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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission File Number 000-33009

MedCath Corporation

10720 Sikes Place

(704) 708-6600

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

     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.    þ    Yes o    No

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    þ

     As of December 16, 2002, there were 18,011,520 shares of the Registrant’s Common Stock outstanding. The aggregate market value of the Registrant’s Common Stock held by non-affiliates as of December 16, 2002 was approximately $59.8 million (computed by reference to the closing sales price of such stock on the Nasdaq National Market® on such date).

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Registrant’s Proxy Statement for its Annual Meeting of Stockholders to be held on March 5, 2003 are incorporated by reference into Part III of this Report

MEDCATH CORPORATION

FORM 10-K

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     Some of the statements and matters discussed in this report and its exhibits constitute forward-looking statements. Words such as “expects,” “anticipates,” “approximates,” “believes,” “estimates,” “intends” and “hopes” and variations of such words and similar expressions are intended to identify such forward-looking statements. We have based these statements on our current expectations and projections about future events. These forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. The forward-looking statements contained in this report and its exhibits include, among others, statements about the following:

	•	demographic changes,
	•	changes in medical or other technology,
	•	changes in Medicare and Medicaid payment levels,
	•	our ability, when appropriate, to enter into managed care provider arrangements and the terms of those arrangements,
	•	our ability to successfully develop additional hospitals, open them according to plan and gain significant market share in the market,

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	•	the availability and terms of capital to fund our development strategy,
	•	our relationships with physicians who use our hospitals,
	•	our ability to attract and retain nurses and other qualified personnel to provide quality services to patients in our hospitals,
	•	competition from other hospitals,
	•	existing governmental regulations and changes in, or failure to comply with, governmental regulations,
	•	our information systems,
	•	changes in generally accepted accounting principles, and
	•	liability and other claims asserted against us.

     Although we believe that these statements are based upon reasonable assumptions, we cannot assure you that we will achieve our goals. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report and exhibits might not occur. Our forward-looking statements speak only as of the date of this report or the date they were otherwise made. Other than as may be required by federal securities laws to disclose material developments related to previously disclosed information, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

     An investment in our common stock involves a high degree of risk. You should consider carefully all of the information contained in this report and, in particular, the discussion of risk factors filed as Exhibit 99.1 to this report, before making an investment decision with respect to our common stock.

INITIAL PUBLIC OFFERING AND RELATED TRANSACTIONS

     Concurrent with our initial public offering in July 2001, we completed a series of transactions that we undertook to prepare for the offering and to increase our ownership interest in some of our hospitals. First, we established MedCath Corporation as our new holding company by issuing shares of its common stock in exchange for all of the outstanding shares of common stock of our predecessor holding company, MedCath Holdings, Inc. Second, we completed a series of transactions in which we issued shares of our common stock valued at the public offering price and paid cash to acquire additional ownership interests in five of our hospitals from our physician and hospital partners in each of those hospitals. As a result of these transactions, we began consolidating in our financial statements one of these hospitals for which we had previously been required to use the equity method of accounting.

     References in this report to “we,” “us” and “our” for periods prior to July 27, 2001 are references to our holding company prior to the transactions described above, MedCath Holdings, Inc., its subsidiaries and unconsolidated affiliates, including each of our hospitals, and “our predecessor company,” unless the context requires otherwise. For periods subsequent to July 27, 2001, references to “we,” “us” and “our” are references to our holding company after the transactions described above, MedCath Corporation, its subsidiaries and unconsolidated affiliates, including each of our hospitals, unless the context requires otherwise. References in this report to our predecessor company are to MedCath Incorporated, which was acquired from its public stockholders in July 1998 by several private investment partnerships sponsored by Kohlberg Kravis Roberts & Co., L.P. and Welsh, Carson, Anderson & Stowe, and members of our management team.

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PART I

Item 1.    Business

Overview

     We focus primarily on the diagnosis and treatment of cardiovascular disease. We design, develop, own and operate hospitals in partnership with physicians that we believe have established reputations for clinical excellence, most of whom are cardiologists and cardiovascular surgeons. While each of our hospitals is a freestanding, licensed general acute care hospital that includes an emergency department or chest pain clinic, operating rooms, catherization laboratories, pharmacy, laboratory, radiology department, cafeteria and food service and is capable of providing a full complement of health services, we focus primarily on serving the unique needs of patients suffering from cardiovascular disease. The medical staff at each of our hospitals is open to all qualified physicians performing healthcare services in the market, except for certain hospital-based physicians such as anesthesiologists, radiologists, and emergency physicians. We are also committed to improving the productivity and work environment of physicians, nurses and other medical personnel providing care. As of September 30, 2002, we owned and operated eight hospitals, together with our physician partners, who own an equity interest in the hospital where they practice, as well as other investors. On October 2, 2002, we opened our newest hospital in Harlingen, Texas, which increased our total number of owned and operated hospitals to nine. The Harlingen Medical Center focuses on cardiovascular care as well as orthopedics, neurology, obstetrics and gynecology. Our existing nine hospitals have a total of 577 licensed beds and are located in Arizona, Arkansas, California, New Mexico, Ohio, South Dakota and Texas. We have begun developing our tenth hospital, which will be a heart hospital located in St. Tammany Parish just north of New Orleans, Louisiana, our eleventh hospital, which will be a heart hospital located in San Antonio, Texas, our twelfth hospital, which will be a heart hospital located in the city of Glendale, near Milwaukee, Wisconsin, and our thirteenth hospital, which will be a heart hospital located in Lafayette, Louisiana. We expect to open these new hospitals during March 2003 (St. Tammany Parish), the late summer of 2003 (San Antonio), and the fall of 2003 (Glendale and Lafayette). These new hospitals are expected to have a total of 182 licensed beds. Our hospital division accounted for 83.7% of our net revenue for our fiscal year ended September 30, 2002.

     In addition to our hospitals, we provide cardiovascular care services in diagnostic and therapeutic facilities located in eight states and through mobile cardiac catheterization laboratories. Our mobile diagnostic facilities are typically leased to hospitals and used by physicians to evaluate the functioning of patients’ hearts and coronary arteries and serve areas that do not have the patient volume to support a full-time facility. We also provide consulting and management services tailored primarily to cardiologists and cardiovascular surgeons.

     Our predecessor company was developed in late 1988 and 1989 by our chairman and our president and chief executive officer and for a number of years was primarily engaged in operating mobile and other cardiac catheterization laboratories. In 1994, our predecessor company conducted an initial public offering and began developing its first hospital, which opened in 1996. By July 1998, the predecessor company had developed and opened three additional heart hospitals. At that time, several private investment partnerships sponsored by Kohlberg Kravis Roberts & Co., L.P. and Welsh, Carson, Anderson & Stowe, and members of our management team acquired our predecessor company from its public stockholders. While operating as a private company, we:

	•	opened five new hospitals, four of which were already under development at the time of the going private transaction, and sold one hospital,
	•	improved our process for developing new hospitals,
	•	began developing two additional hospitals,
	•	standardized and, when appropriate, centralized our operations across financial and operational areas, and
	•	continued to strengthen our regulatory compliance program at the facility and corporate levels.

     In July 2001, we completed an initial public offering and the transactions described in the introductory notes on the immediately preceding page of this report. Through these transactions we:

	•	raised approximately $137.0 million of net proceeds; and
	•	increased our ownership interests in five of our hospitals, including one hospital which we began to consolidate in our financial statements based on obtaining a majority ownership position and substantive control of that hospital.

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     Of the total $137.0 million in net proceeds we received from the public offering, we immediately used approximately $25.4 million to increase our ownership interest in five of our hospitals and approximately $18.0 million to pay all amounts outstanding under our $100.0 million credit facility. In October 2001, we used $17.4 million of the net proceeds from the offering to increase our ownership interest in Heart Hospital of New Mexico. That acquisition increased our ownership interest in Heart Hospital of New Mexico from a 24.0% minority interest to a 69.0% majority interest ownership position, giving us substantive control of the hospital. Accordingly, we began to consolidate in our financial statements the hospital’s results of operations and financial position beginning October 1, 2001, the date of acquisition. We have also invested approximately $14.1 million of the net proceeds from the public offering in our hospital development program. We expect to use the remaining approximate $62.1 million of the net proceeds from the offering to finance the development of additional hospitals and for working capital and other corporate purposes, including the possible acquisition of additional interests in our existing hospitals. Although we have identified these intended uses of the remaining proceeds, we have broad discretion in the use of the net proceeds from the offering. Pending those uses, we are investing the funds, along with our operating cash, in money market funds or similar short-term interest bearing, investment-grade securities, which we include in cash and cash equivalents in our consolidated balance sheet.

     In July 2001, we also became a party to a new $189.6 million credit facility, which provided a source of capital to refinance approximately $79.6 million of indebtedness of some of our existing hospitals and provided us with an additional $110.0 million of available capital to partially finance real estate acquisition, construction and related costs for our hospital development program. As of September 30, 2002, $63.0 million of the initial $110.0 million had been designated or borrowed to finance the development of Harlingen Medical Center and Louisiana Heart Hospital. In November 2002, an additional $31.6 million was designated for use in funding the development of Heart Hospital of San Antonio. The remaining $15.4 million is available to finance other projects in our hospital development program.

The Cardiovascular Care Market

     The American Heart Association estimates that total domestic expenditures for the treatment of cardiovascular disease were approximately $199.5 billion in 2002 and that these expenditures have grown at a rate of 5.8% annually since 1997. Of these expenditures, 63.2%, or approximately $126.1 billion, was spent on hospital and other facility-based charges. Cardiovascular disease is a progressive illness that develops without symptoms over a number of years and frequently goes undiagnosed until the patient suffers an acute episode such as a stroke or heart attack. Cardiovascular disease includes coronary heart disease, hypertensive disease — which is a risk factor for more serious cardiovascular diseases — rheumatic fever/rheumatic heart disease, stroke and congenital cardiovascular defects. The American Heart Association estimates that approximately 61.8 million Americans have one or more types of cardiovascular disease. Cardiovascular disease claimed 960,000 lives, representing 40.1% of all deaths, in the United States in 1999. This represented 116,800 more lives than the next five leading causes of death combined, including cancer, chronic obstructive pulmonary disease, accidents, pneumonia/influenza and diabetes mellitus.

     Most of the invasive procedures physicians perform to treat patients with cardiovascular disease, such as coronary artery angioplasties with stent placement and coronary artery bypass graft surgery, are performed in hospitals on an inpatient basis. Cardiovascular disease creates the largest demand for hospital bed use in the United States, being the first listed diagnosis of 6.3 million inpatients in 1999. Approximately 12.6 million of the estimated 61.8 million Americans suffering from cardiovascular disease have coronary heart disease, which generates the single greatest demand for cardiac diagnostic and therapeutic procedures.

     According to the American Heart Association, it is estimated that physicians performed the following number of procedures to diagnose and treat cardiovascular disease in 1999:

	•	571,000 coronary artery bypass graft operations,
	•	601,000 coronary artery angioplasty procedures,
	•	1.4 million inpatient cardiac catheterization procedures, and
	•	472,000 outpatient cardiac catheterization procedures.

     The demand for cardiology and cardiovascular disease diagnosis and treatment procedures is expected to increase in the future as people age 55 and older, the primary recipients of cardiac care services, increase in number and represent a growing proportion of the total population. According to the 2000 census by the U.S. Census Bureau, the proportion of Americans over age 55 was 21.1% and is expected to increase to 27.5% by

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Our Strategy

     We focus primarily on the diagnosis and treatment of cardiovascular disease. We develop, own and operate hospitals in partnership with physicians with the goal of improving the quality of care and enhancing the overall experience of patients and physicians. Key elements of our strategy include:

	•	Cardiovascular Disease Focus

	We design and operate our hospitals with a focus primarily on serving the unique needs of patients suffering from cardiovascular disease and improving the work environment of physicians, nurses and other medical personnel providing care. We have developed an innovative facility design and infrastructure specifically tailored to the cardiovascular care delivery system that combines staff, equipment and physical layout to deliver high-quality, cost-effective care. Because the clinical protocols and procedures for treatment of patients with cardiovascular disease are generally the same throughout the United States, we are able to use our standard facility design — with only small variations — in each of the markets in which we develop a hospital.
	By focusing primarily on a single disease category, we are able to schedule patient procedures more efficiently and allow our physicians, nurses, medical technicians and other staff members to concentrate on and enhance their professional cardiovascular care skills, thereby better serving the needs of patients in the community. We are also able to invest our available funds primarily in equipment and technology for cardiovascular care, rather than allocating those funds among the equipment and technology needs of many different healthcare services as occurs at general acute care hospitals. We believe our focused approach increases patient, physician and staff satisfaction and allows us to provide high-quality, cost-effective patient care.

