FIRST HEALTH GROUP CORP - 10-Q Quarterly Report

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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

{X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004
OR
{ } 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 0-15846

First Health Group Corp.
(Exact name of registrant as specified in its charter)

Delaware 36-3307583
------------------------------- ------------------------------------
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)

3200 Highland Avenue, Downers Grove, Illinois 60515
---------------------------------------------------
(Address of principal executive offices, Zip Code)

(630) 737-7900
------------------------------------------------
(Registrant's phone number, including area code)

__________________________
(Former name, former address and former fiscal year,
if changed since last report)

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 by Rule 12b-2 of the Exchange Act).

Yes X No ________

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

The number of shares of Common Stock, par value $.01 per share, outstanding
on August 1, 2004, was 91,667,748.

First Health Group Corp. and Subsidiaries

INDEX

Part I. Financial Information
Page Number
-----------
Item 1. Financial Statements

Consolidated Balance Sheets - Assets at June 30, 2004
and December 31, 2003 ................................... 3

Consolidated Balance Sheets - Liabilities and Stockholders'
Equity at June 30, 2004 and December 31, 2003 ........... 4

Consolidated Statements of Operations for the three months
ended June 30, 2004 and 2003 ............................ 5

Consolidated Statements of Operations for the six months
ended June 30, 2004 and 2003 ............................ 6

Consolidated Statements of Comprehensive Income for the
three and six months ended June 30, 2004 and 2003 ....... 7

Consolidated Statements of Cash Flows for the six months
ended June 30, 2004 and 2003 ............................ 8-9

Notes to Consolidated Financial Statements ................ 10-15

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............. 16-25

Item 3. Quantitative and Qualitative Disclosures About
Market Risk ..................................... 26

Item 4. Controls and Procedures ........................... 26

Part II. Other Information

Item 1. Legal Proceedings ................................. 27

Item 2. Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities ........... 27

Item 4. Submission of Matters to a Vote of
Security Holders ................................ 27

Item 5. Other Information ................................. 28

Item 6. Exhibits and Reports on Form 8-K .................. 28

Signatures....................................................... 29

PART 1. Financial Information
First Health Group Corp. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in millions) (Unaudited)
-----------------------------------------------------------------------------

ASSETS June 30, December 31,
2004 2003
-------- --------

Current Assets:
Cash and cash equivalents .................... $ 38.9 $ 8.0
Short-term investments ....................... 2.3 2.0
Accounts receivable, less allowances for
doubtful accounts of $22.9
and $21.1 respectively..................... 98.5 102.9
Deferred income taxes ........................ 26.8 26.8
Other current assets ......................... 30.4 37.4
-------- --------
Total current assets ......................... 196.9 177.1

Long-Term Investments:
Marketable securities ........................ 58.6 63.0
Other ........................................ 66.8 66.7
-------- --------
125.4 129.7
-------- --------
Property and Equipment:
Land, buildings and improvements ............. 105.4 103.1
Computer equipment and software .............. 315.2 281.5
Office furniture and equipment ............... 42.4 37.9
-------- --------
463.0 422.5
Less accumulated depreciation and
amortization ............................... (221.6) (186.6)
-------- --------
Net property and equipment ................... 241.4 235.9
-------- --------

Goodwill........................................ 327.8 324.3

Intangible assets, less accumulated amortization
of $13.0 and $9.3, respectively .............. 81.4 82.6

Reinsurance recoverable......................... 25.2 24.3

Other Assets.................................... 3.2 3.5
-------- --------
Total Assets $ 1,001.3 $ 977.4
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in millions) (Unaudited)
-----------------------------------------------------------------------------

LIABILITIES AND STOCKHOLDERS' EQUITY

June 30, December 31,
2004 2003
-------- --------
Current Liabilities:
Accounts payable ............................. $ 77.1 $ 73.2
Accrued expenses ............................. 44.0 47.8
Claims reserves .............................. 23.9 23.8
Income taxes payable ......................... 26.7 8.1
-------- --------
Total current liabilities .................... 171.7 152.9

Long-Term Debt.................................. 210.0 270.0
Claims Reserves - Noncurrent.................... 25.2 24.3
Deferred Taxes.................................. 125.7 126.5
Other Noncurrent Liabilities.................... 23.8 25.2
-------- --------
Total liabilities ............................ 556.4 598.9
-------- --------

Commitments and Contingencies................... -- --

Stockholders' Equity:
Common stock ................................. 1.4 1.4
Additional paid-in capital ................... 344.5 335.5
Retained earnings ............................ 730.9 672.0
Accumulated other comprehensive loss ......... (3.2) (1.7)
Treasury stock, at cost ...................... (628.7) (628.7)
-------- --------
Total stockholders' equity ................... 444.9 378.5
-------- --------
Total Liabilities and Stockholders' Equity $ 1,001.3 $ 977.4
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions except per share amounts) (Unaudited)
-----------------------------------------------------------------------------

Three Months Ended June 30,
---------------------------
2004 2003
-------- --------
Revenues......................................... $ 220.8 $ 218.6
-------- --------
Operating expenses:
Cost of services .............................. 104.9 100.1
Selling and marketing ......................... 20.8 21.4
General and administrative .................... 19.3 15.4
Health care benefits .......................... 7.3 4.4
Depreciation and amortization ................. 19.5 15.6
-------- --------
171.8 156.9
-------- --------

Income from operations........................... 49.0 61.7

Other (income) expense:
Interest expense .............................. 1.7 1.4
Interest income ............................... (1.2) (1.4)
-------- --------
Income before income taxes....................... 48.5 61.7
Income taxes..................................... (18.4) (24.5)
-------- --------
Net income....................................... $ 30.1 $ 37.2
======== ========

Weighted average shares outstanding - basic...... 91.6 95.3
======== ========
Net income per common share - basic ............. $ .33 $ .39
======== ========
Weighted average shares outstanding - diluted ... 92.9 97.7
======== ========
Net income per common share - diluted ........... $ .32 $ .38
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions except per share amounts) (Unaudited)
-----------------------------------------------------------------------------

Six Months Ended June 30,
-------------------------
2004 2003
-------- --------
Revenues......................................... $ 438.9 $ 432.4
-------- --------
Operating expenses:
Cost of services .............................. 211.3 196.3
Selling and marketing ......................... 41.7 42.4
General and administrative .................... 38.9 30.6
Health care benefits .......................... 13.6 9.6
Depreciation and amortization ................. 37.9 30.7
-------- --------
343.4 309.6
-------- --------
Income from operations........................... 95.5 122.8

Nonoperating expense (income):
Interest expense .............................. 3.5 2.7
Interest income ............................... (2.9) (2.7)
-------- --------
Income before income taxes....................... 94.9 122.8
Income taxes..................................... (36.0) (48.8)
-------- --------
Net income....................................... $ 58.9 $ 74.0
======== ========

Weighted average shares outstanding - basic ..... 91.4 96.2
======== ========
Net income per common share - basic ............. $ .64 $ .77
======== ========
Weighted average shares outstanding - diluted ... 92.9 98.7
======== ========
Net income per common share - diluted ........... $ .63 $ .75
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions) (Unaudited)
-----------------------------------------------------------------------------

