges related to the impairment of long-lived assets of one
of its ongoing clinic operations. The Company had invested significantly in the
operation of the Lexington Clinic to support the growth and expansion of the
clinic and its affiliated health maintenance organization ("HMO"). Lexington
Clinic's financial performance has been negatively impacted by the combination
of poor financial performance at a number of satellite locations, a challenging
and extended information system conversion, a potential loss arising from a
dispute with one of the HMO's payors and the repayment of funds used to finance
the Lexington Clinic's and the HMO's growth. In light of the existing
circumstances, realization of certain of the Company's assets related to the
Lexington Clinic was unlikely. Accordingly, the Company recorded a charge in the
fourth quarter of 1998 to reduce to net realizable value its investments in
numerous satellite operations and to provide a reserve for amounts owed by the
Lexington Clinic to the Company. This charge included current assets, property
and equipment, other assets and intangible assets of $1.3 million, $800,000,
$25.6 million and $7.0 million, respectively.

         In the third quarter of 1998, the Company recorded approximately $16.6
million of asset revaluation charges related to the impairment of long-lived
assets of one of its ongoing group formation clinic operations. See below for
additional discussion of group formation clinics. Although this clinic exhibited
the characteristics of high risk new group formation clinics as discussed below,
the Company did not intend to dispose of this clinic. The Company implemented
plans to try to maintain the operations of the clinic, however, all intangible
assets were written off based


                                       30
<PAGE>   30
on the Company's experience with new group formations and the belief that the
clinic may have to be liquidated. The clinic was subsequently disposed of in the
fourth quarter of 1999. Fair value for the long-lived assets was determined
primarily by utilizing the results of a cash flow analysis and an expectation of
recoveries in asset dispositions.

         In the fourth quarter of 1997, the Company recorded pre-tax asset
revaluation charges totaling approximately $54.2 million related to impairment
of assets at certain clinic operations. These charges were in response to
issues, which arose at four multi-specialty clinics that the Company considered
to be "group formation clinics" and included current assets, property and
equipment, other assets and intangible assets of approximately $500,000, $2.1
million, $800,000 and $50.8 million, respectively. Group formation clinics
represented the Company's attempt to create multi-specialty groups by combining
the operations of several small physician groups or individual physician
practices. These clinics were considered to have an impairment of certain assets
due to certain groups of physicians within the clinic terminating their
relationship with the medical group affiliated with the Company, thereby
affecting future cash flows. The amount of impairment was determined at the
lowest level of identifiable cash flows, which was at the level of individual
groups or physicians which were put together to form the group formation clinic.
To the extent that cash flows did not support the level of intangibles or other
assets, the Company wrote down the assets and related intangibles associated
with those operations. During the third quarter of 1998, the Company decided to
dispose of the clinics because the restructuring plan was unsuccessful.

         Restructuring Charges

         In the first quarter of 1998, the Company adopted and implemented
restructuring plans and recorded pre-tax restructuring charges totaling $22.0
million with respect to clinics that were being sold or restructured whose asset
revaluation charges were taken in the fourth quarter of 1997. These charges
included approximately $15.3 million in facility and lease termination costs,
$4.6 million in severance costs and $2.1 million in other exit costs. These
restructuring plans included the involuntary termination of 344 local clinic
management and business office personnel. During 1998, the Company paid
approximately $3.0 million in facility and lease termination costs, $2.7 million
in severance costs and $1.4 million in other exit costs related to the first
quarter 1998 charge. At December 31, 1998, accrued expenses payable included
remaining liabilities for clinics to be disposed of and exit costs for disposed
clinic operations of approximately $4.1 million, which included approximately
$700,000 in facility and lease termination costs, $1.7 million in severance
costs and $1.7 million in other exit costs. The Company estimates that all of
the remaining liabilities at December 31, 1998 will be paid out during the next
12 months. Restructuring charges recorded in the first quarter of 1998 related
to facility and lease termination costs of approximately $10.8 million were
reversed in the third quarter of 1998 as a result of the Company's decision to
dispose of the assets of two clinics when the restructuring plan was
unsuccessful.

         The Company currently anticipates recording a restructuring charge in
the first quarter of 1999 of approximately $9.5 million with respect to
operations that are being sold or restructured whose asset revaluation charges
were taken in the fourth quarter of 1998.

         There can be no assurance that in the future a similar combination of
negative characteristics will not develop at a clinic affiliated with the
Company and result in the termination of the service agreement or that in the
future additional clinics will not terminate their relationships with the
Company in a manner that may materially adversely affect the Company.

LIQUIDITY AND CAPITAL RESOURCES

         At December 31, 1998, the Company had $187.9 million in working
capital, compared to $203.3 million as of December 31, 1997. Also, the Company
generated $161.2 million of cash flow from operations in 1998 compared to $116.0
million in 1997. At December 31, 1998, net accounts receivable of $378.7 million
amounted to 64 days of net clinic revenue compared to $391.7 million and 72 days
at the end of the prior year.

         In conjunction with the securities repurchase program, PhyCor has
repurchased approximately 2.6 million shares of common stock for approximately
$12.6 million, 2.2 million shares of which were repurchased in the fourth
quarter of 1998.



                                       31
<PAGE>   31
         In 1998, $2.0 million of convertible subordinated notes issued in
connection with physician group asset acquisitions were converted into common
stock. These conversions, the issuance of common stock and option exercises, net
of repurchases of common stock, increased shareholders' equity $205.3 million.
This increase in shareholders' equity, less losses in 1998 of $111.4 million,
resulted in a net increase in shareholders' equity of $93.9 million at December
31, 1998 compared to December 31, 1997.

         Capital expenditures during 1998 totaled $67.6 million. The Company is
responsible for capital expenditures at its affiliated clinics under the terms
of its service agreements. The Company expects to make approximately $70 million
in capital expenditures during 1999.

         In June 1995, the Company purchased a minority interest of
approximately 9% in PMC and managed PMC pursuant to a ten year administrative
services agreement. PMC developed and managed IPAs and provided other services
to physician organizations. PhyCor acquired the remaining interests of PMC on
March 31, 1998 for approximately 956,300 shares of the Company's common stock
and integrated PMC's operations into NAMM.

         Effective January 1, 1995, the Company completed its acquisition of
NAMM. The Company paid $20.0 million at closing and made additional payments
pursuant to an earn-out formula during 1996 and 1997, totaling $35.0 million. A
final payment of $35.0 million was made in April 1998, of which $13.0 million
was paid in shares of the Company's common stock.

         In addition, deferred acquisition payments are payable to physician
groups in the event such physician groups attain predetermined financial targets
during established periods of time following the acquisitions. If each group
satisfied its applicable financial targets for the periods covered, the Company
would be required to pay an aggregate of approximately $63.0 million of
additional consideration over the next five years, of which a maximum of $15.8
million would be payable during 1999.

         During 1998, the Company sold clinic operating assets and terminated
the related service agreements with a number of clinics affiliated with the
Company. For additional discussion related to these clinics and the asset
revaluation and restructuring charges associated with these clinics, see "Asset
Revaluation and Clinic Restructuring - Assets Held for Sale" and "Asset
Revaluation and Clinic Restructuring - Restructuring Charges". For the year
ended December 31, 1998 the Company received consideration which consisted of
approximately $16.1 million in cash and $5.6 million in notes receivable, in
addition to certain liabilities being assumed by the purchasers, related to the
sale of assets associated with these clinics. The amounts received upon
disposition of the assets approximated the post-charge net carrying value. As of
March 31, 1999, the Company had completed the sale of one clinic and received
approximately $4.8 million of proceeds on those assets held for sale in form of
notes receivable, with the purchasers assuming certain liabilities.

         During 1998, the Company has recorded restructuring charges related to
operations that are being sold, restructured or closed. These charges primarily
relate to facility and lease termination costs, severance costs, and other exit
costs incurred or expected to be incurred when these assets are sold,
restructured, or closed. For additional discussion, see "Asset Revaluation and
Clinic Restructuring - Restructuring Charges". During 1998, the Company paid
approximately $3.0 million in facility and lease termination costs, $2.7 million
in severance costs and $1.4 million in other exit costs. The Company estimates
that all the remaining liabilities at December 31, 1998 will be paid out during
the next 12 months.

         The Company also recorded a pre-tax charge to earnings of approximately
$14.2 million in the first quarter of 1998 relating to its terminated merger
with MedPartners, Inc. This charge represents PhyCor's share of investment
banking, legal, travel, accounting and other expenses incurred during the merger
process.

         PhyCor has been the subject of an audit by the Internal Revenue Service
("IRS") covering the years 1988 through 1993. The IRS has proposed adjustments
relating to the timing of recognition for tax purposes of deductions relating to
uncollectible accounts. PhyCor disagrees with the positions asserted by the IRS
and is vigorously contesting these proposed adjustments. Most of the issues
originally raised by the IRS as to revenues and deductions and the Company's
relationship with affiliated physician groups have been resolved by the National
Office of the IRS in favor


                                       32
<PAGE>   32
of the Company and with respect to these issues, no additional taxes, penalties
or interest are owed by the Company related to such claims. The IRS Appeals
Office has raised a related issue concerning the recognition of income with
respect to accounts receivable, but it is unclear whether the IRS will pursue
this issue. The Company is prepared to continue to vigorously contest any
proposed adjustment on this related issue. The Company believes that any
adjustments resulting from resolution of this disagreement would not affect the
reported net earnings of PhyCor, but would defer tax benefits and change the
levels of current and deferred tax assets and liabilities. For the years under
audit, and potentially, for subsequent years, any such adjustments could result
in material cash payments by the Company. Any successful adjustment by the IRS
would cause an interest expense to be incurred. PhyCor does not believe the
resolution of this matter will have a material adverse effect on its financial
condition, although there can be no assurance as to the outcome of this matter.
In addition, the IRS is in the process of examining the Company's 1994 and 1995
federal tax returns.

         The Company modified its bank credit facility in April and September
1998 and March 1999. The Company's bank credit facility, as amended, provides
for a five-year, $500.0 million revolving line of credit for use by the Company
prior to April 2003 for acquisitions, working capital, capital expenditures and
general corporate purposes. The total drawn cost under the facility during 1998
was either (i) the applicable eurodollar rate plus .50% to 1.25% per annum or
(ii) the agent's base rate plus .25% to .575% per annum. The total weighted
average drawn cost of outstanding borrowings at December 31, 1998 was 6.18%.
Effective in March 1999, total drawn cost is now either (i) the applicable
eurodollar rate plus .625% to 1.50% per annum or (ii) the agent's base rate plus
 .40% to .65% per annum.

         The March 1999 amendment also provides for an increase from $25 million
to $50 million for the aggregate amount of letters of credit which may be issued
by the Company and provides that in the event of a reduced rating by certain
rating agencies, the Company would be required to pledge as security for
repayment of the credit facility the capital stock the Company holds in certain
of its subsidiaries. The March 1999 modifications provide for acquisitions
without bank approval of up to $25 million individually or $150 million in the
aggregate during any 12-month period and limit the amount of its securities
PhyCor may repurchase based upon certain financial criteria.

         In 1997, the Company entered into an interest rate swap agreement to
reduce the exposure to fluctuating interest rates with respect to $100 million
of its bank credit facility. During 1998, the Company amended the previous
interest rate swap agreement and entered into additional swap agreements. At
December 31, 1998, notional amounts under interest rate swap agreements totaled
$210.2 million. Fixed interest rates range from 5.14% to 5.78% relative to the
one month or three month floating LIBOR. Up to an additional $15.8 million may
be fixed at 5.28% as additional amounts are drawn under the synthetic lease
facility prior to April 28, 2000. The swap agreements mature at various dates
from July 2003 to April 2005. The lender may elect to terminate the agreement
covering $100 million beginning September 2000, and another $100 million
beginning October 2000. The FASB has issued Statement of Financial Accounting
Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging
Activities, which the Company will be required to adopt in the first quarter of
2000. Adoption of SFAS No. 133 will require the Company to mark certain of its
interest rate swap agreements to market due to lender optionality features
included in those swap agreements. Had the Company adopted SFAS No. 133 as of
March 24, 1999, the Company estimates it would have recorded a non-cash charge
to earnings of $3.7 million. The Company has historically not engaged in trading
activities in its interest rate swap agreements and does not intend to do so in
the future.

         The Company also entered into a $100 million synthetic lease facility
in April 1998. The synthetic lease facility provides off balance sheet financing
with an option to purchase the leased facilities at the end of the lease term.
The total drawn cost under the synthetic lease facility during 1998 was .375% to
1.00% above the applicable eurodollar rate. At December 31, 1998, an aggregate
of $19.1 million was drawn under the synthetic lease facility. In March 1999,
the Company amended its synthetic lease facility to $60 million and total drawn
cost is now .50% to 1.25% above the applicable eurodollar rate. Of the $60
million available under the synthetic lease facility, $21.6 million has been
committed to lease properties associated with two of PhyCor's affiliated
clinics. The synthetic lease facility, as amended in March 1999, is not project
specific but is expected to be used for, among other projects, the construction
or acquisition of medical office buildings related to the Company's operations.



                                       33
<PAGE>   33
         The Company's bank credit facility and the synthetic lease facility
contain covenants which, among other things, require the Company to maintain
certain financial ratios and impose certain limitations or prohibitions on the
Company with respect to (i) the incurring of certain indebtedness, (ii) the
creation of security interests on the assets of the Company, (iii) the payment
of cash dividends on, and the redemption or repurchase of, securities of the
Company, (iv) investments and (v) acquisitions.

         The Company has two stock option plans and two stock purchase plans.
Compensation expense calculated in determining pro forma earnings per share in
accordance with FAS 123, Earnings per Share, increased diluted loss per share
$0.27 in 1998 and decreased diluted earnings per share $0.27 and $0.11 in 1997
and 1996, respectively. Pro forma diluted earnings per share will likely
continue to be significantly below diluted earnings per share because the
Company plans to continue to grant stock options in future periods.

         In August 1998, the Company adopted a stock option exchange program
available to all option holders, excluding the Company's executive officers and
its board of directors. Such holders were given the opportunity to exchange
options granted after October 1994 for new options with renewed four-year
vesting schedules representing fewer shares at an exercise price of $7.91 per
share. Options to purchase an aggregate of 3,964,000 shares were issued as a
result of the exchange of previously issued options to purchase 8,575,000
shares, which constitute 91% of the options eligible for exchange.

         Market Risks Associated with Financial Instruments

         The Company's interest expense is sensitive to changes in the general
level of interest rates. To mitigate the impact of fluctuations in interest
rates, the Company generally maintains a portion of its debt as fixed rate in
nature either by borrowing on a long-term basis or entering into interest rate
swap transactions. The interest rate swap agreements are contracts to
periodically exchange fixed and floating interest rate payments over the life of
the agreements. The floating-rate payments are based on LIBOR and fixed-rate
payments are dependent upon market levels at the time the swap agreement was
consummated. The interest rate swap agreements do not constitute positions
independent of the underlying exposures. The Company does not hold or issue
derivative instruments for trading purposes and is not a party to any
instruments with leverage features. Certain swap agreements allow the
counterparty the option to terminate at the end of the initial term. The Company
is exposed to credit losses in the event of nonperformance by the counterparties
to its financial instruments. The counterparties are creditworthy financial
institutions, and the Company anticipates that the counterparties will be able
to fully satisfy their obligations under the contracts. For the years ended
December 31, 1998 and 1997, the Company received a weighted average rate of
5.52% and 5.75% and paid a weighted average rate on its interest rate swap
agreements of 5.68% and 5.85% respectively.

         The table below presents information about the Company's
market-sensitive financial instruments, including long-term debt and interest
rate swaps as of December 31, 1998. For debt obligations, the table presents
principal cash flows and related weighted-average interest rates by expected
maturity dates. For interest rate swap agreements, the table presents notional
amounts by expected maturity date (assuming the options to cancel are not
exercised) and weighted average interest rates based on rates in effect at
December 31, 1998. The fair values of long-term debt and interest rate swaps
were determined based on quoted market prices at December 1998 for the same or
similar debt issues.

<TABLE>
<CAPTION>
                                                                                                                       FAIR
EXPECTED MATURITY DATE                1999       2000        2001       2002       2003     THEREAFTER     TOTAL       VALUE
----------------------                ----       ----        ----       ----       ----     ----------     -----       -----
                                                                         (IN THOUSANDS)
<S>                               <C>            <C>        <C>         <C>       <C>       <C>            <C>         <C>
Long-term debt:
    Fixed rate                    $   16,472     11,393     10,407      3,036     201,756       3,297      246,361     164,116
    Average interest rate(1)            8.58%      8.75%      7.79%      7.62%       4.52%       7.47%        5.21%
    Variable rate                      2,583      2,250      1,250         --     377,000      23,295      406,378     389,102
    Average interest rate(1)            6.12%      6.14%      6.25%        --        6.19%       5.87%        6.16%
Interest rate swaps:
    Pay variable/ receive
        fixed notional amounts            --         --        --          --     200,000      26,000      226,000      (7,256)
    Average pay rate                      --         --        --          --        5.46%       5.31%        5.45%
    Average receive rate                  --         --        --          --        5.03%       5.03%        5.03%
</TABLE>


                                       34
<PAGE>   34
(1) Average interest rates exclude deferred loan costs and debt offering costs.