	•	Patient-Focused Care

	Our philosophy, developed in partnership with physicians, is to center care around the patient rather than expect the patient to adapt to our facilities and staff. We have designed our hospitals, particularly the patient rooms, around the requirements of our patients in order to improve their experience and the quality of their care. Our large, single-patient rooms are capable of handling all of our patients’ needs during their entire stay, including critical care, telemetry and post-surgical care. This allows us to avoid moving our patients repeatedly and to have their care provided by the same group of staff members during their entire stay. For patients and their families, this creates a familiarity with, and a high level of trust in, their care providers while enabling the care providers to understand each patient’s needs on an individual basis. The design of our rooms and our unlimited visiting hours also allow patients’ family members to be involved in their care. For example, the size of our patient rooms lets us provide sleeping arrangements for family members who desire to stay with the patient during the patient’s recovery. In most general acute care facilities, which have a limited number of rooms with cardiovascular monitoring capabilities, patients are required to be transferred repeatedly within the facility during the course of their stay. Moving patients almost always involves risk to the patient, new care providers and an unsettling reorientation period for the patient and the patient’s family. We believe moving patients also reduces physician efficiency, results in delays in providing the services patients need and can lead to a longer patient stay.
	We believe our patient care staffing ratios are equal to or better than those of our competitors. We also believe that our patient care staff is more available to our patients because of our unique facility design and our investments in technology. For example, we invest in technology that facilitates communication between patients and care providers by:

	•	allowing patients and their family members to easily contact and directly communicate with specific members of the nursing staff regardless of where the nurse is located at that time, and
	•	electronically providing information about the patient’s medical condition directly to the members of the nursing staff providing care to the patient rather than through a central monitoring station.

	We monitor and evaluate patient satisfaction in our hospitals by conducting patient surveys. These performance surveys have consistently demonstrated a high level of patient satisfaction with our facilities,

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staff and care coordination. For example, in patient satisfaction surveys conducted in our hospitals, 98% of our patients who completed these surveys indicated that they would return to our hospital for any future cardiac procedures. And more than 98% indicated that they were satisfied with the physical comfort of our hospital, the patient education we provided and the way in which we allowed family members to be closely involved in their care.

	•	Partnering with Cardiologists and Cardiovascular Surgeons

	When we develop a hospital we form a venture with physicians, individually or in groups, practicing in the market where we plan to develop the hospital. In some instances, local market conditions have made it advantageous for us to organize a hospital with a community hospital investing as a partner in addition to physicians. We and our partners invest capital and own pro rata interests in the venture based upon the amount of capital contributed. We own between 51.0% and 70.9% of the equity of eight of the nine hospitals that we currently operate, and we own a minority interest in the other hospital, for which we are currently required to use the equity method of accounting. We own 51.0% or greater of each of our tenth, eleventh, twelfth, and thirteenth hospitals, which are currently under development.
	We partner with cardiologists, cardiovascular surgeons, and other physicians that we believe have established reputations for clinical excellence. These physician partners, who own an equity interest in the hospital where they practice, as well as other investors including other hospitals, participate in decisions on strategic matters at that hospital such as site selection, facility size and layout, the hospital marketing plan and community outreach programs. They, as well as the numerous other physicians providing services in our hospitals, also participate in decisions on a wide range of operational matters such as development of clinical care protocols, supply selection and usage, equipment purchases, patient procedure scheduling and local staff and management team selection. Our physician partners are empowered by their role in the development of a new hospital and in the strategic decisions affecting the hospital. We believe that our physician partners take greater pride and interest in a hospital they view as their own and that the influence they have over decisions in the hospital motivates them to provide patient-focused care on a cost-effective basis. The opportunity to have a role in how our hospitals are managed encourages our physician partners to share new ideas, concepts and practices.

	•	Developing New Hospitals

We intend to begin development on one to three new hospitals annually in markets where we can establish relationships with highly regarded physicians, most of whom are cardiologists and cardiovascular surgeons. Before entering a new market, we use publicly available information to analyze a variety of factors, including licensing and regulatory (e.g., certificate of need requirements), growth characteristics, Medicare reimbursement rates and strengths and weaknesses of competing hospitals in the market. Our facility design for each new hospital focuses on improving physician and staff efficiency and providing higher quality patient care than is typically provided in general acute care facilities. We expect to leverage our experience and expertise from the development of our existing hospitals to continue to improve our hospital development program. All of our hospitals are designed for possible future expansion in an efficient and rapid manner.

	•	Measuring the Quality of Care

We believe that by focusing primarily on diagnosing and treating cardiovascular disease we can improve the quality of cardiovascular care. We assess the quality of cardiovascular care — that is, the degree to which our services increase the likelihood of desired patient outcomes — by monitoring several key criteria, including mortality rates, patient acuity, average length of stay and patient satisfaction. We believe our hospitals generally achieve lower mortality rates and a shorter average length of stay for patients with generally higher acuity levels as compared to our competitors in each of our markets. We engaged the Lewin Group, a national health and human services consulting group, to conduct an objective study on cardiovascular patient outcomes, using publicly available Medicare data from 2000. The Lewin Group reviewed records for 1,139 hospitals that perform open heart surgery in the United States. The hospitals in this study included 193 Major Teaching hospitals with interns and residents-to bed of at least 0.25 and

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	Peer Community hospitals, which include all other hospitals in the study. The Lewin study found the following:

	•	Length of stay — on average, our hospitals have a 17.4% shorter length of stay (adjusted for severity) for cardiac cases than Peer Community hospitals and a 22.4% shorter length of stay than Major Teaching hospitals.
	•	Mortality rates — after adjusting for risk of mortality, our hospitals, on average, exhibit 12.1% lower mortality rates than Peer Community hospitals and 9.4% lower mortality rates than Major Teaching hospitals.
	•	Severity case mix index — on average, patients arriving at our hospitals have a more severe case mix index of 1.48 compared to 1.19 at Peer Community hospitals and 1.26 at Major Teaching hospitals.

	We operate all of our hospitals under a quality improvement program to provide an objective assessment of the quality of the services we provide. All of our hospitals are accredited by the Joint Commission on Accreditation of Healthcare Organizations, an independent accrediting organization that is widely recognized in the hospital industry.

	•	Applying Our Experience Across Our Hospitals

Our cost-effective operations reflect the impact of shared experiences of physicians and hospital management at each of our hospitals. We encourage our hospital management and physician partners to regularly share information and implement best practices, which is made easier by our standard facility design and operational similarities. We share information through regular meetings of our hospital management teams to enable them to discuss new practices and methodologies such as supply selection and management as well as scheduling efficiencies. We also coordinate opportunities for our physician partners to discuss — both on an informal basis and at our periodic meetings of our physician partners — such matters as clinical protocols, patient management and procedure techniques. These efforts have allowed our hospitals to benefit from the innovations that occur at one hospital and our hospital managers and physicians to become more efficient and productive.

Our Hospitals

     We currently own and operate nine hospitals, including our newest hospital in Harlingen, Texas which opened on October 2, 2002. This hospital focuses on cardiovascular care as well as orthopedics, neurology, obstetrics and gynecology. We also currently have four hospitals under development, including a heart hospital in St. Tammany Parish just north of New Orleans, Louisiana, a heart hospital in San Antonio, Texas, a heart hospital in Glendale near Milwaukee, Wisconsin, and a heart hospital in Lafayette, Louisiana. We expect to begin development on one to three new hospitals each year. Once a new hospital venture is formed and the partners have contributed their capital, it typically takes 18 to 24 months to develop the hospital.

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     The following table identifies key characteristics of our nine hospitals in operation and the four hospitals we have under development, including our current ownership percentages.

(1)	Our ownership of Heart Hospital of New Mexico was 24.0% at September 30, 2001. Effective October 1, 2001, we increased our ownership interest to 69.0% by acquiring an additional 45.0% interest from our physician and hospital partners in this hospital venture. As a result of this increase to a majority ownership position, we obtained substantive control of the hospital and began to consolidate in our financial statements the hospital’s results of operations and financial position from October 1, 2001 (the first day of our fiscal year 2002).
(2)	After October 1, 2001, Heart Hospital of South Dakota is the only hospital in which we do not have a majority ownership interest. We use the equity method of accounting for this hospital, which means that we include in our consolidated statement of operations only a percentage of the hospital’s reported net income or loss for each reporting period.
(3)	As of December 16, 2002, the hospital was under development and is scheduled to open in the period indicated in the table.

     Before designing and constructing our first hospital in 1994, we met frequently with our physician partners to analyze the operations, facilities and work flow of existing hospitals and found what we believed to be many inefficiencies in the way cardiovascular care was provided in existing hospitals. Based upon this analysis, we designed a hospital that we believed would enhance physician and staff productivity and allow for the provision of high-quality, patient-focused care. Based upon subsequent operating experience and input from physicians at our other hospitals, we have further refined our basic hospital layout to allow us to combine site selection, facility size and layout, staff and equipment to deliver quality cardiovascular care. We believe that a newly constructed and equipped hospital enjoys a significant competitive advantage over hospitals that have been repeatedly renovated and expanded over several decades, which often results in an inefficient layout and workflow. We also believe that a hospital and staff with a clear focus on diagnosing and treating cardiovascular disease can provide higher quality care and be more cost effective than general acute care hospitals that seek to provide multiple healthcare services to patients with a wide variety of diseases.

     The innovative characteristics of our hospitals include:

     Universal patient rooms. Our large, single-patient rooms enable our staff to provide all levels of care required for our patients during their entire hospital stay, including critical care, telemetry and post-surgical care. Each room is equipped as an intensive care unit, which enables us to keep a patient in the same room throughout

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     Centrally located inpatient services. We have centrally located all services required for inpatients, including radiology, laboratory, pharmacy and respiratory therapy, in close proximity to the patient rooms, which are usually all located on a single floor in the hospital. This arrangement reduces scheduling conflicts and patient waiting time. Additionally, this eliminates the need for costly transportation staff to move patients from floor to floor and department to department.

     Distributed nursing stations. Unlike traditional hospitals with large central nursing stations which serve as many as 30 patients, we have corner configuration nursing stations on our patient floors where each station serves six to eight patients and is located in close proximity to the patient rooms. This design provides for excellent visual monitoring of patients, allows for flexibility in staffing to accommodate the required levels of care, shortens travel distances for nurses, allows for fast response to patient calls and offers proximity to the nursing station for family members.

     Efficient work flow. We have designed and constructed our various procedure areas in close proximity to each other allowing for both patient safety and efficient staff work flow. For example, our cardiac catheterization laboratories are located only a few feet from the operating rooms, outpatient services are located immediately next to procedure areas and emergency services are located off the staff work corridor leading directly to the diagnostic and treatment areas.

     Extra capacity for critical cardiac procedures. We design and construct our hospitals with more operating rooms and cardiac catheterization laboratories than we believe are available in the program of a typical general acute care hospital. This feature of our hospitals ensures that the physicians practicing in our hospitals will experience fewer conflicts in scheduling procedures for their patients. In addition, all of our operating rooms are designed primarily for cardiovascular procedures, which allows them to be used more efficiently by physicians and staff.