Three Months Ended June 30,
---------------------------
2004 2003
-------- --------
Net income....................................... $ 30.1 $ 37.2
-------- --------
Unrealized gains (losses) on securities,
before tax..................................... (2.2) 1.2
Unrealized losses on limited partnership
derivatives.................................... (0.4) --
-------- --------
Other comprehensive income (loss), before tax.... (2.6) 1.2
Income tax (expense) benefit related to items
of other comprehensive income.................. 0.9 (0.5)
-------- --------
Other comprehensive income (loss)................ (1.7) 0.7
-------- --------
Comprehensive income............................. $ 28.4 $ 37.9
======== ========

Six Months Ended June 30,
-------------------------
2004 2003
-------- --------
Net income....................................... $ 58.9 $ 74.0
-------- --------
Unrealized gains (losses) on securities,
before tax..................................... (1.9) 1.0
Unrealized losses on limited partnership
derivatives.................................... (0.4) --
-------- --------
Other comprehensive income (loss), before tax.... (2.3) 1.0
Income tax (expense) benefit related to items
of other comprehensive income.................. 0.8 (0.4)
-------- --------
Other comprehensive income (loss)................ (1.5) 0.6
-------- --------
Comprehensive income............................. $ 57.4 $ 74.6
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions) (Unaudited)
-----------------------------------------------------------------------------

Six Months Ended June 30,
-------------------------
2004 2003
-------- --------
Cash flows from operating activities:
Net Income .................................... $ 58.9 $ 74.0
-------- --------
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and amortization ............... 37.9 30.7
Change in allowance for uncollectible
receivables ............................... 1.6 (0.1)
Provision for deferred income taxes ......... -- 0.1
Tax benefits from stock options exercised ... 1.7 6.2
Income from limited partnership ............. (1.6) (1.3)
Other, net .................................. 0.3 --

Changes in Assets and Liabilities (net of
effects of acquired businesses):
Accounts receivable ......................... 4.7 (13.9)
Other current assets ........................ 7.0 0.7
Reinsurance recoverable ..................... (0.9) 1.4
Accounts payable and accrued expenses........ (2.8) (2.6)
Claims reserves ............................. 1.0 (0.7)
Income taxes payable ........................ 18.6 15.1
Noncurrent assets and liabilities ........... (1.0) 0.8
-------- --------
Net cash provided by operating activities ..... 125.4 110.4
-------- --------
Cash flows from investing activities:
Purchases of investments ...................... (21.1) (20.7)
Sales of investments .......................... 24.2 24.4
Acquisition of business, net of cash acquired.. (6.2) (3.4)
Purchase of property and equipment ............ (38.8) (30.6)
-------- --------
Net cash used in investing activities ......... (41.9) (30.3)
-------- --------
Cash flows from financing activities:
Purchase of treasury stock .................... -- (119.1)
Proceeds from issuance of long-term debt ...... 35.0 105.0
Repayment of long-term debt ................... (95.0) (75.0)
Proceeds from issuance of common stock ........ 7.4 14.7
Stock option loan repayments .................. -- 0.2
-------- --------
Net cash used in financing activities ......... (52.6) (74.2)
-------- --------
Net increase in cash and cash equivalents ....... 30.9 5.9

Cash and cash equivalents, beginning of period... 8.0 20.9
-------- --------
Cash and cash equivalents, end of period ........ $ 38.9 $ 26.8
======== ========

First Health Group Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions) (Unaudited)
-----------------------------------------------------------------------------

Six Months Ended June 30,
-------------------------
2004 2003
-------- --------
Supplemental cash flow data:

Stock options exercised in exchange
for common stock............................... $ -- $ 0.5
Health care benefits paid........................ (15.3) (8.7)
Interest paid.................................... (3.0) (2.3)
Interest income received......................... 1.2 1.6
Income taxes paid, net........................... (15.8) (27.5)

Acquisition of businesses:
Fair value of assets acquired,
net of cash acquired......................... $ 3.1 $ (0.5)
Goodwill ...................................... 3.5 3.8
Intangible Assets ............................. 2.5 --
Fair value of liabilities assumed ............. (2.9) 0.1
-------- --------
$ 6.2 $ 3.4
======== ========

See Notes to Consolidated Financial Statements

First Health Group Corp. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
-----------------------------------------------------------------------------

1. The unaudited financial statements herein have been prepared by the
Company pursuant to the rules and regulations of the Securities and
Exchange Commission. The accompanying interim financial statements have
been prepared under the presumption that users of the interim financial
information have either read or have access to the audited financial
statements for the latest fiscal year ended December 31, 2003.
Accordingly, footnote disclosures which would substantially duplicate
the disclosures contained in the December 31, 2003 audited financial
statements have been omitted from these interim financial statements.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been condensed
or omitted pursuant to such rules and regulations. In our opinion, the
accompanying unaudited consolidated financial statements contain all
adjustments necessary for a fair presentation. Although the Company
believes that the disclosures are adequate to make the information
presented not misleading, it is suggested that these interim financial
statements be read in conjunction with the financial statements and the
notes thereto included in the Company's latest Annual Report on Form
10-K.

2. On October 31, 2003, the Company completed the acquisition of all of
the outstanding shares of capital stock of Health Net Employer
Services, Inc. ("Employer Services"), from Health Net, Inc. for
approximately $79 million. Health Net Employer Services, Inc. has been
renamed First Health Employer Services, Inc. The acquisition was
financed with borrowings under the Company's credit facility. The
allocation of the purchase price is expected to be completed in the
fourth quarter of 2004 when the liability for restructuring and
integration is finalized.

Purchase price has been allocated, on a preliminary basis, as follows
(in millions):

Fair value of tangible assets acquired $ 17.1
Goodwill 43.5
Intangible assets 29.5
Liabilities assumed (8.0)
Liability for restructuring and integration costs (2.9)
------
$ 79.2
======

On October 31, 2003, the Company completed the acquisition of PPO
Oklahoma for a purchase price of approximately $10 million, subject to
certain purchase price considerations. The acquisition was financed
with borrowings under the Company's credit facility. Additional
goodwill may be recognized in the fourth quarter of 2004 when the
contingent purchase provisions are resolved.

Purchase price has been allocated, on a preliminary basis, as follows
(in millions):

Fair value of tangible assets acquired $ 0.6
Goodwill 6.6
Intangible assets 3.7
Liabilities assumed (0.2)
Liability for restructuring and integration costs (0.3)
------
$ 10.4
======

On April 7, 2004, The Company completed the acquisition of COMP Medical
for a purchase price of approximately $6 million, subject to certain
purchase price considerations depending on future performance. COMP
Medical has been renamed First Health Priority Services, Inc. ("FHPS").
The acquisition was funded with cash from operating activities.
Additional goodwill may be recognized when the annual contingent
purchase provisions are resolved.