         Summary

         At February 28, 1999, the Company had cash and cash equivalents of
approximately $78.7 million and at March 24, 1999, approximately $55.3 million
available under its current bank credit facility. The Company believes that the
combination of funds available under the Company's bank credit facility and
synthetic lease facility, together with cash reserves, cash flow from other
operations and proceeds from asset dispositions, should be sufficient to meet
the Company's current planned acquisition, expansion, capital expenditure and
working capital needs through 1999. The disposition of assets will generate
short-term liquidity. However, if these dispositions were to affect the
Company's leverage ratios negatively, such effect could impact the Company's
long-term liquidity by impacting the Company's ability to obtain or maintain its
bank credit facility. The Company does not currently expect these dispositions
to materially increase it leverage ratio, therefore not impacting the bank
credit facility further. The Company currently expects to reduce amounts
outstanding under its bank credit facility during 1999 from cash flow from
operations after capital expenditures and proceeds from asset dispositions. In
addition, in order to provide the funds necessary for the continued pursuit of
the Company's long-term acquisition and expansion strategy, the Company may
continue to incur, from time to time, additional short-term and long-term
indebtedness and to issue equity and debt securities, the availability and terms
of which will depend upon market and other conditions. There can be no assurance
that such additional financing will be available on terms acceptable to the
Company. The Company's current stock price and growth expectations could
negatively impact its ability to issue equity and other debt securities which
could increase the Company's dependence on its bank credit facility as a source
of capital. There can be no assurance that in the future a similar combination
of negative characteristics discussed above will not develop at a clinic
affiliated with the Company and result in the termination of the service
agreement, or that in the future additional clinics will not terminate their
relationships with the Company in a manner that may materially adversely affect
the Company and its liquidity.

YEAR 2000

         The Following Material is Designated as Year 2000 Readiness Disclosure
for Purposes of the Year 2000 Information and Readiness Disclosure Act.

         PhyCor has developed a program designed to identify, assess, and
remediate potential malfunctions and failures that may result from the inability
of computers and embedded computer chips within the Company's information
systems and equipment to appropriately identify and utilize date-sensitive
information relating to periods subsequent to December 31, 1999. This issue is
commonly referred to as the "Year 2000 issue" and affects not only the Company,
but virtually all companies and organizations with which the Company does
business. The Company is dependent upon Year 2000 compliant information
technology systems and equipment in applications critical to the Company's
business. The Company's information technology systems ("IT systems") can be
broadly categorized into the following areas: (i) practice management, (ii)
managed care information, (iii) consumer decision support system that supports
the operations of CareWise, (iv) ancillary information systems, including
laboratory, radiology, pharmacy and clinical ancillary systems and (v) other
administrative information systems including accounting, payroll, human resource
and other desktop systems and applications.

         The Company generally owns and provides to its various affiliated
multi-specialty clinics the IT systems in use at those locations, and such
systems represent a variety of vendors. In addition, the Company generally owns
and provides biomedical equipment (laboratory equipment, radiology equipment,
diagnostic equipment and medical treatment equipment) for use by its affiliated
physician groups and by its Company-owned hospitals, as well as other equipment
in use at Company-owned or leased facilities such as telephone and HVAC systems.
Such non-information technology ("Non-IT") equipment often contains embedded
computer chips that could be susceptible to failure or malfunction as a result
of the Year 2000 issue.

         To address the Year 2000 issue, the Company has formed a Year 2000
committee comprised of representatives from a cross-section of the Company's
operations as well as the Company's senior management. Beginning in August 1997,
the committee, with the assistance of outside consultants, developed a
comprehensive plan


                                       35
<PAGE>   35
to address the Year 2000 issue within all facets of the Company's operations.
The plan includes processes to inventory, assess, remediate or replace as
necessary, and test the Company's IT and Non-IT systems and equipment. In
addition, the Company has appointed local project coordinators at all
Company-owned facilities who are responsible for overseeing and implementing the
comprehensive project management activities at the local subsidiary level. Each
project coordinator is responsible for developing a local project plan that
includes processes to inventory, assess, remediate or replace as necessary, and
test the Company's IT and Non-IT systems and equipment. Each local project
coordinator is also responsible for assessing the compliance of the electronic
trading partners and business critical vendors for that location. However, the
compliance of certain vendors providing business critical IT systems in wide use
within the Company is being addressed by the Company's senior management.

         The Company has completed the inventory and assessment phase of
business critical IT systems and is in the process of upgrading or replacing
those business critical IT systems found not to be compliant, either internally
or through the upgrades provided by the Company's vendors. In certain cases, the
Company's plan provides for verification of Year 2000 compliance of
vendor-supplied IT systems by obtaining warranties and legal representations of
the vendors. Much of the remediation is being accomplished as a part of the
Company's normal process of standardizing various IT systems utilized by its
affiliated clinics and IPAs, although in certain cases the standardization
process is moving at an accelerated pace as a result of the Year 2000 issue. As
of February 28, 1999, management believed approximately 70% of the Company's
business critical IT systems at the Company and its subsidiaries to be Year 2000
compliant as a result of upgrades, replacements or testing. The Company
anticipates that all remediation and testing of its business critical IT systems
will be completed by October 1999.

         The Company is in the process of completing the inventory and
assessment phase of its Non-IT systems and equipment, which are comprised
primarily of medical equipment with embedded chip technology that are located
throughout the subsidiaries' facilities. The Company is relying primarily on its
local project coordinators and on the equipment vendors' representations in
order to complete the inventory and assessment phase and either remediate or
replace non-compliant equipment. As of February 28, 1999, substantially all of
the Company's subsidiaries had completed the inventory and assessment phase, and
those facilities had completed approximately 70% of the remediation and testing
of Non-IT systems and equipment. The Company estimates that substantially all of
its subsidiaries will have substantially completed remediation and testing of
Non-IT systems and medical equipment by October 1999.

         The Company is substantially dependent on a wide variety of third
parties to operate its business. These third parties include medical equipment
and IT software and hardware vendors, medical claims processors that act as
intermediaries between the Company's medical practice subsidiaries and the
payors of such claims, and the payors themselves, which includes HCFA. HCFA paid
to the Company Medicare claims that comprised approximately 19% of the Company's
net revenue in fiscal 1998. In most cases, these third party relationships
originate and are managed at the local clinic level. The Company estimates that
information concerning the Year 2000 readiness of the most significant third
parties will be received and analyzed by the Company by October 1999. Together
with its trade associations and other third parties the Company is monitoring
the status and progress of HCFA's Year 2000 compliance. HCFA has represented
that its systems are or will soon be Year 2000 compliant. As of April 5, 1999,
HCFA will require all Medicare providers that submit Medicare claims
electronically to do so in an approved Year 2000 compliant format. The process
of billing and collecting for Medicare claims involves a number of third parties
which the Company does not control, including intermediaries and HCFA
independent contractors. The Company believes that most of these third parties
are able to comply with HCFA billing requirements. The Company is in the process
of verifying the Year 2000 compliance of third parties upon which the Company
relies to process claims, including significant third party payors.

         The Company currently is working at the parent company level and with
local project coordinators in each of its subsidiary locations to develop
contingency plans for business critical IT systems and Non-IT medical equipment
to minimize business interruptions and avoid disruption to patient care as a
result of Year 2000 related issues. The Company anticipates that contingency
plans for non-compliant business critical IT systems and non-compliant Non-IT
medical equipment will be completed by October 1999.



                                       36
<PAGE>   36
         There are a number of risks arising out of Year 2000 related failure,
any of which could have a material adverse effect on the Company's financial
condition or results of operations. These risks include (i) failures or
malfunctions in practice management applications that could prevent automated
scheduling, accounts receivable management and billing and collection on which
each of the subsidiary locations is substantially dependent, (ii) failures or
malfunctions of claims processing intermediaries or payors that may result in
substantial payment delays that could negatively impact cash flows, or (iii) the
failure of certain critical pieces of medical equipment that could result in
personal injury or misdiagnosis of patients treated at the Company's affiliated
clinics or hospitals. The Company has a number of ongoing obligations that could
be materially adversely impacted by one or more of the above described risks. If
the Company has insufficient cash flow to meet its expenses as a result of a
Year 2000 related failure, it will need to borrow available funds under its
credit lines or obtain additional financing. There can be no assurance that such
funds or any other additional financing will be available in the future when
needed.

         To date, the Company estimates that it has spent approximately $16.0
million on the development and implementation of its Year 2000 compliance plan.
In addition, the Company believes that it will need to spend a total of
approximately $28 million to complete all phases of its plan, which amounts will
be funded from cash flows from operations and, if necessary, with borrowings
under the Company's primary credit facility. Of those costs, an estimated $24
million is expected to be incurred to acquire replacement systems and equipment,
including amounts spent in connection with standardizing certain of the
Company's IT systems that it would have spent regardless of the Year 2000
initiative.

         The foregoing estimates and conclusions regarding the Company's Year
2000 plan contain forward looking statements and are based on management's best
estimates of future events. Risks to completing the Year 2000 plan include the
availability of resources, the Company's ability to discover and correct
potential Year 2000 problems that could have a serious impact on specific
systems, equipment or facilities, the ability of material third party vendors
and trading partners to achieve Year 2000 compliance, the proper functioning of
new systems and the integration of those systems and related software into the
Company's operations. Some of these risks are beyond the Company's control.

RISK FACTORS

         Our disclosure and analysis in this report contain some forward-looking
statements. Forward-looking statements give our current expectations or
forecasts of future events. You can identify these statements by the fact that
they do not relate strictly to historical or current facts. From time to time,
we also may provide oral or written forward-looking statements in other
materials we release to the public.

         Any of our forward-looking statements in this report and in any other
public statements we make may turn out to be incorrect. These statements can be
affected by inaccurate assumptions we might make or by known or unknown risks
and uncertainties. Many factors mentioned in the discussion - for example,
PhyCor's ability to successfully restructure its relationships with certain of
its affiliated physician groups, IPAs and their payors, PhyCor's ability to
consolidate clinics and IPAs and operate them profitably, competition in the
healthcare industry, regulatory developments and changes, the nature of
capitated fee arrangements and other methods of payment for medical services,
the risk of professional liability claims, PhyCor's dependence on the revenue
generated by its affiliated clinics, the outcome of pending litigation and the
risks associated with Year 2000 related failure- will be important in
determining future results. Consequently, no forward-looking statement can be
guaranteed. Actual future results may vary materially.

         We undertake no obligation to publicly update any forward-looking
statements, whether as a result of new information, future events or otherwise.
You are advised, however, to consult any further disclosures we make on related
subjects in our 10-Q, 8-K and 10-K reports to the SEC. In addition, we include
the following discussion of cautions, risks and uncertainties relevant to our
businesses.

CERTAIN CLINIC RELATIONSHIPS MAY BE TERMINATED OR RESTRUCTURED.

         Because of a variety of circumstances, we have terminated or
renegotiated the service agreements with some of our clinics and recorded
significant asset revaluation charges in 1998. Currently, we are exploring
changes to our


                                       37
<PAGE>   37
relationships with several affiliated multi-specialty medical groups, and as a
result may seek to restructure such operations or terminate our service
agreements with some of these groups. The outcome of these discussions may
result in additional charges to earnings to provide for restructuring costs and
for revaluing assets to reflect lower expected future cash flows from operations
or the disposition of the related assets. There can be no assurance as to the
outcome of any of these discussions.

         Certain negative characteristics have contributed to instability at
some of our affiliated clinic relationships, including the clinic's market
position and demographics, physician relations, departure rates, declining
physician incomes, physician productivity, operating results and ongoing
viability of the existing medical group. These factors have been caused or may
be exacerbated by weak economic conditions in some markets, declining government
and managed care payments, poor financial performance and other factors, many of
which are outside of our control. There can be no assurance that these negative
influences will not contribute to additional restructurings or terminations of
relationships with some of our affiliated physician groups. As a result, we
could incur additional asset revaluation charges that may have a material
adverse effect on our financial condition and results of operations.

WE ARE DEPENDENT ON OUR AFFILIATED PHYSICIANS.

         A significant majority of our revenue is derived from the service or
management agreements with our affiliated clinics. If certain of these
agreements were terminated, or declared unenforceable, our revenues would be
materially adversely affected because of lost revenues and funds advanced to the
clinics. Additionally, physicians in certain clinics have challenged the
enforceability of the non-competition provisions contained in their employment
agreements with their clinics. If these provisions were declared unenforceable,
our revenues at those clinics could be materially adversely affected because the
service fees are typically based on a percentage of the affiliated clinic's
operating income plus reimbursement of clinic expenses. Accordingly, if the
operating results of the affiliated clinics are adversely affected because of,
for example, physicians leaving the physician group and new physicians were not
added to replace them, our business and financial results could be materially
adversely affected.

THERE MAY BE CONSTRAINTS ON OUR ABILITY TO GROW.

         Our growth is primarily dependent on our ability to (1) consolidate
multi-specialty medical clinics, (2) sustain or increase the profitability of
those clinics and (3) develop and manage IPAs. It is a lengthy and complex
process to negotiate successfully the affiliation with a physician group or to
develop a physician network. Further, clinic and physician network operations
require intensive management in a changing marketplace subject to constant
pressure to control costs. Additionally, pursuant to our bank credit facility,
the lenders must consent to borrowings that relate to the acquisition of certain
assets above certain purchase price thresholds. Although we continue to pursue
the acquisition of the assets of additional clinics and other medical network
management companies, there can be no assurance that we will be able to
consummate such acquisitions in the future.

         Our success in managing and developing IPAs is dependent on our ability
to: (1) form networks of physicians, (2) obtain favorable payor contracts and
(3) manage and control costs. Many of the physicians in PhyCor-managed IPAs did
not enter into exclusive arrangements. Therefore, they could join competing
networks or terminate their relationships with the IPAs. We may not be able to
establish new physician networks or maintain our physician networks in the
future.

WE MAY HAVE ADDITIONAL FINANCING NEEDS.

         Our clinic acquisition and expansion program and our IPA development
and management plans require substantial capital resources. Clinic operations
require recurring capital expenditures for renovation, expansion, and the
purchase of costly medical equipment and technology. We will need capital to
develop new IPAs and to expand and manage existing IPAs. It is possible that our
capital needs in the next several years will exceed the capital generated from
our operations. Thus, we may incur additional debt or issue additional debt or
equity securities from time to time. This may include the issuance of common
stock or convertible notes in connection with acquisitions. We may be unable to
obtain sufficient financing on terms satisfactory to us or at all.



                                       38
<PAGE>   38
THERE MAY BE DECLINES IN OUR COMMON STOCK VALUE.

         Our common stock is traded on the Nasdaq Stock Market. The market price
of our stock has declined significantly in the past year. Developments that
could cause the market price of the stock to be volatile include quarterly
operating results below analysts' expectations, changes in the health care
service and medical network management industries and changes in general
conditions in the economy or financial markets. We have considered in the past
and continue to consider a number of strategic financial alternatives that may
benefit our shareholders, bondholders, clinics, IPAs and other affiliates in the
long term. We cannot give assurance that our stock price will maintain its
current levels or improve or that we will pursue or consummate any strategic
alternative.

INDUSTRY COMPETITION MAY INCREASE.

         Managing physician organizations is a competitive business. We compete
with many businesses to acquire medical clinics, manage these clinics, employ
physicians and provide services to IPAs. These competitors include:

         -   other medical network management companies;
         -   hospitals and health systems;
         -   multi-specialty clinics;
         -   single-specialty clinics;
         -   health care service companies; and
         -   insurance companies and HMOs.

         Some of our competitors have longer operating histories and greater
financial resources. We may not be able to compete successfully with existing or
new competitors. Additional competition may make it more difficult for us to
acquire assets of clinics on beneficial terms.

FIXED FEE PATIENT ARRANGEMENTS NOT BE PROFITABLE.

         Many of the PhyCor-managed IPA contracts with third party payors are
based on fixed or capitated fee arrangements. Under these capitated
arrangements, health care providers receive a fixed fee per person covered under
the payor plan per month and bear the risk, subject to certain loss limits, that
the total costs of providing medical services to the insured persons will exceed
the fixed fee. Because capitated payments are made on a "per member" basis, the
total payments paid to the IPA can vary from month to month as patients move
into or out of payor plans. The IPAs' management fees are based, in part, upon a
share of the remaining portion, if any, of the fixed fees. Some agreements with
payors also contain "shared risk" provisions under which we and the IPA can
share additional compensation, or can share in losses, based on the utilization
of services by unsecured persons. Any such losses could have a material adverse
effect on our business.

