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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2002

OR

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

For the transition period from to                      to

Commission file number 0-20488

PSYCHIATRIC SOLUTIONS, INC.
(Exact Name of Registrant as Specified in Its Charter)

(615) 312-5700
(Registrant’s Telephone 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   o

     As of October 31, 2002, Psychiatric Solutions, Inc. had 7,738,643 shares of common stock outstanding.

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PSYCHIATRIC SOLUTIONS, INC.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PSYCHIATRIC SOLUTIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In Thousands)

See notes to condensed consolidated financial statements

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PSYCHIATRIC SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands except for per share amounts)

See notes to condensed consolidated financial statements

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PSYCHIATRIC SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, In Thousands)

See notes to condensed consolidated financial statements

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

1. MERGER WITH PMR CORPORATION

On August 5, 2002, pursuant to a definitive Merger Agreement dated May 6, 2002 and with respective stockholder and regulatory approvals, PMR Acquisition Corporation, a newly formed, wholly-owned subsidiary of PMR Corporation, merged with and into Psychiatric Solutions, Inc., a Delaware corporation whose name, subsequent to the merger, was changed to Psychiatric Solutions Hospitals, Inc. (“PSH”). Concurrently, the name of PMR Corporation was changed to Psychiatric Solutions, Inc. (“PSI” or the “Company”). The surviving corporation in the merger was PSH, which has become a wholly-owned subsidiary of the Company. In exchange for their outstanding shares of common stock or preferred stock in PSH, stockholders of PSH received newly-issued shares of Company common stock. Options to acquire PSH common stock were converted into options to purchase shares of Company common stock based on the common stock exchange ratio used in the merger. Warrants of PSH will enable the holders to exercise these securities into shares of Company common stock. After giving effect to the exercise of all outstanding options and warrants of PSH following the merger, the former PSH stockholders and the Company’s pre-merger stockholders received approximately 72% and 28% of the common stock of the Company, respectively. The headquarters of the combined company has been relocated to Franklin, Tennessee. In addition, effective August 6, 2002, the shares of the Company were approved for listing on the Nasdaq National Market under the ticker symbol “PSYS.” The Merger Agreement is on file with the Securities and Exchange Commission (“SEC”) as an exhibit to Amendment No. 1 to the Company’s Registration Statement on Form S-4 filed on June 12, 2002, as amended July 11, 2002.

Inasmuch as the former PSH stockholders own more than half of the surviving corporation’s outstanding common stock pursuant to the merger, PSH has been treated as the acquiring company for accounting purposes. The condensed consolidated financial statements located herein relate to PSH only prior to August 5, 2002, and to the merged company on and subsequent to August 5, 2002. Historical financial information relating to PMR Corporation just prior to the merger can be found in the Company’s quarterly report on Form 10-Q for the quarter ended July 31, 2002, as filed with the SEC on September 16, 2002.

2. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for audited financial statements. The condensed consolidated balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial position of the Company have been included. Operating results for the three and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for the full year. For further information, refer to the financial statements and footnotes thereto included in the Company’s Registration Statement on Form S-4 filed on June 12, 2002, as amended July 11, 2002.

PSH’s Series A Preferred Stock, Series B Preferred Stock and Common Stock were converted to post merger Common Stock on August 5, 2002 at rates pursuant to the merger agreement with PMR Corporation of 0.246951, 0.312864 and 0.115125, respectively. All periods prior to August 5, 2002 have been retroactively restated to reflect conversion at the applicable conversion rates. The following table sets forth the effect of retroactive conversion as of December 31, 2001 (in thousands):

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

3. EARNINGS PER SHARE

Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings per Share, requires dual presentation of basic and diluted earnings per share by entities with complex capital structures. Basic earnings per share includes no dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of the entity. The Company has calculated its earnings per share in accordance with SFAS No. 128 for all periods presented.

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

Diluted earnings per share for the nine months ended September 30, 2002, does not include debt outstanding which is convertible into 422,000 shares, as its effect would be antidilutive.