Purchase price has been allocated, on a preliminary basis, as follows
(in millions):

Fair value of tangible assets acquired $ 3.2
Goodwill 3.5
Intangible assets 2.5
Liabilities assumed (2.8)
Liability for restructuring and integration costs (0.1)
------
$ 6.3
======
3. Acquired Intangible Assets

As of June 30, 2004 As of December 31, 2003
--------------------- -----------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
(in millions) Amount Amortization Amount Amortization
------------- ------ ------------ ------ ------------
Amortized intangible
assets:
Customer contracts
and relationships $ 80.7 $ 11.6 $ 78.2 $ 8.3
Provider Contracts 13.7 1.4 13.7 1.0
----- ----- ----- -----
Total $ 94.4 $ 13.0 $ 91.9 $ 9.3
===== ===== ===== =====

Customer contracts and relationships represent added value to the
Company's business for existing long-term contracts and long-term
business relationships. Provider contracts represent additions to the
First Health[R] Network that the Company has acquired. The aggregate
amortization expense recorded during the six months ended June 30, 2004
and 2003, respectively, was $3.7 million and $2.1 million. The
estimated amortization expense for each of the years ending December
31, 2004 through 2007 is approximately $7.5 million. The estimated
amortization expense for the year ending December 31, 2008 is
approximately $6.9 million.

The changes in the carrying amount of goodwill for the six months ended
June 30, 2004 and the twelve months ended December 31, 2003 are as
follows:

(in millions) 2004 2003
------ ------
Balance, January 1 $ 324.3 $ 279.4
Goodwill acquired 3.5 50.0
Other changes -- (5.1)
------ ------
Ending balance $ 327.8 $ 324.3
====== ======

The goodwill acquired in 2004 represents the goodwill from the FHPS
acquisition. The goodwill acquired in 2003 represents goodwill from the
Employer Services and PPO Oklahoma acquisitions. The other goodwill
adjustments in 2003 represented finalization of the allocation of the
purchase price related to prior acquisitions.

4. Accounts receivable valuation allowances for client-specific items were
$39.2 million and $36.5 million as of June 30, 2004 and December 31,
2003, respectively. These valuation allowances for matters such as
performance guarantees and claim, eligibility and data adjustments, are
netted against the gross accounts receivable balance in the
consolidated balance sheets. The Company's largest client, Mail
Handlers Benefit Plan ("MHBP" or the "Plan"), generated revenue of
approximately $50.3 million and $101.6 million (23% of total revenues)
during the three and six months ended June 30, 2004 compared to $54.4
million and $106.0 million in revenues (25% of total revenues) during
the comparable periods of 2003.

5. Allowances for doubtful accounts were $22.9 million and $21.1 million
as of June 30, 2004 and December 31, 2003, respectively. The allowances
for doubtful accounts are established based on historical experience
and current economic circumstances and are adjusted monthly based upon
updated information.

6. The Company's investments in marketable securities, which are
classified as available for sale, had a net unrealized loss in market
value of $1.2 million, net of deferred income taxes, for the six month
period ended June 30, 2004. The accumulated net unrealized loss as of
June 30, 2004, included as a component of stockholders' equity, was
$0.7 million, net of deferred income taxes. The Company has eight
separate investments in a limited liability company that invests in
equipment that is leased to third parties. The total investment as of
June 30, 2004 and December 31, 2003 was $59.1 million and $59.0
million, respectively, and is accounted for using the equity method.
The Company's proportionate share of the partnership's income was $1.6
million and $1.3 million for the six months ended June 30, 2004 and
2003, respectively, and is included in interest income. The total
investment recorded at June 30, 2004 and December 31, 2003 is net of an
unrealized loss on interest rate swaps of $2.5 million ($0.3 million of
which was recorded in the quarter ended June 30, 2004), net of $1.3
million in related taxes, which is recorded in accumulated other
comprehensive income. A member of the Company's Board of Directors is
associated with a group that owns approximately 90% of this
partnership. The Company has between a 20% and 33% interest in each
individual tranche of the partnership.

7. In 2003 the Company's Board of Directors approved the repurchase of up
to 5 million shares of the Company's outstanding common stock. The
Board had previously approved the repurchase of up to 10 million shares
of common stock. Purchases may be made from time to time, depending on
market conditions and other relevant factors. The Company did not
repurchase any shares during the six months ended June 30, 2004. During
the six months ended June 30, 2003, the Company repurchased 5.2 million
shares (1 million shares in the second quarter) on the open market for
approximately $125.5 million ($27.7 million in the second quarter). The
actual cash paid of $119.1 million excludes $6.4 million for trades
dated in June that were settled during the first three days of July. As
of June 30, 2004, approximately 6.1 million shares remain available for
repurchase under the Company's current repurchase authorization.

8. Weighted average shares outstanding for the diluted earnings per share
calculation increased by 1.3 million and 1.5 million and by 2.4 million
and 2.5 million for the three and six months ended June 30, 2004 and
2003, respectively, due to the effect of stock options outstanding.
Diluted net income per share was $.01 less than basic net income per
share for both the three months ended June 30, 2004 and 2003, due to
the effect of stock options outstanding. Diluted net income per share
was $.01 less than basic net income per share for the six months ended
June 30, 2004 and $.02 less than basic net income per share for the six
months ended June 30, 2003, due to the effect of stock options
outstanding.

9. Effective January 1, 2003, the Company adopted Statement of Financial
Accounting Standards No. 146 ("SFAS 146"), "Accounting for Costs
Associated with Exit or Disposal Activities", which requires companies
to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or
disposal plan. Examples of costs covered by the standard include lease
termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, or other exit
or disposal activity. During the quarter ended March 31, 2004, the
Company initiated a plan to terminate approximately 200 employees for a
total cost of $1.4 million in termination benefits. The plan is
expected to be completed by the third quarter of 2004. Substantially
all of the termination costs were incurred in the first quarter of
2004. This termination plan is solely for the Commercial segment of the
Company. The following table summarizes the termination cost activity
for the six months ended June 30, 2004 (in millions):

Expenses Liability
Incurred Amounts As of
To-Date Paid June 30, 2004
------- ---- -------------
$1.4 $1.3 $0.1

The liability is recorded in "accrued expenses" in the consolidated
balance sheet.

10. Effective January 1, 2003, the Company adopted SFAS No. 148 ("SFAS
148"), "Accounting for Stock-Based Compensation - Transition and
Disclosure," which amends SFAS No. 123 ("SFAS 123"), "Accounting for
Stock Based Compensation." The Company accounts for these plans under
the recognition and measurement principles of APB Opinion No. 25,
"Accounting for Stock Issued to Employees" and related Interpretations.
No stock-based employee compensation cost is reflected in net income
(other than compensation cost for consultants), as all options granted
under these plans had an exercise price at least equal to the market
value of the underlying common stock on the date of grant. As permitted
by SFAS 123, and amended by SFAS 148, the Company follows only the
disclosure requirements of SFAS 123 and SFAS 148. The following table
illustrates the effect on net income and earnings per share if the
Company had applied the fair value recognition provisions to all
outstanding and unvested awards in each period:

Three Months Six Months
(in millions except EPS) Ended June 30, Ended June 30,
------------------------ -------------- --------------
2004 2003 2004 2003
------ ------ ------ ------
Net income, as reported $ 30.1 $ 37.2 $ 58.9 $ 74.0

Add: Stock-based employee
compensation expense included
in reported net income, net
of related tax effects. -- (0.1) -- --

Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effects (3.1) (4.3) (6.0) (7.2)
------ ------ ------ ------
Pro forma net income $ 27.0 $ 32.8 $ 52.9 $ 66.8
====== ====== ====== ======
Earnings per share:
Basic, as reported $ .33 $ .39 $ .64 $ .77
Basic, pro forma $ .29 $ .35 $ .58 $ .69

Diluted, as reported $ .32 $ .38 $ .63 $ .75
Diluted, pro forma $ .29 $ .34 $ .57 $ .68

11. The Company and its subsidiaries are subject to various claims arising
in the ordinary course of business and are parties to various legal
proceedings that constitute litigation incidental to the business of
the Company and its subsidiaries. The Company does not believe that the
outcome of such matters will have a material effect on the Company's
financial position, results of operations or cash flows.