         The health care providers' ability to efficiently manage the patient's
use of medical services and the costs of such services determine the
profitability of the capitated fee arrangement. The management fees are also
based upon a percentage of revenue collected by the IPA. Any loss of revenue by
an IPA because of the loss of affiliated physicians, the termination of third
party payor contracts or otherwise may decrease our management fees. We, like
other managed care providers and management entities, are often subject to
liability claims arising from activities such as utilization management and
compensation arrangements designed to control costs by reducing services. A
successful claim on this basis against us, an affiliated clinic or IPA could
have a material adverse effect on our business and financial results.

YEAR 2000 PROBLEMS MAY ADVERSELY AFFECT OPERATIONS.

         As described in the "Year 2000" section, we are working to address
"Year 2000" problems. If we should fail to identify or fix all such problems in
our own operations, or if we are affected by the inability of a supplier or
major customer to continue operations due to such a problem, our business and
financial results could be materially adversely affected.



                                       39
<PAGE>   39
THE OUTCOME OF SHAREHOLDER LITIGATION MAY ADVERSELY AFFECT OUR BUSINESS AND
FINANCIAL RESULTS.

         Claims have been brought against us and our executive officers and
directors alleging various violations of the securities laws. The ultimate
disposition of these matters could have a material adverse effect on our
financial condition or cash flows and results of operations, as described in the
discussions of such matters in "Legal Proceedings" in Item 3 in this report.

THERE ARE NUMEROUS REGULATORY RISKS ASSOCIATED WITH OUR BUSINESS AND INDUSTRY.

         The state and federal governments highly regulate the health care
industry and physicians' medical practices. All states restrict the unlicensed
practice of medicine. In addition, many states prohibit physicians from
splitting or sharing fees with nonphysician entities and do not enforce
noncompetition agreements against physicians. Most of the states only prohibit
the sharing of fees if a physician shares fees with a referral source. Because
we do not refer business to our managed groups, the fee-splitting laws in most
states should not restrict the physician groups from paying our management fee.
If courts determined that we violated the corporate practice of medicine or
fee-splitting statutes, the physicians' licenses could be revoked or suspended,
lowering our revenue. Courts could also hold the contracts between us and our
managed physicians invalid.

         In Florida, however, the Florida Board of Medicine recently interpreted
the Florida fee-splitting law very broadly. This interpretation may prohibit the
payment of any percentage-based management fee, even to a management company
that does not refer patients to the managed groups. We manage four of our six
affiliated physician groups in Florida under service agreements for which we are
paid a percentage-based fee. The Florida Board of Medicine stayed its own
decision pending judicial interpretation of its decision. The Florida courts and
regulatory authorities may make a determination that could adversely affect our
financial condition and operating results.

         Many states also prohibit the "corporate practice of medicine" by an
unlicensed corporation or other nonphysician entity that employs physicians.
Except in the states of Florida and Georgia, we do not employ physicians but
instead manage the physician groups. The physicians are employed at the group
level by professional associations or corporations, which are authorized to
employ physicians under most states' laws. In Georgia and Florida, physicians
can be employed by corporations and other entities.

         Federal law prohibits offering, paying, soliciting or receiving payment
for referrals, or arranging for referrals of, Medicare or other federal or state
health program patients or patient care opportunities. It also prohibits
payments in return for the purchase, lease or order of items or services that
are covered by Medicare or other federal or state health programs. The
government has adopted or proposed several different exceptions or safe harbors
for arrangements that will not be deemed to violate the Anti-Kickback law. In
1998, the federal government released advisory opinion 98-4, which states that a
percentage-based management fee does not fit within any safe harbor and that
such a fee could implicate the Anti-Kickback law if any part of the management
fee is intended to compensate the manager for its efforts in arranging for
referrals to its managed group. The management fee structure of most of our
service agreements does not fit within a safe harbor because they are calculated
in part on a percentage basis. Accordingly, there can be no assurance that the
fee structure will not be successfully challenged.

         In addition, physicians with certain financial relationships with
health care providers cannot refer certain types of Medicare or Medicaid
reimbursed "designated health services" unless the referral fits within an
exception to the law. The most often used exception requires that the physician
groups be included within a definition of "group practice" to be permitted to
make referrals within the group. Federal antitrust law also prohibits conduct
that may result in price fixing or other anticompetitive conduct.

         All of our physician groups are structured so they fit within the
definition of "group practice," and all referrals from those physicians are
structured to fit within an exception to federal law. In addition, we do not
make or arrange referrals to our physicians, and we are not compensated based on
referral levels between the physicians. Nevertheless, because of the structure
of our relationships with our physician groups and managed IPAs, courts or
regulatory authorities may determine our arrangements violate federal law which
could adversely affect our financial condition and results of operations. Also,
the health care regulatory environment may change in a way that would restrict
our


                                       40
<PAGE>   40
existing operations or limit the expansion of our business or otherwise
adversely affect us. If we violate the Medicare or Medicaid statutes, civil and
criminal penalties could be assessed, and we could be excluded from further
participation in Medicare or state health care programs.

         There is increasing scrutiny of arrangements between health care
providers and potential referral sources by (1) law enforcement authorities, (2)
the office of Inspector General or the Department of Health and Human Services,
(3) the courts and (4) the Congress. Investigators are demonstrating a
willingness to look beyond the business transaction documents to determine if
the purpose of these arrangements is really the payment for referrals and
opportunities. Enforcement actions are increasing. Although we are not aware of
any investigations of us that would negatively affect our business, we may be
investigated in the future.

         In addition, Congress and many state legislatures routinely consider
proposals to control health care spending. Government efforts to reduce health
care expenses through the use of managed care or the reduction of Medicare and
Medicaid reimbursement may adversely affect our cost of doing business and our
contractual relationships. For example, recent developments that affect our
business include: (1) federal legislation requiring a health plan to continue
coverage for individuals who are no longer eligible for group health benefits
and prohibiting the use of "pre-existing condition" exclusions that limited the
scope of coverage; (2) a Health Care Financing Administration policy prohibiting
restrictions in Medicare risk HMO plans on a physician's recommendation of other
health plans and treatment options to patients; and (3) regulations imposing
restrictions on physician incentive provisions in physician provider agreements.
These types of legislation, programs and other regulatory changes may have a
material adverse effect on our business.

         Our profitability may be adversely affected by Medicare and Medicaid
regulations, decisions of third party payors and other payment factors which are
out of our control. The federal Medicare program has undergone significant
legislative and regulatory changes in the reimbursement and fraud and abuse
areas. These changes may have a negative impact on our revenue. Efforts to
control health care costs are increasing. Many of our physician groups are
affiliating with provider networks, managed care organizations and other
organized health care systems to provide fixed fee schedules or capitation
arrangements that are lower than standard charges. Our profitability in this
changing health care environment is likely to be affected significantly by
management of health care costs, pricing of services and agreements with payors.
Because we derive our revenue from the revenues generated by our clinics, any
reductions in the payments to physicians or changes in payment for health care
services may reduce our profitability.

INSURANCE REGULATIONS MAY ADVERSELY AFFECT OUR BUSINESS.

         Our managed IPAs enter into contracts and joint ventures with licensed
insurance companies such as HMOs. Under these contracts, the IPAs may be paid on
a capitated fee basis. Under capitation arrangements, health care providers bear
the risk, subject to certain loss limits, that the total costs of providing
medical services to members will exceed the premiums received. The IPAs may be
deemed to be in the business of insurance if they subcontract with physicians or
other providers to provide services on a fee-for-service basis. Thus, the IPAs
may be subject to a variety of regulatory and licensing requirements applicable
to insurance companies and HMOs.
These requirements could increase the managed IPAs cost and lower our revenue.

         From time to time, we acquire HMOs that are affiliated with
multi-specialty medical clinics. The HMO industry is highly regulated at the
state level and is highly competitive. Further, the HMO industry has been
subject to numerous legislative initiatives during the last few years. One
initiative creates additional liabilities for HMOs for patient malpractice. This
increases HMO costs and lowers our revenue. These developments may have an
adverse effect on our wholly-owned HMOs or on other HMOs with which we are
financially involved. In addition, PrimeCare Medical Network, Inc., a subsidiary
of PrimeCare, holds a Knox-Keene license from the California Department of
Corporations. Knox-Keene licenses are subject to extensive regulation on the
state level, and our operations in California could come under increased
governmental scrutiny.



                                       41
<PAGE>   41
THERE ARE RISKS ASSOCIATED WITH HOSPITAL OWNERSHIP.

         In January 1997, we consummated our merger with Straub, an integrated
health care system with a 152-physician multi-specialty clinic and 159-bed acute
care hospital located in Honolulu, Hawaii. In connection with the transaction
with Straub, we agreed to provide certain management services to both a
physician group practice and a hospital owned by the group. In May 1998, we
consummated a merger with PrimeCare, a management company that manages several
IPAs and physician practices in California and also owns and operates a hospital
and other ancillary providers in California. Because hospitals are subject to
extensive regulation on both the federal and state levels and because hospital
management companies have, in some instances, been viewed as referral sources by
federal regulatory agencies, the relationship between us and the physician group
could come under increased scrutiny under the Medicare fraud and abuse law.

THERE IS A RISK OF TAX AUDIT ADJUSTMENTS.

         The IRS audited us for the years 1988 through 1993. It proposed that we
make adjustments relating to the timing of recognition of certain revenue and
deductions. The revenue and deductions relate to uncollectible accounts and our
relationship with affiliated physician groups. We disagree with the IRS
position, including any recharacterization, and are vigorously contesting the
proposed adjustments. The IRS National Office has agreed with our position on
the major issue, but the IRS Appeals Office has raised a potential alternative
position with respect to our accounting for accounts receivable and
uncollectible accounts. It is unclear whether the IRS will pursue this
alternative position. If such alternative position is pursued by the IRS, we
will vigorously contest any proposed adjustment. We believe any adjustments that
result will not affect our reported net earnings, but will defer tax benefits
and change levels of current and deferred tax assets and liabilities. Any
adjustments for the years under the audit, and potentially for subsequent years,
could result in our making material cash payments. Any successful adjustment by
the IRS would cause an interest expense to be incurred. We do not believe that
this matter will materially adversely affect us, but we can not make any
assurances.

OUR INVOLVEMENT IN THE MEDICAL SERVICES BUSINESS EXPOSES US TO RISK OF
PROFESSIONAL LIABILITY CLAIMS.

         As a result of the fact that our affiliated physician groups deliver
medical services to the public, there is a risk of professional liability claims
against us. Claims of this nature, if successful, could result in an award of
damages that exceeds the limits of insurance coverage. Insurance against losses
of this type can be expensive and varies from state to state. In the substantial
majority of our markets, we do not control our affiliated physicians and
physician groups' practice of medicine or compliance with regulatory
requirements. Successful malpractice claims brought against the physician
groups, the managed IPAs and physician members could have a material adverse
effect on us. In certain of our Florida clinics and Georgia clinics, we directly
employ physicians. These employment relationships increase the risk of
malpractice liability and increase scrutiny under health care regulations and
laws.

ANTI-TAKEOVER PROVISIONS COULD PREVENT AN ACQUISITION OF OUR COMPANY.

         We are authorized to issue up to 10,000,000 shares of preferred stock.
The Board of Directors determines the rights of the preferred stock. In February
1994, the Board of Directors approved the adoption of a Shareholder Rights Plan.
The Shareholder Rights Plan is meant to encourage potential acquirers of PhyCor
to negotiate with the Board of Directors instead of making coercive,
discriminatory and unfair proposals. Our stock incentive plans allow the
acceleration of the vesting of options if there is a change of control. Our
Charter classifies our Board of Directors into three classes. Each class of
directors serves staggered terms of three years. The executive officers'
employment agreements provide that they are compensated after termination, in
some cases for 24 months, following a change in control. Most of the physician
groups can terminate their service agreements if there is a change of control
that was not approved by the Board. A change of control without the bank's
consent also is a default under the bank credit facility. All of these factors
may discourage or make it more difficult for there to be a change of control.



                                       42
<PAGE>   42
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         See Item 7. "Management's Discussion and Analysis of Results of
Operations and Financial Condition. Liquidity and Capital Resources - Market
Risks Associated With Financial Instruments."

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


                          PHYCOR, INC. AND SUBSIDIARIES

                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                             PAGE
<S>                                                                          <C>
Independent Auditors' Report...............................................   39

Consolidated Balance Sheets................................................   40

Consolidated Statements of Operations......................................   41

Consolidated Statements of Shareholders' Equity............................   42

Consolidated Statements of Cash Flows......................................   43

Notes to Consolidated Financial Statements.................................   44
</TABLE>



                                       43
<PAGE>   43
                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders
PhyCor, Inc.:

We have audited the consolidated balance sheets of PhyCor, Inc. and subsidiaries
as of December 31, 1998 and 1997 and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the years in the
three-year period ended December 31, 1998. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of PhyCor, Inc. and
subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1998, in conformity with generally accepted accounting
principles.


                                                 /s/ KPMG LLP



Nashville, Tennessee
February 23, 1999, except for
Notes 10 and 17, which are as of
March 17, 1999




                                       44
<PAGE>   44
                          PHYCOR, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS

                           DECEMBER 31, 1998 AND 1997
                    (ALL AMOUNTS ARE EXPRESSED IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                          1998               1997
                                                                          ----               ----
<S>                                                                    <C>                <C>
ASSETS
Current assets:
  Cash and cash equivalents                                            $    74,314             38,160
  Accounts receivable, less allowances of $230,785 in 1998
    and $208,534 in 1997                                                   378,732            391,668
  Inventories                                                               19,852             18,578
  Prepaid expenses and other current assets                                 55,988             44,921
  Assets held for sale                                                      41,225              3,237
                                                                       -----------        -----------
      Total current assets                                                 570,111            496,564
Property and equipment, net                                                241,824            235,685
Intangible assets, net                                                     981,537            807,726
Other assets                                                                53,067             22,801
                                                                       -----------        -----------
      Total assets                                                     $ 1,846,539          1,562,776
                                                                       ===========        ===========

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Current installments of long-term debt                               $     4,810              1,144
  Current installments of obligations under capital leases                   5,687              3,564
  Accounts payable                                                          50,972             34,622
  Due to physician groups                                                   51,941             50,676
  Purchase price payable                                                    73,736            114,971
  Salaries and benefits payable                                             37,077             37,141
  Incurred but not reported claims payable                                  59,333             12,832
  Other accrued expenses and current liabilities                            98,701             38,313
                                                                       -----------        -----------
      Total current liabilities                                            382,257            293,263
Long-term debt, excluding current installments                             388,644            210,893
Obligations under capital leases, excluding current installments             6,018              5,093
Purchase price payable                                                       8,967             23,545
Deferred tax credits and other liabilities                                   8,663             57,918
Convertible subordinated notes payable to physician groups                  47,580             61,576
Convertible subordinated debentures                                        200,000            200,000
                                                                       -----------        -----------
      Total liabilities                                                  1,042,129            852,288
                                                                       -----------        -----------
Shareholders' equity:
  Preferred stock, no par value, 10,000 shares authorized                       --                 --
  Common stock, no par value; 250,000 shares authorized;
    issued and outstanding 75,824 shares in 1998 and 64,530
    shares in 1997                                                         850,657            645,288
  Retained earnings (deficit)                                              (46,247)            65,200
                                                                       -----------        -----------
      Total shareholders' equity                                           804,410            710,488
                                                                       -----------        -----------
Commitments, contingencies and subsequent event
      Total liabilities and shareholders' equity                       $ 1,846,539          1,562,776
                                                                       ===========        ===========
</TABLE>

See accompanying notes to consolidated financial statements.




                                       45
<PAGE>   45
                          PHYCOR, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                  YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
     (ALL AMOUNTS ARE EXPRESSED IN THOUSANDS, EXCEPT FOR EARNINGS PER SHARE)

<TABLE>
<CAPTION>
                                                                                      1998             1997              1996
                                                                                      ----             ----              ----
<S>                                                                               <C>              <C>              <C>
Net revenue                                                                       $ 1,512,499        1,119,594          766,325
Operating expenses:
  Cost of provider services                                                           134,302               --               --
  Salaries, wages and benefits                                                        513,646          421,716          291,361
  Supplies                                                                            227,440          181,565          119,081
  Purchased medical services                                                           37,774           31,171           21,330
  Other expenses                                                                      218,359          171,480          125,947
  General corporate expenses                                                           29,698           26,360           21,115
  Rents and lease expense                                                             126,453          100,170           65,577
  Depreciation and amortization                                                        90,238           62,522           40,182
  Provision for asset revaluation and clinic
    restructuring                                                                     224,900           83,445               --
  Merger expenses                                                                      14,196               --               --
      Net operating expenses                                                        1,617,006        1,078,429          684,593
Earnings (loss) from operations                                                      (104,507)          41,165           81,732
Other (income) expense:
  Interest income                                                                      (3,032)          (3,323)          (3,867)
  Interest expense                                                                     36,266           23,507           15,981
      Earnings (loss) before income taxes and minority interest                      (137,741)          20,981           69,618
Income tax expense (benefit)                                                          (39,890)           6,098           22,775
Minority interest in earnings of consolidated partnerships                             13,596           11,674           10,463
      Net earnings (loss)                                                         $  (111,447)           3,209           36,380
                                                                                  ===========      ===========      ===========
Earnings (loss) per share:
  Basic                                                                           $     (1.55)            0.05             0.67
  Diluted                                                                               (1.55)            0.05             0.60
                                                                                  ===========      ===========      ===========
Weighted average number of shares and dilutive share equivalents outstanding:
  Basic                                                                                71,822           62,899           54,608
  Diluted                                                                              71,822           66,934           61,096
                                                                                  ===========      ===========      ===========
</TABLE>

See accompanying notes to consolidated financial statements.




