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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended November 30, 2004



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



Commission File Number: 000-21574



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DYNACQ HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 76-0375477                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|10304 Interstate 10 East, Suite 369                            |  |                                     
|Houston, Texas                                                 |  | 77029                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



(713) 378-2000

(Registrants telephone number, including area code)



---



Indicate by
check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No ̈



As of January 5, 2005, the number of shares outstanding of the registrants common stock, par value $.001 per share, was 14,851,568.



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##### Table of Contents

Table of Contents



|                                                        |  |                                                                                             |  |   
|------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --
|Report of Independent Registered Public Accounting Firm |  | 3                                                                                          
|                                                        | 
|PART I
FINANCIAL INFORMATION                           |  |                                                                                            
|                                                        |  |                                                                                            
|Item 1.                                                 |  | Financial Statements.                                                                       |  | 4 
|                                                        |  |                                                                                            
|                                                        |  | Consolidated Balance Sheets as of November 30, 2004 and August 31, 2004                     |  | 4 
|                                                        |  |                                                                                            
|                                                        |  | Consolidated Statements of Operations for the three months ended November 30, 2004 and 2003 |  | 6 
|                                                        |  |                                                                                            
|                                                        |  | Consolidated Statements of Cash Flows for the three months ended November 30, 2004 and 2003 |  | 7 
|                                                        |  |                                                                                            
|                                                        |  | Notes to Consolidated Financial Statements                                                  |  | 8 
|                                                        |  |                                                                                            
|Item 2.                                                 |  | Managements Discussion and Analysis of Financial Condition and Results of Operations.      |  | 14
|                                                        |  |                                                                                            
|Item 3.                                                 |  | Quantitative and Qualitative Disclosure About Market Risk.                                  |  | 17
|                                                        |  |                                                                                            
|Item 4.                                                 |  | Controls and Procedures.                                                                    |  | 17
|                                                        | 
|PART II
OTHER INFORMATION                              |  |                                                                                            
|                                                        |  |                                                                                            
|Item 1.                                                 |  | Legal Proceedings.                                                                          |  | 18
|                                                        |  |                                                                                            
|Item 2.                                                 |  | Unregistered Sales of Equity Securities and Use of Proceeds.                                |  | 19
|                                                        |  |                                                                                            
|Item 3.                                                 |  | Defaults Upon Senior Securities.                                                            |  | 19
|                                                        |  |                                                                                            
|Item 4.                                                 |  | Submission of Matter to a Vote of Security Holders.                                         |  | 19
|                                                        |  |                                                                                            
|Item 5.                                                 |  | Other Information.                                                                          |  | 19
|                                                        |  |                                                                                            
|Item 6.                                                 |  | Exhibits.                                                                                   |  | 19
|                                                        | 
|Signatures                                              |  | 20                                                                                         
|                                                        | 
|Index of Exhibits                                       |  | 21                                                                                         



2



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



|To: | The Stockholders and Board of Directors
|--- | ---------------------------------------

Dynacq Healthcare, Inc.

Houston, Texas



We have reviewed the consolidated balance sheet of Dynacq Healthcare, Inc., as of November
30, 2004, and the related consolidated statements of operations and cash flows for the three-month periods ended November 30, 2004 and 2003. These interim financial statements are the responsibility of the Companys management.



We conducted our review in accordance with the standards of the Public Company Accounting
Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope
than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express
such an opinion.



Based on our reviews, we are not aware of any material
modifications that should be made to the consolidated interim financial statements for them to be in conformity with United States generally accepted accounting principles.



We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheet of Dynacq Healthcare, Inc., as of August 31, 2004, and the related consolidated statements of operations, stockholders equity, and cash flows for the year then ended not presented herein, and in our report dated
October 30, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of August 31, 2004, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been derived.



/s/ Killman, Murrell & Company, P.C.

Killman, Murrell & Company, P.C.

Houston, Texas

January 5, 2005



3



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PART I - FINANCIAL INFORMATION



ITEM I - FINANCIAL STATEMENTS



Dynacq Healthcare, Inc.

Consolidated Balance Sheets



|                                                                                                                                                                                                                                                             |  |                  |            |                |   |           
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------- | ---------- | -------------- | - | ----------
|                                                                                                                                                                                                                                                             |  | November 30,2004 |            | August 31,2004
|                                                                                                                                                                                                                                                             |  | (Reviewed)       |            | (Audited)     
|Assets                                                                                                                                                                                                                                                       |  |                  |            |                |   |           
|Current assets:                                                                                                                                                                                                                                              |  |                  |            |                |   |           
|Cash                                                                                                                                                                                                                                                         |  | $                | 7,723,074  |                | $ | 5,537,776 
|Current portion of accounts receivable, net of contractual allowances of approximately $73,890,000 and $76,736,000 and allowances for
uncollectible accounts of approximately $744,000 and $719,000 at November 30, 2004 and August 31, 2004, respectively   |  |                  | 15,475,191 |                |   | 16,629,780
|Accounts receivable - other                                                                                                                                                                                                                                  |  |                  | 332,929    |                |   | 152,525   
|Inventories                                                                                                                                                                                                                                                  |  |                  | 2,545,705  |                |   | 2,576,067 
|Prepaid expenses                                                                                                                                                                                                                                             |  |                  | 540,655    |                |   | 668,270   
|Deferred tax assets                                                                                                                                                                                                                                          |  |                  | 1,335,326  |                |   | 1,294,555 
|Income taxes receivable                                                                                                                                                                                                                                      |  |                  | 3,833,298  |                |   | 5,523,248 
|                                                                                                                                                                                                                                                             |  |                  |            |                |   |           
|Total current assets                                                                                                                                                                                                                                         |  |                  | 31,786,178 |                |   | 32,382,221
|                                                                                                                                                                                                                                                             |  |                 
|Property and equipment, net                                                                                                                                                                                                                                  |  |                  | 37,687,498 |                |   | 38,004,680
|Long-term portion of accounts receivable, net of contractual allowances of approximately $56,765,000 and $51,445,000 and allowances for
uncollectible accounts of approximately $572,000 and $482,000 at November 30, 2004 and August 31, 2004, respectively |  |                  | 11,888,584 |                |   | 11,148,789
|Goodwill                                                                                                                                                                                                                                                     |  |                  | 582,547    |                |   | 582,547   
|Other assets                                                                                                                                                                                                                                                 |  |                  | 1,043,183  |                |   | 1,023,595 
|                                                                                                                                                                                                                                                             |  |                  |            |                |   |           
|Total assets                                                                                                                                                                                                                                                 |  | $                | 82,987,990 |                | $ | 83,141,832
|                                                                                                                                                                                                                                                             |  |                  |            |                |   |           



See accompanying
notes.



4



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##### Table of Contents

Dynacq Healthcare, Inc.