     Our physician partners in our hospital ventures participate in the material strategic and operating decisions we make for a hospital. They do so either through their representatives on the governing board of the venture or through a requirement in the venture’s governing documents that we obtain the consent of their representatives before taking certain actions. In those ventures where we have a community hospital partner as well as physician partners, the community hospital partner also participates in these decisions, which include such matters as site selection, facility size and layout, and selection and employment of the key members of the hospital’s senior management team. After a hospital opens and begins operating, the members of the hospital’s senior management team make all routine operating decisions for the hospital. We must generally obtain the approval or consent, however, of our partners before taking action on matters such as adopting the hospital’s annual operating budget and making capital expenditures in excess of specified amounts. We must also generally obtain the consent of our partners or their representatives before making any material amendments to the operating or partnership agreement for the hospital venture or admitting additional members or partners. The operating or partnership agreement for each hospital venture contains provisions specifying the criteria for, and timing of, distributions to the partners as well as provisions limiting redemptions, and restricting the transfer, of ownership interests. In some of our hospital ventures, we must obtain the consent of our partners before making any distributions.

     Our hospitals have different operating characteristics than traditional general acute care hospitals. For example, in our hospital division, our labor costs represent approximately 30% of our net revenue (based on our fiscal year ended September 30, 2002) as compared, we believe, to approximately 40% of net revenue in the average for-profit hospital and approximately 45% to 50% in the average not-for-profit hospital. We achieve our cost-effective operating results in a number of ways, including:

	•	designing our hospitals to reduce the labor costs associated with transporting patients, equipment and supplies. The delays and lack of coordination associated with transporting patients around a large general acute care hospital also hinders the physicians’ ability to provide quality care on a timely basis and can result in patient dissatisfaction,
	•	eliminating duplicative layers of administrative and support personnel,
	•	staffing our hospitals with only four non-caregiving executive employees including a president, vice president of finance, vice president of nursing and vice president of business development. This staffing model greatly reduces administrative costs associated with traditional general acute care hospitals,

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	•	using working team leaders to supervise our nurses and medical technical personnel at each of our hospitals. These team leaders spend a majority of their time providing cardiovascular care services. This working team leader approach reduces the need for supervisory personnel,
	•	centralizing our non-clinical hospital support services such as finance, management information systems, regulatory compliance and managed care contracting, as appropriate, and
	•	investing in technology and training our physicians, nurses and other staff members so that they are familiar with all details of quality cardiovascular care, can work more efficiently and provide patient-focused care.

Our Hospital Development Program

     An important step in developing a new hospital is establishing relationships with physicians providing cardiovascular care that we believe have established reputations for clinical excellence. We regularly receive unsolicited inquiries from groups of physicians interested in partnering with us to take advantage of our hospital development and management expertise and access to capital. We also receive referrals to potential partners from our physician partners in our existing hospitals and from the leaders of physician groups to which we provide cardiovascular care consulting services. Our experience has been that physician groups most interested in partnering with us are those whose members wish to improve their current practice environment. Since these physicians frequently have pre-existing relationships with our existing physician partners in other markets, they can quickly conduct their own informal evaluation to understand the benefits of partnering with us to develop a hospital.

     An equally important step in developing a new hospital is performing a detailed market analysis using publicly available data from a number of sources. We use a disciplined, data-driven process, which includes extensive demographic research, the use of publicly available information from Medicare and other sources and sophisticated modeling of potential operating results for a new hospital. The process includes an analysis of the:

	•	overall market size for cardiovascular care, including the surrounding communities,
	•	projected population growth in the market, particularly for the population group over the age of 55 because they are the primary recipients of cardiovascular care services,
	•	Medicare reimbursement rates, which vary depending upon the wage index for the market,
	•	effect on reimbursement due to payor mix, including managed care penetration of the market,
	•	competitive strengths and weaknesses of each hospital in the market, and
	•	licensing and regulatory requirements, including certificate of need requirements.

Diagnostic and Therapeutic Facilities

     We have participated in the development of or have acquired interests in, and provide management services to, fourteen additional facilities where physicians diagnose and treat cardiovascular disease. We manage four additional hospital-based cardiac catheterization laboratories. We also own and operate a fleet of mobile cardiac catheterization laboratories serving hospital networks and maintain a number of mobile and modular cardiac catheterization laboratories in a rental fleet that we lease on a short-term basis. These diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories are equipped to allow the physicians using them to employ a range of diagnostic and treatment options for patients suffering from cardiovascular disease.

     We currently own and/or manage the operations of fourteen cardiac diagnostic and therapeutic facilities. Seven of these facilities are located at hospitals operated by other parties and offer invasive diagnostic and sometimes therapeutic procedures. The remaining seven are not located at hospitals and offer only diagnostic

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(1)	We have an ownership interest in each of these facilities.
(2)	Either party may terminate the agreement for this facility upon six months prior written notice not earlier than seven years from the date the first patient procedure was performed in this facility. We have reason to believe that our hospital partner intends to exercise the early termination option during calendar 2003.
(3)	Our management agreement with each of these facilities includes an option for us to extend the initial term at increments ranging from 1 to 10 years, through an aggregate of up to an additional 40 years for some of the facilities.
(4)	The management agreement with each of these facilities includes an early termination provision upon notice.
(5)	The termination date provided for this facility refers to the professional services agreement with the physician.

     We also managed the operations of Wake Heart Cardiac Diagnostic Center during our fiscal 2002, but we exercised our option to terminate early this management arrangement and to close the center effective October 2002 because the center’s operations were not meeting our objectives.

     Our management services generally include providing all non-physician personnel required to delivering patient care and the administrative, management and support functions required in the operation of the facility. The physicians who supervise or perform diagnostic and therapeutic procedures at these facilities have complete control over the delivery of cardiovascular healthcare services. The management agreements for each of these centers generally have an extended initial term and several renewal options ranging from one to ten years each. The physicians and hospitals with which we have contracts to operate these centers may terminate the agreements under certain circumstances. We may terminate most of these agreements for cause or upon the occurrence of specified material adverse changes in the business of the centers. We intend to develop with physician groups, or acquire contracts to manage, additional diagnostic and therapeutic facilities in the future.

     We are the largest provider of mobile catheterization services to hospital networks in the United States. Mobile laboratories serving hospital networks are moved, usually on a daily basis, from one hospital to another in a particular hospital network or geographic area. Each mobile laboratory is fully equipped and operated by our medical technicians and nurses, which provides a hospital or physician group with a turnkey catheterization laboratory. Our mobile laboratories permit a group of hospitals located in geographic proximity to one another, each with limited cardiovascular patient volume, to offer cardiovascular services through shared access to equipment and personnel. This also allows hospitals and physicians to offer cardiovascular care services while

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     In addition to our mobile catheterization laboratories serving hospital networks, we maintain a rental fleet of mobile and modular cardiac catheterization laboratories. We lease these laboratories on a short-term basis to hospitals while they are either adding capacity to their existing facilities or replacing or upgrading their equipment. We also lease these laboratories to hospitals that experience a higher demand for cardiac catheterization procedures during a particular season of the year and choose not to expand their own facilities to meet peak period demand. Our rental and modular laboratories are manufactured by leading original equipment manufacturers and have advanced technology and enable cardiologists to perform both diagnostic and interventional therapeutic procedures. Each of our rental units is generally in service for at least nine months of the year. These units allow us to be responsive to immediate demand and create flexibility in our operations.

Major Procedures Performed at Our Facilities

     The following is a brief description of the major cardiovascular procedures physicians perform at our hospitals and other facilities.

     Cardiac catheterization: percutaneous intravascular insertion of a catheter into any chamber of the heart or great vessels for diagnosis, assessment of abnormalities, interventional treatment, and evaluation of the effects of pathology on the heart and great vessels.

     Percutaneous cardiac intervention (PCI) including the following:

	Atherectomy: A technique using a cutting device to remove plaque from an artery. (Can be used for coronary and non-coronary artery)
	Angioplasty: a method of treating narrowing of a vessel (if coronary usually called PTCA-percutaneous transluminal coronary angioplasty), using a balloon catheter to dilate the narrowed vessel.
	Percutaneous Balloon Angioplasty: the insertion of one or more balloons across a stenotic heart valve.
	Stent: a small expandable wire tube, usually stainless steel, with a self-expanding mesh introduced into an artery. It is used to prevent lumen closure (restenosis) NOTE: stents can be placed in coronary arteries, renal, aortic and other peripheral arteries.
	Brachytherapy: a radiation therapy using implants of radioactive material placed inside a coronary stent with restenosis.

     Electrophysiology (EP) study: a diagnostic study of the electrical system of the heart. Procedures include the following:

	Cardiac ablation: Removal of a part, pathway or function by surgery, chemical destruction, electrocautery, or radio frequency.
	Pacemaker implant: An electrical device that can substitute for a defective natural pacemaker and control the beating of the heart by a series of rhythmic electrical discharges.
	Automatic Internal Cardiac Defibrillator (AICD, ICD): Cardioverter implanted in patients at high risk for sudden death from ventricular arrhythmias.
	Cardiac assist devices: (example LVAD Left ventricular assist device) a kind of mechanical heart. It is placed inside of a person’s chest where it helps the heart pump oxygen rich blood through out the body.

     Coronary artery bypass graft surgery: A surgical establishment of a shunt that permits blood to travel from the aorta to a branch of the coronary artery at a point past the obstruction.

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     Valve Replacement Surgery. Valve replacement is an open-heart surgical procedure involving the replacement of valves that regulate the flow of blood between chambers in the heart, which have become narrowed or ineffective due to the build-up of calcium or scar tissue or the presence of some other physical damage.

     Cardiac magnetic resonance imaging. This test uses a powerful magnet to produce highly detailed, accurate and reproducible images of the heart and surrounding structures as well as the blood vessels in the body without the need for contrast agents.

     Echocardiogram with color flow doppler, or ultrasound test. This test produces real time images of the interior of the heart muscle and valves, which are used to accurately evaluate heart valve and muscle problems and measure heart muscle damage.

     Nuclear treadmill exercise test, or nuclear angiogram. This test, which involves the injection of a low level radioactive tracer isotope into the patient’s bloodstream during exercise on a motorized treadmill, frequently is used to screen patients who may need cardiac catheterization and to evaluate the results in patients who have undergone angioplasty or cardiac surgery.

     Standard treadmill exercise test. This test, which involves a patient exercising on a motorized treadmill while the electrical activity of the patient’s heart is measured, frequently is used to screen for heart disease.

     Ultrafast computerized tomography. This test detects the buildup of calcified plaque in coronary arteries before the patient experiences any symptoms.

Cardiology Consulting and Management Services

     We provide business consulting and management services to primarily cardiovascular physician group practices nationwide. We currently consult for and/or manage physician groups with a combined total of over 100 cardiovascular physicians. Services provided include primarily business process reengineering, strategic planning and ancillary development. The physicians in the practices who supervise or provide healthcare services have complete control over the delivery of healthcare services.

Compliance Program

     We have a compliance program that is consistent with guidelines issued by the Office of Inspector General of the Department of Health and Human Services. As part of this compliance program, we adopted a Code of Ethics and designated compliance officers at the corporate level and at individual heart hospitals. Our program includes an anonymous reporting system, compliance training programs, auditing and monitoring programs, including our internal audit function, and a disciplinary system to enforce our code of ethics and other compliance policies. It also includes a process for screening all employees through applicable federal and state databases of sanctioned individuals. Auditing and monitoring activities include claims preparation and submission, and also cover issues such as coding, billing, cost reporting and financial arrangements with physicians and other referral sources. These areas are also the focus of our specialized training programs. The compliance committee of our board of directors oversees the compliance program in coordination with the audit committee of our board of directors that oversees the internal audit function.

Employees

     As of September 30, 2002, we employed 3,729 persons, including 2,607 full-time and 1,122 part-time employees. None of our employees is a party to a collective bargaining agreement, and we consider our relationship with our employees to be good. There currently is a nationwide shortage of nurses and other medical support personnel, which makes recruiting and retaining these employees difficult. We provide competitive wages and benefits and offer our employees a professional work environment that we believe helps us recruit and retain the staff we need to operate our hospitals and other facilities.