                                       46
<PAGE>   46
                          PHYCOR, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

                  YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                    (ALL AMOUNTS ARE EXPRESSED IN THOUSANDS)

<TABLE>
<CAPTION>
                                                    Common                                Retained
                                                  Stock Shares          Amount            Earnings            Total
                                                  ------------          ------            --------            -----
<S>                                               <C>                 <C>                <C>                <C>
Balances at December 31, 1995                         53,399          $ 363,211             25,611            388,822
  Issuance of common stock and warrants,
    net of placement commissions and
    offering expenses totaling $192                      261             10,312                 --             10,312
  Conversion of subordinated notes payable
    to common stock                                      859             11,450                 --             11,450
  Stock options exercised and related
    tax benefits                                         312              4,739                 --              4,739
  Net earnings                                            --                 --             36,380             36,380
                                                   ---------          ---------          ---------          ---------
Balances at December 31, 1996                         54,831            389,712             61,991            451,703
  Issuance of common stock and warrants,
    net of placement commissions and
    offering expenses totaling $8,957                  8,109            232,422                 --            232,422
  Conversion of subordinated notes payable
    to common stock                                    1,046             14,816                 --             14,816
  Stock options exercised and related
    tax benefits                                         544              8,338                 --              8,338
  Net earnings                                            --                 --              3,209              3,209
                                                   ---------          ---------          ---------          ---------
Balances at December 31, 1997                         64,530            645,288             65,200            710,488
  Issuance of common stock and warrants,
    net of placement commissions and
    offering expenses totaling $140                   12,663            204,286                 --            204,286
  Repurchase of common stock                          (2,628)           (12,590)                --            (12,590)
  Conversion of subordinated notes payable
    to common stock                                      209              2,000                 --              2,000
  Stock options exercised and related
    tax benefits                                       1,050             11,673                 --             11,673
  Net loss                                                --                 --           (111,447)          (111,447)
                                                   ---------          ---------          ---------          ---------
Balances at December 31, 1998                         75,824          $ 850,657            (46,247)           804,410
                                                   =========          =========          =========          =========
</TABLE>

See accompanying notes to consolidated financial statements.



                                       47
<PAGE>   47
                          PHYCOR, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                  YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                    (ALL AMOUNTS ARE EXPRESSED IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                           1998           1997           1996
                                                                                           ----           ----           ----
<S>                                                                                     <C>            <C>            <C>
Cash flows from operating activities:
  Net earnings (loss)                                                                   $(111,447)         3,209         36,380
  Adjustments to reconcile net earnings (loss) to
    net cash provided by operating activities:
    Depreciation and amortization                                                          90,238         62,522         40,182
    Deferred income taxes                                                                 (43,011)        (9,677)         9,616
    Minority interests                                                                     13,596         11,674         10,463
    Provision for asset revaluation and clinic restructuring                              224,900         83,445             --
    Merger expenses                                                                        14,196             --             --
    Increase (decrease) in cash, net of effects of acquisitions, due to changes in:
          Accounts receivable, net                                                           (777)       (28,920)       (36,376)
          Inventories                                                                        (865)        (1,929)        (1,880)
          Prepaid expenses and other current assets                                        (9,620)           137        (16,481)
          Accounts payable                                                                 (2,356)         2,211         (3,291)
          Due to physician groups                                                          (1,365)        10,396         13,489
          Incurred but not reported claims payable                                           (535)         1,448          1,785
          Other accrued expenses and current liabilities                                  (11,766)       (18,468)        21,221
                                                                                        ---------      ---------      ---------
          Net cash provided by operating activities                                       161,188        116,048         75,108
                                                                                        ---------      ---------      ---------
Cash flows from investing activities:
  Payments for acquisitions, net                                                         (185,743)      (299,191)      (252,270)
  Purchase of property and equipment                                                      (67,612)       (66,486)       (50,053)
  Payments to acquire other assets                                                        (17,914)       (12,711)        (4,719)
                                                                                        ---------      ---------      ---------
          Net cash used by investing activities                                          (271,269)      (378,388)      (307,042)
                                                                                        ---------      ---------      ---------
Cash flows from financing activities:
  Net proceeds from issuance of stock and warrants                                         18,591        226,458          4,975
  Net proceeds from issuance of convertible debentures                                         --             --        194,395
  Repurchase of common stock                                                              (12,590)            --             --
  Proceeds from long-term borrowings                                                      173,000        295,000        161,000
  Repayment of long-term borrowings                                                       (16,156)      (235,972)      (104,546)
  Repayment of obligations under capital leases                                            (6,139)        (4,088)        (1,811)
  Distributions of minority interests                                                     (10,130)       (11,107)       (10,291)
  Loan costs incurred                                                                        (341)          (321)           (85)
                                                                                        ---------      ---------      ---------
          Net cash provided by financing activities                                       146,235        269,970        243,637
                                                                                        ---------      ---------      ---------
Net increase in cash and cash equivalents                                                  36,154          7,630         11,703
Cash and cash equivalents - beginning of year                                              38,160         30,530         18,827
                                                                                        ---------      ---------      ---------
Cash and cash equivalents - end of year                                                 $  74,314         38,160         30,530
                                                                                        =========      =========      =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
  Cash paid (received) during the year for:
    Interest                                                                            $  34,792         23,005         13,745
    Income taxes, net of refunds                                                          (14,510)        18,314         13,991
                                                                                        =========      =========      =========
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
  Effects of acquisitions, net:
    Assets acquired, net of cash                                                        $ 377,649        450,872        384,807
    Liabilities paid (assumed), net of deferred purchase price payments                    25,583       (131,681)       (89,326)
    Issuance of convertible subordinated notes payable                                     (8,317)       (11,286)       (36,084)
    Issuance of common stock and warrants                                                (193,057)        (8,714)        (7,127)
    Cash received from disposition of clinic assets                                       (16,115)            --             --
                                                                                        ---------      ---------      ---------
          Payments for acquisitions, net                                                $ 185,743        299,191        252,270
                                                                                        =========      =========      =========
Capital lease obligations incurred to acquire equipment                                 $     808            555            471
Conversion of subordinated notes payable to common stock                                    2,000         14,816         11,450
</TABLE>

See accompanying notes to consolidated financial statements.





                                       48
<PAGE>   48
                          PHYCOR, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                        DECEMBER 31, 1998, 1997 AND 1996

(1)      ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND
         PRACTICES

         (a)      Description of Business

         PhyCor, Inc. (the Company) is a medical network management company that
         operates multi-specialty medical clinics, develops and manages
         independent practice associations (IPAs) and provides health care
         decision-support services, including demand management and disease
         management services, to managed care organizations, health care
         providers, employers and other group associations. In connection with
         our multi-specialty clinic operations, the Company manages and operates
         two hospitals and four HMOs. PhyCor's strategy is to organize
         physicians into professionally managed networks that assist physicians
         in assuming increased responsibility for delivering cost-effective
         medical care while attaining high-quality clinical outcomes and patient
         satisfaction. The Company, through wholly-owned subsidiaries, acquires
         certain assets of and operates clinics under long-term service
         agreements with affiliated physician groups that practice exclusively
         through such clinics. The Company provides administrative and technical
         support for professional services rendered by the physician groups
         under service agreements. Under most service agreements, the Company is
         reimbursed for all clinic expenses, as defined in the agreement, and
         participates at varying levels in the excess of net clinic revenue over
         clinic expenses. As of December 31, 1998, the Company operated 56
         clinics with 3,693 physicians in 27 states.

                  The Company also manages IPAs which are networks of
         independent physicians. Fees earned from managing the IPAs are based
         upon a percentage of revenue collected by the IPAs and also upon a
         share of surplus, if any, of capitated revenue of the IPAs. At December
         31, 1998, these IPAs included approximately 22,900 physicians in 35
         markets. Our affiliated physicians provided capitated medical services
         to approximately 1,643,000 members, including approximately 304,000
         Medicare and Medicaid members. The Company provides health care
         decision-support services to approximately 2.2 million individuals
         within the United States and 500,000 additional individuals under
         foreign country license arrangements.

         (b)      Principles of Consolidation

         The consolidated financial statements include the accounts of the
         Company and its majority owned subsidiaries, partnerships and other
         entities in which the Company has more than a 50% ownership interest or
         exercises control. All significant intercompany balances and
         transactions are eliminated in consolidation. The Company does not
         consolidate the physician practices it manages as it does not have
         operating control as defined in EITF 97-2, "Application of APB Opinion
         No. 16 and FASB Statement No. 94 to Physician Practice Entities."
         Physician practices which are owned and operated by the Company are
         consolidated.

         (c)      Cash and Cash Equivalents

         The Company considers all highly liquid investments with a maturity of
         three months or less when purchased to be cash equivalents. Cash and
         cash equivalents as of December 31, 1998 include approximately
         $22,480,000 of consolidated partnership cash. These balances may only
         be used for the operations of the respective partnerships.

         (d)      Accounts Receivable

         Accounts receivable principally represent receivables from patients and
         third-party payors for medical services provided by physician groups.
         Terms of the service agreements require the Company to purchase


                                       49
<PAGE>   49
         receivables generated by the physician groups on a monthly basis. Such
         amounts are recorded net of contractual allowances and estimated bad
         debts. Accounts receivable are a function of net clinic revenue rather
         than net revenue of the Company (See note 2).

         (e)      Inventories

         Inventories are comprised primarily of medical supplies, medications
         and other materials used in the delivery of health care services by the
         physician groups at the Company's clinics and hospitals. The Company
         values inventories at the lower of cost or market with cost determined
         using the first-in, first-out (FIFO) method.

         (f)      Property and Equipment

         Property and equipment are stated at cost. Equipment held under capital
         leases is stated at the present value of minimum lease payments at the
         inception of the related leases. Depreciation of property and equipment
         is calculated using the straight-line method over the estimated useful
         lives of the assets. Equipment held under capital leases and leasehold
         improvements are amortized on a straight line basis over the shorter of
         the lease term or estimated useful life of the assets.

         (g)      Intangible Assets

         Clinic Service Agreements

         Costs of obtaining clinic service agreements are amortized using the
         straight-line method over the periods during which the agreements are
         effective, up to a maximum of twenty-five years. Clinic service
         agreements represent the exclusive right to operate the Company's
         clinics in affiliation with the related physician groups during the
         term of the agreements. In the event of termination of a service
         agreement, the related physician group is obligated to purchase all
         clinic assets, including the unamortized portion of intangible assets,
         generally at the current net book value.

         Excess of Cost of Acquired Over Fair Value

         Excess of cost of acquired assets over fair value (goodwill) is
         amortized using the straight-line method over a period not to exceed
         twenty-five years.

         Other Intangible Assets

         Other intangible assets include costs associated with obtaining
         long-term financing which are being amortized systematically over the
         terms of the related debt agreements and franchise rights which are
         being amortized over fifteen years.

         Amortization and Recoverability

         Effective April 1, 1998, the Company changed its policy with respect to
         amortization of intangible assets. All existing and future intangible
         assets will be amortized over a period not to exceed 25 years from the
         inception of the respective intangible assets. Had the Company adopted
         this policy at the beginning of 1997, amortization expense would have
         increased and diluted earnings per share would have decreased by
         approximately $11.2 million and $0.10, respectively, for the year. On
         the same basis, for the first quarter of 1998, amortization expense
         would have increased by approximately $3.3 million, resulting in a
         decrease in diluted earnings per share of $0.03. Amortization of
         intangibles amounted to $38,034,000, $23,865,000, and $15,150,000 for
         1998, 1997 and 1996, respectively.

         The Company periodically reviews its intangible assets to assess
         whether recoverability and impairments would be recognized in the
         statement of operations if a permanent impairment were determined to
         have


                                       50
<PAGE>   50
         occurred. Recoverability of intangibles is determined based on
         undiscounted future operating cash flows from the related business unit
         or activity. The amount of impairment, if any, is measured based on
         discounted future operating cash flows using a discount rate reflecting
         the Company's average cost of funds or based on the fair value of the
         related business unit or activity. The assessment of the recoverability
         of intangible assets will be impacted if estimated future operating
         cash flows are not achieved.

         (h)      Impairment of Long-Lived Assets

         The Company reviews long-lived assets and certain identifiable
         intangibles for impairment whenever events or changes in circumstances
         indicate that the carrying amount of an asset may not be recoverable.
         Recoverability of assets to be held and used is measured by a
         comparison of the carrying amount of an asset to future net cash flows
         expected to be generated by the asset. If such assets are considered to
         be impaired, the impairment to be recognized is measured by the amount
         by which the carrying amount of the assets exceeded the fair value of
         the assets.

         (i)      Income Taxes

         Income taxes are accounted for under the asset and liability method.
         Deferred tax assets and liabilities are recognized for the future tax
         consequences attributable to differences between the financial
         statement carrying amounts of existing assets and liabilities and their
         respective tax bases. Deferred tax assets and liabilities are measured
         using enacted tax rates expected to apply to taxable income in the
         years in which those temporary differences are expected to be recovered
         or settled. The effect on deferred tax assets and liabilities of a
         change in the tax rates is recognized in income in the period that
         includes the enactment date.

         (j)      Incurred but not Reported Claims

         Incurred but not reported claims payable represent the liability for
         covered services that have been performed by physicians for enrollees
         of various medical plans. These liabilities include medical expense
         claims reported to the Company and an actuarially determined estimate
         of claims that have been incurred but not reported to the Company. The
         estimated claims incurred but not reported is based on the Company's
         historical claims data, current enrollment, health service utilization
         statistics and other related information.

         (k)      Financial Instruments

         In 1997, the Company entered into an interest rate swap agreement to
         reduce the exposure to fluctuating interest rates with respect to
         $100,000,000 of its bank credit facility. During 1998, the Company
         amended the previous interest rate swap agreement and entered into
         additional swap agreements. At December 31, 1998, notional amounts
         under interest rate swap agreements totaled $210.2 million. Fixed
         interest rates range from 5.14% to 5.78% relative to the one month or
         three month floating LIBOR. Up to an additional $15.8 million may be
         fixed at 5.28% as additional amounts are drawn under the synthetic
         lease facility prior to April 28, 2000. The swap agreements mature at
         various dates from July 2003 to April 2005. The lender may elect to
         terminate the agreement covering $100 million beginning September 2000
         and an additional $100 million beginning October 2000. These agreements
         are accounted for on the accrual method. Gains and losses resulting
         from these instruments are recognized in the same period as the related
         interest expense. Gains and losses are included in interest expense.
         The Company does not use interest rate swap agreements or other
         derivative financial instruments for speculative or trading purposes.

         The FASB has issued Statement of Financial Accounting Standards (SFAS)
         No. 133., Accounting for Derivative Instruments and Hedging Activities,
         which the Company will be required to adopt in the first quarter of
         2000. Adoption of SFAS No. 133 will require the Company to mark certain
         of its interest rate swap agreements to market due to lender
         optionality features included in those swap agreements. Had the Company
         adopted SFAS No. 133 as of December 31, 1998, the Company estimates it
         would have recorded a non-cash charge to earnings of 7.3 million.



                                       51
<PAGE>   51
         (l)      Stock Option Plans

         The Company accounts for its compensation and stock option plans in
         accordance with the provisions of Accounting Principles Board ("APB")
         Opinion No. 25, Accounting for Stock Issued to Employees, and related
         interpretations. As such, compensation expense would be recorded on the
         date of grant only if the current market price of the underlying stock
         exceeded the exercise price. In accordance with SFAS No. 123,
         Accounting for Stock-Based Compensation (SFAS No. 123), the Company
         provides pro forma net income and pro forma earnings per share
         disclosures for employee stock option grants made in 1995 and
         subsequent years as if the fair-value-based method defined in SFAS No.
         123 had been applied.