Consolidated Balance Sheets (continued)



|                                                                                                                                   |  |                  |            |   |                |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ---------- | - | -------------- | - | ---------- | -
|                                                                                                                                   |  | November 30,2004 |            |   | August 31,2004 |  
|                                                                                                                                   |  | (Reviewed)       |            |   | (Audited)      |  
|Liabilities and stockholders equity                                                                                               |  |                  |            |   |                |   |            |  
|Current liabilities:                                                                                                               |  |                  |            |   |                |   |            |  
|Cash overdraft                                                                                                                     |  | $                |           |   |                | $ | 622,375    |  
|Accounts payable                                                                                                                   |  |                  | 4,379,827  |   |                |   | 4,741,992  |  
|Accrued liabilities                                                                                                                |  |                  | 6,110,232  |   |                |   | 4,912,816  |  
|Notes payable                                                                                                                      |  |                  | 6,466,683  |   |                |   | 6,590,004  |  
|Current taxes payable                                                                                                              |  |                  | 454,016    |   |                |   | 379,094    |  
|Current portion of capital lease obligations                                                                                       |  |                  | 141,225    |   |                |   | 127,087    |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Total current liabilities                                                                                                          |  |                  | 17,551,983 |   |                |   | 17,373,368 |  
|Non-current liabilities:                                                                                                           |  |                  |            |   |                |   |            |  
|Deferred tax liabilities                                                                                                           |  |                  | 1,499,698  |   |                |   | 1,600,705  |  
|Long-term portion of capital lease obligations                                                                                     |  |                  | 242,231    |   |                |   | 290,308    |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Total liabilities                                                                                                                  |  |                  | 19,293,912 |   |                |   | 19,264,381 |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Minority interests                                                                                                                 |  |                  | 717,386    |   |                |   | 666,794    |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Commitments and contingencies                                                                                                      |  |                  |           |   |                |   |           |  
|Stockholders equity:                                                                                                              |  |                  |            |   |                |   |            |  
|Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued or outstanding                                           |  |                  |           |   |                |   |           |  
|Common stock, $.001 par value; 100,000,000 shares authorized, 16,399,843 shares issued at November 30, 2004 and at August 31,
2004 |  |                  | 16,400     |   |                |   | 16,400     |  
|Treasury stock, 1,548,275 shares at November 30, 2004 and at August 31, 2004, at cost                                              |  |                  | (7,424,449 | ) |                |   | (7,424,449 | )
|Additional paid-in capital                                                                                                         |  |                  | 18,980,710 |   |                |   | 18,982,951 |  
|Retained earnings                                                                                                                  |  |                  | 51,835,852 |   |                |   | 52,113,026 |  
|Deferred compensation                                                                                                              |  |                  | (431,821   | ) |                |   | (477,271   | )
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Total stockholders equity                                                                                                         |  |                  | 62,976,692 |   |                |   | 63,210,657 |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  
|Total liabilities and stockholders equity                                                                                         |  | $                | 82,987,990 |   |                | $ | 83,141,832 |  
|                                                                                                                                   |  |                  |            |   |                |   |            |  



See accompanying
notes.



5



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##### Table of Contents

Dynacq Healthcare, Inc.

Consolidated Statements of Operations

(Reviewed)



|                                                                           |  |                                 |            |   |      |   |            |  
|-------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                           |  | Three months ended November 30, |           
|                                                                           |  | 2004                            |            |   | 2003 |  
|Net patient service revenue                                                |  | $                               | 15,011,711 |   |      | $ | 18,098,825 |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Costs and expenses:                                                        |  |                                 |            |   |      |   |            |  
|Compensation and benefits                                                  |  |                                 | 4,686,560  |   |      |   | 5,656,185  |  
|Medical services and supplies                                              |  |                                 | 2,694,195  |   |      |   | 2,489,292  |  
|Other operating expenses                                                   |  |                                 | 6,895,445  |   |      |   | 6,115,683  |  
|Provision for uncollectible accounts                                       |  |                                 | 114,516    |   |      |   | 130,639    |  
|Depreciation and amortization                                              |  |                                 | 1,056,936  |   |      |   | 871,066    |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Total costs and expenses                                                   |  |                                 | 15,447,652 |   |      |   | 15,262,865 |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Income (loss) from operations                                              |  |                                 | (435,941   | ) |      |   | 2,835,960  |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Other income (expense):                                                    |  |                                 |            |   |      |   |            |  
|Rent and other income                                                      |  |                                 | 132,975    |   |      |   | 90,632     |  
|Interest income                                                            |  |                                 | 10,136     |   |      |   | 1,920      |  
|Interest expense                                                           |  |                                 | (76,646    | ) |      |   | (63,104    | )
|                                                                           |  |                                 |            |   |      |   |            |  
|Total other income, net                                                    |  |                                 | 66,465     |   |      |   | 29,448     |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Income (loss) before income tax, minority interests and extraordinary gain |  |                                 | (369,476   | ) |      |   | 2,865,408  |  
|Benefit (provision) for income taxes                                       |  |                                 | 27,644     |   |      |   | (1,391,625 | )
|Minority interest in loss (earnings)                                       |  |                                 | 64,658     |   |      |   | (197,044   | )
|                                                                           |  |                                 |            |   |      |   |            |  
|Income (loss) before extraordinary gain                                    |  |                                 | (277,174   | ) |      |   | 1,276,739  |  
|Extraordinary gain, net of $114,170 of income tax expense in 2003          |  |                                 |           |   |      |   | 186,870    |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Net income (loss)                                                          |  | $                               | (277,174   | ) |      | $ | 1,463,609  |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Basic earnings (loss) per common share:                                    |  |                                 |            |   |      |   |            |  
|Income (loss) before extraordinary gain                                    |  | $                               | (0.02      | ) |      | $ | 0.09       |  
|Extraordinary gain, net of tax                                             |  |                                 |           |   |      |   | 0.01       |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Net income (loss)                                                          |  | $                               | (0.02      | ) |      | $ | 0.10       |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Diluted earnings (loss) per common share:                                  |  |                                 |            |   |      |   |            |  
|Income (loss) before extraordinary gain                                    |  | $                               | (0.02      | ) |      | $ | 0.08       |  
|Extraordinary gain, net of tax                                             |  |                                 |           |   |      |   | 0.01       |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Net income (loss)                                                          |  | $                               | (0.02      | ) |      | $ | 0.09       |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Weighted average common sharesbasic                                       |  |                                 | 14,851,568 |   |      |   | 14,865,932 |  
|                                                                           |  |                                 |            |   |      |   |            |  
|Weighted average common sharesdiluted                                     |  |                                 | 14,851,568 |   |      |   | 15,538,938 |  
|                                                                           |  |                                 |            |   |      |   |            |  



See accompanying
notes.



6



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##### Table of Contents

Dynacq Healthcare, Inc.

Consolidated Statements of Cash Flows

(Reviewed)