The provisions of the contract with the Plan's sponsor, the National
Postal Mail Handlers Union, require that the Company fund any deficits
in the Plan after the Plan's reserves have been fully utilized. As of
June 30, 2004, the Plan has approximately $385 million in reserves
to cover Plan expenses, which may exceed the premiums charged and
collected from the Plan participants by the Plan sponsor. The Plan had
approximately $346 million in such reserves as of December 31, 2003.
There are no known Plan deficits as of June 30, 2004.

FASB Interpretation No. 45, "Guarantees, Including Indirect Guarantees
of Indebtedness to Others," requires the Company to disclose certain
guarantees, including contractual indemnifications, it has assumed. The
Company generally declines to provide indemnification to its customers.
In limited circumstances, to secure long-term customer contracts at
favorable rates, the Company may negotiate risk allocation through
mutual indemnification provisions that, in the Company's judgment,
appropriately allocate risk relative to the value of the customer.
Management believes that any liability under these indemnification
provisions would not be material.

12. The Company operates in two segments: Commercial and Public Sector. In
the Commercial segment, the Company often bundles its products and
services to offer a comprehensive health benefits solution to the
customer centered around the First Health[R] Network. In the Public
Sector segment, the Company offers products and services more
specialized to the needs of the individual customer as public sector
health programs move toward more efficient utilization of health
services. The Company has one executive management team that reviews
and approves all strategic and resource allocations for each of the two
segments. Discreet financial information is available for each of the
two segments and is reviewed regularly by the chief operating decision
maker.

The Company calculates income from operations and net income for each
segment consistent with the accounting policies for the consolidated
financial statements. Interest expense for the Company's credit
facility is charged primarily to the Commercial segment. The Commercial
segment also includes the Company's treasury, legal, tax and other
similar corporate functions. Income taxes are computed using the
consolidated income tax rate of the Company.

Summarized segment financial information for the three and six months
ended June 30 is as follows (in millions):

Three months ended June 30,
---------------------------
2004 2003
-------------------------------- --------------------------------
Public Public
(in millions) Commercial Sector Consolidated Commercial Sector Consolidated
------------- ---------- ------ ------------ ---------- ------ ------------

Revenue $178.2 $ 42.6 $ 220.8 $174.4 $ 44.2 $218.6
Net income 29.3 0.8 30.1 35.4 1.8 37.2
Total assets $956.4 $ 44.9 $1,001.3 $821.7 $ 41.2 $862.9

Six Months Ended June 30,
-------------------------
2004 2003
-------------------------------- --------------------------------
Public Public
(in millions) Commercial Sector Consolidated Commercial Sector Consolidated
------------- ---------- ------ ------------ ---------- ------ ------------
Revenue $357.0 $ 81.9 $ 438.9 $348.6 $ 83.8 $432.4
Net income 58.3 0.6 58.9 70.7 3.3 74.0
Total assets $956.4 $ 44.9 $1,001.3 $821.7 $ 41.2 $862.9

First Health Group Corp. and Subsidiaries

Item 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(Unaudited)
-----------------------------------------------------------------------------

Forward-Looking Information
---------------------------
This Management's Discussion and Analysis of Financial Condition and
Results of Operations may include certain forward-looking statements, within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, including
(without limitation) statements with respect to anticipated future operating
and financial performance, growth and acquisition opportunities and other
similar forecasts and statements of expectation. Words such as "expects",
"anticipates", "intends", "plans", "believes", "seeks", "estimates", "could"
and "should" and variations of these words and similar expressions, are
intended to identify these forward-looking statements. Forward-looking
statements made by the Company and its management are based on estimates,
projections, beliefs and assumptions of management at the time of such
statements and are not guarantees of future performance. The Company
disclaims any obligation to update or revise any forward-looking statement
based on the occurrence of future events, the receipt of new information or
otherwise.

Actual future performance, outcomes and results may differ materially
from those expressed in forward-looking statements made by the Company and
its management as a result of a number of risks, uncertainties and
assumptions. Representative examples of these factors include (without
limitation) general industry and economic conditions; interest rate trends;
cost of capital and capital requirements; competition from other managed
care companies; customer contract cancellations; the ability to expand
certain areas of the Company's business; shifts in customer demands; changes
in operating expenses, including employee wages, benefits and medical
inflation; governmental and public policy changes and the continued
availability of financing in the amounts and on the terms necessary to
support the Company's future business. In addition, if the Company does not
continue to successfully implement new contracts and programs and control
health care benefit expenses, or if the Company does not successfully
integrate its recent acquisitions; then the Company may not achieve its
anticipated 2004 financial results.

Significant Developments
------------------------

Overview
--------
The following information concerning significant business developments is
important to understanding the comparability of the 2004 and 2003 financial
results.

Mail Handlers Benefit Plan
--------------------------
The Mail Handlers Benefit Plan ("MHBP" or the "Plan") is part of the
Company's Federal Employee Health Benefit Plan ("FEHBP") sector and the
Company's largest customer. Revenue was $50.3 million and $101.6 million
(23% of total Company revenue) during the three and six months ended June
30, 2004, respectively, as compared to $54.4 million and $106.0 million
during the comparable periods of 2003 (25 % of total revenue). Adjustments
to revenue are recorded on a client specific and aggregated basis based on
empirical data in each period and may be subject to further adjustments in
subsequent periods. During the second quarter of 2004, the Company recorded
$3 million of revenue as a result of the internal claims reconciliation
process related to 2003.

The adjustment resulted primarily from factors that the Company has
historically used in its internal claims reconciliation process. The
internal reconciliation process involves reconciling fees and savings
associated with each medical claim, the eligibility of each Plan member, the
allowability of each claim in relation to the Plan definition and the
coordination of benefits with other insurers. This completes the 2003
reconciliation process. In addition, the MHBP may include an audit performed
by a governmental agency within a three to five year period after a fiscal
year end. This retrospective review of claims data may result in changes to
previous estimates made for eligibility, coordination of benefits and other
Plan provisions. See the "Critical Accounting Policies" section for a
further description of revenue adjustments.

The provisions of the contract with the Plan's sponsor, the National
Postal Mail Handlers Union, require that the Company fund any deficits in
the Plan after the Plan's reserves have been fully utilized. As of June 30,
2004, the Plan has approximately $385 million in reserves to cover Plan
expenses that may exceed the premiums charged and collected from the Plan
participants by the Plan sponsor. The Plan had approximately $359 million
and $346 million in such reserves as of June 30, 2003 and December 31, 2003,
respectively. There are no known Plan deficits as of June 30, 2004.