         (m)      Earnings Per Share

         Basic earnings per share is computed based on weighted average shares
         outstanding and excludes any potential dilution. Diluted earnings per
         share reflects the potential dilution from the exercise or conversion
         of all dilutive securities into common stock based on the average
         market price of common shares outstanding during the period.

         (n)      Comprehensive Income

         Effective January 1, 1998, the Company adopted Statement of Financial
         Accounting Standards No. 130, Reporting Comprehensive Income.
         Comprehensive income generally includes all changes in equity during a
         period except those resulting from investments by shareholders and
         distributions to shareholders. Net income was the same as comprehensive
         income for 1998, 1997 and 1996.

         (o)      Use of Estimates

         Management of the Company has made certain estimates and assumptions
         relating to the reporting of assets and liabilities and the disclosure
         of contingent assets and liabilities to prepare these consolidated
         financial statements in conformity with generally accepted accounting
         principles. Actual results could differ from those estimates.

         (p)      Reclassifications

         Certain prior year amounts have been reclassified to conform to the
         1998 presentation.

(2)      NET REVENUE

         Net revenue of the Company is comprised of net clinic service agreement
         revenue, IPA management revenue, net hospital revenues and other
         operating revenues. Clinic service agreement revenue is equal to the
         net revenue of the clinics, less amounts retained by physician groups.
         Net clinic revenue recorded by the physician groups and net hospital
         revenue are recorded at established rates reduced by provisions for
         doubtful accounts and contractual adjustments. Contractual adjustments
         arise as a result of the terms of certain reimbursement and managed
         care contracts. Such adjustments represent the difference between
         charges at established rates and estimated recoverable amounts and are
         recognized in the period the services are rendered. Any differences
         between estimated contractual adjustments and actual final settlements
         under reimbursements contracts are recognized as contractual
         adjustments in the year final settlements are determined. With the
         exception of the Company's wholly-owned subsidiary, PrimeCare
         International, Inc. (PrimeCare) and certain clinics acquired as part of
         the First Physician Care, Inc. ("FPC") acquisition, the physician
         groups, rather than the Company, enter into managed care contracts.
         Through calculation of its service fees, the Company shares indirectly
         in any capitation risk assumed by its affiliated physician groups.

         IPA management revenue is equal to the difference between the amount of
         capitation and risk pool payments payable to the IPAs managed by the
         Company less amounts retained by the IPAs. The Company


                                       52
<PAGE>   52
         has not historically been a party to capitated contracts entered into
         by the IPAs, but is exposed to losses to the extent of its share of
         deficits, if any, of the capitated revenue of the IPAs. Through the
         PrimeCare and The Morgan Health Group, Inc. (MHG) acquisitions, the
         Company became a party to certain managed care contracts. Accordingly,
         the cost of provider services for the PrimeCare and MHG contracts is
         not included as a deduction to net revenue of the Company but is
         reported as an operating expense.

         The following represent amounts included in the determination of net
         revenue (in thousands):

<TABLE>
<CAPTION>
                                                                        1998             1997              1996
                                                                        ----             ----              ----
<S>                                                                 <C>                <C>              <C>
Gross physician group, hospital and other revenue                   $ 3,498,668        2,849,646        1,928,045
Less:
     Provisions for doubtful accounts and contractual
         adjustments                                                  1,415,933        1,090,329          699,186
                                                                    -----------        ---------        ---------

     Net physician group, hospital and other revenue                  2,082,735        1,759,317        1,228,859
     IPA revenue                                                        773,089          411,912          255,181
                                                                    -----------        ---------        ---------
     Net physician group, hospital and IPA revenue                    2,855,824        2,171,229        1,484,040
Less amounts retained by physician groups and IPAs:
     Physician groups                                                   714,081          634,983          459,179
     Clinic technical employee compensation                              94,906           74,715           50,395
     IPAs                                                               534,338          341,937          208,141
                                                                    ------------       ---------        ---------
Net revenue                                                         $ 1,512,499        1,119,594          766,325
                                                                    ===========        =========        =========
</TABLE>

         The Company derives most of its net revenue from 56 physician groups
         located in 27 states with which it has service agreements at December
         31, 1998. The Company's affiliated physician groups derived
         approximately 26%, 27% and 24% of their net revenues from services
         provided under the Medicare program for the years ended December 31,
         1998, 1997 and 1996, respectively. Other than the Medicare program, the
         physician groups have no customers which represent more than 10% of
         aggregate net clinic revenue for the years ended December 31, 1998,
         1997 and 1996 or 5% of accounts receivables at December 31, 1998 and
         1997.

(3)      ACQUISITIONS

         (a)      Multi-Specialty Medical Clinics

         During 1998, 1997 and 1996, the Company, through wholly-owned
         subsidiaries, acquired certain operating assets of the following
         clinics:

<TABLE>
<CAPTION>
        CLINIC                                               EFFECTIVE DATE             LOCATION
        ------                                               --------------             --------
<S>                                                          <C>                        <C>
        1998:
        Grove Hill Medical Center                            March 1, 1998              New Britain, Connecticut
        Huntington Medical Group                             October 1, 1998            Huntington, New York

        1997:
        Vancouver Clinic                                     January 1, 1997            Vancouver, Washington
        First Physicians Medical Group                       February 1, 1997           Palm Springs, California
        St. Petersburg-Suncoast Medical Group                February 28, 1997          St. Petersburg, Florida
        Greater Chesapeake Medical Group (i)                 May 1, 1997                Annapolis, Maryland
        Welborn Clinic                                       June 1, 1997               Evansville, Indiana
        White-Wilson Medical Center                          July 1, 1997               Ft. Walton Beach, Florida
        Maui Medical Group                                   September 1, 1997          Maui, Hawaii
        Murfreesboro Medical Clinic                          October 1, 1997            Murfreesboro, Tennessee
        West Florida Medical Center Clinic                   October 1, 1997            Pensacola, Florida
</TABLE>


                                       53
<PAGE>   53
<TABLE>
<S>                                                          <C>                        <C>
        Northern California Medical Association              December 1, 1997           Santa Rosa, California
        Lakeview Medical Center (ii)                         December 1, 1997           Suffolk, Virginia

        1996:
        Arizona Physicians Center (iii)                      January 1, 1996            Phoenix, Arizona
        Clinics of North Texas                               March 1, 1996              Wichita Falls, Texas
        Carolina Primary Care (iv)                           May 1, 1996                Columbia, South Carolina
        Harbin Clinic                                        May 1, 1996                Rome, Georgia
        Focus Health Services                                July 1, 1996               Denver, Colorado
        Clark-Holder Clinic                                  July 1, 1996               LaGrange, Georgia
        Medical Arts Clinic                                  August 1, 1996             Minot, North Dakota
        Wilmington Health Associates                         August 1, 1996             Wilmington, North Carolina
        Gulf Coast Medical Group (v)                         August 1, 1996             Galveston, Texas
        Hattiesburg Clinic                                   October 1, 1996            Hattiesburg, Mississippi
        Straub Clinic & Hospital (vi)                        October 1, 1996            Honolulu, Hawaii
        Toledo Clinic                                        November 1, 1996           Toledo, Ohio
        Lewis-Gale Clinic                                    November 1, 1996           Roanoke, Virginia
</TABLE>

         (i)      Certain assets associated with Greater Chesapeake Medical
                  Group were disposed of in the fourth quarter of 1998.

         (ii)     Lakeview Medical Center was operated under a management
                  agreement during December 1997. Effective January 1, 1998, the
                  Company completed the purchase of certain clinic operating
                  assets and entered into a long-term service agreement with the
                  affiliated physician group.

         (iii)    Certain assets associated with Arizona Physicians Center were
                  disposed of in the second quarter of 1998.

         (iv)     Certain assets associated with Carolina Primary Care were
                  disposed of in the third quarter of 1998.

         (v)      Certain assets associated with Gulf Cost Medical Group were
                  disposed of in the first quarter of 1999.

         (vi)     Straub Clinic & Hospital (Straub) was operated under an
                  administrative service agreement effective October 1, 1996.
                  The Company completed its merger and entered into a long-term
                  service agreement with Straub effective January 17, 1997.

         In addition, the Company acquired certain operating assets of various
         individual physician practices and single specialty groups which were
         merged into clinics already operated by the Company. Service agreement
         rights of approximately $70.4 million were recorded in conjunction with
         1998 acquisitions and are being amortized over 25 years.

         The Company acquires operating assets and liabilities in exchange for
         cash, convertible debentures, common stock or a combination thereof.
         Such consideration for the above clinic acquisitions and single
         specialty mergers was $152,344,000 for 1998, $430,757,000 for 1997, and
         $357,458,000 for 1996. The acquisitions were accounted for as
         purchases, and the accompanying consolidated financial statements
         include the results of their operations from the dates of their
         respective acquisitions. Simultaneous with each acquisition, the
         Company entered into a long-term service agreement with the related
         clinic physician group. In conjunction with certain acquisitions, the
         Company is obligated at December 31, 1998 to make deferred payments to
         physician groups of which $73,736,000 are due on demand or within one
         year and $7,863,000, $841,000, and $263,000 are due in 2000, 2001, and
         2002, respectively. Such payments are included in purchase price
         payable in the accompanying consolidated balance sheets.



                                       54
<PAGE>   54
         (b)      Independent Practice Associations (IPAs)

         Effective January 1, 1995, the Company completed its merger with North
         American Medical Management, Inc. (NAMM), an operator and manager of
         IPAs. The Company made additional payments for the NAMM acquisition
         pursuant to an earn-out formula during 1996 and 1997 totaling $35.0
         million. A final payment of $35 million was made in April 1998, of
         which $13.0 million was paid in shares of the Company's common stock.
         In July 1998, the Company acquired MHG, an Atlanta-based IPA, for
         approximately 500,000 shares of common stock and assumed liabilities
         for an aggregate purchase price of approximately $33.1 million, of
         which $31.6 million was recorded as goodwill at the time of acquisition
         (See note 13). In addition, the Company acquired an IPA management
         company and an HMO during 1998, and goodwill of approximately $14.3
         million was recorded and is being amortized over 25 years.

         (c)      Phycor Management Corporation (PMC)

         In June 1995, the Company purchased a minority interest of
         approximately 9% in PMC and managed PMC pursuant to a 10-year
         administrative services agreement. PMC developed and managed IPAs and
         provided other services to physician organizations. The Company
         acquired the remaining interests of PMC on March 31, 1998 for an
         aggregate purchase price of approximately $21.0 million paid in shares
         of the Company's common stock and integrated the operations of PMC into
         NAMM. Goodwill of approximately $20.8 million was recorded in
         conjunction with the purchase and is being amortized over 25 years.

         (d)      Primecare

         In May 1998, the Company acquired PrimeCare, a medical network
         management company serving southern California's Inland Empire area, in
         a purchase business combination for approximately 4.0 million shares of
         common stock, assumed liabilities and cash for an aggregate purchase
         price of approximately $170.0 million. PrimeCare's delivery network is
         comprised of an integrated campus, including the Desert Valley Medical
         Group, Desert Valley Hospital and Apple Valley Surgery Center, as well
         as the Inland Empire area IPA network. Goodwill of approximately $117.9
         million was recorded in conjunction with the purchase and is being
         amortized over 25 years.

         (e)      Carewise, Inc. (Carewise)

         In July 1998, the Company acquired Seattle-based CareWise, a nationally
         recognized leader in the health care decision-support industry for
         approximately 3.1 million shares of common stock and assumed
         liabilities for an aggregate purchase price of approximately $67.5
         million. The acquisition was accounted for as a purchase. Goodwill of
         approximately $59.9 million was recorded in conjunction with the
         purchase and is being amortized over 20 years.

         (f)      First Physician Care, Inc. (FPC)

         In July 1998, the Company acquired Atlanta-based FPC, a privately-held
         physician practice management company that operated in six markets in
         Texas, Florida, Illinois, New York and Georgia, and provided practice
         management services to approximately 140 physicians. The acquisition
         was made for approximately 2.9 million shares of common stock and
         assumed liabilities for an aggregate purchase price of approximately
         $60.4 million, and was accounted for as a purchase. Goodwill of
         approximately $43.4 million was recorded in conjunction with the
         purchase and is being amortized over 25 years. During the fourth
         quarter of 1998, the Company disposed of the assets associated with the
         New York market (See Note 13).



                                       55
<PAGE>   55
         (g)      Pro Forma Information

         The unaudited consolidated pro forma net revenue, net loss and per
         share amounts of the Company assuming the PrimeCare, MHG, CareWise and
         FPC acquisitions had been consummated on January 1, 1997 are as follows
         (in thousands, except for loss per share):

<TABLE>
<CAPTION>
                                                                   1998                1997
                                                                   ----                ----
<S>                                                              <C>                  <C>
                 Net revenue                                     $ 1,577,792          1,286,509
                 Net loss                                           (116,099)           (12,261)
                 Loss per share:
                      Basic                                           (1.51)              (.17)
                      Diluted                                         (1.51)              (.17)
</TABLE>

         The consolidated statements of operations include the results of the
         above businesses from the dates of their respective acquisitions.

(4)      BUSINESS SEGMENTS

         The Company has two reportable segments based on the way management has
         organized its operations: physician clinics and IPAs. The physician
         clinics have been subdivided into multi-specialty and group formation
         clinics for purposes of disclosure. The Company derives its revenues
         primarily from operating multi-specialty medical clinics and managing
         IPAs (See Note 2). In addition the Company provides health care
         decision-support services and operates two hospitals which do not meet
         the quantitative thresholds for reportable segments and have therefore
         been aggregated within the corporate and other category.

         The accounting policies of the segments are the same as those described
         in the summary of significant accounting polices. The Company evaluates
         performance based on earnings from operations before asset revaluation
         and clinic restructuring charges, merger expenses, minority interest
         and income taxes. The following is a financial summary by business
         segment for the periods indicated (in thousands):

<TABLE>
<CAPTION>
                                                                   1998               1997               1996
                                                                   ----               ----               ----
<S>                                                            <C>                <C>                <C>
        Multi-specialty clinics:
          Net revenue                                          $ 1,139,616           933,081            636,183
          Operating expenses(1)                                  1,021,811           818,328            560,172
          Interest income                                           (1,282)           (1,534)            (1,920)
          Interest expense                                          73,451            58,693             30,302
        Earnings before taxes and
          minority interest(1)                                      45,636            57,594             47,570
        Depreciation and amortization                               71,073            49,542             31,059
        Segment Assets                                           1,347,843         1,240,954            860,240

        Group formation clinics:
          Net revenue                                               98,377           122,429             83,102
          Operating expenses(1)                                     89,277           111,186             75,484
          Interest (income) expense                                   (198)               37                 (8)
          Interest expense                                          11,915            12,163              6,665
        Earnings (loss) before taxes and
          minority interest(1)                                      (2,617)             (957)               961
        Depreciation and amortization                                6,645             7,587              5,246
        Segment Assets                                              66,316           160,493            159,063
</TABLE>

                                       56
<PAGE>   56
<TABLE>
<S>                                                            <C>                <C>                <C>
        IPAs:
        Net revenue                                                242,812            63,638             47,040
        Operating expenses(1)                                      209,625            40,048             29,438
        Interest income                                             (1,729)           (1,378)              (791)
        Interest expense                                             9,362             4,434              2,697
        Earnings before taxes and
          minority interest(1)                                      11,958             8,860              5,233
        Depreciation and amortization                                8,963             3,021              1,929
        Segment Assets                                             299,641            92,527             61,685

        Corporate and other(2):
          Net revenue                                               31,694               446                  0
          Operating expenses(1)                                     57,197            25,422             19,479
          Interest (income) expense                                    177              (448)            (1,148)
          Interest expense (income)                                (58,462)          (51,783)           (23,683)
          Earnings before taxes and
            minority interest(1)                                    32,782            27,255              5,391
          Depreciation and amortization                              3,557             2,372              1,948
          Segment Assets                                           132,739            68,802             37,593
</TABLE>

         (1)      Amounts exclude provision for asset revaluation and clinic
                  restructuring and merger expenses.

         (2)      This segment includes all corporate costs and real estate
                  holdings as well as the results for CareWise and the hospitals
                  managed by the Company.





                                       57
<PAGE>   57
(5)      PROPERTY AND EQUIPMENT

         Property and equipment at December 31, consists of the following (in
         thousands):

<TABLE>
<CAPTION>
                                                                             1998               1997
                                                                             ----               ----
<S>                                                                         <C>                <C>
        Land and improvements                                                 $6,661             6,018
        Buildings and leasehold improvements                                  81,902            70,558
        Equipment                                                            270,092           232,039
        Construction in progress                                               7,134            13,318
                                                                            --------           -------
                                                                             365,789           321,933
        Less accumulated depreciation
                and amortization                                             123,965            86,248
                                                                            --------           -------
                Property and equipment, net                                 $241,824           235,685
                                                                            ========           =======
</TABLE>

         At December 31, 1998 and 1997, equipment with a cost of approximately
         $17,523,000 and $20,080,000, and accumulated depreciation of
         approximately $8,039,000 and $8,215,000, respectively, was held under
         capital leases.