|                                                                                         |  |                                |           |   |      |   |            |  
|---------------------------------------------------------------------------------------- |  | ------------------------------ | --------- | - | ---- | - | ---------- | -
|                                                                                         |  | Three months endedNovember 30, |          
|                                                                                         |  | 2004                           |           |   | 2003 |  
|Cash flows from operating activities                                                     |  |                                |           |   |      |   |            |  
|Net income (loss)                                                                        |  | $                              | (277,174  | ) |      | $ | 1,463,609  |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                                |           |   |      |   |            |  
|Extraordinary gain, net of tax                                                           |  |                                |          |   |      |   | (186,870   | )
|Depreciation and amortization                                                            |  |                                | 1,056,936 |   |      |   | 871,066    |  
|Provision for uncollectible accounts                                                     |  |                                | 114,516   |   |      |   | 130,639    |  
|Deferred income taxes                                                                    |  |                                | (141,778  | ) |      |   | 265,395    |  
|Minority interests in earnings (loss)                                                    |  |                                | (64,658   | ) |      |   | 197,044    |  
|Stock options issued for compensation                                                    |  |                                | (2,241    | ) |      |   | 913,648    |  
|Deferred stock compensation amortization                                                 |  |                                | 45,450    |   |      |   | 45,450     |  
|Changes in operating assets and liabilities:                                             |  |                                |           |   |      |   |            |  
|Accounts receivable                                                                      |  |                                | 300,278   |   |      |   | 2,755,699  |  
|Inventories                                                                              |  |                                | 30,362    |   |      |   | 1,702      |  
|Prepaid expenses                                                                         |  |                                | 127,615   |   |      |   | 146,494    |  
|Income taxes receivable                                                                  |  |                                | 1,689,950 |   |      |   | 1,080,190  |  
|Other assets                                                                             |  |                                | (22,088   | ) |      |   | 45,469     |  
|Cash overdrafts                                                                          |  |                                | (622,375  | ) |      |   |           |  
|Accounts payable                                                                         |  |                                | (362,165  | ) |      |   | (174,037   | )
|Accrued liabilities                                                                      |  |                                | 504,651   |   |      |   | (292,304   | )
|Income taxes payable                                                                     |  |                                | 74,922    |   |      |   | (10,449    | )
|                                                                                         |  |                                |           |   |      |   |            |  
|Net cash provided by operating activities                                                |  |                                | 2,452,201 |   |      |   | 7,252,745  |  
|                                                                                         |  |                                |           |   |      |   |            |  
|Cash flows from investing activities                                                     |  |                                |           |   |      |   |            |  
|Purchase of property and equipment                                                       |  |                                | (737,254  | ) |      |   | (2,497,833 | )
|Accrued liabilities related to purchase of property and equipment                        |  |                                | 692,765   |   |      |   | 1,729,902  |  
|Purchase of accounts receivable - other                                                  |  |                                | (244,000  | ) |      |   |           |  
|Collections on purchased accounts receivable - other                                     |  |                                | 63,596    |   |      |   |           |  
|Payment of accrued liabilities related to purchase of property and equipment             |  |                                |          |   |      |   | (1,650,000 | )
|                                                                                         |  |                                |           |   |      |   |            |  
|Net cash used in investing activities                                                    |  |                                | (224,893  | ) |      |   | (2,417,931 | )
|                                                                                         |  |                                |           |   |      |   |            |  
|Cash flows from financing activities                                                     |  |                                |           |   |      |   |            |  
|Payment on notes payable                                                                 |  |                                | (123,321  | ) |      |   | (5,359,860 | )
|Deposit for proposed sale of accounts receivable                                         |  |                                |          |   |      |   | 3,360,000  |  
|Payments on capital leases                                                               |  |                                | (33,939   | ) |      |   | (42,360    | )
|Proceeds from exercise of stock options                                                  |  |                                |          |   |      |   | 140,481    |  
|Distributions to minority interest holders                                               |  |                                | (84,750   | ) |      |   | (715,000   | )
|Sale (purchase) of minority interests                                                    |  |                                | 200,000   |   |      |   | (400,000   | )
|                                                                                         |  |                                |           |   |      |   |            |  
|Net cash used in financing activities                                                    |  |                                | (42,010   | ) |      |   | (3,016,739 | )
|                                                                                         |  |                                |           |   |      |   |            |  
|Net increase in cash                                                                     |  |                                | 2,185,298 |   |      |   | 1,818,075  |  
|Cash at beginning of period                                                              |  |                                | 5,537,776 |   |      |   | 1,883,833  |  
|                                                                                         |  |                                |           |   |      |   |            |  
|Cash at end of period                                                                    |  | $                              | 7,723,074 |   |      | $ | 3,701,908  |  
|                                                                                         |  |                                |           |   |      |   |            |  
|Supplemental cash flow disclosures                                                       |  |                                |           |   |      |   |            |  
|Cash paid during the period for:                                                         |  |                                |           |   |      |   |            |  
|Interest                                                                                 |  | $                              | 64,870    |   |      | $ | 101,101    |  
|                                                                                         |  |                                |           |   |      |   |            |  
|Income taxes                                                                             |  | $                              | 4,488     |   |      | $ | 56,759     |  
|                                                                                         |  |                                |           |   |      |   |            |  



See accompanying
notes.



7



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##### Table of Contents

Dynacq Healthcare, Inc.



Notes
to Consolidated Financial Statements



November 30, 2004

(reviewed)



Basis of Presentation



The accompanying reviewed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated
financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal and recurring nature. The majority of the Companys expenses are
cost of revenue items. Costs that could be classified as general and administrative by the Company would include the corporate office costs, including advertising and marketing expenses, which were approximately $4.1 million and $3.4
million for the quarters ended November 30, 2004 and 2003, respectively. These consolidated financial statements also include the accounts of Vista Hospital of Baton Rouge, LLC, an indirect majority-owned subsidiary of the Company that operates the
Baton Rouge Facility, which is currently in Chapter 11 bankruptcy proceedings. These reviewed financial statements should be read in conjunction with the audited financial statements at August 31, 2004. Operating results for the quarter ended
November 30, 2004 are not necessarily indicative of the results that may be expected for the year ending August 31, 2005.



The Company operates in one line of business and its strategy is to develop and operate general acute care hospitals designed to handle specialized
general surgeries such as bariatric, orthopedic and neuro spine surgeries. The Company manages these hospitals on an individual basis. The hospitals economic characteristics, nature of their operations, regulatory environment in which they
operate and the manner in which they are managed are all similar. Accordingly, the Company aggregates its hospitals into a single reportable segment as that term is defined by SFAS No. 131 Disclosures About Segments of an Enterprise and
Related Information.



General



As of November 30, 2004, the Company operated two facilities in the Houston
metropolitan area (Pasadena and West Houston Facilities), and one each in the Dallas-Fort Worth area (Garland Facility) and in Baton Rouge (Baton Rouge Facility). The Garland Facility was acquired in August 2003, and surgical procedures started at
this facility at the end of November 2003.



Use of Estimates



The preparation of financial statements in conformity
with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The most significant of the
Companys estimates is the determination of revenue to recognize for the services the Company provides and the determination of the contractual allowance. See Revenue Recognition below for further discussion. Actual results could
differ materially from those estimates used in preparation of these financial statements.



Reclassification



Accounts receivable-other of $152,525 has been stated separately out of other assets as of August 31, 2004 to be consistent with the current presentation.



Stock Based Compensation



The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations in
accounting for its employee stock compensation. As required by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123), the Company has



8



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##### Table of Contents

determined pro forma net income and earnings per share, as if compensation cost for the employees stock options had been determined based upon fair values at
the grant dates. These pro forma amounts are as follows:



|                                                                                  |  |                                |          |   |      |   |           |  
|--------------------------------------------------------------------------------- |  | ------------------------------ | -------- | - | ---- | - | --------- | -
|                                                                                  |  | Three months endedNovember 30, |         
|                                                                                  |  | 2004                           |          |   | 2003 |  
|Net income (loss) as reported                                                     |  | $                              | (277,174 | ) |      | $ | 1,463,609 |  
|Add: stock-based compensation costs included in reported net income, net of taxes |  |                                | 29,543   |   |      |   | 29,543    |  
|Deduct: stock based compensation costs, net of taxes under SFAS 123               |  |                                | (141,834 | ) |      |   | (141,834  | )
|                                                                                  |  |                                |          |   |      |   |           |  
|Pro forma net income (loss)                                                       |  | $                              | (389,465 | ) |      | $ | 1,351,318 |  
|                                                                                  |  |                                |          |   |      |   |           |  
|Per share information:                                                            |  |                                |          |   |      |   |           |  
|Basic, as reported                                                                |  | $                              | (0.02    | ) |      | $ | 0.10      |  
|Basic, pro forma                                                                  |  |                                | (0.03    | ) |      |   | 0.09      |  
|Diluted, as reported                                                              |  |                                | (0.02    | ) |      |   | 0.09      |  
|Diluted, pro forma                                                                |  |                                | (0.03    | ) |      |   | 0.09      |  



The fair value of the stock-based
awards was estimated using the Black-Scholes model with the following weighted average assumptions:



|                        |  |                                 |       |   |      |   |       |  
|----------------------- |  | ------------------------------- | ----- | - | ---- | - | ----- | -
|                        |  | Three months ended November 30, |      
|                        |  | 2004                            |       |   | 2003 |  
|Estimated fair value    |  | $                               | 7.25  |   |      | $ | 7.25  |  
|Expected life (years)   |  |                                 | 4.62  |   |      |   | 4.62  |  
|Risk free interest rate |  |                                 | 4.20  | % |      |   | 4.20  | %
|Volatility              |  |                                 | 60.00 | % |      |   | 60.00 | %
|Dividend yield          |  |                                 |      | % |      |   |      | %



Revenue Recognition



Background



The Companys revenue recognition policy is significant because net patient service revenue is a primary component of
its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to be recognized in connection with the Companys services is subject to significant judgments and estimates, which are
discussed below.