4. DEBT

In conjunction with its hospital acquisition in November 2001, Psychiatric Solutions entered into a senior credit facility of $33.2 million (“2001 Senior Credit Facility”). The 2001 Senior Credit Facility was amended on June 28, 2002 to provide for an additional $7.95 million pursuant to a new non-revolving term note. The 2001 Senior Credit Facility, as revised, includes two lines of credit for a total credit facility of $41.15 million, made up of $23.65 million of non-revolving term loans and a $17.5 million revolving working capital line of credit. Both lines are secured by substantially all of Psychiatric Solutions’ assets and stock of its subsidiaries. The term loans accrue interest at the Citibank, N.A. prime rate plus 4.25% to 4.75%. The revolving line of credit accrues interest at the Citibank, N.A. prime rate plus 2% and is due in November 2004. At September 30, 2002, the interest rate was 7.25%. Until the due date, Psychiatric Solutions may borrow, repay and re-borrow an amount not to exceed the lesser of $17.5 million or the borrowing base (as defined in the 2001 Senior Credit Facility). As of September 30, 2002 the Company had $6.5 million available under the revolving line of credit. On July 1, 2002, Psychiatric Solutions drew $2.9 million on the revolving line of credit in connection with its purchase of Riveredge Hospital. Following the acquisition of Riveredge Hospital on July 1, 2002, there was $2.2 million available under the revolving line of credit. Under the revolving line of credit, all of Psychiatric Solutions’ collections, except for Medicare and Medicaid payments, are deposited into lockbox accounts controlled by the lender. The funds deposited in the lockbox are applied to outstanding borrowings with the lender on a daily basis. As a result, the outstanding borrowings under the revolving line of credit are classified as short term as of December 31, 2001 and September 30, 2002. Psychiatric Solutions must pay an unused fee in the amount of 0.05% per month of the monthly unused portion of the 2001 Senior Credit Facility. Such fees were approximately $34,000 as of September 30, 2002.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

The 2001 Senior Credit Facility contains customary covenants which include: (i) a specified monthly patient census for any owned, operated or leased hospitals, (ii) a limitation on capital expenditures, sales of assets, mergers, changes of ownership and management, new lines of business and dividends and (iii) various financial covenants. As of September 30, 2002, Psychiatric Solutions was in compliance with all applicable debt covenant requirements. Should Psychiatric Solutions’ results of operations or cash flows decline and result in violation of one or more of these covenants, amounts outstanding under the 2001 Senior Credit Facility could become immediately payable and additional borrowings could be restricted. As of September 30, 2002, approximately $22.0 million was outstanding.

In connection with the 2001 Senior Credit Facility, Psychiatric Solutions was required to expense the remaining deferred loan costs associated with its prior credit facility in the amount of $419,000 and incurred early termination penalties of $818,000 in the fourth quarter of 2001.

In October 2000 Psychiatric Solutions issued subordinated notes totaling $1.0 million with certain of its stockholders (the “Bridge Loan”). In connection with the Bridge Loan, Psychiatric Solutions issued warrants to purchase a total of 398,579 shares of its Series B preferred stock. The Bridge Loan was used to fund short-term working capital requirements and accrued interest at 10% per annum, payable monthly. The Bridge Loan was paid in full in April 2002. The warrants were exercised on August 1, 2002, and, in conjunction with the PMR merger, converted to 124,700 common shares on August 5, 2002.

In connection with the acquisition of Sunrise in May 2000, Psychiatric Solutions issued subordinated convertible notes in the amount of $3.6 million. These convertible notes are due May 1, 2005 and accrue interest at 9% per annum. The principal amount of these convertible notes is convertible into shares of the Company’s common stock based on conversion prices of $8.53 to $9.59 per share.

Psychiatric Solutions also issued promissory notes totaling $4.5 million in connection with its acquisitions of three hospitals. One note in the amount of $2.5 million accrues interest at 9% per annum and matured on June 30, 2002. Psychiatric Solutions paid off this note in full with a portion of the proceeds of its subordinated debt offering described below. The remaining $2.0 million note accrues interest at 9% per annum and is due June 30, 2005. Among other customary covenants, both notes contain cross default covenants triggered by a default of any other indebtedness of at least $1.0 million. Psychiatric Solutions was in compliance with these covenants as of September 30, 2002.