     We do not employ any practicing physicians at any of our hospitals or other facilities, except in one instance, whereby one of our hospitals intends to employ a physician for an outlying clinic. Our hospitals are staffed by licensed physicians who have been admitted to the medical staffs of individual hospitals. Any licensed physician — not just our physician partners — may apply to be admitted to the medical staff of any of our

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Environmental Matters

     We are subject to various federal, state and local laws and regulations governing the use, discharge and disposal of hazardous materials, including medical waste products. We believe that all of our facilities and practices comply with these laws and regulations and we do not anticipate that any of these laws will have a material adverse effect on our operations. We cannot predict, however, whether environmental issues may arise in the future.

Insurance

     Like most health care companies, we are subject to claims and legal actions in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance (see additional discussion in Item 7 of this report under the caption Critical Accounting Policies) and general liability insurance in amounts and with deductibles and levels of self-insured retention that we believe are sufficient for our operations. We also maintain umbrella liability coverage to cover claims not covered by our professional malpractice liability or general liability insurance policies.

     Due to unfavorable pricing and availability trends in the general and professional liability insurance markets, the cost of commercial professional and general liability insurance coverage has risen significantly. As a result, we expect our total insurance premiums, including professional and general liability, property, business, auto, directors and officers, workers compensation and other coverages to increase approximately $5.5 million for our fiscal 2003 compared to fiscal 2002. In addition, we expect to assume a greater portion of the risk, through self-insured retention and higher deductibles, under our new commercial insurance policies during fiscal 2003 than in prior fiscal years. For example, the actuarial determined estimate of the costs of our self-insured retention under our current one-year professional liability policy period through May 31, 2003 has been determined to be approximately $2.9 million.

     As we open new hospitals and diagnostic and therapeutic centers, we also expect to incur additional premium costs and self-insured retention costs to reflect the additional risk exposure. Lastly, we cannot be assured that our professional liability and general liability insurance, nor our recorded reserves for self-insured retention, will cover all claims against us or continue to be available at reasonable costs for us to maintain adequate levels of insurance in the future.

Competition

     In executing our business strategy, we compete primarily with other cardiovascular care providers, principally for-profit and not-for-profit general acute care hospitals. We also compete with other companies pursuing strategies similar to ours, and with not-for-profit general acute care hospitals that may elect to develop a heart hospital. In some of our markets, such as Sioux Falls, South Dakota, we may have only one competitor. In other markets, such as Phoenix, Arizona, our hospitals compete for patients with the heart programs of numerous other hospitals in the same market. In most of our markets we compete for market share of cardiovascular procedures with three to six hospitals. Some of these hospitals are part of large for profit or not-for-profit hospital systems with greater financial resources than we have available to us, and all of them have been operating in the markets they serve for many years. When we open a new hospital, we generally will not be successful unless we capture significant market share from existing hospitals already operating in the market. We believe that all eight of our hospitals in operation as of September 30, 2002 rank first or second in market share of key cardiovascular

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     Some of the hospitals that compete with our hospitals are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. Some of our competitors are larger, are more established, have greater geographic coverage, offer a wider range of services or have more capital or other resources than we do. If our competitors are able to finance capital improvements, recruit physicians, expand services or obtain favorable managed care contracts at their facilities, we may experience a decline in market share. In operating our hospitals, particularly in performing outpatient procedures, we compete with free-standing diagnostic and therapeutic facilities located in the same markets.

     We are not aware of any national competitors in the mobile cardiac catheterization laboratory business seeking to serve networks of hospitals. It is possible that some of the hospitals currently served by our mobile catheterization laboratories may elect to install their own facilities. There are several other companies offering cardiac catheterization laboratories for rental on a short-term basis.

Government Regulation

     The healthcare industry is required to comply with extensive government regulation at the federal, state, and local levels. Under these laws and regulations, hospitals must meet requirements to be licensed under state law and be certified to participate in government programs, including the Medicare and Medicaid programs. These requirements relate to matters such as the adequacy of medical care, equipment, personnel, operating policies and procedures, emergency medical care, maintenance of records, relationships with physicians, cost reporting and claim submission, rate-setting, compliance with building codes, and environmental protection. There are also extensive government regulations that apply to our owned and managed diagnostic facilities and the physician practices that we manage. If we fail to comply with applicable laws and regulations, we could be subject to criminal penalties and civil sanctions, our hospitals could lose their licenses, and our hospitals and other healthcare facilities could lose their ability to participate in the Medicare, Medicaid and other federal and state health care programs. In addition, government laws and regulations, or the interpretation of such laws and regulations, may change. If that happens, we may have to make changes in our facilities, equipment, personnel, services or business structures so that our hospitals and other healthcare facilities remain qualified to participate in these programs. We believe that our hospitals and other health care facilities are in substantial compliance with current federal, state, and local regulations and standards.

     Licensure and accreditation. Our hospitals are subject to state and local licensing requirements. In order to verify compliance with these requirements, our hospitals are subject to periodic inspection by state, and local authorities. All of our hospitals are licensed as general acute care hospitals under applicable state law. In addition, our hospitals are accredited by the Joint Commission on Accreditation of Healthcare Organizations, a

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     Certification. In order to participate in the Medicare program, each provider must meet applicable regulations of the Department of Health and Human Services relating to, among other things, the type of facility, equipment, personnel, standards of medical care and compliance with applicable state and local laws. All hospitals and our diagnostic and therapeutic facilities are certified to participate in the Medicare and Medicaid programs.

     Emergency Medical Treatment and Active Labor Act. The Emergency Medical Treatment and Active Labor Act imposes requirements as to the care that must be provided to anyone who seeks care at facilities providing emergency medical services. Regulations have been adopted that expand the areas within a hospital system that must provide emergency treatment. Sanctions for failing to fulfill these requirements include exclusion from participation in the Medicare and Medicaid programs and civil money penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm as a direct result of a violation of the law to sue the offending hospital for damages and equitable relief. A hospital that suffers a financial loss as a direct result of another participating hospital’s violation of the law also has a similar right. Although we believe that our emergency care practices are in compliance with the law, we cannot assure you that governmental officials responsible for enforcing the law or others will not assert that we are in violation of these laws.

     Certificate of Need laws. In some states, the construction of new facilities, the acquisition of existing facilities or the addition of new beds or services may be subject to review by state regulatory agencies under a certificate of need program. These laws generally require appropriate state agency determination of public need and approval prior to the addition of beds or services. Currently, we do not operate any hospitals in states that have adopted certificate of need laws. However, these laws may limit our ability to acquire or develop new facilities in states that have such laws. We operate diagnostic facilities in some states with certificate of need laws and we believe they are operated in compliance with applicable requirements. However, we cannot assure you that government officials will agree with our interpretation of these laws.

     Professional licensure. Healthcare professionals at our hospitals and diagnostic and therapeutic facilities are required to be individually licensed or certified under applicable state law. We take steps to ensure that our employees and agents have all necessary licenses and certifications, and we believe that our employees and agents comply with all applicable state laws.

     Corporate practice of medicine and fee-splitting. Some states have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that prohibit direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of the business arrangements. These laws vary from state to state, are often vague and in most states have seldom been interpreted by the courts or regulatory agencies. We have attempted to structure our arrangements with healthcare providers to comply with the relevant state law. However, we cannot assure you that governmental officials charged with responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws may also be interpreted by the courts in a manner inconsistent with our interpretations.

     Various federal and state laws govern financial and other arrangements among healthcare providers and prohibit the submission of false or fraudulent claims to the Medicare, Medicaid and other government healthcare programs. Penalties for violation of these laws include civil and criminal fines, imprisonment and exclusion from participation in federal and state healthcare programs. The Health Insurance Portability and Accountability Act of 1996 broadened the scope of certain fraud and abuse laws by adding several civil and criminal statutes that apply to all healthcare services, whether or not they are reimbursed under a federal healthcare program. Among other things, the Health Insurance Portability and Accountability Act of 1996 established civil monetary penalties for certain conduct, including upcoding and billing for medically unnecessary goods or services. In addition, the federal False Claims Act allows an individual to bring a lawsuit on behalf of the government, in what are known as qui tam or whistleblower actions, alleging false Medicare or Medicaid claims or other violations of the statute. The use of these private enforcement actions against healthcare providers has increased dramatically in the recent past, in part because the individual filing the initial complaint may be entitled to share in a portion of any settlement or judgment.

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     Anti-kickback statute. The federal anti-kickback statute prohibits providers of healthcare and others from soliciting, receiving, offering or paying, directly or indirectly, any type of remuneration in connection with the referral of patients covered by the federal healthcare programs. Violations of the anti-kickback statute may be punished by a criminal fine of up to $25,000 or imprisonment for each violation, civil fines of up to $50,000, damages of up to three times the total dollar amount involved, and exclusion from federal healthcare programs, including Medicare and Medicaid.

     As authorized by Congress, the Office of Inspector General of the Department of Health and Human Services has published safe harbor regulations that outline activities and business relationships that are deemed protected from prosecution under the anti-kickback statute. However, the failure of a particular activity to comply with the safe harbor regulations does not mean that the activity violates the anti-kickback statute. There are safe harbors for various types of arrangements, including those for personal services and management contracts and others for investment interests, such as stock ownership in companies with more than $50 million in undepreciated net tangible assets related to healthcare items and services. This publicly traded company safe harbor contains additional criteria, including that the stock must be obtained on terms and at a price equally available to the public when trading on a registered security exchange.

     The Office of Inspector General is primarily responsible for enforcing the anti-kickback statute and generally for identifying fraud and abuse activities affecting government programs. In order to fulfill its duties, the Office of Inspector General performs audits and investigations. In addition, the agency provides guidance to healthcare providers by issuing Special Fraud Alerts and Bulletins that identify types of activities that could violate the anti-kickback statute and other fraud and abuse laws. The Office of the Inspector General has identified the following arrangements with physicians as potential violations of the statute:

	•	payment of any incentive by the hospital each time a physician refers a patient to the hospital,
	•	use of free or significantly discounted office space or equipment for physicians in facilities usually located close to the hospital,
	•	provision of free or significantly discounted billing, nursing, or other staff services,
	•	free training for a physician’s office staff including management and laboratory techniques,
	•	guarantees which provide that if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder,
	•	low-interest or interest-free loans, or loans which may be forgiven if a physician refers patients to the hospital,
	•	payment of the costs of a physician’s travel and expenses for conferences,
	•	payment of services which require few, if any, substantive duties by the physician, or payment for services in excess of the fair market value of the services rendered, or
	•	purchasing goods or services from physicians at prices in excess of their fair market value.

     We have a variety of financial relationships with physicians who refer patients to our hospitals. Physicians own interests in each of our hospitals and some of our cardiac catheterization laboratories. Physicians may also own our stock. We also have contracts with physicians providing for a variety of financial arrangements, including leases, management agreements, independent contractor agreements, right of first refusal agreements, and professional service agreements. Although we believe that our arrangements with physicians have been structured to comply with the current law and available interpretations, some of our arrangements do not expressly meet the requirements for safe harbor protection. We cannot assure you that regulatory authorities will not determine that these arrangements violate the anti-kickback statute or other applicable laws. Also, most of the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payors, not just to federal health care programs. Many of these state laws do not have safe harbor regulations comparable to the federal anti-kickback law and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these anti-kickback laws we could be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid, or other governmental healthcare programs.

     Physician self-referral law. Section 1877 of the Social Security Act, commonly known as the Stark Law, prohibits physicians from referring Medicare and Medicaid patients for certain designated health services to

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     Phase I of the final Stark regulations was issued in January 2001, and largely went into effect on January 4, 2002, except for one provision interpreting the requirement in many Stark Law exceptions that a physician’s compensation must be “set in advance.” The anticipated release date for the interpretation of this term in the Phase I regulations, which would have precluded certain percentage compensation arrangements from qualifying for these exceptions, has now been extended, and, therefore, the effective date of that portion of Phase I has been extended to July 7, 2003. The Centers for Medicare & Medicaid Services has not yet finalized the balance of the regulations. Phase II is expected to be published before July 7, 2003 and will address those exceptions not addressed in Phase I, and application of the law under the Medicaid program. Until the Phase II regulations are issued, the government has indicated that it will accept any reasonable interpretation of the statutory language. There have been few enforcement actions taken and relatively few cases interpreting the Stark Law to date, although a recent case struck down one aspect of the Phase I regulations relating to the Stark Law’s applicability to certain types of services. As a result, there is little indication as to how courts will interpret and apply the Stark Law; however, enforcement is expected to increase. We believe we have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and the regulatory exceptions in Phase I of the final regulations. In particular, we believe that our physician ownership arrangements meet the Stark whole hospital exception. In addition, we expect to meet the exception for publicly traded securities. The diagnostic and other facilities that we own do not furnish any designated health services as defined under the Phase I regulations and thus referrals to them are not subject to the Stark Law’s prohibitions. We cannot predict the final form that such regulations will take or the effect those regulations will have on us or our arrangements with physicians.