Revenue Recognition Policy



The Company is normally not a party to any managed care contracts. The
Company records revenue pursuant to the following policy. The Company has established billing rates for its medical services that it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Companys
estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues are based on historical cash collections as discussed below and may not represent amounts ultimately expected to be collected.
At such time as the Company can determine that ultimate collections exceeded or have been less than the revenue recorded on a group of accounts, additional revenue or reduction in revenue is recorded.



Contractual Allowance



The Company computes its contractual allowance based on the ratio of the Companys historical cash collections during
the trailing twelve months on a case-by-case basis to gross billed revenue on a case-by-case basis



9



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by operating facility. This ratio of cash collections to billed services is then applied to the gross billed services by operating facility. The following
table shows gross revenues and contractual allowances for the three months ended November 30, 2004 and 2003:



|                                 |  |      |            |   |      |   |            |  
|-------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                                 |  | 2004 |            |   | 2003 |  
|Gross billed charges             |  | $    | 32,913,501 |   |      | $ | 32,097,545 |  
|Contractual allowance            |  |      | 17,901,790 |   |      |   | 13,998,720 |  
|                                 |  |      |            |   |      |   |            |  
|Net revenue                      |  | $    | 15,011,711 |   |      | $ | 18,098,825 |  
|                                 |  |      |            |   |      |   |            |  
|Contractual allowance percentage |  |      | 54         | % |      |   | 44         | %
|                                 |  |      |            |   |      |   |            |  



Accounts Receivable



Accounts receivable represent net receivables for services provided by
the Company. The estimated accounts receivable not expected to be collected within twelve months of the balance sheet date have been shown as long-term receivables and represent receivables in the Medical Dispute Resolution (MDR) and
legal third party financial class. The contractual allowance is provided as revenue is recognized. At each balance sheet date management reviews the accounts receivables for collectibility. If after the review management believes certain receivables
would be uncollectible, the receivable would be written down to the expected collectable amount. Management has not written down any receivables during the quarters ended November 30, 2004 and 2003 as a result of the collectibility test.



The contractual allowance stated as a percentage of gross receivables at
the balance sheet dates is larger than the contractual allowance percentage used to reduce gross billed charges due to the application of partial cash collections to the outstanding gross receivable balances without any adjustment being made to the
contractual allowance. The contractual allowance amounts netted against gross receivables are not adjusted until such time as the final collections on the receivables is recognized.



Collections for services provided are generally settled or written off as uncollectible against the contractual allowance
within six months of the date of service except for services provided to injured workers in Texas. Collections for services provided to injured workers in Texas may take up to three years or longer to be completely adjudicated. Because the Company
has in recent years focused on providing services to injured workers in Texas, accounts receivable in the workers compensation and MDR financial classes have increased.



The MDR process is an established reimbursement resolution process available to providers of healthcare services under the
regulations guiding reimbursement for services provided to injured workers in the State of Texas. Accounts generally do not become subject to the MDR process prior to being outstanding for at least 90 days subsequent to patient discharge. For
medical services provided to injured workers in the state of Texas, the MDR process is specifically based upon the administrative and statutory regulations promulgated by the Texas Labor Code and Texas Administrative Code provisions.



Due to a number of factors outside the Companys control,
including a change in the Companys reimbursement collection experience associated with potential changes in the reimbursement environment in which the Company operates, it is possible that managements estimates of patient service
revenues could change, which could have a material impact on the Companys revenue and profitability in the future.



Allowance for Uncollectible Accounts



The Company has estimated uncollectible accounts expense as 1% of gross outpatient revenue. The Company normally makes no charge offs against allowance
for uncollectible accounts, as historically all charge offs have been against the contractual allowance. However, during the quarter ended November 30, 2003, the Company charged $200,254 against the allowance for uncollectible accounts.



10



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Minority Interests



The equity of minority investors (generally physician groups and other healthcare providers that perform surgeries at the Companys facilities) in
certain subsidiaries of the Company is reported on the consolidated balance sheets as minority interests. Minority interests reported in the consolidated income statements reflect the respective interests in the income or loss of the limited
partnerships or limited liability companies attributable to the minority investors (equity interests ranged from 2.14% to 10.0% at November 30, 2004). During the quarter ended November 30, 2003, the Company purchased minority interest from certain
minority interest holders at an amount that was $301,040 less than the net book value of the minority interest liability on the date of purchase. The $301,040 less applicable income taxes of $114,170 has been recorded as an extraordinary gain during
the quarter ended November 30, 2003. The partnership agreement provided a means for the minority interest holders to be cashed out at the net book value. The amounts paid to the minority interest holders were less than the buy out amount that was
called for in the partnership agreements. Legal counsel has advised the Company that the acquisitions were negotiated transactions occurring outside the partnership agreement.



Bankruptcy Filing by Subsidiary



On October 8, 2004, Vista Hospital of Baton Rouge, LLC (VHBR), an indirect majority-owned subsidiary of the Company that operates the Baton
Rouge Facility, filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas. VHBR continues to operate its business and manage its property as a
debtor in possession under the jurisdiction of the bankruptcy court.



VHBR filed for bankruptcy protection because, among other reasons, VHBR is unable to pay the alleged damages sought by, and the costs of defending against, a lawsuit, Liljeberg Enterprises International, L.L.C. v.
Vista Hospital of Baton Rouge, LLC, d/b/a Vista Surgical Hospital, filed by Liljeberg Enterprises International, L.L.C. in September 2003 against both the Company and VHBR in the Twenty Fourth Judicial District Court for the Parish of Jefferson,
State of Louisiana (case number 598-564).



On December 7, 2004,
the Bankruptcy Court denied Liljebergs motion to dismiss and motion for relief from stay. VHBR intends to file a plan of reorganization to fully pay all creditors as soon as possible. Dynacq cannot predict the outcome of the Chapter 11
proceeding or the lawsuit.



Debtor-in-Possession financial
statements. Under the Bankruptcy Code, VHBR is required to periodically file with the bankruptcy court various documents, including financial statements of the VHBR as a Debtor-in-Possession. These financial statements are prepared according to
requirements of the Bankruptcy Code. While these financial statements accurately provide information required by the Bankruptcy Code, which is not wholly in accordance with generally accepted accounting principles in the United States of America
(U.S. GAAP), they are unconsolidated, unaudited, and prepared in a format different from that used in our consolidated financial statements filed under the securities laws and from that used in the consolidated financial statements, which are
prepared in accordance with U.S. GAAP. Accordingly, we believe the substance and format of the financial statements prepared for the bankruptcy court do not allow meaningful comparison with the following financial statements.