On June 28, 2002, Psychiatric Solutions entered into a securities purchase agreement with 1818 Mezzanine Fund II, L.P. to issue up to $20 million of senior subordinated notes with detachable nominal warrants. At the closing on June 28, 2002, a total of $10 million of the senior subordinated notes were issued. Approximately $7.5 million of the proceeds were used to fund a portion of the acquisition of Riveredge Hospital, and approximately $2.5 million of the proceeds were used to reduce current indebtedness. The remaining $10 million of senior subordinated notes may be issued to fund additional acquisitions of free-standing psychiatric hospitals and for general working capital purposes, subject generally to approval by the 1818 Fund. The notes have a term of seven years and bear interest at 12% annually, payable quarterly. The notes provide for a prepayment penalty of 6%, 3% and 1% if the notes are prepaid prior to the first anniversary, second anniversary and third anniversary of the closing date, respectively. The notes grant the holders the right to require prepayment in the event of a change of control of Psychiatric Solutions, subject to a prepayment penalty of 1% if redeemed on or before the third anniversary of the closing date. The notes also require Psychiatric Solutions to comply with financial and other covenants.

5. ACQUISITIONS

Acquiring free-standing psychiatric hospitals is a key part of Psychiatric Solutions’ business strategy. Since Psychiatric Solutions has grown through mergers and acquisitions accounted for as purchases, it is difficult to make meaningful comparisons between its financial statements for the fiscal periods presented. In addition, since Psychiatric Solutions owns a relatively small number of hospitals, an individual acquisition may have a material effect on its overall operating performance. At the time a hospital is acquired, a number of measures to lower costs are implemented and significant investments may also be made in the facility. Therefore, the financial performance of a newly acquired hospital may adversely affect its overall performance in the short-term.

On September 1, 2001, Psychiatric Solutions acquired the assets of Cypress Creek Hospital and West Oaks Hospital in Houston, Texas for approximately $14.2 million. The acquisition was financed through a seller-financed subordinated convertible note as well as other long-term borrowings.

Effective November 1, 2001, Psychiatric Solutions acquired the assets of Texas NeuroRehab Hospital in Austin, Texas for approximately $8.4 million, which was financed through a seller-financed subordinated convertible note and additional long-term borrowings.

On December 1, 2001, Psychiatric Solutions acquired the assets of Holly Hill Hospital in Raleigh, North Carolina for approximately $8.4 million which was financed through long-term borrowings under a line of credit.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

On July 1, 2002, Psychiatric Solutions acquired all of the capital stock of Aeries Healthcare Corporation and its wholly owned subsidiary, Aeries Healthcare of Illinois, Inc. for $16.1 million, prior to certain adjustments. Aeries Healthcare of Illinois owns the assets and operations of Riveredge Hospital located near Chicago, Illinois. The acquisition was financed in part through an amendment to Psychiatric Solutions’ Senior Credit Facility. The allocation of purchase price reflected in the September 30, 2002 condensed consolidated balance sheet is preliminary. Final purchase price will be determined once certain conditions are met to relieve funds held in escrow.

On August 5, 2002, Psychiatric Solutions merged with PMR Corporation, an operator of case management programs in Tennessee and a manager of two outpatient psychiatric programs with one acute care hospital in California. For accounting purposes the merger was treated as a purchase of PMR Corporation by Psychiatric Solutions. PMR Corporation shareholders were issued approximately 2.4 million shares of Psychiatric Solutions common stock. The Company acquired approximately $6.0 million in cash in the PMR transaction. Psychiatric Solutions was guaranteed approximately $5.2 million in cash as a part of the PMR transaction. Any additional monies above the $5.2 million as well as subsequent collections of certain legacy receivables of PMR, if any, received by Psychiatric Solutions are payable to certain former PMR shareholders as defined in the Contingent Value Rights Agreement (“CVR”). The Company has accrued approximately $770,000 at September 30, 2002, for payment to CVR holders. The Company expects to make a payment to CVR holders during the fourth quarter of 2002. Additional future payments to CVR holders may be necessary, however, the Company cannot anticipate the amount or timing of such payments as they are contingent upon the Company collecting certain legacy receivables of PMR.