(6)      INTANGIBLE ASSETS

         Intangible assets at December 31, net of accumulated amortization,
         consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                             1998               1997
                                                                             ----               ----
<S>                                                                         <C>                <C>
        Clinic service agreements                                           $671,486           732,848
        Excess of cost of acquired assets
             over fair value                                                 302,698            67,384
        Franchise rights                                                       2,174             2,078
        Loan issuance costs                                                    5,179             5,416
                                                                            --------           -------
             Intangible assets, net                                         $981,537           807,726
                                                                            ========           =======
</TABLE>

(7)      FAIR VALUE OF FINANCIAL INSTRUMENTS

         As of December 31, 1998 and 1997, the fair value of the Company's cash
         and cash equivalents, accounts receivable, accounts payable, purchase
         price payable due to physician groups, and accrued expenses
         approximated their carrying value because of the short maturities of
         those financial instruments. The fair value of the Company's long-term
         debt also approximates its carrying value since the related notes bear
         interest at current market rates.

         The estimated fair value of the convertible subordinated notes payable
         to physician groups was approximately $27,119,000 and $65,218,000 as of
         December 31, 1998 and 1997, respectively. The carrying value of these
         notes was approximately $47,580,000 and $61,576,000 at December 31,
         1998 and 1997, respectively. The estimated fair value of these
         convertible securities is based on the greater of their yield to
         maturity and quoted market prices for similar debt issues or the
         closing market value of the common shares into which they could have
         been converted at the respective balance sheet date. The estimated fair
         value of the Company's convertible subordinated debentures was
         $120,940,000 and $195,000,000 as of December 31, 1998 and 1997,
         respectively, compared to a carrying value of $200,000,000 in both
         periods. The estimated fair value of these convertible debentures is
         based on quoted market prices at these dates.



                                       58
<PAGE>   58
(8)      CONVERTIBLE SUBORDINATED NOTES PAYABLE TO PHYSICIAN GROUPS

         At December 31, 1998 and 1997, the Company had outstanding subordinated
         convertible notes payable to affiliated physician groups in the
         aggregate principal amount of approximately $47,580,000 and
         $61,576,000, respectively. These notes bear interest at rates of 5.86%
         to 7.0% and are convertible into shares of the Company's common stock
         at conversion prices ranging from $26.35 to $57.78 per share. A
         convertible subordinated note of $33,295,000 issued in connection with
         the Guthrie Clinic transaction will be convertible into approximately
         903,000 shares of common stock upon the Company's acquisition of the
         clinic's assets prior to November 17, 2005. If the then current price
         of the common stock is less than the conversion price, PhyCor will pay
         the clinic the principal amount of the note. The remaining convertible
         notes may be converted into approximately 732,000 shares of common
         stock, with 162,000 shares convertible at December 31, 1998 and 570,000
         shares convertible commencing on varying dates in 1999 through 2004 at
         the option of the holders.

(9)      CONVERTIBLE SUBORDINATED DEBENTURES

         During February 1996, the Company completed a public offering of
         $200,000,000 convertible subordinated debentures, which mature in 2003.
         Net proceeds from the offering were $194,395,000. The debentures were
         priced at par with a coupon rate of 4.5% and are convertible into the
         Company's common stock at $38.67 per share. From February 15, 1999 to
         maturity, the bonds may be redeemed at prices decreasing from 102.572%
         of face value to 100% of face value.

(10)     LONG-TERM DEBT

         Long-term debt at December 31, consists of the following (in
         thousands):

<TABLE>
<CAPTION>
                                                                                   1998                 1997
                                                                                   ----                 ----
<S>                                                                              <C>                   <C>
        Bank credit facility, bearing interest at a weighted
              average rate of 6.18% at December 31, 1998                         $ 377,000             204,000
        Mortgages payable, bearing interest at rates
              ranging from 8.25% to 10.5%, secured by land,
              building, and certain equipment                                        8,537               3,704
        Other notes payable                                                          7,917               4,333
              Total long-term debt                                                 393,454             212,037
        Less current installments                                                    4,810               1,144
              Long-term debt, excluding current installments                     $ 388,644             210,893
                                                                                 =========             =======
</TABLE>

         The Company modified its bank credit facility (Bank Credit Facility) in
         April and September 1998 and March 1999. The Company's Bank Credit
         Facility, as amended, provides for a five-year, $500.0 million
         revolving line of credit for use by the Company prior to April 2003 for
         acquisitions, working capital, capital expenditures and general
         corporate purposes. The total drawn cost under the Bank Credit Facility
         during 1998 was either (i) the applicable eurodollar rate plus .50% to
         1.25% or (ii) the agent's base rate plus .25% to .575% per annum. The
         total weighted average drawn cost of outstanding borrowings at December
         31, 1998 was 6.18%. After amending the Bank Credit Facility March 15,
         1999, total drawn cost is now either (i) the applicable eurodollar rate
         plus .625% to 1.50% or (ii) the agent's base rate plus .40% to .65% per
         annum.

         On October 17, 1997, the Company entered into an interest rate swap
         agreement to fix the interest rate on $100 million of debt at 5.85%
         relative to the three month floating LIBOR. This interest rate swap
         agreement was amended, effective October 17, 1998, to a fixed rate of
         5.78% and a maturity date of July 2003 with the lender's option to
         terminate beginning October 2000. Effective September 9, 1998, the


                                       59
<PAGE>   59
         Company entered into an interest rate swap agreement to fix the
         interest rate on an additional $100 million of debt at 5.14% relative
         to the three month floating LIBOR. This swap agreement matures
         September 2003 with the lender's option to terminate beginning
         September 2000. Effective September 14, 1998, the Company entered into
         an interest rate swap agreement to fix the interest rate on up to $21
         million of debt under the Company's synthetic lease facility through
         April 2000, of which approximately $5.2 million was outstanding at
         December 31, 1998, at 5.28% relative to the one month floating LIBOR.
         This swap agreement matures April 2005. Effective December 1, 1998, the
         Company entered into an interest rate swap agreement to fix the
         interest rate on $5 million of debt at 5.2425% relative to the one
         month floating LIBOR. This swap agreement matures April 2005. At
         December 31, 1998, notional amounts under interest rate swap agreements
         totaled approximately $210.2 million.

         The Company also entered into a $100 million synthetic lease facility
         (Synthetic Lease Facility) in April 1998. The Synthetic Lease Facility
         provides off balance sheet financing with an option to purchase the
         leased facilities at the end of the lease term and is expected to be
         used for, among other projects, the construction or acquisition of
         certain medical office buildings related to the Company's operations.
         The total drawn cost under the Synthetic Lease Facility during 1998 was
         .375% to 1.00% above the applicable eurodollar rate. At December 31,
         1998, an aggregate of $19.1 million had been utilized under the
         Synthetic Lease Facility. In March 1999, the Company amended its
         Synthetic Lease Facility to $60 million and total drawn cost is now
         .50% to 1.25% above the applicable eurodollar rate.

         The Company's Bank Credit Facility and Synthetic Lease Facility contain
         covenants which, among other things, require the Company to maintain
         certain financial ratios and impose certain limitations or prohibitions
         on the Company with respect to (i) the incurring of certain
         indebtedness, (ii) the creation of security interests on the assets of
         the Company, and (iii) the payment of cash dividends on, and the
         redemption or repurchase of, securities of the Company, (iv)
         investments and (v) acquisitions. The Company is required to obtain
         bank consent for an acquisition with a purchase price of $25.0 million
         or more or purchases aggregating $150 million in any 12-month period.

         The aggregate maturities of long-term debt at December 31, 1998, are as
         follows (in thousands):

<TABLE>
<S>                                                               <C>
                 1999                                             $     4,810
                 2000                                                   4,562
                 2001                                                   2,307
                 2002                                                     923
                 2003                                                 377,883
                 Thereafter                                             2,969
                                                                  -----------
                                                                  $   393,454
                                                                  ===========
</TABLE>

(11)     LEASES

         The Company has entered into operating leases for commercial property
         and equipment with affiliated physician groups and third parties.
         Commercial properties under operating leases include clinic buildings,
         satellite operations, and administrative facilities. Capital leases
         relating to equipment expire at various dates during the next five
         years.





                                       60
<PAGE>   60
         The future minimum lease payments under noncancelable operating leases
         net of sublease income and capital leases at December 31, 1998, are as
         follows (in thousands):

<TABLE>
<CAPTION>
                                                                                         Net
                                                                      Capital         Operating
                                                                      Leases            Leases
                                                                      ------            ------
<S>                                                                   <C>             <C>
                 1999                                                  $ 6,650          11,845
                 2000                                                    3,965           8,655
                 2001                                                    1,488           7,407
                 2002                                                      663           6,908
                 2003                                                      174           5,591
                 Thereafter                                                 12           6,470
                                                                       -------          ------
                       Total minimum lease payments                     12,952          46,876
                                                                       =======          ======
                 Less amount representing interest (at rates
                 ranging from 10% to 13%)                                1,247
                                                                       -------
                 Present value of net minimum capital lease
                 payments                                               11,705
                                                                       -------
                 Less current installments of obligations
                 under capital leases                                    5,687
                                                                       -------
                 Obligations under capital leases,
                 excluding current installments                        $ 6,018
                                                                       =======
</TABLE>

         Net payments under operating leases at December 31, 1998, include total
         commitments of $1,867,359,000 reduced by amounts to be reimbursed under
         clinic service agreements of $1,820,483,000. Payments due under
         operating leases include $1,417,889,000 payable to physician groups and
         their affiliates. Generally, in the event of a service agreement
         termination, any related lease obligations are also terminated.

(12)     SHAREHOLDERS' EQUITY

         (a)      Common Stock

         In the first quarter of 1997, the Company completed a public offering
         of 7,295,000 shares of its common stock. Net proceeds from the offering
         were approximately $210.0 million.

         On May 17, 1996, the Company declared a three-for-two stock split to
         shareholders of record on May 31, 1996. All common share and per share
         data included in the accompanying consolidated financial statements and
         footnotes thereto have been restated to reflect the stock split.

         In September 1998, the Company adopted a common stock repurchase
         program whereby the Company may repurchase up to $50.0 million of its
         common stock. In October 1998, the Company announced the expansion of
         its common stock repurchase program into a securities repurchase
         program to include the Company's 4.5% convertible subordinated
         debentures and other securities, the economic terms of which are
         derived from the common stock and/or debentures. In conjunction with
         the securities repurchase program, the Company has repurchased
         approximately 2,628,000 shares of common stock for approximately
         $12,590,000.

         (b)      Preferred Stock

         The Company has 10,000,000 shares of authorized but unissued preferred
         stock. The Company has reserved for issuance 500,000 shares of Series A
         Junior Participating Preferred Stock issuable in the event of certain
         change-in-control events.



                                       61
<PAGE>   61
         (c)      Warrants

         The following represents a summary of all warrants outstanding at
         December 31, 1998:

<TABLE>
<CAPTION>
                                                                                     EXERCISABLE
                                                                                         AT
        EXPIRATION                                     NUMBER         EXERCISE       DECEMBER 31,
        GRANT DATE                                      DATE          OF SHARES         PRICE             1998
        ----------                                      ----          ---------         -----             ----
<S>                                                    <C>            <C>            <C>                  <C>
        February 1992                                   2002               2,188       $  4.74              2,188

        June 1995                                       2005             348,001         15.40            348,001

        November 1995                                   2003             387,967         25.78                 --

        July 1996                                       2002              67,835         44.23             67,835

        February 1997                                   2007             250,000         31.13                 --

        May 1997                                        2007             250,000         27.75                 --

        August 1997                                     2002              40,000          3.16                 --
                                                                       ---------                          -------
                                                                       1,345,991                          418,024
                                                                       =========                          =======
</TABLE>


         (d)      1988 Stock Incentive Plan and Directors' Stock Plan

         The Company has two stock option plans. Under the Amended 1988
         Incentive Stock Plan ("Incentive Plan"), the Company has reserved
         17,000,000 shares of its common stock for issuance pursuant to option
         and stock grants to employees and directors. Under the Amended 1992
         Directors Stock Plan ("Directors Plan"), 337,500 shares of common stock
         are reserved. Under both plans, stock options are granted with an
         exercise price equal to the estimated fair market value of the
         Company's common stock on the date of grant. Most options under the
         Incentive Plan have a term of ten years and become exercisable in
         installments over periods ranging up to five years. Options under the
         Directors Plan have a term of ten years and are exercisable when
         granted.

         In August 1998, the Company adopted an option exchange program
         available to all option holders, excluding the executive officers and
         the Board of Directors. Such eligible holders were given the
         opportunity to exchange options granted after October 1994 for new
         options with a renewed four year vesting schedule representing fewer
         shares at an exercise price of $7.91 per share. Options to purchase an
         aggregate of 3,964,000 shares were issued as a result of the exchange
         of 8,575,000 previously issued options, (91% of eligible options.)

         At December 31, 1998, there were approximately 2,005,000 and 87,000
         additional shares available for grant under the Incentive Plan and the
         Directors Plan, respectively.

         The per share weighted-average fair value of stock options granted
         during 1998, 1997 and 1996 was $8.24, $15.18, and $16.97 on the date of
         grant using the Black Scholes option-pricing model with the following
         assumptions: an expected dividend yield of 0.0% for all years, expected
         volatility of 105% in 1998, and 56% in 1997 and 1996, risk-free
         interest rate ranging from 4.25% to 5.75% in 1998, 5.88% to 6.33% in
         1997 and 5.25% to 6.63% in 1996, and an expected life of two to five
         years for 1998 and five years for 1997 and 1996.

         The Company applies APB Opinion No. 25 in accounting for its Plans and,
         accordingly, no compensation cost has been recognized for its stock
         options in the consolidated financial statements. Had the Company
         determined compensation cost based on the fair value at the grant date
         for its stock options under SFAS No. 123, the Company's net earnings
         (loss) and per share amounts would have been reduced to the pro forma
         amounts indicated below (in thousands except for earnings per share):




                                       62
<PAGE>   62
<TABLE>
<CAPTION>
                                                                            1998           1997            1996
                                                                            ----           ----            ----
<S>                                                                      <C>              <C>           <C>
                 Net earnings (loss)
                      As reported                                        $ (111,447)        3,209         36,380
                      Pro forma                                            (130,579)      (13,806)        30,133
                 Basic earnings (loss) per share
                      As reported                                             (1.55)         0.05           0.67
                      Pro forma                                               (1.82)        (0.22)          0.55
                 Diluted earnings (loss) per share
                      As reported                                             (1.55)         0.05           0.60
                      Pro forma                                               (1.82)        (0.22)          0.49
</TABLE>

         Pro forma net earnings (loss) reflects only options granted beginning
         in 1995. Therefore, the full impact of calculating compensation cost
         for stock options under SFAS No. 123 is not reflected in the pro forma
         net earnings (loss) amounts presented above because compensation cost
         is reflected over the options' vesting period and compensation cost for
         options granted prior to January 1, 1995 is not considered.

         Stock option activity during the periods indicated is as follows
         (shares in thousands):

<TABLE>
<CAPTION>
                                                                                            Weighted-
                                                                                             Average
                                                                        Number               Exercise
                                                                      of Shares               Price
                                                                      ---------               -----
<S>                                                                   <C>                   <C>
        Balance at December 31, 1995                                     7,554               $ 11.93
              Granted                                                    3,164                 30.55
              Exercised                                                   (297)                 5.25
              Forfeited                                                   (134)                19.49
                                                                        ------               -------
        Balance at December 31, 1996                                    10,287                 17.84
              Granted                                                    3,542                 27.81
              Exercised                                                   (544)                 6.14
              Forfeited                                                   (302)                22.91
                                                                        ------               -------
        Balance at December 31, 1997                                    12,983                 20.99
              Granted                                                    8,742                 12.68
              Assumed in connection with acquisitions                      776                  6.77
              Exercised                                                 (1,050)                 6.64
              Forfeited                                                 (3,426)                21.49
              Exchanged                                                 (4,611)                18.64
                                                                        ------               -------
        Balance at December 31, 1998                                    13,414               $ 10.27
                                                                        ======               =======
</TABLE>

         At December 31, 1998, the range of exercise prices and weighted-average
         remaining contractual life of outstanding options was $0.75 - $30.75
         and 8.06 years, respectively.

         At December 31, 1998, 1997 and 1996, the number of options exercisable
         was 6,366,000, 2,268,000, and 1,392,000, respectively, and the
         weighted-average exercise price of those options was $13.87, $7.02, and
         $5.23, respectively.