Basis of presentation. We continue to consolidate VHBR as the Debtor
in our consolidated financial statements. While generally it is appropriate to deconsolidate a subsidiary during its Chapter 11 proceedings on the basis that control no longer rests with the parent, the facts and circumstances particular to our
situation support the continued consolidation of the subsidiary. Specifically:



| |  | the entire duration of the Chapter 11 proceedings is likely to be short, anticipated to be less than one year, excluding any potential appeals;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  | the Debtor filed Chapter 11 proceedings because, among other reasons, VHBR is unable to pay the alleged damages sought by, and the costs of defending against, the Liljeberg
lawsuit; and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | we anticipate that we will continue to own a majority of the equity of the Debtor upon completion of a plan of reorganization. As such, we do not believe a plan of reorganization
will impact our equity ownership of the Debtor.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

VHBR as Debtor-in-Possession

Condensed Statement of Operations

(Unaudited)



|                                                                           |  |                                     |            |  
|-------------------------------------------------------------------------- |  | ----------------------------------- | ---------- | -
|                                                                           |  | Three Months EndedNovember 30, 2004 |           
|Net patient service revenues                                               |  | $                                   | 4,102,324  |  
|Costs and expenses                                                         |  |                                     | 4,940,342  |  
|                                                                           |  |                                     |            |  
|Loss from operations                                                       |  |                                     | (838,018   | )
|Other income (expense)                                                     |  |                                     | 24,053     |  
|                                                                           |  |                                     |            |  
|Net loss                                                                   |  | $                                   | (813,965   | )
|                                                                           |  |                                     |            |  
|                                                                          
|VHBR as Debtor-in-Possession Condensed Balance Sheet (Unaudited)           | 
|                                                                           |  | November 30, 2004                   |           
|Assets                                                                     |  |                                     |            |  
|Current assets:                                                            |  |                                     |            |  
|Cash                                                                       |  | $                                   | 2,436,643  |  
|Accounts receivable, net                                                   |  |                                     | 4,114,492  |  
|Inventories                                                                |  |                                     | 614,096    |  
|Prepaid expenses                                                           |  |                                     | 209,009    |  
|Amounts receivable from related parties                                    |  |                                     | 3,970,833  |  
|                                                                           |  |                                     |            |  
|Total current assets                                                       |  |                                     | 11,345,073 |  
|Other assets                                                               |  |                                     | 147,654    |  
|                                                                           |  |                                     |            |  
|Total assets                                                               |  | $                                   | 11,492,727 |  
|                                                                           |  |                                     |            |  
|Liabilities and members deficit                                           |  |                                     |            |  
|Current liabilities:                                                       |  |                                     |            |  
|Accounts payable                                                           |  | $                                   | 942,970    |  
|Accrued liabilities                                                        |  |                                     | 485,032    |  
|Amounts due to related parties                                             |  |                                     | 10,531,403 |  
|                                                                           |  |                                     |            |  
|Total current liabilities                                                  |  |                                     | 11,959,405 |  
|                                                                           | 
|Members deficit                                                           |  |                                     | (466,678   | )
|                                                                           |  |                                     |            |  
|Total liabilities and members deficit                                     |  | $                                   | 11,492,727 |  
|                                                                           |  |                                     |            |  
|                                                                          
|VHBR as Debtor-in-Possession Condensed Statement of Cash Flows (Unaudited) | 
|                                                                           |  | Three Months EndedNovember 30, 2004 |           
|Total cash flows used in operating activities                              |  | $                                   | (207,645   | )
|Total cash flows from financing activities                                 |  |                                     | 1,838,930  |  
|                                                                           |  |                                     |            |  
|Increase in cash                                                           |  |                                     | 1,631,285  |  
|Cash at beginning of period                                                |  |                                     | 805,358    |  
|                                                                           |  |                                     |            |  
|Cash at end of period                                                      |  | $                                   | 2,436,643  |  
|                                                                           |  |                                     |            |  



There can be no
assurance that we will obtain the required judicial approval of a proposed plan of reorganization or any revised plan of reorganization acceptable to us. In such event, a prolonged Chapter 11 proceeding could adversely affect the Debtors
relationships with customers, suppliers, and employees, which in turn could adversely affect the Debtors competitive position, financial condition, and results of operations. In



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addition, if the Debtor is unsuccessful in obtaining confirmation of a plan of reorganization, the assets of the Debtor could be liquidated in the Chapter 11
proceedings. Dynacq cannot predict the outcome of the Chapter 11 proceedings.



Contingencies



The Company maintains various
insurance policies that cover each of its facilities. Specifically, the Company has claims-made malpractice coverage for its West Houston Facility and has occurrence coverage for its Pasadena and Garland Facilities. The Company previously had
claims-made malpractice coverage for its Pasadena Facility until August 12, 2002, at which time the Company converted to the occurrence coverage. The Company purchased tail coverage through August 12, 2004 (the applicable statute of limitations
expiration date). In Louisiana, the Company is a member of the Louisiana Patient Compensation Fund and purchases insurance through the Louisiana Patient Compensation Fund for medical malpractice. In addition, all physicians granted privileges at the
Companys facilities are required to maintain medical malpractice insurance coverage. The Company also maintains general liability and property insurance coverage for each facility and flood coverage for the Baton Rouge Facility. The Company
maintains workers compensation coverage for the Baton Rouge Facility, but does not currently maintain workers compensation coverage in Texas. In regard to the Employee Health Insurance Plan, the Company is self insured with specific and
aggregate re-insurance with stop-loss levels appropriate for the Companys group size. Coverages are maintained in amounts management deems adequate.



A shareholder derivative action alleging breach of fiduciary duty, abuse of control, gross mismanagement and unjust enrichment, Flory v. Chan, et
al., H-02-3123, was brought in U.S. District Court for the Southern District of Texas in August 2002, but was stayed on November 12, 2002 by the district court pending the outcome of a previously filed shareholder class action Hamilton v.
Dynacq International, et. al.,in the same court. Given the plaintiffs dismissal of the appeal in the Hamilton shareholder class action and given the state courts dismissal of the same or similar claims in the previously filed
shareholder derivative action Brill v. Chan, et. al.,filed in the 295thDistrict Court of Harris County,
Texas, the Company moved in the fourth quarter of fiscal 2004 to dismiss this derivative action. The court dismissed the action in October 2004 with prejudice against refiling, such dismissal being subject to the right of the plaintiffs to appeal.
The plaintiffs appealed the dismissal to the United States Fifth Circuit Court of Appeals on November 22, 2004.



In September 2003, a lawsuit, case number 598-564, was filed in the Twenty Fourth Judicial District Court for the Parish of Jefferson, State of Louisiana,
by Liljeberg Enterprises International, L.L.C. against Vista Hospital of Baton Rouge, LLC, d/b/a Vista Surgical Hospital, Dynacq International, Inc., and Chiu M. Chan alleging that the plaintiff is owed damages in excess of $1,000,000 for costs of
goods and services rendered for pharmacy operations at the Baton Rouge Facility. The plaintiff has asserted claims for breach of contract, fraud, negligence, fraudulent misrepresentation, negligent misrepresentation, civil conspiracy and gross
negligence. On August 6, 2004, the plaintiff filed a Motion for Partial Summary Judgment claiming damages in the breach of contract claim in the amount of approximately $725,000 plus accounting fees.On October 8, 2004, Vista Hospital of
Baton Rouge, an indirect majority-owned subsidiary of Dynacq, filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas. During the proceeding, Vista
Hospital of Baton Rouge continues to operate the Baton Rouge Facility and manage its property as a debtor in possession under the jurisdiction of the bankruptcy court. Vista Hospital of Baton Rouge filed for bankruptcy protection
because, among other reasons, it is unable to pay the alleged damages sought by, and the costs of defending against, the lawsuit. On the date of Vista Hospital of Baton Rouges bankruptcy filing, the lawsuit was removed to the United States
District Court for the Eastern District of Louisiana. On December 7, 2004, the Bankruptcy Court denied Liljebergs motion to dismiss and motion for relief from stay. Vista Hospital of Baton Rouge intends to file a plan of reorganization to
fully pay all creditors as soon as possible. Dynacq cannot predict the outcome of the Chapter 11 proceeding or the lawsuit.