Acquisitions
------------
On October 31, 2003, the Company completed the acquisition of all of the
outstanding shares of capital stock of Health Net Employer Services, Inc.
("Employer Services") from Health Net, Inc. for approximately $79 million.
The purchase also included Health Net Plus Managed Care Services, Inc. and
Health Net CompAmerica, Inc. Employer Services is a workers' compensation
managed care company based in Irvine, California. The acquisition was
financed with borrowings under the Company's credit facility. Health Net
Employer Services, Inc. has been renamed First Health Employer Services,
Inc.

On October 31, 2003, the Company also completed the acquisition of PPO
Oklahoma for a purchase price of approximately $10 million, subject to
certain purchase price considerations. PPO Oklahoma operates almost
exclusively in the state of Oklahoma. The acquisition was financed with
borrowings under the Company's credit facility.

On April 7, 2004, the Company completed the acquisition of COMP Medical,
a workers' compensation company headquartered in Woodland Hills, California
that specializes in appointment setting for chronic pain management,
diagnostic imaging and electrodiagnostic procedures, as well as Medicare
set-aside allocations. The purchase price was approximately $6 million,
subject to additional purchase price considerations depending on future
performance, and was paid with cash from operating activities. COMP Medical
has been renamed First Health Priority Services, Inc. ("FHPS").

Termination Plan
----------------
During the quarter ended March 31, 2004, the Company initiated a plan to
terminate approximately 200 employees at an estimated cost of $1.4 million
in termination benefits. The Company recorded substantially all of these
costs during the first quarter of 2004. Management believes this termination
plan should save the Company in excess of $7 million in salaries and related
expenses during the second half of 2004 and in excess of $10 million in
expenses during 2005 (primarily in "cost of services" in the consolidated
statement of operations).

Results of Operations
---------------------
The Company's revenues consist primarily of fees for cost management
services provided on a predetermined contractual basis or on a percentage-
of-savings basis. Revenues also include insurance premium revenue from the
Company's insurance company operations.

The following table sets forth information with respect to the sources of
the Company's revenues for the three and six months ended June 30, 2004 and
2003, respectively:

Sources of Revenue
($ in millions)
Three Months Ended June 30,
------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
PPO plus Administration
Services $ 80.2 37% $ 91.1 41%
PPO 33.1 15 38.9 18
Premiums 9.4 4 4.2 2
------ ---- ------ ----
Total Group Health 122.7 56 134.2 61
------ ---- ------ ----
Workers' Compensation:
PPO plus Administration
Services 31.6 14 25.1 12
PPO 23.9 11 15.1 7
------ ---- ------ ----
Total Workers' Compensation 55.5 25 40.2 19
------ ---- ------ ----
Total Commercial Revenue 178.2 81 174.4 80
------ ---- ------ ----
Public Sector Revenue 42.6 19 44.2 20
------ ---- ------ ----
Total Revenue $ 220.8 100% $ 218.6 100%
====== ==== ====== ====

($ in millions)
Six Months Ended June 30,
------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
PPO plus Administration
Services $164.2 38% $ 180.0 42%
PPO 67.8 15 79.8 18
Premiums 18.5 4 8.4 2
------ ---- ------ ----
Total Group Health 250.5 57 268.2 62
------ ---- ------ ----
Workers' Compensation:
PPO plus Administration
Services 63.8 14 50.1 12
PPO 42.7 10 30.3 7
------ ---- ------ ----
Total Workers' Compensation 106.5 24 80.4 19
------ ---- ------ ----
Total Commercial Revenue 357.0 81 348.6 81
------ ---- ------ ----
Public Sector Revenue 81.9 19 83.8 19
------ ---- ------ ----
Total Revenue $ 438.9 100% $ 432.4 100%
====== ==== ====== ====

Supplemental Revenue Information

The following table sets forth supplemental information by revenue sector:

($ in millions)
Three Months Ended June 30,
------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
FEHBP $ 57.2 26% $ 62.4 28%
Corporate 40.4 18 50.9 23
Insurers/TPA 25.1 12 20.9 10
------ ---- ------ ----
Total Group Health 122.7 56 134.2 61
------ ---- ------ ----
Workers' Compensation 55.5 25 40.2 19
------ ---- ------ ----
Total Commercial 178.2 81 174.4 80
------ ---- ------ ----
Public Sector 42.6 19 44.2 20
------ ---- ------ ----
Total Revenue $ 220.8 100% $ 218.6 100%
====== ==== ====== ====

($ in millions)
Six Months Ended June 30,
------------------------------
2004 % 2003 %
------ ---- ------ ----
Commercial Revenue:
Group Health:
FEHBP $ 115.9 26% $ 121.8 28%
Corporate 84.4 19 103.1 24
Insurers/TPA 50.2 12 43.3 10
------ ---- ------ ----
Total Group Health 250.5 57 268.2 62
------ ---- ------ ----
Workers' Compensation 106.5 24 80.4 19
------ ---- ------ ----
Total Commercial 357.0 81 348.6 81
------ ---- ------ ----
Public Sector 81.9 19 83.8 19
------ ---- ------ ----
Total Revenue $ 438.9 100% $ 432.4 100%
====== ==== ====== ====

This supplemental revenue data provides information about the mix of
clients within the Company's revenue sectors. In addition to the
supplemental information above, the Company has generated approximately 40%
of total Company revenues on a percentage-of-savings basis for the three and
six months ended June 30, 2004 compared to 38% and 39% for the comparable
periods of 2003.

Total revenue for the three and six months ended June 30, increased $2.1
million (1.0%) and $6.5 million (1.5%) from the comparable periods of 2003.
The components of the Company's quarterly revenue are as follows:

Group Health revenue of $122.7 million and $250.5 million for the three
and six months ended June 30, 2004 decreased $11.5 million (8.6%) and $17.7
million (6.6%) from the comparable periods of 2003. Group Health revenue
represents revenue from the corporate, FEHBP, small group carrier and third
party administrator payors. Group Health PPO plus Administration Services
revenue for the three and six months ended June 30, 2004 decreased $11.0
million (12.1%) and $15.9 million (8.8%) from the comparable periods of 2003
due in part to increased price competition, less new business and higher
client attrition than expected. Group Health PPO revenue for the three and
six months ended June 30, 2004 decreased $5.9 million (15.1%) and $12.0
million (15.0%) from the comparable periods of 2003 due primarily to clients
taking advantage of a wider array of the Company's services (which is
reported under PPO plus Administration Services). Premium revenue for the
three and six months ended June 30, 2004 increased $5.3 million (129.0%) and
$10.2 million (121.5%) from the comparable periods of 2003 as a result of
new client activity, particularly due to the New England Financial ("NEF")
block of small group, multi-sited business the Company signed in the fourth
quarter of 2003. The Company ceded 80% of the premiums and related policy
benefits to a highly-rated insurance carrier.