         (e)      Stock Purchase Plans

         The Company has reserved 843,750 common shares for issuance pursuant to
         its employee stock purchase plan. During 1998 and 1997, approximately
         163,000 and 82,000 shares, respectively, were issued relative to the
         employee stock purchase plan. Shares issued under the employee stock
         purchase plan will generally


                                       63
<PAGE>   63
         be priced at the lower of 85% of the fair market value of the Company's
         common stock on the first or the last trading days of the plan year.

         The Company also established the 1996 Affiliate Stock Purchase Plan and
         has reserved 2,250,000 common shares for this plan. Eligible
         participants generally include physicians and other employees of
         medical clinics with which the Company has a management or service
         agreement and employees of limited liability companies and partnerships
         in which the Company has an equity interest of at least 50%. Shares
         issued under the plan to employees of limited liability companies and
         partnerships in which the Company has an equity interest of at least
         50% are priced using a method similar to that of the employee stock
         purchase plan. Shares issued under the plan to other participants are
         priced equal to 95% of the market price on the purchase date. During
         1998 and 1997, approximately 760,000 and 343,000 shares, respectively,
         were issued under this plan.

         Pro forma compensation expense included in the pro forma calculation
         above is recognized for the fair value of each stock purchase right
         estimated on the date of grant using the Black Scholes pricing model.
         The following assumptions were used for stock purchases: an expected
         dividend yield of 0.0% for all years, expected volatility of 105% in
         1998 and 56% in 1997 and 1996, risk-free interest rate of 5.5% in 1998,
         6.0% in 1997 and 6.25% in 1996, and an expected life of one year for
         all years.

         (f)      Reconciliation of Earnings Per Share Calculation

         The following is a reconciliation of the numerators and denominators of
         the basic and diluted earnings per share computations for net earnings
         (loss):

<TABLE>
<CAPTION>
                                                                     INCOME
                                                                     (LOSS)            SHARES          PER SHARE
                                                                   (NUMERATOR)      (DENOMINATOR)        AMOUNT
                                                                   -----------      -------------        ------
<S>                                                                <C>              <C>                <C>
        FOR THE YEAR ENDED DECEMBER 31, 1998
        BASIC EPS
        Loss attributable to common shareholders                     $(111,447)          71,822         $ (1.55)
                                                                                                        =======
        EFFECT OF DILUTIVE SECURITIES
        Options                                                             --               --
        Warrants                                                            --               --
        Convertible Notes                                                   --               --
                                                                     ---------           ------
        DILUTED EPS
        Loss attributable to common shareholders                     $(111,447)          71,822         $ (1.55)
                                                                     =========           ======         =======

        FOR THE YEAR ENDED DECEMBER 31, 1997
        BASIC EPS
        Income available to common shareholders                      $   3,209           62,899         $  0.05
                                                                                                        =======
        EFFECT OF DILUTIVE SECURITIES
        Options                                                             --            2,353
        Warrants                                                            --              225
        Convertible Notes                                                   --            1,457
                                                                     ---------           ------
        DILUTED EPS
        Income available to common shareholders                      $   3,209           66,934         $  0.05
                                                                     =========           ======         =======

        FOR THE YEAR ENDED DECEMBER 31, 1996
        BASIC EPS
        Income available to common shareholders                       $ 36,380           54,608         $  0.67
                                                                                                        =======

        EFFECT OF DILUTIVE SECURITIES
        Options                                                             --            4,520
        Warrants                                                            --              290
        Convertible Notes                                                                    --        1,678
                                                                                         ------        --------
</TABLE>


                                       64
<PAGE>   64
<TABLE>
<CAPTION>
                                                                     INCOME
                                                                     (LOSS)            SHARES          PER SHARE
                                                                   (NUMERATOR)      (DENOMINATOR)        AMOUNT
                                                                   -----------      -------------        ------
<S>                                                                <C>              <C>                <C>

        Diluted EPS
        Income available to common shareholders                       $ 36,380           61,096         $  0.60
                                                                      ========           ======         =======
</TABLE>

         Options and warrants to purchase 14,760,000 and 3,662,000 shares of
         common stock were outstanding at December 31, 1998 and 1997,
         respectively, but were not included in the computation of diluted EPS
         because the options' and warrants' exercise prices were greater than
         the average market price of the common shares and, in 1998, due to a
         loss for the year, resulting in the options and warrants being
         antidilutive. Antidilutive securities at December 31, 1998 also
         included 212,000 shares of common stock to be issued at future dates
         related to clinic acquisitions. Additionally, subordinated notes
         payable convertible into 1,636,000 and 1,057,000 shares at December 31,
         1998 and 1997, respectively, were antidilutive. Interest paid on the
         convertible notes is offset by service agreement fees received by the
         Company of an equal amount.

(13)     ASSET REVALUATION AND CLINIC RESTRUCTURING

         In the fourth quarter of 1997, the Company recorded a pre-tax charge to
         earnings of $83.4 million related to the revaluation of assets of seven
         of the Company's multi-specialty clinics. Included in the seven clinics
         were three clinic operations the Company determined to dispose of
         because of a variety of negative operating and market-specific issues.
         The pre-tax charge to earnings included $29.2 million related to write
         down of assets to be disposed of to fair value less costs to sell. The
         Company completed the disposal of one of these clinics in March of
         1998, a second in April 1998 and the third in July 1998. Amounts
         received upon the dispositions approximated the post-charge net
         carrying value of those assets. Clinic net assets to be disposed of
         included current assets, property and equipment, intangibles and other
         assets totaling $3,237,000 at December 31, 1997.

         In addition, the Company reviewed certain of its clinics, consistent
         with SFAS 121, when specific events occurred in the fourth quarter of
         1997 that indicated that the four clinics included in the charge could
         be impaired (i.e. physician group declared bankruptcy, notifications of
         physician termination, etc.). The Company determined that an impairment
         had occurred and wrote down the associated clinic assets and service
         agreement intangibles to fair value determined by discounting future
         operating cash flows of the related physician groups. The pre-tax
         charge to earnings included $54.2 million related to the impairment of
         assets at these four clinics.

         Restructuring charges totaling $22.0 million were recorded in the first
         quarter of 1998 with respect to clinics that were being sold or
         restructured. These charges were comprised of facility and lease
         termination costs, severance costs and other exit costs in the amounts
         of $15,316,000, $4,611,000 and $2,073,000, respectively. These
         restructuring plans included the involuntary termination of 344 local
         clinic management and business office personnel. During 1998, the
         Company paid approximately $3,033,000 in costs associated with facility
         and lease terminations, $2,690,000 in costs associated with severance
         and $1,398,000 in other exit costs. At December 31, 1998, accrued
         expenses payable included remaining reserves for clinics to be
         restructured and exit costs for disposed clinic operations of
         approximately $4,105,000, which included facility and lease termination
         costs, severance costs and other exit costs in the amounts of $740,000,
         $1,713,000 and $1,652,000, respectively. Remaining liabilities from the
         first quarter 1998 restructuring charge of approximately $10,774,000
         were reversed against the third quarter 1998 asset revaluation charge
         as the Company determined to dispose of certain clinic operations that
         were originally anticipated to be restructured.

         In the third quarter of 1998, the Company recorded a net pre-tax asset
         revaluation charge of $92.5 million, which is comprised of a $103.3
         million charge less the reversal of certain restructuring charges
         recorded in the first quarter of 1998. This third quarter charge
         related to deteriorating negative operating trends for


                                       65
<PAGE>   65
         three clinic operations which were included in the fourth quarter 1997
         asset revaluation charge, and the corresponding decision to dispose of
         those assets. Amounts received upon the dispositions of net assets
         approximated the post-charge net carrying value. Additionally, this
         charge provided for the disposition of assets of another clinic,
         completed in the third quarter, not included in the fourth quarter 1997
         asset revaluation charge, and the revaluation of assets at two other
         clinics that were being disposed of or restructured. The Company
         completed the disposal of one of these clinics in the fourth quarter,
         and amounts received upon the disposition approximated the post-charge
         net carrying value of those assets.

         In the fourth quarter of 1998, the Company recorded a pre-tax asset
         revaluation charge of $110.4 million. This charge related to
         adjustments of the carrying value of the Company's assets at two
         clinics as a result of agreements to sell certain assets associated
         with the related service agreements that are expected to be terminated,
         and an adjustment to recognize the decline in future cash flows from
         the acquired physician practice management company, FPC, pursuant to
         SFAS 121. Additionally, this charge provided for the write-off of
         goodwill recorded in connection with the MHG acquisition and the write
         down of certain assets to net realizable value and service agreement
         intangibles to fair value at another clinic.

         Clinic net assets to be disposed of totaled $41,225,000 at December 31,
         1998, and consisted of current assets, property and equipment,
         intangibles and other assets from three clinics associated with the
         fourth quarter 1998 asset revaluation charge and one clinic included in
         the fourth quarter 1997 and third quarter 1998 asset revaluation
         charges. The Company expects to dispose of the assets and terminate the
         service agreements related to such clinics in 1999. Net revenue and
         pre-tax income (loss) from the clinics and IPA disposed of or to be
         disposed of totaled $175,408,000 and $(2,064,000), respectively, in
         1998 and $186,296,000 and $1,507,000, respectively, in 1997.

(14)     MERGER EXPENSES

         The Company recorded a pre-tax charge to earnings of approximately
         $14.2 million in the first quarter of 1998 relating to the termination
         of its merger agreement with MedPartners, Inc. This charge represents
         the Company's share of investment banking, legal, travel, accounting
         and other expenses incurred during the merger negotiation process.

(15)     INCOME TAX EXPENSE

         Income tax expense for the years ended December 31, 1998, 1997 and
         1996, consists of (in thousands):

<TABLE>
<CAPTION>
                                             1998                1997                1996
                                             ----                ----                ----
<S>                                      <C>                   <C>                 <C>
        Current:
              Federal                    $     300              12,724              10,935
              State                          2,821               3,051               2,224
        Deferred:
              Federal                      (42,124)            (10,391)              9,354
              State                           (887)                714                 262
                                         ---------             -------              ------
                                         $ (39,890)              6,098              22,775
                                         =========             =======              ======
</TABLE>

         For federal income tax purposes, the Company receives a deduction
         arising from the exercise of non-qualified stock options equal to the
         difference between the fair market value at date of exercise and the
         exercise price. This tax benefit was recorded as a credit to common
         stock in the amount of $4,686,000, $5,464,000, and $2,940,000 in 1998,
         1997 and 1996, respectively.

         Total income tax expense (benefit) differed from the amount computed by
         applying the U.S. federal income tax rate of 35 percent in 1998, 1997
         and 1996 to earnings (loss) before income taxes as a result of the
         following (in thousands):



                                       66
<PAGE>   66
<TABLE>
<CAPTION>
                                                                        1998               1997              1996
                                                                        ----               ----              ----
<S>                                                                   <C>                 <C>               <C>
Computed "expected" tax expense (benefit)                             $(52,968)            3,257            20,704

Increase (reduction) in income taxes resulting from:

State income taxes, net of federal income tax benefit                    1,257             2,447             1,616

Amortization of nondeductible goodwill                                   4,103               791               499

Nondeductible goodwill written off                                       8,582                --                --

Other, net                                                                (864)             (397)              (44)

      Total income tax expense (benefit)                              $(39,890)            6,098            22,775
                                                                      ========             =====            ======
</TABLE>


         The tax effects of temporary differences that give rise to significant
         portions of the deferred tax assets and deferred tax liabilities at
         December 31 are presented below (in thousands):

<TABLE>
<CAPTION>
                                                                                     1998                1997
                                                                                     ----                ----
<S>                                                                                <C>                <C>
        Deferred tax assets:
             Reserves (including incurred but not reported
                 self-insurance claims)                                            $ 39,241           $   9,289
             Operating loss carryforwards                                            88,959               9,668
             Cash to accrual adjustment                                              11,476              14,883
             Other                                                                    6,717               2,406
                 Total gross deferred tax asset                                     146,393              36,246
        Valuation allowance                                                          43,519              12,315
             Net deferred tax assets                                                102,874              23,931
        Deferred tax liabilities:
             Plant and equipment, principally due to differences in
                 depreciation                                                        14,430              10,398
             Capital leases                                                           4,339               3,672
             Clinic service agreements                                               41,626              24,971
             Prepaid expenses                                                         1,634               2,033
             Income from partnerships                                                 3,336               4,889
             Accounts receivable                                                      2,853               3,811
             Other                                                                    1,910               1,397
                 Total gross deferred tax liabilities                                70,128              51,171
                 Net deferred tax assets (liabilities)                             $ 32,746            $(27,240)
                                                                                   ========            ========
</TABLE>

         The significant components of the deferred tax expense as of December
         31, 1998 and 1997 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                     1998                1997
                                                                                     ----                ----
<S>                                                                                <C>                 <C>
        Change in net deferred tax assets (liabilities)                            $(59,986)           $  9,966
        Deferred taxes of acquired entities                                          16,975             (19,643)
                  Deferred tax benefit                                             $(43,011)           $ (9,677)
                                                                                   ========            ========
</TABLE>

         The net change in the total valuation allowance for the year ended
         December 31, 1998, which primarily relates to federal and state net
         operating loss carryforwards and expenses relating to the provision for
         asset revaluation and restructuring charges not expected to be
         deductible for state tax purposes, was an increase of $31,204,000. As
         of December 31, 1998, the Company had approximately 207,897,000 of
         federal and $352,633,000 of state net operating loss carryforwards
         which begin to expire in 2007. The utilization of these carryforwards
         is subject to the future level of taxable income of the Company and its
         applicable subsidiaries. However, the Company believes the full benefit
         of the deferred tax assets (net of valuation allowance) will be
         obtained based upon its evaluation of the Company's anticipated
         profitability over the


                                       67
<PAGE>   67
         period of years the operating loss carryforwards are available for
         utilization or that the other temporary differences are expected to
         become tax deductions. Regardless of the Company's expectations, there
         can be no assurance that the Company will generate any specific level
         of continuing earnings. Refundable federal and state income taxes
         totaled approximately $13,968,000 and $14,751,000 at December 31, 1998
         and 1997, respectively.

         The Company has been the subject of an audit by the Internal Revenue
         Service (IRS) covering the years 1988 through 1993. The IRS has
         proposed adjustments relating to the timing of recognition for tax
         purposes of deductions relating to uncollectible accounts. PhyCor
         disagrees with the positions asserted by the IRS and is vigorously
         contesting these proposed adjustments. Most of the issues originally
         raised by the IRS as to revenues and deductions and the Company's
         relationship with affiliated physician groups have been resolved by the
         National Office of the IRS in favor of the Company and with respect to
         these issues, no additional taxes, penalties or interest are owed by
         the Company related to such claims. The IRS Appeals Office has raised
         another but similar issue concerning the recognition of income with
         respect to accounts receivable but it is unclear whether the IRS will
         pursue this similar issue. The Company is prepared to continue to
         vigorously contest any proposed adjustment on this similar issue. The
         Company believes that any adjustments resulting from resolution of this
         disagreement would not affect reported net earnings of PhyCor, but
         would defer tax benefits and change the levels of current and deferred
         tax assets and liabilities. For the years under audit, and potentially
         for subsequent years, any such adjustments could result in material
         cash payments by the Company. Any successful adjustment by the IRS
         would cause interest expense to be incurred. PhyCor does not believe
         the resolution of this matter will have a material adverse effect on
         its financial condition, although there can be no assurance as to the
         outcome of this matter. In addition, the IRS is in the process of
         examining the Company's 1994 and 1995 federal tax returns.

(16)     EMPLOYEE BENEFIT PLANS

         As of January 1, 1989, the Company adopted the PhyCor, Inc. Savings and
         Profit Sharing Plan. The Plan is a defined contribution plan covering
         most employees. Company contributions are based on specified
         percentages of employee compensation. The Company funds contributions
         as accrued. The plan expense for 1998, 1997 and 1996 amounted to
         $14,012,000, $10,245,000, and $7,803,000, respectively. Approximately
         $803,000 of the increase in 1998 plan expense was due to 1998
         acquisitions and the timing of 1997 acquisitions.

         In connection with certain of the Company's acquisitions, the Company
         adopted defined contribution employee retirement plans previously
         sponsored solely by the physician groups. The Company has recognized as
         expense its required contributions to be made to the plans of
         approximately $7,632,000, $4,789,000, and $3,174,000 relative to its
         employees for 1998, 1997 and 1996, respectively. Approximately
         $1,900,000 of the increase in 1998 plan expense was due to 1998
         acquisitions and the timing of 1997 acquisitions.

(17)     COMMITMENTS AND CONTINGENCIES

         (a)      Employment Agreements

         The Company has entered into employment agreements with certain of its
         management employees, which include, among other terms, non-compete
         provisions and salary and benefits continuation.

         (b)      Commitments to Physician Groups

         Under terms of certain of its service agreements, the Company is
         committed to provide capital for the improvement and expansion of
         clinic facilities. The commitments vary depending on such factors as
         total capital expenditures, the number of physicians practicing at each
         clinic, and the cost of specific planned projects. All projects funded
         under these commitments must be approved by the Company before they
         commence.