From time to time, the Company is involved in litigation and administrative proceedings that are incidental to its business. The Company cannot predict
whether any litigation to which it is currently a party will have a material adverse effect on the Companys results of operations, cash flows, or financial condition. See Item 3. Legal Proceedings on our Annual Report on Form 10-K
for the fiscal year ended August 31, 2004.



13



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



This quarterly report on Form 10-Q contains forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as
may, will, should, expects, intends, plans, anticipates, believes, estimates, predicts, potential, or the negative of
these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Such forward-looking statements relate to future events or future financial performance and involve known and unknown
risks, uncertainties and other factors that may cause our Companys actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or
implied by the forward-looking statements, including the risks and uncertainties described in Risk Factors in our annual report on Form 10-K for the fiscal year ended August 31, 2004. Although we believe that the expectations reflected
in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. You must read the following discussion of the results of our business and our operations and financial condition
in conjunction with our reviewed consolidated financial statements, including the notes, included in this quarterly report on Form 10-Q and our audited consolidated financial statements, including the notes, included in our Annual Report on Form
10-K for the fiscal year ended August 31, 2004.



Executive Summary



Bankruptcy Filing by Subsidiary



On October 8, 2004, Vista Hospital of Baton Rouge, LLC (VHBR),
an indirect majority-owned subsidiary of the Company that operates the Baton Rouge Facility, filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas.
VHBR continues to operate its business and manage its property as a debtor in possession under the jurisdiction of the bankruptcy court.



VHBR filed for bankruptcy protection because, among other reasons, VHBR is unable to pay the alleged damages sought by, and the costs of defending
against, a lawsuit, Liljeberg Enterprises International, L.L.C. v. Vista Hospital of Baton Rouge, LLC, d/b/a Vista Surgical Hospital, filed by Liljeberg Enterprises International, L.L.C. in September 2003 against both the Company and VHBR in
the Twenty Fourth Judicial District Court for the Parish of Jefferson, State of Louisiana (case number 598-564).



On December 7, 2004, the Bankruptcy Court denied Liljebergs motion to dismiss and motion for relief from stay. VHBR intends to file a plan of
reorganization to fully pay all creditors as soon as possible. Dynacq cannot predict the outcome of the Chapter 11 proceeding.



Update on Critical Accounting Policies and Estimates



There have been no changes to the critical accounting policies used in our reporting of results of operations and financial position for the quarter ended
November 30, 2004. For a discussion of our critical accounting policies see Managements Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K for the fiscal year ended August 31, 2004.



14



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Results of Operations



|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|-------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - |  | --- | -- | ---- | - | ---------- | - |  | --- | -
|                                                                           |  | Three months ended November 30, |           
|                                                                           |  | 2004                            |            |   |  |     |    | 2003 |   |            |   | 
|Net patient service revenue                                                |  | $                               | 15,011,711 |   |  | 100 | %  |      | $ | 18,098,825 |   |  | 100 | %
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Costs and expenses:                                                        |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Compensation and benefits                                                  |  |                                 | 4,686,560  |   |  | 31  |    |      |   | 5,656,185  |   |  | 31  |  
|Medical services and supplies                                              |  |                                 | 2,694,195  |   |  | 18  |    |      |   | 2,489,292  |   |  | 14  |  
|Other operating expenses                                                   |  |                                 | 6,895,445  |   |  | 46  |    |      |   | 6,115,683  |   |  | 34  |  
|Provision for uncollectible accounts                                       |  |                                 | 114,516    |   |  | 1   |    |      |   | 130,639    |   |  | 1   |  
|Depreciation and amortization                                              |  |                                 | 1,056,936  |   |  | 7   |    |      |   | 871,066    |   |  | 5   |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Total costs and expenses                                                   |  |                                 | 15,447,652 |   |  | 103 |    |      |   | 15,262,865 |   |  | 84  |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Income (loss) from operations                                              |  |                                 | (435,941   | ) |  | (3  | )  |      |   | 2,835,960  |   |  | 16  |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Income (loss) before income tax, minority interests and extraordinary gain |  |                                 | (369,476   | ) |  | (2  | )  |      |   | 2,865,408  |   |  | 16  |  
|Benefit (provision) for income taxes                                       |  |                                 | 27,644     |   |  |    |    |      |   | (1,391,625 | ) |  | (8  | )
|Minority interest in loss (earnings)                                       |  |                                 | 64,658     |   |  |    |    |      |   | (197,044   | ) |  | (1  | )
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Income (loss) before extraordinary gain                                    |  |                                 | (277,174   | ) |  | (2  | )  |      |   | 1,276,739  |   |  | 7   |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Net income (loss)                                                          |  | $                               | (277,174   | ) |  | (2  | )% |      | $ | 1,463,609  |   |  | 8   | %
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Operational statistics (Number of medical procedures):                     |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Inpatient:                                                                 |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Bariatrics                                                                 |  |                                 | 104        |   |  |     |    |      |   | 168        |   |  |     |  
|Orthopedics                                                                |  |                                 | 224        |   |  |     |    |      |   | 100        |   |  |     |  
|Other                                                                      |  |                                 | 71         |   |  |     |    |      |   | 26         |   |  |     |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Total inpatient procedures                                                 |  |                                 | 399        |   |  |     |    |      |   | 294        |   |  |     |  
|Outpatient:                                                                |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Orthopedics                                                                |  |                                 | 140        |   |  |     |    |      |   | 175        |   |  |     |  
|Other                                                                      |  |                                 | 644        |   |  |     |    |      |   | 642        |   |  |     |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Total outpatient procedures                                                |  |                                 | 784        |   |  |     |    |      |   | 817        |   |  |     |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  
|Total procedures                                                           |  |                                 | 1,183      |   |  |     |    |      |   | 1,111      |   |  |     |  
|                                                                           |  |                                 |            |   |  |     |    |      |   |            |   |  |     |  



Three Months Ended November 30,
2004 Compared to the Three Months Ended November 30, 2003



Net patient service revenue decreased by $3,087,114 or 17% from $18,098,825 to $15,011,711 and total surgical cases increased by 6% from 1,111 cases to 1,183 cases for the quarters ended November 30, 2003 and 2004, respectively. For the
hospital facilities that were in operations in each of the quarters ended November 30, 2003 and 2004, the net patient service revenues and cases declined as follows:



|             |  |                                      |  |      
|------------ |  | ------------------------------------ |  | -----
|             |  | Percentage decline from 2003 to 2004
|Facility     |  | Net patient revenue                  |  | Cases
|Pasadena     |  | 36%                                  |  | 40%  
|West Houston |  | 53                                   |  | 7    
|Baton Rouge  |  | 20                                   |  | 37   
|Overall      |  | 33                                   |  | 33   



These declines in net patient revenue
and cases were partially offset by the $2,832,000 of revenue and 444 cases reported by the Garland Facility in the quarter ended November 30, 2004. This facility had started operations towards the end of November 2003.



The net patient revenue per case declined $3,600 or 22% from $16,290 in 2003 to $12,690 in 2004. The decline in net patient revenue per case was
the result of a 38% decline in bariatric cases, such cases having a significantly higher average rate, and by a change in the mix of orthopedic cases. The low insurance reimbursement rate for the bariatric cases at the Baton Rouge Facility caused
the Company to de-emphasize these surgery cases. The decline in the number of cases at the Pasadena Facility was the result of the loss of doctors practicing at the facility in fiscal year 2004.



We are actively engaged in efforts to recruit new physicians to the staff.
While we have added several new physicians to the staffs of our facilities, we do not currently expect our financial results to significantly improve in the near future. If we were unable to attract and retain physicians on the staffs of our
facilities, our financial situation could be adversely impacted.