Group Health revenue is further broken down into the FEHBP, Corporate and
Insurers/TPA sectors. FEHBP sector revenue for the three and six months
ended June 30, 2004 decreased $5.2 million (8.4%) and $5.9 million (4.8%)
from the comparable periods of 2003. This decrease is due primarily to the
MHBP which experienced an approximate 10% decrease in enrollment, lower
participant utilization and a change in the mix of plan options. The revenue
decrease was partially offset by $3 million the Company recorded in the
second quarter of 2004 as part of its retrospective review of claims data
related to 2003 MHBP business. Corporate sector revenue for the three and
six months ended June 30, 2004 decreased $10.5 million (20.6%) and $18.7
million (18.2%) from the comparable periods of 2003. This decrease is due to
client attrition, less new business than anticipated and increased price
competition in the sector. Insurers/TPA sector revenue for the three and six
months ended June 30, 2004 increased $4.2 million (19.8%) and $6.9 million
(16.0%) from the comparable periods of 2003 due primarily to new business
with insurers, principally the NEF business discussed earlier.

Workers' Compensation revenue of $55.5 million and $106.5 million for the
three and six months ended June 30, 2004 increased $15.2 million (37.7%) and
$26.1 million (32.4%) from the comparable periods of 2003. This increase is
due primarily to $13.0 million and $28.7 million in revenues earned as a
result of the Employer Services acquisition for the three and six months
ended June 30, 2004. Workers' Compensation revenue increased $4.5 million
(8.8%) from the first quarter of 2004 due primarily to $2.3 million in
revenues earned from the FHPS acquisition. Absent these acquisitions
Workers' Compensation revenue decreased slightly from 2003.

Public Sector revenue of $42.6 million and $81.9 million for the three
and six months ended June 30, 2004 decreased $1.6 million (3.5%) and $1.9
million (2.2%) from the comparable periods of 2003. Public Sector revenue
represents fees associated with pharmacy benefit management, fiscal agent
services and health care management from clients within the public sector.
This decrease in revenue is due primarily to less revenue from non-recurring
HIPAA support and pharmacy program implementations. Public Sector revenue in
the second quarter of 2003 was favorably impacted by $11.5 million of such
non-recurring implementations compared to $0.8 million of such revenue in
the second quarter of 2004. On a continuing revenue basis, the 2004
quarterly revenue would have increased $9.1 million or 28% from the
comparable quarter of 2003. Public Sector revenue increased $3.4 million
(8.5%) from the first quarter of 2004 due to new pharmacy contracts.

Cost of services increased $4.7 million (4.7%) and $15.0 million (7.6%)
for the three and six months ended June 30, 2004 from the comparable periods
in 2003 due primarily to costs associated with the Employer Services, PPO
Oklahoma and FHPS acquisitions and, to a lesser extent costs associated with
the Company's termination plan. Cost of services decreased $1.5 million
(1.4%) from the first quarter of 2004 as the Company cost reduction programs
have begun to take effect. Cost of services consists primarily of salaries
and related costs for personnel involved in claims administration, PPO
administration, development and expansion, utilization management programs,
fee schedule and other cost management and administrative services offered
by the Company. To a lesser extent, cost of services includes telephone
expenses, facility expenses and information processing costs. As a
percentage of revenue, cost of services increased to 47.5% and 48.1% for the
three and six months ended June 30, 2004, respectively, from 45.8% and 45.4%
in the comparable periods of 2003, but decreased from 48.8% in the first
quarter of 2004. The increase as a percentage of revenue from 2003 is due
primarily to the costs associated with the various acquisitions as well as a
trend toward providing more administrative services which are more cost-
intensive.

Selling and marketing costs for the three and six months ended June 30,
2004 decreased $0.6 million (2.6%) and $0.7 million (1.6%) from the
comparable periods in 2003 primarily due to a decrease in costs associated
with the Company's ad campaign. Selling and marketing costs were essentially
flat compared to the first quarter of 2004.

General and administrative costs for the three and six months ended June
30, 2004 increased $3.8 million (24.5%) and $8.2 million (26.6%) from the
comparable periods in 2003 due primarily to increases in professional
liability insurance and other professional fees associated with cost savings
initiatives designed to improve efficiencies and profitability. General and
administrative costs decreased slightly from the first quarter of 2004.

Health care benefits represent medical losses incurred by insureds of the
Company's insurance entities. Health care benefits increased $2.9 million
(65.7%) and $4.0 million (42.2%) for the three and six months ended June 30,
2004 from the comparable periods of 2003. This increase was due primarily to
new business, particularly the NEF business discussed above. Health care
benefits increased $1.0 million (15.2%) from the first quarter of 2004 also
due to the NEF business. The loss ratio (health care benefits as a percent
of premium revenue) was 77% and 73% for the three and six months ended June
30, 2004 compared to 106% and 114% for the comparable periods of 2003. The
decrease in the loss ratio from 2003 is due primarily to improved experience
in the Company's stop loss business and the NEF small group business.
Management reviews the book of business in detail on a monthly basis to
minimize the loss ratio. Stop-loss insurance is related to the PPO and
claims administration businesses and is used as a way to attract additional
PPO business, which is the Company's most profitable product.

Depreciation and amortization expenses increased $4.0 million (25.6%) and
$7.2 million (23.6%) for the three and six months ended June 30, 2004 from
the comparable periods in 2003 due primarily to increased software
investments made over the course of the past few years, and, to a lesser
extent, amortization of intangible assets related to the various
acquisitions the Company has made. Depreciation expense will continue to
grow primarily as a result of continuing investments the Company is making
in its infrastructure.

Income from operations of $49.0 million and $95.5 million for the three
and six months ended June 30, 2004 decreased $12.7 million (20.6%) and $27.3
million (22.2%) from the comparable periods of 2003. Income from operations
increased $2.5 million (5.4%) from the first quarter of 2004. Operating
margin (income from operations as a percentage of revenue) was 22.2% in the
second quarter of 2004, 28.2% in the second quarter of 2003 and 21.3% in the
first quarter of 2004. The decrease in income from operations and operating
margins from 2003 is due to a change in the mix of revenue to lower-margin
administrative services business as well as expenses the Company incurred
associated with cost savings initiatives. These initiatives had a positive
effect beginning in the second quarter of 2004.

Interest income for the three and six months ended June 30, 2004 is
comparable to prior periods. The Company has used $60 million of its
available cash in 2004 to repay debt.

Interest expense for the three and six months ended June 30, 2004
increased $0.3 million (21.6%) and $0.8 million (30.6%) from the comparable
periods in 2003. Interest expense has increased as the outstanding debt
increased from $150 million at June 30, 2003 to $210 million at June 30,
2004. The effective marginal interest rate on June 30, 2004 was
approximately 2.2% per annum.

Diluted net income per common share for the three and six months ended
June 30, 2004 decreased 15.8% to $.32 per share and 16.0% to $.63 per share
from the comparable periods of 2003. The decrease in net income per common
share was due primarily to the change in revenue mix and the expenses
associated with cost savings initiatives discussed above. For the three and
six months ended June 30, 2004, diluted common shares outstanding decreased
4.9% and 5.9% from the comparable periods of 2003.

Segment Information
-------------------
The Company reports its financial results under two segments: the
Commercial segment, where the Company provides its health benefit services
to Commercial customers in the Group Health and Workers' Compensation
markets, and the Public Sector segment, where the Company services are
provided to customers within state and local governments. The Commercial
Group Health market represents payors from the FEHBP, corporate and third
party administrators/insurers sectors. Management believes this presentation
reflects how the Company markets and sells its products and services. In the
Commercial sector, the Company often bundles its products and services to
offer a comprehensive health benefits solution, and it does not sell
administrative services (claims administration, bill review, pharmacy
benefit management, clinical management) on a stand-alone basis without PPO
network services. In the Public Sector, the Company offers products and
services more specialized to the needs of the individual customer as public
sector health programs move toward more efficient utilization of health
services.