The pro forma unaudited results of operations for the three and nine months ended September 30, 2002 and September 30, 2001, assuming the acquisitions of Riveredge (actual acquisition date of July 1, 2002) and PMR (actual acquisition date of August 5, 2002) occurred as of January 1, 2001, are as follows (in thousands, except per share amounts):

For further detail on the pro forma unaudited results of operations for the nine months ended September 30, 2002 refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part 1, Item 2 of this quarterly report on Form 10-Q for September 30, 2002.

6. INCOME TAXES

During prior years, the Company generated net operating loss (NOL) carryforwards for federal and state income tax purposes. The NOL carryforwards are applicable to both discontinued and continuing operations. As a result of each period’s loss and existing NOL carryforwards, the Company has not recorded a provision for current federal income tax during the year ended December 31, 2001 or the nine months ended September 30, 2002. The Company does not anticipate exhausting its NOL carryforward for federal income tax purposes until the first quarter of 2003.

7. DISCLOSURES ABOUT REPORTABLE SEGMENTS

In accordance with the criteria of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company determined that, as of September 30, 2002, it operates in two reportable segments: (1) Psychiatric Unit Management, and (2) Freestanding Specialty Hospitals. The Psychiatric Unit Management division provides psychiatric management and development services to behavioral health units in hospitals and clinics. The Freestanding Specialty Hospitals division includes owned psychiatric hospitals. As of September 30, 2002, the Company managed 48 behavioral health units and owned five psychiatric hospitals in three states. Activities classified as “Other” in the following schedule relate primarily to unallocated home office items.

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

The following is a financial summary by business segment for the periods indicated. EBITDA represents income from continuing operations before interest expense (net of interest income), income taxes, depreciation, and amortization. EBITDA is commonly used as an analytical indicator within the healthcare industry and serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under accounting principles generally accepted in the United States, and the items excluded in determining EBITDA are significant components in understanding and assessing financial performance. Because neither is a measurement determined in accordance with accounting principles generally accepted in the United States, it is susceptible to varying calculations, and as a result our calculation of EBITDA as presented may not be comparable to EBITDA or other similarly titled measures used by other companies (in thousands):

8. DISCONTINUED OPERATIONS

Discontinued operations relate to the Company’s implementation of plans during 2000 to exit its physician practice management and Employee Assistance Programs businesses. During the year ended December 31, 2001, the Company reported income from discontinued operations of $1.6 million primarily the result of the sale of its Employee Assistance Programs division.

9. RECENT PRONOUNCEMENTS

During July 2001, the Financial Accounting Standards Board (“FASB”) issued Statements of Financial Accounting Standards No. 141, Business Combinations (“SFAS 141”) and No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 141 is effective for transactions completed subsequent to June 30, 2001 and SFAS 142 is effective for years beginning after December 15, 2001. Under the provisions of SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. The Company completed the transitional impairment test during the quarter ended June 30, 2002, which resulted in no goodwill impairment. A reconciliation of previously reported net income to the pro forma amounts adjusted for the exclusion of goodwill amortization follows (in thousands, except per share amounts):

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PSYCHIATRIC SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2002

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), which supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS 144 removes goodwill from its scope and clarifies other implementation issues related to SFAS 121. SFAS 144 also provides a single framework for evaluating long-lived assets to be disposed of by sale. The Company does not expect SFAS 144 to have a material effect on its results of operations or financial position.

     In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). SFAS 145 prohibits the classification of gains or losses from debt extinguishments as extraordinary items unless the criteria outlined in APB Opinion No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, are met. SFAS 145 also eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS 145 is effective for fiscal years beginning after May 15, 2002, with early adoption encouraged. The Company intends to adopt the provisions of SFAS 145 during fiscal 2003 and restate its prior audited consolidated financial statements for the reclassification of extraordinary loss on extinguishment of debt.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.