15



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Total costs and expenses increased by $184,787 or 1% from $15,262,865 in 2003 to $15,447,652 in 2004. The
following discusses the various changes in costs and expenses:



Compensation and benefits declined $969,625 or 17%, however, compensation and benefits expenses remained constant as a percentage of net patient revenues. The Company made a concerted effort to reduce employee costs and expenses to match
the decline in revenue.



Medical services and supplies expenses
increased $204,903 or 8% while the number of surgery cases increased 6%. The increase in expenses was the direct result of the increase in the number of cases and higher prices paid for medical supplies.



Other operating expenses did not decline proportionately with the decline in
revenue but increased by $779,762 or 13%. The inverse relationship was caused by the operations of the Garland Facility in the first quarter of 2005 and increased legal, accounting and marketing expenses. The other operating expenses at the Garland
Facility aggregated $801,971 for the quarter ended November 30, 2004. The other operating expenses at the Companys other facilities that were in operations during the quarters ended November 30, 2004 and 2003 did not change appreciably, as
declines in facility operating expenses were offset by increases in general and administrative expenses.



Depreciation and amortization expense increased $185,870 or 21% primarily due to the addition of the Baton Rouge and Garland Facilities.



Minority interest in earnings decreased $261,702 or 133% as compared to the
quarter ended November 30, 2003, primarily due to the decrease in earnings of those subsidiaries with minority owners.



Liquidity and Capital Resources



The Company maintained sufficient liquidity in the quarter ended November 30, 2004 to meet its business needs. As of November 30, 2004, its principal
source of liquidity included $7,723,074 in cash.



Cash flow from operating
activities



Total cash flow from operating activities was
$2,452,201 during the period ended November 30, 2004, primarily due to the receipt of an income tax refund of $1,655,000.



Cash flow from investing activities



Total cash flow used in investing activities was $224,893 during the current period primarily due to the purchase of certain accounts receivable from a
physician.



Cash flow from financing activities



Total cash flow used in financing activities was $42,010 during the current
period. During the quarter ended November 30, 2004, the Company repaid its line of credit by $123,321. During the quarter ended November 30, 2004, the Company collected $200,000 towards sales of minority interest at its Garland Facility.



The Company had working capital of $14,234,195 as of November 30, 2004,
and maintained a liquid position by a current ratio of approximately 1.8 to 1. The Companys management believes that available cash and funds generated from operations will be sufficient for the Company to finance working capital requirements
for the current fiscal year.



The Company has a reducing
revolving line of credit with a financial institution. The line is reduced monthly by an amount equal to 1/180thof
the original loan amount. The maturity date of the line of credit is February 28, 2005. The amount drawn under the line of credit at November 30, 2004 was approximately $5.8 million. The interest rate on the line of credit is based on the
dealer commercial paper rate plus 2.3%. There can be no assurance that the Company will have sufficient funds available to meet all of its capital needs.



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The Company intends to refinance or repay such amounts prior to the maturity date. If the Company is
unable to repay all outstanding balances by the maturity date, the lender may assess a late charge in the amount of 5% of the then outstanding obligations, immediately initiate legal proceedings and proceed against the Companys assets to
satisfy its obligations under the agreement. The Companys obligations under the agreement are secured by substantially all of its assets.



Subsequent Events/Recent Developments



Grant of Stock Options to Employees



On December 16, 2004, the Compensation Committee of the Board of Directors granted stock options to full time employees (other than the executive
officers) of the Company and its subsidiaries, such grants totaling 933,000 shares of common stock, vesting in each of the subsequent four (4) years on the anniversary date of the grant, and having an exercise price of $4.90 per share. On January 4,
2005, the Compensation Committee granted stock options to two full time employees (not executive officers) of the Company and its subsidiaries, such grants totaling 3,000 shares of common stock, vesting in each of the subsequent four (4) years on
the anniversary date of the grant, and having an exercise price of $5.00 per share.



Changes in Directors and Executive Officers



On December 31, 2004, James N. Baxter, who had served as a Companys Executive Vice President and Investor Relations Director since July 2003, resigned from the Company.



Election of Directors and Ratification of Engagement of Independent Auditors



On January 4, 2005, the Company held its Annual Meeting of
Stockholders. Each of our directors were reelected to serve until our next annual meeting of shareholders or until their respective successors are elected and qualified. Messrs. Gerace, Chu and Huber were reappointed to the Audit Committee, and
Messrs. Gerace, Chu and Votaw were reappointed to the Compensation Committee.



The stockholders also ratified the engagement of Killman, Murrell & Company, P.C. as the independent auditors for the fiscal year ending August 31, 2005.



Item 3. Quantitative and Qualitative Disclosures About Market Risk.



Market risks relating to the Companys operations result primarily from changes in interest rates as well as credit risk concentrations. Except for
the refundable deposit made in the second fiscal quarter of 2003 of approximately $604,000 for the lease of land in Shanghai, China, which is in local currency, all of the Companys contracts are denominated in US dollars and, therefore, the
Company has no significant foreign currency risk.



The Company
had $5.8 million drawn under the line of credit as of November 30, 2004. The total interest expense incurred by the Company during this quarter was approximately $60,000.



Other than as disclosed herein, there have been no material changes in the Companys exposure to market risk from the
disclosure included in Item 7A. Quantitative and Qualitative Disclosures About Market Risk in the Companys Annual Report on Form 10-K for the fiscal year ended August 31, 2004.



Item 4. Controls and Procedures.



In connection with the audit of our financial statements for fiscal year ended August 31, 2004, our outside auditors identified and orally brought to the attention of the Audit Committee what they consider to be material weaknesses in our
internal controls relating to:



| |  | the non-compliance by various departments in submitting information in accordance with procedures to ensure proper and timely recording of accounts payable;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | family relationships among certain of our officers and employees; and
| | - | ---------------------------------------------------------------------



| |  | the failure to properly utilize the inventory software to track and report our inventory quantities on a real time basis.
| | - | -------------------------------------------------------------------------------------------------------------------------



Further, as stated in our annual report on Form 10-K for the fiscal year
ended August 31, 2004, based on our review of the accounts payable process and inventory tracking system, we determined that our accounts payable process had failed to record certain liabilities on a timely basis and our inventory management system
had failed to track inventory on a continuous basis. With respect to the first fiscal quarter of 2005 ended on November 30, 2004, we quantified this material weakness in internal controls relating to accounts payable recordation by reconciling our
liabilities to our subsequent payments. We quantified the inventory process control weakness by taking complete physical inventories at the end of each quarter and reconciling the physical counts to our records.



Our management carried out an evaluation, with the participation of our Chief
Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of November 30, 2004. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer
have determined that they cannot reasonably conclude that our disclosure controls and procedures were effective as of November 30, 2004 at the reasonable assurance level and designed to ensure that information required to be disclosed in our SEC
reports is recorded, processed, summarized and reported within the requisite time periods.



Despite the material weaknesses in our internal controls identified as of such date, our Chief Executive Officer and Chief Financial Officer believe that there are no material inaccuracies or omissions of material
facts necessary to make the statements included in this report not misleading in light of the circumstances under which they are made. To overcome the material weaknesses, the Companys Chief Executive Officer and Chief Financial Officer
directed our internal accounting staff to provide additional substantive accounting information and data to our outside auditors, in conjunction with their review of the consolidated financial statements for the three months ended November 30, 2004.



PART II - OTHER INFORMATION



Item 1. Legal Proceedings.