     The Stark Law may also be amended in ways that we cannot predict at this time, including possible changes to the current physician ownership and compensation exceptions. For example, in July 2001 Representative Kleczka introduced a bill, with Representative Stark as a co-sponsor, that would amend the Stark Law to add as a requirement to the exception for a physician’s ownership in an entire hospital that the physician purchase the ownership interest on terms generally available to the public. If enacted as proposed, this provision would apply only to ownership and other investment interests purchased by physicians on or after the effective date of this proposed amendment to the Stark Law. Thus, this change in the Stark Law would not apply to the ownership interests of the physicians who previously invested in the ventures that own and operate our existing heart hospitals or of those who invest in ventures formed to develop future hospitals as long as their interests are purchased prior to the effective date. Since Congress failed to act before the end of the 107th legislative session, the Kleczka bill expired. However, it or another similar piece of legislation could be introduced during the next Congressional session. Possible amendments to the Stark Law could require us to change the manner in which we establish relationships with physicians to develop a heart hospital. We cannot predict whether this or any other law or amendment will be enacted or the effect they might have on us.

     Many states in which we operate also have adopted, or are considering adopting physician self-referral laws which may prohibit certain physician referrals or require certain disclosures. Some of these state laws apply regardless of the source of payment for care. These statutes typically provide criminal and civil penalties as well as loss of licensure and may have broader prohibitions than the Stark Law or more limited exceptions. While there is little precedent for the interpretation or enforcement of these state laws, we have attempted to structure our financial relationships with physicians and others in light of these laws. In addition, existing state self-referral laws may be amended. For example, two bills on this subject have been introduced in the Ohio General Assembly.

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     Civil monetary penalties. The Social Security Act contains provisions imposing civil monetary penalties for various fraudulent and/or abusive practices, including, among others, hospitals which knowingly make payments to a physician as an inducement to reduce or limit medically necessary care or services provided to Medicare or Medicaid beneficiaries. In July 1999, the Office of Inspector General issued a Special Advisory Bulletin on gainsharing arrangements.

     The Bulletin warns that clinical joint ventures between hospitals and physicians may implicate these provisions as well as the anti-kickback statute, and specifically refers to specialty hospitals which are marketed to physicians in a position to refer patients to the venture, and structured to take advantage of the exception to the Stark statute for physician investments in whole hospitals. Hospitals specializing in heart, orthopedic and maternity care are mentioned, and the Bulletin states that these ventures may induce investor-physicians to reduce services to patients through participation in profits generated by cost savings, in violation of a civil monetary penalty provision. Despite this initial broad interpretation of this civil monetary penalty law, in February 2001, the Office of Inspector General issued an advisory opinion which declined to sanction a particular gainsharing arrangement under this civil monetary penalty provision, or the anti-kickback statute, because of the specific circumstances and safeguards built into the arrangement. We believe that the ownership distributions paid to physicians by our heart hospitals do not constitute payments made to physicians under gainsharing arrangements. We cannot assure you, however, that government officials will agree with our interpretation of applicable law.

     False claims prohibitions. False claims are prohibited by various federal criminal and civil statutes. In addition, the federal False Claims Act prohibits the submission of false or fraudulent claims to the Medicare, Medicaid and other government healthcare programs. Penalties for violation of the Act include substantial civil and criminal fines, including treble damages, imprisonment and exclusion from participation in federal health care programs. In addition, the Federal False Claims Act allows an individual to bring lawsuits on behalf of the government, in what are known as qui tam or whistleblower actions, alleging false Medicare or Medicaid claims or other violations of the statute.

     A number of states, including states in which we operate, have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court.

     The federal government, private insurers and various state enforcement agencies have increased their scrutiny of providers’ business arrangements and claims in an effort to identify and prosecute fraudulent and abusive practices. There are ongoing federal and state investigations in the healthcare industry regarding multiple issues including cost reporting, billing and charge-setting practices, unnecessary utilization, physician recruitment practices, physician ownership of healthcare providers and joint ventures with hospitals. Certain of these investigations have targeted hospitals and physicians. We have substantial Medicare, Medicaid and other governmental billings, which could result in heightened scrutiny of our operations. We continue to monitor these and all other aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices are consistent with both legal requirements and current industry standards. However, because the federal and state fraud and abuse laws are complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations that are inconsistent with industry practices, including ours. Evolving interpretations of current, or the adoption of new, federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In public statements surrounding current investigations, governmental authorities have taken positions on a number of issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some instances, government investigations that in the past have been conducted under the civil provisions of federal law may now be conducted as criminal investigations.

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     A number of healthcare investigations are national initiatives in which federal agencies target an entire segment of the healthcare industry. One example involved the federal government’s initiative regarding hospitals’ improper requests for separate payments for services rendered to a patient on an outpatient basis within three days prior to the patient’s admission to the hospital, where reimbursement for such services is included as part of the reimbursement for services furnished during an inpatient stay. The government targeted all hospital providers to ensure conformity with this reimbursement rule. Further, the federal government continues to investigate Medicare overpayments to prospective payment system hospitals that incorrectly report transfers of patients to other prospective payment system hospitals as discharges. Law enforcement authorities, including the Office of the Inspector General and the Department of Justice, are also increasing scrutiny of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and business opportunities. Investigators also have demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources.

     It is possible that governmental entities could initiate investigations on these or other subjects in the future at our facilities and that such investigations could result in significant costs in responding to such investigations and penalties to us, as well as adverse publicity, declines in stock value and lawsuits brought by shareholders. It is also possible that our executives, managers and Board members, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, could be included in governmental investigations or named as defendants in private litigation. We are not aware of any material governmental investigations involving any of our facilities, our executives, managers or Board members. The positions taken by authorities in any future investigations of us, our executives, managers, Board members or other healthcare providers, and the liabilities or penalties that may be imposed could have a material adverse effect on our business, financial condition and results of operations.

     Our hospitals serve as research sites for physician clinical trials sponsored by pharmaceutical and device manufacturers and therefore may perform services on patients enrolled in those studies, including implantation of experimental devices. Only physicians who are members of the medical staff of the hospital may participate in such studies at the hospital. All trials are approved by an Institutional Review Board, which has the responsibility to review and monitor each study pursuant to applicable law and regulations. Such clinical trials are subject to various regulatory requirements.

     The industry standard for conducting preclinical testing is embodied in the investigational new drug regulations administered by the Food and Drug Administration. Research conducted at institutions supported by funds from the National Institutes of Health must also comply with multiple project assurance agreements and with regulations and guidelines governing the conduct of clinical research that are administered by the National Institutes of Health, the HHS Office of Research Integrity and the office of Human Research Protection. Research funded by the National Institutes of Health must also comply with the federal financial reporting and record keeping requirements incorporated into any grant contract awarded. The requirements for facilities engaging in clinical trials are set forth in the code of federal regulations and published guidelines. Regulations related to good clinical practices and investigational new drugs have been mandated by the Food and Drug Administration and have been adopted by similar regulatory authorities in other countries. These regulations contain requirements for research, sponsors, investigators, institutional review boards and personnel engaged in the conduct of studies to which these regulations apply. The regulations require that written protocols and standard operating procedures are followed during the conduct of studies and for the recording, reporting and retention of study data and records. The centers for Medicare and Medicaid services also impose certain requirements for billing of services provided in connection with clinical trials.

     The Food and Drug Administration and other regulatory authorities require that study results and data submitted to such authorities are based on studies conducted in accordance with the provisions related to good clinical practices and investigational new drugs. These provisions include:

	•	complying with specific regulations governing the selection of qualified investigators,
	•	obtaining specific written commitments from the investigators,
	•	disclosure of financial conflicts-of-interest,
	•	verifying that patient informed consent is obtained;

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	•	instructing investigators to maintain records and reports,
	•	verifying drug or device safety and efficacy; and
	•	permitting appropriate governmental authorities access to data for their review.

     Records for clinical studies must be maintained for specific periods for inspection by the Food and Drug Administration or other authorities during audits. Non-compliance with the good clinical practices or investigational new drug requirements can result in the disqualification of data collected during the clinical trial. It may also lead to department of an investigator or institution if fraud or substantial non-compliance is detected. Finally, non-compliance could lead to revocation, or non-renewal of government research grants.

     Although we believe that we are currently in compliance in all material respects with applicable federal, state and international laws such laws may be modified, interpreted or enforced differently in the future. Failure to comply with new or revised existing laws and regulations could subject us and physician investigators to loss of the right to conduct research, civil fines, criminal penalties and other enforcement actions.

     Finally, new final rules have been adopted by the Department of Health and Human Services related to the responsibilities of healthcare entities to maintain the privacy of patient identifiable medical information. These rules are discussed in more detail in the following section. We are working to comply with these rules as they apply to clinical research when compliance is required on April 14, 2003, and to obtain all required patient authorizations.

     The Administrative Simplification Provisions of the Health Insurance Portability and Accountability Act of 1996 require the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. These provisions are intended to encourage electronic commerce in the healthcare industry. On August 17, 2000, the Department of Health and Human Services published final regulations establishing electronic data transmission standards that all healthcare providers must use when submitting or receiving certain healthcare transactions electronically. Compliance with these regulations is required by October 16, 2002. However, Congress passed legislation in December 2001 which delayed the effective date for one year for those organizations which submitted a plan by October 2002 demonstrating how they will achieve compliance with the regulations by October 16, 2003. We cannot predict the impact that any new law or the final regulations, when fully implemented, will have on us.

     The Administrative Simplification Provisions also require the Department of Health and Human Services to adopt standards to protect the security and privacy of health-related information. The Department of Health and Human Services proposed regulations containing security standards on August 12, 1998. These proposed security regulations have not been finalized, but as proposed, would require healthcare providers to implement organizational and technical practices to protect the security of electronically maintained or transmitted health- related information. In addition, the Department of Health and Human Services released final regulations containing privacy standards on December 28, 2000. These privacy regulations are effective April 14, 2001, but compliance with these regulations is not required until April 2003. The government issued further modifications to these regulations on August 14, 2002. The privacy regulations will extensively regulate the use and disclosure of individually identifiable health-related information. The security regulations, as proposed, and the privacy regulations could impose significant costs on our facilities in order to comply with these standards. We cannot predict the final form that these regulations will take or the impact that final regulations, when fully implemented, will have on us.

     Violations of the Administrative Simplification Provisions could result in civil penalties of up to $25,000 per type of violation in each calendar year and criminal penalties of up to $250,000 per violation. In addition, our facilities will continue to remain subject to any state laws that are more restrictive than the regulations issued under the Administrative Simplification Provisions. These statutes vary by state and could impose additional penalties.

     The healthcare industry continues to attract much legislative interest and public attention. In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the healthcare system. Proposals that have been considered

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     The Office of Inspector General has issued guidelines to promote voluntarily developed and implemented compliance programs for the healthcare industry. In February 1998, the Office of Inspector General issued compliance program guidance for hospitals. In response to the original 1998 guidelines, the Company adopted a Code of Ethics, designated compliance officers in the parent corporation and individual hospitals, established a toll free compliance line, which permits anonymous reporting, implemented various compliance training programs, and developed a process for screening all employees through applicable federal and state databases.

     The Company has established a reporting system, auditing and monitoring programs, and a disciplinary system to enforce the Code of Ethics and other compliance policies. Auditing and monitoring activities include claims preparation and submission, and cover numerous issues such as coding, billing, cost reporting, and financial arrangements with physicians and other referral sources. These areas are also the focus of training programs.