                                       68
<PAGE>   68
         The Company is also committed to provide, under certain circumstances,
         advances to physician groups to principally finance the recruitment of
         new physicians. These advances will be repaid out of the physician
         groups' share of future clinic revenue. At December 31, 1998 and 1997,
         $2,883,000 and $4,038,000, respectively, of such advances were
         outstanding.

         (c)      Litigation

         The Company and certain of its current and former officers and
         directors have been named defendants in nine securities fraud class
         actions filed between September 8 and October 23, 1998. The factual
         allegations of the complaints in all nine actions are substantially
         identical and assert that during various periods between April 22, 1997
         and September 22, 1998, the defendants issued false and misleading
         statements which materially misrepresented the earnings and financial
         condition of the Company and its clinic operations and misrepresented
         and failed to disclose various other matters concerning the Company's
         operations in order to conceal the alleged failure of the Company's
         business model. Plaintiffs further assert that the alleged
         misrepresentations caused the Company's securities to trade at inflated
         levels while the individual defendants sold shares of the Company's
         stock at such levels. In each of the nine actions, the plaintiff seeks
         to be certified as the representative of a class of all persons
         similarly situated who were allegedly damaged by the defendants'
         alleged violations during the "class period." Each of the actions seeks
         damages in an indeterminate amount, interest, attorneys' fees and
         equitable relief, including the imposition of a trust upon the profits
         from the individual defendants' trades. The federal court actions have
         been consolidated in the U.S. District Court for the Middle District of
         Tennessee. Defendants' motion to dismiss is pending before that court.
         The state court actions have been consolidated in Davidson County,
         Tennessee. The Company believes that it has meritorious defenses to all
         of the claims, and intends to vigorously defend against these actions.
         There can be no assurance, however, that such defenses will be
         successful or that the lawsuits will not have a material adverse effect
         on the Company. The Company's Restated Charter provides that the
         Company shall indemnify the officers and directors for any liability
         arising from these suits unless a final judgment establishes liability
         (a) for a breach of the duty of loyalty to the Company or its
         shareholders, (b) for acts or omissions not in good faith or which
         involve intentional misconduct or a knowing violation of law or (c)
         under Section 48-18-304 of the Tennessee Business Corporation Act.

         On January 23, 1999, the Company and Holt-Krock entered into a
         settlement agreement with Sparks to resolve their lawsuits and all
         related claims between the parties and certain former Holt-Krock
         physicians. As a result, Sparks is expected to acquire certain assets
         from PhyCor, offer employment to a substantial number of Holt-Krock
         physicians and enter into a long-term agreement whereby PhyCor will
         provide key physician practice management resources to Sparks. These
         transactions are expected to be completed on or before May 31, 1999,
         upon execution of definitive agreements. However, there can be no
         assurance that the transaction will be completed or that it will be
         completed on the terms described above.

         On February 2, 1999, the former majority shareholder in PrimeCare filed
         suit against the Company and certain of its current and former
         executive officers in United States District Court for the Central
         District of California. The complaint asserts fraudulent inducement
         relating to the PrimeCare acquisition and that the defendants issued
         false and misleading statements which materially misrepresented the
         earnings and financial condition of the Company and its clinic
         operations and misrepresented and failed to disclose various other
         matters concerning the Company's operations in order to conceal the
         alleged failure of the Company's business model. The Company believes
         that it has meritorious defenses to all of the class and intends to
         vigorously defend this suit, however, there can be no assurance that
         such litigation, if the Company is not successful, will not have a
         material adverse effect on the Company.

         On February 6, 1999, White-Wilson Medical Center filed suit against the
         PhyCor subsidiary with which it is a party to a service agreement in
         the United States District Court for the Northern District of Florida.
         White-Wilson is seeking a declaratory judgment regarding the
         enforceability of the fee arrangement in light of the Florida Board of
         Medicine opinion and OIG Advisory Opinion 98-4. Additionally, on March
         17, 1999, the Clark-Holder Clinic filed suit against the PhyCor
         subsidiary with which it is a party to a


                                       69
<PAGE>   69
         service agreement in Georgia Superior Court for Troup County, Georgia
         similarly questioning the enforceability of the fee arrangement in
         light of OIG Advisory Opinion 98-4. The terms of the service agreements
         provide that the agreements shall be modified if the laws are changed,
         modified or interpreted in a way that requires a change in the
         agreements. PhyCor intends to vigorously defend these suits, however,
         there can be no assurance that such litigation, if the Company is not
         successful, will not have a material adverse effect on the Company.

         Certain litigation is pending against the physician groups affiliated
         with the Company and IPAs managed by the Company. The Company has not
         assumed any liability in connection with such litigation. Claims
         against the physician groups and IPAs could result in substantial
         damage awards to the claimants which may exceed applicable insurance
         coverage limits. While there can be no assurance that the physician
         groups and IPAs will be successful in any such litigation, the Company
         does not believe any such litigation will have a material adverse
         effect on the Company. Certain other litigation is pending against the
         Company and certain subsidiaries of the Company, none of which
         management believes would have a material adverse effect on the
         Company's financial position or results of operations.

         (d)      Insurance

         The Company and its affiliated physician groups are insured with
         respect to medical malpractice risks on a claims-made basis. There are
         known claims and incidents that may result in the assertion of
         additional claims, as well as claims from unknown incidents that may be
         asserted. Management is not aware of any claims against it or its
         affiliated physician groups which might have a material impact on the
         Company's financial position.

         (e)      Letters of credit

         On behalf of certain of the Company's affiliated IPAs, the Company has
         been required to underwrite letters of credit to managed care payors to
         help ensure payment of health care costs for which the affiliated IPAs
         have assumed responsibility. As of December 31, 1998, letters of credit
         aggregating $7.0 million were outstanding under the credit facility for
         the benefit of managed care payors. The Company would ask reimbursement
         from an IPA if there was a draw on a letter of credit. No draws on any
         of these letters of credit have occurred to date.

         (f)      Contingent consideration

         In connection with the acquisition of clinic operating assets, the
         Company is contingently obligated to pay an estimated additional
         $63,000,000 in future years, depending on the achievement of certain
         financial and operational objectives by the related physician groups.
         Such liability, if any, will be recorded in the period in which the
         outcome of the contingencies become known. Any payment made will be
         recorded to clinic service agreements and will not immediately be
         charged to expense.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

         Not Applicable.




                                       70
<PAGE>   70
                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         Information with respect to the executive officers of the Company is
set forth in the Company's Definitive Proxy Statement relating to the Annual
Meeting of Shareholders to be held on May 25, 1999 under the caption "Executive
Compensation Executive Officers of the Company" and is incorporated herein by
reference. Information with respect to the directors of the Company is set forth
in the Company's Definitive Proxy Statement relating to the Annual Meeting of
Shareholders to be held on May 25, 1999 under the caption "Election of
Directors" and is incorporated herein by reference. Information with respect to
compliance with Section 16(a) of the Securities Exchange Act of 1934 is set
forth in the Company's Definitive Proxy Statement relating to the Annual Meeting
of Shareholders to be held on May 25, 1999 under the caption "Compliance With
Reporting Requirements of the Exchange Act" and is incorporated herein by
reference.

ITEM 11. EXECUTIVE COMPENSATION

         Information with respect to executive compensation is set forth in the
Company's Definitive Proxy Statement relating to the Annual Meeting of
Shareholders to be held on May 25, 1999 under the caption "Executive
Compensation" and is incorporated herein by reference, except that the
Comparative Performance Graph and the Compensation Committee Report on Executive
Compensation included in the Definitive Proxy Statement are expressly not
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         Information with respect to the security ownership of certain
beneficial owners and management is set forth in the Company's Definitive Proxy
Statement relating to the Annual Meeting of Shareholders to be held on May 25,
1999 under the caption "Voting Securities and Principal Holders Thereof" and is
incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Information with respect to certain relationships and related
transactions is set forth in the Company's Definitive Proxy Statement relating
to the Annual Meeting of Shareholders to be held on May 25, 1999 under the
caption "Certain Relationships and Related Transactions" and is incorporated
herein by reference.

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)      Index to Consolidated Financial Statements, Financial Statement
         Schedules and Exhibits

         (1)      Financial Statements: See Item 8 herein.

         (2)      Financial Statement Schedules:

                  Independent Auditors' Report                              S-1

                  Schedule II - Valuation and Qualifying Accounts           S-2

All other schedules are omitted, because they are not applicable or not
required, or because the required information is included in the consolidated
financial statements or notes thereto.




                                       71
<PAGE>   71
(3)      Exhibits:

<TABLE>
<CAPTION>
EXHIBIT
NUMBER             DESCRIPTION OF EXHIBITS
------             -----------------------
<S>       <C>      <C>
3.1       --       Amended Bylaws of the Registrant (1)
3.2       --       Restated Charter of the Registrant (1)
3.3       --       Amendment to Restated Charter of the Registrant (2)
3.4       --       Amendment to Restated Charter of the Registrant (3)
4.1       --       Form of 4.5% Convertible Subordinated Debenture due 2003(4)
4.2       --       Form of Indenture by and between the Registrant and First American National Bank, N.A. (4)
10.1      --       Form of Amended and Restated Employment Agreements dated August 1, 1997 entered into by each of
                   Messrs. Hutts, Reeves, Dent and Wright (5)
10.2      --       Registrant's Amended 1988 Incentive Stock Plan (5)
10.3      --       Registrant's Amended 1992 Non-Qualified Stock Option Plan  for Non-Employee Directors (5)
10.4      --       Registrant's 1991 Amended Employee Stock Purchase Plan (6)
10.5      --       Registrant's Savings and Profit Sharing Plan (6)
10.6      --       $500,000,000 Second Amended and Restated Revolving Credit Agreement dated as of April 2, 1998,
                   among the Registrant, the Banks named therein and Citibank, N.A. (5)
10.7      --       Amended and Restated Agreement of Merger, dated October 1, 1996, by and between the Registrant
                   and Straub Clinic & Hospital, Incorporated (7)
10.8      --       Service Agreement, dated as of January 17, 1997, by and between PhyCor of Hawaii, Inc. and
                   Straub Clinic & Hospital, Inc. (8)
10.9      --       Supplemental Executive Retirement Plan (5)
21        --       List of subsidiaries of the Registrant (9)
23        --       Consent of KPMG LLP
27        --       Financial Data Schedule for fiscal year ended December 31, 1998 (for SEC use only) (9)
</TABLE>

--------------------
(1)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1994,
          Commission No. 0-19786.
(2)       Incorporated by referenced to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Commission No. 33-93018.
(3)       Incorporated by referenced to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Commission No. 33-98528.
(4)       Incorporated by reference to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Registration No. 333-328.
(5)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1997,
          Commission No. 0-19786.
(6)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1993,
          Commission No. 0-19786.
(7)       Incorporated by reference to exhibits filed with the Registrant's
          Registration Statement on Form S-4, Commission No. 333-15459.
(8)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1991,
          Commission No. 0-19786.
(9)       Previously filed.




                                       72
<PAGE>   72
                  EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS

         The following is a list of all executive compensation plans and
arrangements filed as exhibits to this Annual Report on Form 10-K:

         (1)      Form of Amended Employment Agreement, dated as of August 1,
                  1997, between the Registrant and each of Messrs. Hutts,
                  Reeves, Dent and Wright (filed as Exhibit 10.1)

         (2)      Registrant's Amended 1988 Incentive Stock Plan (filed as
                  Exhibit 10.2)

         (3)      Registrant's Amended 1992 Non-Qualified Stock Option Plan for
                  Non-Employee Directors (filed as Exhibit 10.3)

         (4)      Supplemental Executive Retirement Plan (filed as Exhibit 10.9)

(b)      Reports on Form 8-K

         Not applicable.

(c)      Exhibits

         The response to this portion of Item 14 is submitted as a separate
         section of this report. See Item 14(a)(3)

(d)      Financial Statement Schedules

         The response to this portion of Item 14 is submitted as a separate
         section of this report. See Item 14(a)(2).





                                       73
<PAGE>   73
                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Nashville,
State of Tennessee, on February 14, 2000.

                                           PHYCOR, INC.

                                           By:    /s/ JOSEPH C. HUTTS
                                              ----------------------------------
                                                     Joseph C. Hutts
                                                  Chairman of the Board
                                            and Chief Executive Officer
<PAGE>   74
                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders
PhyCor, Inc.:

Under date of February 23, 1999, except as to notes 10 and 17 which are as of
March 17, 1999, we reported on the consolidated balance sheets of PhyCor, Inc.
and subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
years in the three-year period ended December 31, 1998, as contained in the 1998
annual report to shareholders. These consolidated financial statements and our
report thereon are included in the Annual Report on Form 10-K for the year 1998.
In connection with our audits of the aforementioned consolidated financial
statements, we also audited the related financial statement schedule. The
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on the financial statement schedule
based on our audits.

In our opinion, the financial statement schedule, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly,
in all material respects, the information set forth therein.


                                            /s/ KPMG LLP

Nashville, Tennessee
February 23, 1999






                                      S-1
<PAGE>   75
                          PHYCOR, INC. AND SUBSIDIARIES

                                   SCHEDULE II
                        VALUATION AND QUALIFYING ACCOUNTS




<TABLE>
<CAPTION>
                                                            BEGINNING       ADDITIONS      DEDUCTIONS      OTHER(1)      ENDING
                                                             BALANCE         EXPENSE       ----------      -------       BALANCE
                                                             -------         -------                                     -------
<S>                                                        <C>              <C>            <C>             <C>           <C>
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND
CONTRACTUAL ADJUSTMENTS (IN THOUSANDS)
December 31, 1996                                          $  82,205           699,186       (688,276)      41,441       134,556
                                                           =========         =========     ==========       ======       =======

December 31, 1997                                           $134,556         1,090,329     (1,050,164)      33,813       208,534
                                                            ========         =========     ==========       ======       =======

December 31, 1998                                           $208,534         1,419,501     (1,432,358)      35,108       230,785
                                                            ========         =========     ==========       ======       =======
</TABLE>

--------------------
(1)      represents allowances of acquisitions


See accompanying independent auditors' report.






                                      S-2
<PAGE>   76
                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                 DESCRIPTION OF EXHIBITS
------                 -----------------------
<S>           <C>      <C>
     3.1      --       Amended Bylaws of the Registrant (1)
     3.2      --       Restated Charter of the Registrant (1)
     3.3      --       Amendment to Restated Charter of the Registrant (2)
     3.4      --       Amendment to Restated Charter of the Registrant (3)
     4.1      --       Form of 4.5% Convertible Subordinated Debenture due 2003(4)
     4.2      --       Form of Indenture by and between the Registrant and First American National Bank, N.A. (4)
     10.1     --       Form of Amended and Restated Employment Agreements dated August 1, 1997 entered into
                       by each of Messrs. Hutts, Reeves, Dent and Wright (5)
     10.2     --       Registrant's Amended 1988 Incentive Stock Plan (5)
     10.3     --       Registrant's Amended 1992 Non-Qualified Stock Option Plan for Non-Employee Directors (5)
     10.4     --       Registrant's 1991 Amended Employee Stock Purchase Plan (6)
     10.5     --       Registrant's Savings and Profit Sharing Plan (6)
     10.6     --       $500,000,000 Second Amended and Restated Revolving Credit Agreement dated as of April
                       2, 1998, among the Registrant, the Banks named therein and Citibank, N.A. (5)
     10.7     --       Amended and Restated Agreement of Merger, dated October 1, 1996, by and between the
                       Registrant and Straub Clinic & Hospital, Incorporated (7)
     10.8     --       Service Agreement, dated as of January 17, 1997, by and between PhyCor of Hawaii, Inc.
                       and Straub Clinic & Hospital, Inc. (7)
     10.9     --       Supplemental Executive Retirement Plan (5)
     21       --       List of subsidiaries of the Registrant (9)
     23       --       Consent of KPMG LLP
     27.1     --       Financial Data Schedule for fiscal year ended December 31, 1998 (for SEC use only) (9)
</TABLE>

--------------------

(1)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1994,
          Commission No. 0-19786.
(2)       Incorporated by referenced to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Commission No. 33-93018.
(3)       Incorporated by referenced to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Commission No. 33-98528.
(4)       Incorporated by reference to exhibits filed with the Registrant's
          Registration Statement on Form S-3, Registration No. 333-328.
(5)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1997,
          Commission No. 0-19786.
(6)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1993,
          Commission No. 0-19786.
(7)       Incorporated by reference to exhibits filed with the Registrant's
          Registration Statement on Form S-4, Commission No. 333-15459.
(8)       Incorporated by reference to exhibits filed with the Registrant's
          Annual Report on Form 10-K for the year ended December 31, 1991,
          Commission No. 0-19786.
(9)       Previously filed.