Commercial Three months ended June 30, Six months ended June 30,
($ in millions) 2004 2003 2004 2003
---------------------- ------ ------ ------ ------
Revenues $ 178.2 $ 174.4 $ 357.0 $ 348.6
Operating expenses 130.5 115.7 262.5 231.3
------ ------ ------ ------
Income from operations 47.7 58.7 94.5 117.3
------ ------ ------ ------
Operating margin 26.8% 33.6% 26.5% 33.6%

Interest income (1.2) (1.4) (2.9) (2.7)
Interest expense 1.7 1.4 3.5 2.7
------ ------ ------ ------
Income before income taxes 47.2 58.7 93.9 117.3
Income taxes (17.9) (23.3) (35.6) (46.6)
------ ------ ------ ------
Net income $ 29.3 $ 35.4 $ 58.3 $ 70.7
====== ====== ====== ======

The decline in income from operations and net income for the Commercial
segment is due to a number of factors including: increased price competition
(particularly in the Corporate sector); new business in the lower margin
third party administrator/insurance sector; lower PPO savings in the FEHBP
sector; and the costs incurred associated with savings initiatives. The
Company's termination plan, discussed above, is designed to improve the
profitability of the Commercial segment beginning in the second half of
2004.

Public Sector Three months ended June 30, Six months ended June 30,
($ in millions) 2004 2003 2004 2003
---------------------- ------ ------ ------ ------
Revenues $ 42.6 $44.2 $ 81.9 $ 83.8
Operating expenses 41.3 41.2 80.9 78.3
------ ------ ------ ------
Income from operations 1.3 3.0 1.0 5.5
------ ------ ------ ------
Operating margin 3.1% 6.9% 1.3% 6.6%

Interest expense -- -- -- --
------ ------ ------ ------
Income before income taxes 1.3 3.0 1.0 5.5
Income taxes (0.5) (1.2) (0.4) (2.2)
------ ------ ------ ------
Net income $ 0.8 $ 1.8 $ 0.6 $ 3.3
====== ====== ====== ======

The decline in income from operations and net income in the Public Sector
segment is due primarily to the decline in non-recurring HIPAA support and
pharmacy program business discussed earlier. The revenue and profitability
is expected to increase going forward in 2004, as the pharmacy benefit
management ("PBM") business grows and efficiency initiatives are put in
place to help control costs. The Company has won 14 of its last 16 contract
bids for PBM services within the Public Sector. PBM business is higher-
margin business and now represents more than half of the Public Sector
revenue.

Liquidity and Capital Resources
-------------------------------
The Company had $25.2 million in working capital on June 30, 2004
compared with working capital of $24.1 million at December 31, 2003. Total
cash and investments amounted to $166.6 million at June 30, 2004 compared to
$139.7 million at December 31, 2003.

Cash and cash equivalents at June 30, 2004 include $23.1 million
accumulated in the accounts of the Company's insurance entities due to the
timing of the collection of insurance premiums in advance of related
payments for commissions and payments to re-insurers.

Cash flow from operations was driven by the timing of collections of
accounts receivable and the timing of payment of its insurance-related
liabilities. Strong accounts receivable collection efforts in the second
quarter of 2004 provided $4.7 million of cash in 2004 versus a use of $13.9
million of cash in 2003. The Company has also collected $8 million in
reinsurance recoverable balances in 2004 (in "Other current assets" in the
consolidated balance sheets). These collection efforts offset lower net
income in 2004 and contributed to a $15 million increase in cash from
operations. Cash collected from the exercise of stock options has declined
from prior years, which was anticipated in the Company's 2003 Annual Report
on Form 10-K.

The Company's most significant uses of cash continue to be for payment of
operating expenses, income taxes and capital expenditures. Management
currently expects that capital expenditures for 2004 will be approximately
8% of revenues or $75 million, slightly below the 10% investment of the past
several years. The Company anticipates that its operating expenses will
decrease in the second half of 2004 when the steps taken to increase
profitability are expected to take full effect.

The Company's outstanding debt at June 30, 2004 decreased to $210 million
from $270 million at December 31, 2003 as the Company used cash generated
from operations to pay down debt.

The following table summarizes the contractual obligations the Company has
outstanding as of June 30, 2004:

(in millions) Payments due by period
----------------------
Less than 1-3 3-5 Over 5
Contractual Obligations Total 1 year years years years
----------------------- ----- ------ ----- ----- -----
Long-term debt $210.0 $ - $210.0 $ - $ -
Operating leases 55.8 14.6 21.8 14.0 5.4
Purchase obligations 1.0 1.0 - - -
----- ----- ----- ----- -----
Total $266.8 $ 15.6 $231.8 $ 14.0 $ 5.4
===== ===== ===== ===== =====

The purchase obligation is a commitment to a limited partnership
investment. The Company has no capital lease obligations, off-balance sheet
financing arrangements or other contractual obligations as of June 30, 2004.

The Company believes that its working capital, long-term investments,
credit facility and cash generated from future operations will be sufficient
to fund the Company's anticipated operations and expansion plans.

In accordance with FASB Interpretation No. 45 ("FIN 45"), "Guarantees,
Including Indirect Guarantees of Indebtedness to Others", the Company
is required to disclose certain guarantees, including contractual
indemnifications, it has assumed. The Company generally declines to provide
indemnification to its customers. In limited circumstances, to secure long-
term customer contracts at favorable rates, the Company may negotiate risk
allocation through mutual indemnification provisions that, in the Company's
judgment, appropriately allocate risk relative to the value of the customer.
Management believes that any liability under these indemnification
provisions would not be material.

2004 Outlook
------------
The Company reaffirms the revenue, earnings and cash flow guidance it
released in April 2004. The Company has taken a number of key steps to
improve profitability including the Company's termination plan, deeper
sector focus (operationally and functionally), growth initiatives to develop
new market opportunities (especially in the workers' compensation and public
sectors) and initiatives to drive operational efficiencies (especially in
the group health and public sectors). These steps are expected to favorably
impact earnings for the last six months of 2004.