     It is our policy to require our officers and employees to participate in compliance training programs. The board of directors has established a compliance committee, which oversees implementation of the compliance program. The committee consists of three outside directors, and is chaired by Galen Powers, a director and former chief counsel for the Health Care Financing Administration (now known as the Centers for Medicare & Medicaid Services), where he was responsible for providing legal advice on federal healthcare programs, particularly Medicare and Medicaid. The compliance committee of the board meets at least quarterly.

     The corporate compliance officer is appointed by the board, and reports to the chief executive officer and to the compliance committee of the board at least quarterly. The corporate compliance officer is a senior vice president, and has a background in nursing and hospital administration. Each hospital has its own compliance committee that reports to its governing board. The hospital president serves as the hospital’s compliance officer. The board of directors’ compliance committee assesses each hospital’s compliance program at least annually. The corporate compliance officer annually visits the hospitals for compliance reviews, provides an audit guide to the hospitals to evaluate compliance with our policies and procedures, and serves on the compliance committee of each hospital.

     The objective of the program is to ensure that our operations at all levels are conducted in compliance with applicable federal and state laws regarding both public and private healthcare programs. The OIG announced in its work plan for fiscal year 2003 that it is considering revisions to its compliance guidance for hospitals, and if revisions are published, we will endeavor to modify our compliance program accordingly.

     Medicare. Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Under the Medicare program, we are paid for certain inpatient and outpatient services performed by our hospitals and also for services provided at our diagnostic and other facilities.

     Medicare payments for inpatient acute services are generally made pursuant to a prospective payment system. Under this system, our hospitals are paid a prospectively-determined amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a diagnosis-related group. Based upon the patient’s condition and treatment during the relevant inpatient stay, each diagnosis-related group is assigned a payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. Such payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, diagnosis-related group payments are adjusted by a predetermined geographic adjustment factor assigned to the geographic area in which the hospital is located. While hospitals generally do not receive direct payment in addition to a diagnosis-related group payment, hospitals may qualify for an outlier payment when the relevant patient’s treatment costs are extraordinarily high and exceed a specified threshold.

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     The diagnosis-related group rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The update factor is determined, in part, by the projected increase in the cost of goods and services that are purchased by hospitals, referred to as the market basket index. The annual update factor historically has been lower than the projected increases in the market basket index. For federal fiscal years 2002 and 2003, hospitals will receive the market basket index minus 0.55 percentage points, and in federal fiscal year 2004 and subsequently hospitals will receive the full market basket index update. Future legislation may increase or decrease diagnosis-related group payment updates, or otherwise modify Medicare reimbursement to acute care hospitals, but we are not able to predict the amount of any such reimbursement changes or the effect that such changes will have on us.

     Outpatient services were traditionally paid at the lower of customary charges or on a reasonable cost basis. The Balanced Budget Act of 1997 established a prospective payment system for outpatient hospital services that commenced on August 1, 2000. Based upon our experience with the new prospective payment system for outpatient hospital services, we do not believe the new system will have a substantial adverse effect on our operating results. Under the final outpatient hospital rule for 2003, published November 2, 2002, total payments to outpatient hospitals departments are expected to be $18.7 billion, up from $17.7 billion in 2002, with Medicare rates increasing for each service by an average of 3.7 percent. Moreover, Medicare will fully fund pass-through payments for “new tech” drugs and devices for 2003. The final rule also establishes payment for 95 categories of devices and approximately 240 drugs that qualify for temporary pass-through payments through the end of 2002, but which will not be eligible for these add-on payments in 2003. Based on our preliminary review of CMS’ final regulation, at this time we anticipate that the reimbursement changes will not have a substantial impact on our future operating results.

     Services provided at our freestanding diagnostic facilities are typically reimbursed on the basis of the physician fee schedule which is revised periodically, and bases payment on various factors including resource-based practice expense relative value units, or RVUs, and geographic practice cost indices. CMS estimates that Medicare physician fee schedule rates will decrease by an average 4.4 percent as of February 1, 2003, although several bills are expected to be introduced in the next legislative session to provide some additional reimbursement to physicians and other types of providers. Future legislation or regulations may increase or decrease the reimbursement rates set on the physician fee schedule or otherwise modify reimbursement to our diagnostic and therapeutic facilities but we are not able to predict the amount of any changes or their effect on us.

     Medicaid. Medicaid is a state-administered program for low income individuals which is funded jointly by the federal and individual state governments. Most state Medicaid payments for hospitals are made under a prospective payment system or under programs that negotiate payment levels with individual hospitals. Many states are currently considering significantly reducing Medicaid funding, while at the same time in some cases expanding Medicaid benefits. This could adversely affect future levels of Medicaid payments received by our hospitals. We are unable to predict what impact, if any, future Medicaid managed care systems might have on our operations.

     The Medicare and Medicaid programs are subject to statutory and regulatory changes, retroactive and prospective rate adjustments, administrative rulings, court decisions, executive orders and freezes and funding reductions, all of which may adversely affect our business. There can be no assurance that payments for hospital services and cardiac diagnostic and other procedures under the Medicare and Medicaid programs will continue to be based on current methodologies or remain comparable to present levels. In this regard, we may be subject to rate reductions as a result of federal budgetary or other legislation related to the Medicare and Medicaid programs. In addition, various state Medicaid programs periodically experience budgetary shortfalls which may result in Medicaid payment reductions and delays in payment to us.

     Utilization review. Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicare patients be reviewed by peer review organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of diagnosis, related group classifications and appropriateness of cases of extraordinary length of stay or cost. Peer review organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services that a provider not in substantial compliance with the standards of the peer review organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.

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     Annual cost reports. Hospitals participating in the Medicare and some Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients.

     Annual cost reports required under the Medicare and some Medicaid programs are subject to routine governmental audits. These audits may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. Finalization of these audits often takes several years. Providers can appeal any final determination made in connection with an audit.

     Managed care. The percentage of admissions and net revenue attributable to managed care plans has increased as a result of pressures to control the cost of healthcare services. We expect that the trend toward increasing percentages related to managed care plans will continue in the future. Generally, we receive lower payments from managed care plans than from traditional commercial/indemnity insurers; however, as part of our business strategy, we intend to take steps to improve our managed care position.

     Commercial insurance. Our hospitals provide services to individuals covered by private healthcare insurance. Private insurance carriers pay our hospitals or in some cases reimburse their policyholders based upon the hospital’s established charges and the coverage provided in the insurance policy. Commercial insurers are trying to limit the costs of hospital services by negotiating discounts, and including the use of prospective payment systems, which would reduce payments by commercial insurers to our hospitals. Reductions in payments for services provided by our hospitals to individuals covered by commercial insurers could adversely affect us.

Item 2.    Properties

     Our executive offices are located in Charlotte, North Carolina in approximately 32,580 square feet of leased commercial office space.

     Each of the ventures we have formed to develop a hospital owns the land and buildings of the hospital, with the exception of the land underlying the Heart Hospital of Austin, which we lease. Each venture has pledged its interest in the land and hospital building to secure the term debt incurred to develop the heart hospital, and substantially all the equipment located at these ventures is pledged as collateral to secure long-term debt. Each venture formed to own and operate a diagnostic and therapeutic facility leases its facility.

     Additional information with respect to our hospital facilities and our diagnostic and therapeutic facilities can be found in Item 1 of this report under the captions, Business — Our Hospitals, and Business — Diagnostic and Therapeutic Facilities.

Item 3.    Legal Proceedings

     We are involved in various litigation and proceedings in the ordinary course of our business. We do not believe, based on advice of counsel, our experience with past litigation, and taking into account our applicable insurance coverage, the outcome of any such litigation, individually or in the aggregate, will have a material adverse effect upon our business, financial condition or results of operations.

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

     None.

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EXECUTIVE OFFICERS OF THE REGISTRANT

     Set forth below is information regarding our executive officers.

     Stephen R. Puckett has been our chairman of the board since December 1999. He was a founder of our predecessor company in 1988 and served as chairman of the board, president and chief executive officer from that time until December 1999 when he became chairman. From 1984 to 1989, Mr. Puckett served as executive vice president and chief operating officer of the Charlotte Mecklenburg Hospital Authority, a large multi-hospital system, and from 1981 to 1983, he served as its senior vice president. Mr. Puckett serves as a director of PharmaNetics. Mr. Puckett received a B.A. from the University of Alabama and an M.S. in Health Management from the University of Alabama at Birmingham.

     David Crane has been our president and chief executive officer since December 1999. From 1989 to 1999, Mr. Crane served as our executive vice president and chief operating officer and has served as a director since 1989. From 1985 to 1989, Mr. Crane was employed by MediVision, Inc., an eye care company. He served as chief operating officer of MediVision from 1987 to 1989. From 1982 to 1985, he was a business and healthcare consultant and manager with Bain & Company. Mr. Crane received a B.A. from Yale University and an M.B.A. from Harvard Business School.

     Michael G. Servais has been our executive vice president and chief operating officer since July 2000. From 1994 to 2000, Mr. Servais served as senior vice president and president of the hospital division of Universal Health Services, Inc. From 1990 to 1994, he was vice president of Universal Health Services, Inc. From 1986 to 1990, Mr. Servais was president of Jupiter Hospital Corporation, a privately held hospital company with seven hospitals and related business entities. From 1981 to 1986, he was vice president of hospital operations for a privately held, for-profit health care company based in Seattle, Washington. From 1968 to 1981, he held a variety of senior management positions in large not-for-profit hospitals in southern California. Mr. Servais received his B.S.B.A. from California State University at Northridge and his M.P.A. from the University of Southern California.

     James E. Harris has been our executive vice president and chief financial officer since December 1999. From 1998 to 1999, Mr. Harris was chief financial officer for Fresh Foods, Inc., a manufacturer of fully cooked food products. From 1987 to 1998, Mr. Harris served in several different officer positions with The Shelton Companies, a private investment company. Prior to joining The Shelton Companies, Mr. Harris spent two years with Ernst & Young as a senior accountant. Mr. Harris received his B.S.B.A. from Appalachian State University and his M.B.A. from Wake Forest University’s Babcock School of Management.

     Dennis I. Kelly has been our executive vice president of development since January 1999. From 1995 to 1999, Mr. Kelly was the vice president of governmental and national accounts for Siemens Medical Systems, Inc. Mr. Kelly initially joined Siemens in 1983 as a sales representative and held various management positions prior to 1995. Mr. Kelly received a B.S. from Westminster College and a Registered Technologist, Radiography from the University of Utah.

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     Thomas K. Hearn III has been president of our diagnostic division since November 1995. From August 1993 to November 1995, Mr. Hearn served as president of Decision Support Systems, Inc., a healthcare software and consulting firm that he co-founded. Mr. Hearn was employed from 1987 to 1993 by the Charlotte Mecklenburg Hospital Authority, a large multi-hospital system, where he served as vice president of administration and administrator of the Authority’s Carolinas Heart Institute. From 1985 to 1987, Mr. Hearn developed managed care products for Voluntary Hospitals of America, a consortium of non-profit hospitals. Mr. Hearn received a B.A. from the College of William and Mary, and the M.P.H. and M.B.A. degrees from the University of Alabama at Birmingham.

     Joan McCanless has been senior vice president of risk management and decision support since 1996 and corporate compliance officer since January 1999. From 1993 to 1996, Ms. McCanless served as a principal of Decision Support Systems, Inc., a healthcare software and consulting firm that she co-founded. Prior to co-founding Decision Support Systems, she was employed at the Charlotte Mecklenburg Hospital Authority where she served as vice president of administration, a department director, head nurse and staff nurse. Ms. McCanless received her B.S. in Nursing from the University of North Carolina at Charlotte.

     R. William Moore, Jr. has been president of our hospital division of since November 1995. From 1994 to 1995, Mr. Moore served as president of our first heart hospital, the McAllen Heart Hospital. From 1989 to 1994, Mr. Moore was administrator of University Hospital, a 130-bed hospital in the Charlotte Mecklenburg Hospital Authority’s large multi-hospital system. Mr. Moore received a B.A. from Ohio Northern University and an M.B.A. from Western Carolina University.