This Quarterly Report on Form 10-Q contains 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. These forward-looking statements include statements regarding intent, belief or current expectations of Psychiatric Solutions, Inc. (the “Company”) and its management. Such forward-looking statements are not guarantees of future performance and involve risks and uncertainties that may cause the Company’s actual results to differ materially from the results discussed in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to: (1) potential competition which alters or impedes the Company’s acquisition strategy by decreasing the Company’s ability to acquire additional hospitals on favorable terms; (2) the ability of the Company to improve the operations of acquired hospitals; (3) the ability to maintain favorable and continuing relationships with physicians who use the Company’s facilities; (4) the limited operating history of the Company; (5) the ability to receive timely additional financing on terms acceptable to the Company to fund the Company’s acquisition strategy and capital expenditure needs; (6) risks inherent to the health care industry, including the impact of unforeseen changes in regulation, reimbursement rates from federal and state health care programs or managed care companies and exposure to claims and legal actions by patients and others; and (7) potential difficulties in integrating the operations of Psychiatric Solutions, Inc. with PMR. The forward-looking statements herein are qualified in their entirety by the risk factors set forth in the Company’s joint proxy statement/prospectus on Form S-4, dated July 11, 2002, under the caption “Risk Factors.” A copy of the Form S-4 may be obtained from the Public Reference Branch of the SEC at 450 Fifth Street NW, Washington, DC at prescribed rates.

OVERVIEW

Psychiatric Solutions was organized in September 1996. It currently has two operating divisions: (i) the ownership and operation of freestanding inpatient psychiatric hospitals and (ii) the operation of psychiatric units in facilities owned by third parties.

As of September 30, 2002, Psychiatric Solutions owned and operated five free-standing psychiatric hospitals which provided psychiatric services to patients in and around the Houston, Texas, Austin, Texas, Raleigh, North Carolina, and Chicago, Illinois areas and managed 48 psychiatric units for third party acute care hospitals in 14 states. Psychiatric Solutions’ objective is to provide high-quality, cost-effective psychiatric services in the communities it serves. Through its managed and freestanding psychiatric hospitals, Psychiatric Solutions offers an extensive continuum of behavioral health programs to critically ill children, adolescents and adults.

On August 5, 2002, pursuant to a definitive Merger Agreement dated May 6, 2002 and with respective stockholder and regulatory approvals, PMR Acquisition Corporation, a newly formed, wholly-owned subsidiary of PMR Corporation, merged with and into Psychiatric Solutions, Inc., a Delaware corporation whose name, subsequent to the merger, was changed to Psychiatric Solutions Hospitals, Inc. (“PSH”). Concurrently, the name of PMR Corporation was changed to Psychiatric Solutions, Inc. (“PSI” or the “Company”). The surviving corporation in the merger was PSH, which has become a wholly-owned subsidiary of the Company. In exchange for their outstanding shares of common stock or preferred stock in PSH, stockholders of PSH received newly-issued shares of Company common stock. Options to acquire PSH common stock were converted into options to purchase shares of Company common stock based on the common stock exchange ratio used in the merger. Warrants of PSH will enable the holders to exercise these securities into shares of Company common stock. After giving effect to the exercise of all outstanding options and warrants of PSH following the merger, the former PSH stockholders and the Company’s pre-merger stockholders received approximately 72% and 28% of the common stock of the Company, respectively. The headquarters of the combined company has been relocated to Nashville, Tennessee. In addition, effective August 6, 2002, the shares of the Company were approved for listing on the Nasdaq National Market under the ticker symbol “PSYS.” The Merger Agreement is on file with the Securities and Exchange Commission (“SEC”) as an exhibit to Amendment No. 1 to the Company’s Registration Statement on Form S-4 filed on July 11, 2002.

Inasmuch as the former PSH stockholders own more than half of the surviving corporation’s outstanding common stock pursuant to the merger, PSH has been treated as the acquiring company for accounting purposes. The condensed consolidated financial statements located herein relate to PSH only prior to August 5, 2002, and to merged company on and subsequent to August 5, 2002. Historical financial information relating to PMR Corporation just prior to the merger can be found in the Company’s quarterly report on Form 10-Q for the quarter ended July 31, 2002, as filed with the SEC on September 16, 2002.