A
shareholder derivative action alleging breach of fiduciary duty, abuse of control, gross mismanagement and unjust enrichment, Flory v. Chan, et al., H-02-3123, was brought in U.S. District Court for the Southern District of Texas in August
2002, but was stayed on November 12, 2002 by the district court pending the outcome of a previously filed shareholder class action Hamilton v. Dynacq International, et. al.,in the same court. Given the plaintiffs dismissal of the
appeal in the Hamilton shareholder class action and given the state courts dismissal of the same or similar claims in the previously filed shareholder derivative action Brill v. Chan, et. al.,filed in the 295thDistrict Court of Harris County, Texas, the Company moved in the fourth quarter of fiscal 2004 to dismiss this derivative
action. The court dismissed the action in October 2004 with prejudice against refiling, such dismissal being subject to the right of the plaintiffs to appeal. The plaintiffs appealed the dismissal to the United States Fifth Circuit Court of Appeals
on November 22, 2004.



In September 2003, a lawsuit, case
number 598-564, was filed in the Twenty Fourth Judicial District Court for the Parish of Jefferson, State of Louisiana, by Liljeberg Enterprises International, L.L.C. against Vista Hospital of Baton Rouge, LLC, d/b/a Vista Surgical Hospital, Dynacq
International, Inc., and Chiu M. Chan alleging that the plaintiff is owed damages in excess of $1,000,000 for costs of goods and services rendered for pharmacy operations at the Baton Rouge Facility. The plaintiff has asserted claims for breach of
contract, fraud, negligence, fraudulent misrepresentation, negligent misrepresentation, civil conspiracy and gross negligence. On August 6, 2004, the plaintiff filed a Motion for Partial Summary Judgment claiming damages in the breach of contract
claim in the amount of approximately $725,000 plus accounting fees.On October 8, 2004, Vista Hospital of Baton Rouge, an indirect majority-owned subsidiary of Dynacq, filed a voluntary petition under Chapter 11 of the United States
Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas. During the proceeding, Vista Hospital of Baton Rouge continues to operate the Baton Rouge Facility and manage its property as a debtor



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in possession under the jurisdiction of the bankruptcy court. Vista Hospital of Baton Rouge filed for bankruptcy protection because, among other
reasons, it is unable to pay the alleged damages sought by, and the costs of defending against, the lawsuit. On the date of Vista Hospital of Baton Rouges bankruptcy filing, the lawsuit was removed to the United States District Court for the
Eastern District of Louisiana. On December 7, 2004, the Bankruptcy Court denied Liljebergs motion to dismiss and motion for relief from stay. Vista Hospital of Baton Rouge intends to file a plan of reorganization to fully pay all creditors as
soon as possible. Dynacq cannot predict the outcome of the Chapter 11 proceeding or the lawsuit.



From time to time, the Company is involved in litigation and administrative proceedings that are incidental to its business. The Company cannot predict
whether any litigation to which it is currently a party will have a material adverse effect on the Companys results of operations, cash flows, or financial condition. See Item 3. Legal Proceedings in our Annual Report on Form 10-K
for the fiscal year ended August 31, 2004.



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



None.



Item 3. Defaults Upon Senior Securities.



None.



Item 4. Submission of Matter to a Vote of Security Holders.



None.



Item 5. Other Information.



None.



Item 6. Exhibits.



|  |   |  |              |  |                                                                                                                                                                                                                                                                                           
|- | - |  | ------------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |   |  | EXHIBIT NO.  |  | IDENTIFICATION OF EXHIBIT                                                                                                                                                                                                                                                                 
|* |   |  | Exhibit 3.1  |  | Certificate of Incorporation, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 000-21574.                                                                                                                                           
|  |   | 
|* |   |  | Exhibit 3.2  |  | Bylaws, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 222-21574.                                                                                                                                                                 
|  |   | 
|* |   |  | Exhibit 10.1 |  | Amendment to Reducing Revolver and Other Loan Documents, dated October 29, 2004, between the Company and Merrill Lynch Business Financial Services, Inc., incorporated by reference to Exhibit
10.9 to the Companys Annual Report on Form 10-K for the fiscal year ended August 31, 2004.
|  |   | 
|* |   |  | Exhibit 10.2 |  | Assumption Agreement, dated October 29, 2004, between the Company and Merrill Lynch Business Financial Services, Inc., incorporated by reference to Exhibit 10.10 to the Companys Annual
Report on Form 10-K for the fiscal year ended August 31, 2004.                                  
|  |   | 
|* | * |  | Exhibit 15.1 |  | Letter Regarding Review of Interim Financial Information.                                                                                                                                                                                                                                 
|  |   | 
|* | * |  | Exhibit 23.1 |  | Auditor Consent.                                                                                                                                                                                                                                                                          
|  |   | 
|* | * |  | Exhibit 31.1 |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       
|  |   | 
|* | * |  | Exhibit 31.2 |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       
|  |   | 
|* | * |  | Exhibit 32.1 |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        
|  |   | 
|* | * |  | Exhibit 32.2 |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        

---

|* | Previously filed and incorporated by reference.
|- | -----------------------------------------------

|** | Filed herewith.
|-- | ---------------



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SIGNATURES



Pursuant to the requirements 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.



|                      |  |                         |  |                                             
|--------------------- |  | ----------------------- |  | --------------------------------------------
|                      |  | DYNACQ HEALTHCARE, INC.
|                      |  |                        
|Date: January 7, 2005 |  | By:                     |  | /s/ Chiu M. Chan                            
|                      |  |                         |  | Chiu M. Chan                                
|                      |  |                         |  | Chief Executive Officer                     
|                      |  |                         |  | (duly authorized officer)                   
|                      |  |                        
|Date: January 7, 2005 |  | By:                     |  | /s/ Philip S. Chan                          
|                      |  |                         |  | Philip S. Chan                              
|                      |  |                         |  | Chief Financial Officer                     
|                      |  |                         |  | (principal financial and accounting officer)



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INDEX OF EXHIBITS



|  |   |  |              |  |                                                                                                                                                                                                                                                                                           
|- | - |  | ------------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |   |  | EXHIBIT NO.  |  | IDENTIFICATION OF EXHIBIT                                                                                                                                                                                                                                                                 
|* |   |  | Exhibit 3.1  |  | Certificate of Incorporation, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 000-21574.                                                                                                                                           
|  |   | 
|* |   |  | Exhibit 3.2  |  | Bylaws, incorporated by reference to the Definitive Information Statement filed October 21, 2003, SEC File No. 222-21574.                                                                                                                                                                 
|  |   | 
|* |   |  | Exhibit 10.1 |  | Amendment to Reducing Revolver and Other Loan Documents, dated October 29, 2004, between the Company and Merrill Lynch Business Financial Services, Inc., incorporated by reference to Exhibit
10.9 to the Companys Annual Report on Form 10-K for the fiscal year ended August 31, 2004.
|  |   | 
|* |   |  | Exhibit 10.2 |  | Assumption Agreement, dated October 29, 2004, between the Company and Merrill Lynch Business Financial Services, Inc., incorporated by reference to Exhibit 10.10 to the Companys Annual
Report on Form 10-K for the fiscal year ended August 31, 2004.                                  
|  |   | 
|* | * |  | Exhibit 15.1 |  | Letter Regarding Review of Interim Financial Information.                                                                                                                                                                                                                                 
|  |   | 
|* | * |  | Exhibit 23.1 |  | Auditor Consent.                                                                                                                                                                                                                                                                          
|  |   | 
|* | * |  | Exhibit 31.1 |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       
|  |   | 
|* | * |  | Exhibit 31.2 |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       
|  |   | 
|* | * |  | Exhibit 32.1 |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        
|  |   | 
|* | * |  | Exhibit 32.2 |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        

---

|* | Previously filed and incorporated by reference.
|- | -----------------------------------------------

|** | Filed herewith.
|-- | ---------------



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