     J. Arthur Parker has been has been senior vice president and treasurer since March 2001. From 1987 to 2001, Mr. Parker served in various positions with Bank of America, which culminated in his position as a high yield bond research analyst with responsibility for coverage of the health care industry at Banc of America Securities. Mr. Parker received his B.A. from the University of Georgia and M.B.A. from Wake Forest University’s Babcock School of Management.

     David W. Perry has been vice president and chief accounting officer since February 2001. From 1994 to 2001, Mr. Perry served in various positions with Deloitte & Touche, which culminated in his position as a senior manager in assurance and advisory services in the Charlotte office of Deloitte & Touche. Prior to 1994, Mr. Perry spent a year with KPMG Peat Marwick as a staff accountant. Mr. Perry received his B.B.A. from James Madison University.

     A. Kenneth Petronis has been president of our cardiology consulting and management business since September 1997. From 1993 to 1997, Mr. Petronis was vice president of network management for PHP, Inc., a subsidiary of United HealthCare of North Carolina, Inc., the largest managed care company in North Carolina. In this role, Mr. Petronis oversaw contractual relationships with over 8,000 physicians and 100 hospitals. Prior to holding that position, Mr. Petronis was with LeBauer HealthCare, the largest multi-specialty clinic in Greensboro, North Carolina, where he was the chief executive officer for four years. Mr. Petronis holds a B.A. degree from Duke University and an M.B.A. from Northwestern University’s Kellogg School.

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PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters

     Our common stock began trading on July 24, 2001, on the Nasdaq National Market® under the symbol “MDTH.” At December 16, 2002, there were 18,011,520 shares of common stock outstanding, 86 holders of record and approximately 2,000 beneficial owners of our common stock. The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as reported by the Nasdaq National Market:

     We have not declared nor paid any cash dividends on our common stock and do not anticipate paying cash dividends on our common stock for the foreseeable future. The terms of our credit agreements also restrict us from paying cash dividends and making other distributions to our stockholders. We anticipate that we will retain all earnings, if any, to develop and expand our business. Payment of dividends in the future will be at the discretion of our board of directors and will depend upon our financial condition and operating results.

     The shares of common stock sold in our initial public offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (File No. 333-60278) that was declared effective by the SEC on July 23, 2001. All 6,000,000 shares of common stock offered in the final prospectus were sold at a price of $25.00 per share. The aggregate gross proceeds of shares offered and sold were $150.0 million. At the time of the offering, we recognized net proceeds of approximately $135.9 million after deducting the underwriting discounts and commissions and other offering expenses. During our fiscal year ended September 30, 2002, we recognized two transactions that increased our net proceeds from the offering by approximately $1.1 million, to a total of $137.0 million. First, we recognized an approximately $800,000 tax benefit relating to approximately $2.1 million of offering expenses which were determined to be deductible for income tax purposes. Second, we recognized an approximately $293,000 reduction in other offering expenses from the final settlement of estimated expenses accrued at the time of the offering. Of the total $137.0 million in net proceeds from the offering, we immediately used approximately $25.4 million to increase our ownership interest in five of our heart hospitals and approximately $18.0 million to pay all amounts outstanding under our $100.0 million credit facility. In October 2001, we used $17.4 million of the net proceeds from the offering to increase our ownership interest in the Heart Hospital of New Mexico. That acquisition increased our ownership interest in the Heart Hospital of New Mexico from a 24.0% minority interest to a 69.0% majority interest ownership position, giving us substantive control of the heart hospital. Accordingly, we began to consolidate in our financial statements the hospital’s results of operations and financial position beginning October 1, 2001, the date of acquisition. We have also invested approximately $14.1 million of the net proceeds from the public offering in our hospital development program.

     We expect to use the remaining approximate $62.1 million of net proceeds from the offering to develop additional hospitals and for working capital and other corporate purposes, including the possible acquisition of additional interests in our existing hospitals. Although we have identified these intended uses of the remaining proceeds, we have broad discretion in the use of the net proceeds from the offering. Pending those uses, we are investing the funds, along with our operating cash, in money market funds or similar short-term interest bearing, investment-grade securities, which are include in cash and cash equivalents in our consolidated balance sheet.

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Item 6.    Selected Consolidated Financial Data

     The following table sets forth selected consolidated financial data of:

	•	MedCath Corporation, subsequent to the initial public offering, and MedCath Holdings, Inc. prior to the initial public offering, as of and for the years ended September 30, 2002, 2001, 2000, 1999 and as of and for the two months ended September 30, 1998; and
	•	our predecessor company, MedCath Incorporated, as of and for the ten months ended July 31, 1998.

     The selected consolidated financial data have been derived from the audited consolidated financial statements of MedCath Corporation and our predecessor company. The selected consolidated financial data should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and related notes, appearing elsewhere in this report.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion and related financial data should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.

Overview

     We focus primarily on the diagnosis and treatment of cardiovascular disease. We design, develop, own and operate hospitals in partnership with physicians, most of whom are cardiologists and cardiovascular surgeons. While each of our hospitals is a freestanding, licensed general acute care hospital, we focus on serving the unique needs of patients suffering from cardiovascular disease. Since January 1994, we have developed ten hospitals in seven states, including Arizona, Arkansas, California, New Mexico, Ohio, South Dakota and Texas, where we opened our newest hospital in Harlingen, Texas on October 2, 2002. As of December 16, 2002, we had nine hospitals in operation with a total of 577 licensed beds and had sold one hospital in McAllen, Texas. We are

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     In addition to our hospitals, we provide cardiovascular care services in diagnostic and therapeutic facilities located in eight states and through mobile cardiac catheterization laboratories. We also provide consulting and management services tailored primarily to cardiologists and cardiovascular surgeons.

     We completed our initial public offering in July 2001 by issuing 6,000,000 new shares of our common stock at a price of $25.00 per share, thereby generating aggregate gross proceeds of $150.0 million. We recognized net proceeds from the public offering of approximately $137.0 million after deducting the underwriting discounts and commissions and other offering expenses. Concurrent with the public offering, we completed a series of transactions that we undertook to prepare for the public offering and to increase our ownership interest in some of our hospitals. First, we established MedCath Corporation as our new holding company by issuing 11,879,918 shares of our common stock in exchange for all of the outstanding shares of common stock of our predecessor holding company, MedCath Holdings, Inc. Second, we completed a series of transactions in which we issued 131,602 shares of our common stock valued at the public offering price and paid approximately $25.4 million cash to acquire additional ownership interests in five of our hospitals from our physician and hospital partners in each of those hospitals. The shares of common stock issued in these transactions were in addition to the shares sold in the public offering. The cash paid in these transactions was financed with a portion of the net proceeds from the public offering.

Hospital Ownership and Capital Structure

     Each of our hospitals is organized as either a limited liability company or limited partnership, with one of our wholly owned subsidiaries serving as the manager or general partner and typically holding from 51% to 71% of the ownership interest in the entity. In most cases, our physician partners own the remaining ownership interests as members or limited partners. In some instances, local market conditions have made it advantageous for us to organize a hospital with a community hospital investing as a partner in addition to physicians. In three of our hospitals, there are hospital partners that hold ownership interests of 3%, 15% and 33%. We include in our consolidated financial statements hospitals over which we exercise substantive control, including all hospitals in which we own more than a 50% interest. We use the equity method of accounting for hospitals in which we hold less than a 50% interest and over which we do not exercise substantive control.

     The following table identifies our hospital ownership percentages as of the end of each of our three most recent fiscal years.

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     As a result of the increase in our ownership interest in Tucson Heart Hospital from a minority to a majority ownership position in July 2001, we obtained substantive control of that hospital and began consolidating in our financial statements the hospital’s results of operations and financial position from the date of acquisition. We had previously been required to use the equity method of accounting for Tucson Heart Hospital, which means that we included in our consolidated statement of operations only a percentage of the hospital’s reported net income or loss for each reporting period as equity in net earnings (losses) of unconsolidated affiliates.

     During our fiscal year 2000, we also included in our consolidated financial statements one hospital, Dayton Heart Hospital, in which we owned less than a 50% interest, but over which we exercised substantive control. At the beginning of our fiscal year 2001, we obtained a greater than 50% interest in Dayton Heart Hospital due to our community hospital partner forfeiting its interest in that hospital.

     Effective October 1, 2001, we used approximately $17.4 million of the net proceeds from the public offering to an acquire additional 45.0% ownership interest in our Heart Hospital of New Mexico from our physician and hospital partners. The acquisition increased our ownership interest in the Heart Hospital of New Mexico from a 24.0% minority ownership position to a 69.0% majority ownership position, and we obtained substantive control of the hospital. Accordingly, we began to consolidate in our financial statements the hospital’s results of operations and financial position from October 1, 2001 (the first day of our fiscal year 2002). Before acquiring this additional interest, we were required to account for our investment in the Heart Hospital of New Mexico using the equity method of accounting, which means that we included in our consolidated statement of operations only a percentage of the hospital’s reported net income or loss for each reporting period as equity in net earnings (losses) of unconsolidated affiliates.

     As of October 1, 2001 (the first day of our fiscal year 2002), our Heart Hospital of South Dakota is the only hospital in which we do not have a majority ownership interest and for which we do not consolidate the hospital’s results of operations and financial position in our consolidated financial statements.

     During 2000, we were approached with two offers to buy our McAllen Heart Hospital, in which we owned a 50.2% interest. On March 1, 2001, the hospital was sold to an affiliate of Universal Health Services, Inc. for approximately $56.0 million. Approximately $38.0 million of the sale proceeds were used to repay the hospital’s long-term debt, including intercompany debt. The net proceeds of the sale have been and will be distributed to the owners of the hospital based on their respective ownership percentages.

     Hospitals under development are typically capitalized with a mix of debt and equity. Equity represents approximately 15% to 20% of our new hospital’s anticipated development costs, which include real estate acquisition, construction costs, equipment purchases and pre-opening expenses, with debt accounting for the remainder of the project costs. Commercial banks or Real Estate Investment Trusts typically provide financing to fund a portion of a hospital’s real estate acquisition, construction and related costs, while lenders affiliated with our equipment vendors typically provide debt financing for a hospital’s equipment needs.

New Hospital Development

     On October 2, 2002, we opened our newest hospital in Harlingen, Texas. This hospital, which represents our ninth hospital in operation, focuses on cardiovascular care as well as orthopedics, neurology, obstetrics and gynecology. As of December 16, 2002, we had four hospitals under development, including a heart hospital that will be located in St. Tammany Parish just north of New Orleans, Louisiana, a heart hospital that will be located in San Antonio, Texas, a heart hospital that will be located in the city of Glendale, near Milwaukee, Wisconsin, and a heart hospital that will be located in Lafayette, Louisiana. These four new hospitals are expected to open during March 2003 (St. Tammany Parish), the late summer of 2003 (San Antonio), and the fall of 2003 (Glendale and Lafayette).

     Once a new hospital venture is formed and the partners have contributed their capital, it typically takes approximately 18 to 24 months to develop the heart hospital. The development costs for our five most recently opened hospitals, including the cost of equipment and capitalized construction period interest, have ranged from $38.0 million to $56.5 million depending on the size of the hospital and its location. These costs were incurred throughout the construction period, with approximately 55% of the costs being incurred in the last six months before opening the hospital. In addition, we incur pre-opening expenses throughout the development process, with the majority of these expenses incurred during the six to eight month period immediately prior to opening the heart hospital. Pre-opening expenses for our five most recently opened hospitals have ranged between $3.3 million and $6.5 million per hospital. Approximately 40.3% of these pre-opening expenses were for personnel and 6.6% for marketing and advertising. The balance was distributed among several categories

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Sources of Revenue by Division

     The largest percentage of our net revenue is attributable to our hospital division, which reflects our continuing strategic focus and investment in new hospitals. Based on our continued investment in the development of hospitals, we believe our hospital division’s percentage of consolidated net revenue will continue to increase in future periods.

     The following table sets forth the percentage contribution of each of our consolidating divisions to consolidated net revenue in the periods indicated, on a pro forma basis to reflect the sale of our McAllen Heart Hospital and the consolidation of the Tucson Heart Hospital resulting from the transactions discussed above.