IMPACT OF MERGERS AND ACQUISITIONS

Acquiring free-standing psychiatric hospitals is a key part of Psychiatric Solutions’ business strategy. Since Psychiatric Solutions has grown through mergers and acquisitions accounted for as purchases, it is difficult to make meaningful comparisons between its financial statements for the fiscal periods presented. In addition, since Psychiatric Solutions owns a relatively small number of hospitals, an individual acquisition may have a material effect on its overall operating performance. At the time a hospital is acquired, a number of measures to lower costs are implemented and significant investments may also be made in the facility. Therefore, the financial performance of a newly acquired hospital may adversely affect its overall performance in the short-term.

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On September 1, 2001, Psychiatric Solutions acquired the assets of Cypress Creek Hospital and West Oaks Hospital in Houston, Texas for approximately $14.2 million. The acquisition was financed through a seller-financed subordinated convertible note as well as other long-term borrowings.

Effective November 1, 2001, Psychiatric Solutions acquired the assets of Texas NeuroRehab Hospital in Austin, Texas for approximately $8.4 million, which was financed through a seller-financed subordinated convertible note and additional long-term borrowings.

On December 1, 2001, Psychiatric Solutions acquired the assets of Holly Hill Hospital in Raleigh, North Carolina for approximately $8.4 million which was financed through long-term borrowings under a line of credit.

On July 1, 2002, Psychiatric Solutions acquired all of the capital stock of Aeries Healthcare Corporation and its wholly owned subsidiary, Aeries Healthcare of Illinois, Inc. for $16.1 million, prior to certain adjustments. Aeries Healthcare of Illinois owns the assets and operations of Riveredge Hospital located near Chicago, Illinois. The acquisition was financed in part through an amendment to Psychiatric Solutions’ Senior Credit Facility.

On August 5, 2002, Psychiatric Solutions merged with PMR Corporation, an operator of case management programs in Tennessee and a manager of two outpatient psychiatric programs with one acute care hospital in California. For accounting purposes the merger was treated as purchase of PMR Corporation by Psychiatric Solutions. PMR Corporation shareholders were issued approximately 2.4 million shares of Psychiatric Solutions common stock. The Company acquired approximately $6.0 million in cash in the PMR transaction. Psychiatric Solutions was guaranteed approximately $5.2 million in cash as a part of the PMR transaction. Any additional monies above the $5.2 million as well as subsequent collections of certain legacy receivables of PMR, if any, received by Psychiatric Solutions are payable to certain former PMR shareholders as defined in the Contingent Value Rights Agreement (“CVR”). The Company has accrued approximately $770,000 at September 30, 2002, for payment to CVR holders. The Company expects to make a payment to CVR holders during the fourth quarter of 2002. Additional future payments to CVR holders may be necessary, however, the Company cannot anticipate the amount or timing of such payments as they are contingent upon the Company collecting certain legacy receivables of PMR.

Unaudited Pro Forma Condensed Consolidated Statement of Earnings

The unaudited pro forma condensed combined consolidated statement of earnings for the nine months ended September 30, 2002 is based on the following:

	–		The historical results of operations for the nine months ended September 30, 2002 for Psychiatric Solutions, including results from PMR and Riveredge Hospital, subsequent to their dates of acquisition;
	–		The historical results of operations of PMR as if such were acquired by Psychiatric Solutions on January 1, 2002 (actual merger date was August 5, 2002);
	–		The results of operations of Riveredge Hospital as if such were acquired by Psychiatric Solutions on January 1, 2002 (actual acquisition date for this hospital was July 1, 2002).

The unaudited pro forma condensed combined consolidated statement of earnings should be read in conjunction with the historical consolidated financial statements and accompanying notes of PMR and Psychiatric Solutions and the summary selected historical consolidated financial data included in the joint proxy statement/prospectus filed with the Securities and Exchange Commission on Form S-4 on July 11, 2002. The unaudited pro forma condensed combined consolidated statement of earnings is not intended to represent or be indicative of the consolidated results of operations that would have been reported had the merger been completed as of the dates presented, and should not be taken as representative of future consolidated results of operations of the combined company.

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Unaudited Pro Forma Condensed Combined Consolidated Statement of Earnings
of PMR and Psychiatric Solutions

Nine Months ended September 30, 2002
(In thousands, except per share amounts)