Critical Accounting Policies
----------------------------
The consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and
include amounts based on management's prudent judgments and estimates.
Management believes that any reasonable deviation from these judgments and
estimates would not have a material impact on the Company's financial
position or results of operations. To the extent that the estimates used
differ from actual results, adjustments to the statement of operations and
the balance sheet would be necessary. Some of the more significant estimates
include the recognition of revenue, allowance for doubtful accounts and
insurance claim reserves. The Company uses the following techniques to
determine estimates:

Revenue recognition - Significant estimates used in recognizing revenue
relate to performance guarantees, other client-specific claim, eligibility
and other data adjustments, and recoverability of receivables. Adjustments
to PPO savings, and, therefore, PPO revenues, occur due to client
corrections of member eligibility data as originally submitted or due to
certain client's inability to resubmit claims adjustments to the Company's
repricing system. In addition, the Company performs a claims reconciliation
process which varies client-by-client and, in some cases, such as with the
MHBP, is performed a number of months after year-end. The claims
reconciliation process is affected by a number of items including: size of
enrollment; volume of claims data; a client's technological infrastructure;
structure of the benefit plan(s); and the specific terms of the client
contract. MHBP is the Company's largest client and presents a complex
combination of these items above which results in a lengthy reconciliation
process. The Company records adjustments in the current accounting period;
further adjustments may be made in future periods based on new information
that becomes available in such future periods. In some cases, such as with
the MHBP, the adjustment process is also subject to an external audit
performed by a governmental agency. The use of such estimates and the claims
reconciliation process enables the Company to report PPO fee revenue more
accurately as information becomes available to support entitlement to fees,
net of actual adjustments. Revenue adjustments are estimated on a client-
specific and aggregated basis using actual, historical adjustment data.
Valuation allowances recorded for such matters were $39.2 million at June
30, 2004 and $36.5 million at December 31, 2003. Total adjustments to
revenue amounted to a reduction of less than 1% of total Company revenue for
the six months ended June 30, 2004 and 2003.

Allowance for doubtful accounts - The Company provides reserves for
uncollectible revenue due to client collectibility issues as an allowance
for doubtful accounts. The primary reasons for nonpayment of these
accounts receivable are client bankruptcy, insolvency or disputes over
eligibility. The methodology for calculating the allowance for doubtful
accounts includes an assessment of specific receivables that are aged and an
assessment of the aging of the total receivable pool. Substantially all of
the Public Sector revenue is received from state and local governments.
The Company's experience with recovering receivables related to Public
Sector revenue is impacted primarily by contract disputes, changes in
administrative personnel and the timing of fiscal appropriations relative to
the billing of our services. The reserving methodology for Public Sector
receivables provides for a longer collection period compared to Commercial
receivables. The Company evaluates the recoverability of Public Sector
receivables based on the aging of receivables, with additional consideration
given to clients with known fiscal appropriations issues. The allowance for
doubtful accounts totaled $22.9 million at June 30, 2004 and $21.1 million
at December 31, 2003.

Insurance claim reserves - Claims reserves are developed based on medical
claims payment history adjusted for specific benefit plan elements (such as
deductibles) and expected savings generated by utilization of The First
Health[R] Network. Based upon this process, management believes that the
insurance claims reserves are appropriate; however, actual claims incurred
and actual settlement values of claims may differ from the original
estimates requiring adjustments to the reserves.

New Accounting Pronouncements
-----------------------------
In March 2004, the FASB Task Force reached a consensus on Issue No. 03-1
("Issue 03-1"), "The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments." Issue 03-1 provides guidance for
determining when an investment is other-than-temporarily impaired. The
Company adopted the disclosure provisions of Issue 03-1 in 2003 and the
guidance for evaluating whether an investment is other-than-temporarily
impaired is effective for reporting periods beginning after June 15, 2004.
The amount of any other-than-temporary impairment that may need to be
recognized upon adoption of Issue 03-1 will be dependent on market
conditions and management's intent and ability at the time of the impairment
evaluation to hold the underwater investments until a forecasted recovery in
fair value up to (or beyond) adjusted cost.

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

The Company's market risk exposure as of June 30, 2004 was consistent
with the types of market risk and amount of exposure presented in its 2003
Annual Report on Form 10-K.

Item 4. Controls and Procedures
-----------------------

The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the
Company's Exchange Act reports is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission's rules and forms and that such information is accumulated and
communicated to the Company's management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow for timely
decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and
management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.

As of June 30, 2004, the end of the quarter covered by this report,
management carried out an evaluation, with the participation of the
Company's Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure
controls and procedures. Based on the foregoing, the Company's Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective at the reasonable
assurance level as of June 30, 2004.

There has been no change in the Company's internal controls over
financial reporting during the Company's most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the
Company's internal controls over financial reporting.

PART II

Item 1. Legal Proceedings
-----------------

The Company and its subsidiaries are subject to various claims arising in
the ordinary course of business and are parties to various legal proceedings
that constitute litigation incidental to the business of the Company and its
subsidiaries. The Company does not believe that the outcome of such matters
will have a material effect on the Company's financial position or results
of operations.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
--------------------------------------------------------------
Equity Securities
-----------------

The following table summarizes any purchases of the Company common stock
made by or on behalf of the Company for the quarter ended June 30, 2004.

Total # of Maximum # of
shares purchased shares that
as part of may yet be
Total # Average publicly purchased
of shares price paid announced under the
Period purchased per share programs programs
------ --------- --------- -------- ---------
April 1 - April 30 -- -- -- 6,109,841
May 1 - May 31 -- -- -- 6,109,841
June 1 - June 30 -- -- -- 6,109,841
--------- --------- -------- ---------
Total -- -- -- 6,109,841
========= ========= ======== =========

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

At the annual meeting of stockholders of the Company on May 13, 2004, all
directors of the Company who stood for reelection were re-elected. The
number of votes cast for and withheld for each director were as follows:

For Withheld
---------- --------
Michael J. Boskin 84,097,648 1,405,900
Daniel S. Brunner 83,108,920 2,394,628
Raul Cesan 84,037,510 1,466,038
Ronald H. Galowich 69,798,218 15,705,330
Harold S. Handlesman 83,201,397 2,302,151
Don Logan 84,282,990 1,220,558
William Mayer 84,276,568 1,226,980
David E. Simon 83,255,866 2,247,682
James C. Smith 83,339,369 2,164,179
Edward L. Wristen 83,337,609 2,165,939

A proposal to ratify the reappointment of Deloitte & Touche LLP as the
Company's independent auditors for the fiscal year 2004 was approved with
84,555,837 shares cast for, 925,416 shares against and 22,295 shares
abstaining.

Item 5. Other Information
-----------------

There has been no material change to the procedures by which security
holders may recommend nominees to the Company's Board of Directors.

Item 6. Exhibits and Reports on Form 8-K
--------------------------------

Exhibits:

(a) Exhibit 11 - Computation of Basic Earnings Per Common Share and
Diluted Earnings Per Common Share

(b) Exhibit 31.1 - Certification of Chief Executive Officer pursuant
to Rule pursuant 13a - 14(a) and Rule 15d - 14(a),
promulgated under the Securities Exchange Act of
1934, as amended.

(c) Exhibit 31.2 - Certification of Chief Financial Officer pursuant
to Rule pursuant 13a - 14(a) and Rule 15d - 14(a),
promulgated under the Securities Exchange Act of
1934, as amended.

(d) 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.

(e) 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.

Reports on Form 8-K:

The Company furnished a report on Form 8-K dated April 26, 2004
reporting under Item 12 lowering its first quarter and full year
2004 financial expectations.

The Company furnished a report on Form 8-K dated May 3, 2004
reporting under Item 12 the results of operations and financial
condition for the three months ended March 31, 2004.

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.

First Health Group Corp.

Dated: August 6, 2004 /s/Edward L. Wristen
-------------------------------------
Edward L. Wristen
President and Chief Executive Officer

Dated: August 6, 2004 /s/William R. McManaman
-------------------------------------
William R. McManaman
Senior Vice President, Chief
Financial Officer
(Principal Financial Officer)