Sources of Revenue by Payor

     We receive payments for our services rendered to patients from the Medicare and Medicaid programs, commercial insurers, health maintenance organizations, and our patients directly. Generally, our net revenue is determined by a number of factors, including the payor mix, the number and nature of procedures performed and the rate of payment for the procedures. Since cardiovascular disease disproportionately affects older people, the proportion of net revenue we derive from the Medicare program is higher than that of most general acute care hospitals. The following table sets forth the percentage of our hospital division’s net revenue we earned by category of payor in each of our last three fiscal years.

     Payments we receive from the Medicare and Medicaid programs for services rendered to patients also comprise a significant part of our total net revenue. The following table sets forth the percentage of consolidated net revenue we earned by category of payor in our last three fiscal years.

     We expect the net revenue that we receive from the Medicare program as a percentage of total consolidated net revenue to increase in future periods because the percentage of our total consolidated net revenue generated by our hospital division will continue to increase as we open new hospitals. Other factors that will cause the percentage of our hospital division’s net revenue received from Medicare to increase include our focus on cardiovascular disease, which disproportionately affects older people, the general aging of the population and the restoration of some payments under the Balanced Budget Refinement Act of 1999 and the Benefits Improvement and Protection Act of 2000.

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     The payment rates under the Medicare program for inpatients are based on a prospective payment system, which correlates to the physician’s diagnosis of the patient’s illness. While these rates are indexed for inflation annually, the increases have historically been less than actual inflation. A reduced rate of increase in Medicare payments may have an adverse impact on our net revenue. The payments we receive under the Medicare program also include outlier payments for patients with higher-than average costs. We are also reimbursed by non-governmental payors using a variety of payment methodologies, such as fee-for-service charges and rates based on diagnosis-related groups, or DRGs. We limit the number of per diem contracts we accept from managed care organizations because we believe these contracts do not reimburse us sufficiently for the efficiencies that we achieve in our hospitals. We do not accept capitation contracts from any payors.

Critical Accounting Policies

     The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our consolidated financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on a regular basis and make changes as experience develops or new information becomes known. Actual results may differ from these estimates under different assumptions or conditions.

     We define critical accounting policies as those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine and (3) have the potential to result in materially different results under different assumptions and conditions. We believe that our critical accounting policies are those described below. For a detailed discussion of the application of these and other accounting policies, see Note 2 to the consolidated financial statements included elsewhere in this report.

     Amounts we receive for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as commercial insurers and health maintenance organizations are generally less than our established billing rates. Payment arrangements with third-party payors may include prospectively determined rates per discharge or per visit, a discount from established charges, per-diem payments, reimbursed costs (subject to limits) and/or other similar contractual arrangements. As a result, net revenue for services rendered to patients is reported at the estimated net realizable amounts as services are rendered. We account for the difference between the estimated realizable rates under the reimbursement program and the standard billing rates as contractual adjustments, which are accrued on an estimated basis in the period that the related services are rendered and adjusted in future periods as adjustments become known and final settlements are determined. Estimates of contractual adjustments are made on a payor-specific basis and based on the best information available regarding our interpretation of the applicable laws, regulations and contract terms. We continually review the contractual estimation process to consider and incorporate updates to the laws and regulations and any changes in the contractual terms of our programs. Final settlements under some of these programs are subject to adjustment based on administrative review and audit by third parties, which can take several years to determine the final amounts earned under the programs. We record adjustments to the estimated billings as contractual adjustments in the periods that such adjustments become known or as the service years are no longer subject to audit, review or investigation. Due to the complexity of laws and regulations governing the Medicare and Medicaid programs, the manner in which they are interpreted and the other complexities involved in estimating our net revenue, there is a reasonable possibility that recorded estimates will change by a material amount in the near term.

     Management fee revenue in our diagnostic services division is recognized under fixed-rate and percentage-of-income contractual arrangements as services are rendered. In some cases, this division also recognizes management fee revenue under cost reimbursement and equipment lease contractual arrangements. Our cardiology consulting and management operations, which is included in our corporate and other division, recognizes management fee revenue under various percentage-of-income and cost reimbursement contractual arrangements and consulting and other revenue under service contractual arrangements.

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     Accounts receivable primarily consist of amounts due from third-party payors and patients in our hospital division. The remainder of our accounts receivable generally consist of amounts due from billings to hospitals for various cardiovascular care services performed in our diagnostics division and amounts due under consulting and management contracts in our cardiology consulting and management division. To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. We estimate this allowance based on such factors as payor mix, aging and the historical collection experience and write-offs of our respective hospitals and other business units. Within our hospital division, which comprised 87.4% of our accounts receivable at September 30, 2002, we rely on periodic detailed reviews of historical collections and write-offs at each of our hospitals to estimate this allowance. Adverse changes in business office operations, payor mix, economic conditions or trends in Federal and state governmental health care reimbursement could affect our collection of accounts receivable.

     Due to unfavorable pricing and availability trends in the general and professional liability insurance markets, the cost of commercial professional and general liability insurance coverage has risen significantly. As a result, we expect our total insurance premiums, including professional and general liability, property, business, auto, directors and officers, workers compensation and other coverages to increase approximately $5.5 million for our fiscal 2003 compared to fiscal 2002. In addition, we expect to assume a greater portion of the risk, through self-insured retention and higher deductibles, under our new commercial insurance policies during fiscal 2003 than in prior fiscal years.

     On June 1, 2002, our three-year combined insurance policy that provided medical malpractice claims coverage on a claims-made, first-dollar basis expired, and we became partially self-insured under a one-year policy providing coverage for claim amounts in excess of $2.0 million of retained liability per claim. At the same time, to provide coverage for claims incurred prior to June 1, 2002, but not reported as of that date under the expired claims-made policy, we purchased tail insurance coverage, the full cost of which we were required by accounting principles generally accepted in the United States to recognize as an operating expense in the third quarter of fiscal 2002. As a result of increasing premiums for malpractice insurance during fiscal 2002, the increase we paid for our new policy compared to the premiums we paid for the old policy was significant. Because we have retained up to $2.0 million of liability per claim under the new policy, we are required to recognize up to the first $2.0 million of estimated expense/liability for each malpractice claim incurred under the new policy period beginning June 1, 2002. As of September 30, 2002, our total estimated liability for its self-insured retention on medical malpractice claims, including incurred but not reported claims, was $858,000, which is included in current liabilities in our consolidated financial statements. We maintain this reserve based on actuarial estimates by an independent third party, who based the estimates on our historical experience with claims and assumptions about future events. The actuarial determined estimate of the costs of the self-insured retention for the current one-year policy period through May 31, 2003 has been determined to be approximately $2.9 million for our consolidated operating entities.

     In addition to reserves for medical malpractice, we also maintain reserves for our self-insured healthcare and dental coverage provided to our employees. As of September 30, 2002, our total estimated reserve for self-insured liabilities on employee health and dental claims was $2.0 million, which is included in current liabilities in our consolidated financial statements. We also maintain commercial stop loss coverage for our health and dental insurance program of $100,000 per plan participant. We maintain this reserve based on our historical experience with claims.

     We continually review our estimates for self-insured liabilities and record adjustments as experience develops or new information becomes known. The changes to the estimated liabilities are included in current operating results. Due to the considerable variability that is inherent in such estimates, including such factors as changes in medical costs and changes in actual experience, there is a reasonable possibility that the recorded estimates will change by a material amount in the near term. Also, there can be no assurance that the ultimate liability will not exceed our estimates.

     We expect both the premium costs and the self-insured retention under our various general and professional liability risk programs will increase our other operating expenses during the next twelve months. As we open new

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     We assess the carrying value of long-lived assets for potential impairment whenever events or changes in circumstances indicate that the carrying value of the asset, or related group of assets, may not be recoverable. We continually consider internal and external factors such as hospital and physician contract changes, local market developments, changes in third-party reimbursement methodologies, national health care trends, and other publicly available information. Measurement of the amount of the impairment, if any, may be based on quoted market prices, if available, or an estimate based on valuation techniques available in the circumstances, including discounted cash flows using our cost of capital. The estimates of these future cash flows are based on assumptions and projections that we believe to be reasonable and supportable. As considerable judgment is necessary to estimate future cash flows and fair values, there is a reasonable possibility that actual results may vary significantly from such estimates.

     Goodwill arising from business combinations completed after June 30, 2001 is accounted for under the provisions of Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangibles. Also effective October 1, 2001, the beginning of our fiscal year 2002, we adopted the remaining provisions of SFAS No. 142. Accordingly, we do not amortize goodwill, but rather we subject our goodwill to an annual test (at September 30) for potential impairment by comparing the estimated fair value of each of our reporting units to its carrying amount, including goodwill. We will also test goodwill of our reporting units between annual tests if an event occurs, or circumstances change, that indicate an impairment may exist. Our reporting units with goodwill include our hospital division and our diagnostics division. We estimated the fair value of our reporting units principally using multiples of earnings valuation methods as of September 30, 2002, which did not result in any impairment loss when compared to the carrying amounts of our reporting units.

     Earnings allocated to minority interests represent the allocation of profits and losses to minority owners in our consolidated subsidiaries. With respect to our consolidated hospitals, each hospital’s profits and losses are generally allocated for accounting purposes to us and our minority partners on a pro rata basis in accordance with the respective ownership percentages. However if the cumulative losses of a hospital exceed its initial capitalization and committed capital obligations of our partners, then we are required, due to the respective at risk capital positions, by accounting principles generally accepted in the United States to recognize a disproportionate share of the hospital’s losses that otherwise would be allocated to all owners on a pro rata basis. In such cases, we will then recognize a disproportionate share of the hospital’s future profits to the extent we have previously recognized a disproportionate share of the hospital’s losses. The determination of at risk capital position is based on the specific terms of each hospital’s operating agreement, including each partners’ contributed capital, obligation to provide working capital loans, to contribute additional capital, or to guarantee the outstanding obligations of the hospital. During each of our last three fiscal years ended September 30, 2002, 2001, and 2000, our reported earnings (losses) allocated to minority interests of $10.5 million, $14.7 million and $3.3 million, respectively, would have been $12.5 million, $17.2 million and $(1.3) million had we not recognized disproportionate allocations as described above. Therefore, for the fiscal years ended September 30, 2002, 2001 and 2000 our reported income (loss) before income taxes and extraordinary item of $27.3 million, $2.4 million and $(13.7) million, respectively, would have been $25.3 million, $(0.1) million and $(9.1) million.

     We expect our earnings allocated to minority interests to fluctuate in future periods as we either recognize disproportionate losses and/or recoveries thereof through disproportionate profits of our hospitals. As of September 30, 2002, we had remaining cumulative disproportionate loss allocations of approximately $16.4 million that we may recover in future periods, or be required to recognize additional disproportionate losses, depending on the results of operations of each of our hospitals. We could also be required to recognize disproportionate losses at our other hospitals not currently in disproportionate allocation depending on their results of operations in future periods.

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     Income taxes are provided for under the liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of differences between the tax basis of assets or liabilities and their carrying amounts in the consolidated financial statements. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will either expire before we are able to realize their benefit or for that future deductibility is uncertain.

     Developing the provision for income taxes requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and, if necessary, any valuation allowances that may be required for deferred tax assets. Our judgments and tax strategies are subject to audit by various taxing authorities. While we believe we have provided adequately for our income tax liabilities in our consolidated financial statements, adverse determinations by these taxing authorities could have a material adverse effect on our consolidated financial condition and results of operations.

     During fiscal 2002, our effective income tax rate was 10.7%, which was below our statutory rate of 35.5% due primarily to the reversal of valuation allowances we had recorded to fully offset our net deferred tax assets at the end of fiscal 2001. In future periods we expect our effective income tax rate, and related income tax expense or benefit, to increase and more closely approximate our statutory rate. In addition, the amount of current income tax liability we will have in future periods may be offset by $29.6 million and $50.8 million of gross federal and state, respectively, net operating loss carryforwards from prior periods we have available as of September 30, 2002.

Results of Operations

     The following table presents, for the periods indicated, information expressed as a percentage of net revenue. This information has been derived from the consolidated statements of operations included elsewhere in this report.

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