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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended December 31, 2003

Commission File Number 000-33009

10720 Sikes Place, Suite 300
Charlotte, North Carolina 28277
(Address of principal executive offices, including zip code)

(704) 708-6600
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes [  ] No [X]

As of January 31, 2004, there were 17,985,644 shares of $0.01 par value common stock outstanding.

MEDCATH CORPORATION

FORM 10-Q

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

MEDCATH CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

See notes to consolidated financial statements.

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MEDCATH CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

See notes to consolidated financial statements.

4

MEDCATH CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(In thousands)
(Unaudited)

See notes to consolidated financial statements.

5

MEDCATH CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See notes to consolidated financial statements.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All tables in thousands, except per share amounts)

1. Business and Organization

     MedCath Corporation (the Company) is a healthcare provider primarily focused on the diagnosis and treatment of cardiovascular disease. The Company designs, develops, owns and operates hospitals in partnership with physicians, whom it believes have established reputations for clinical excellence. Each of the Company’s majority-owned hospitals (collectively, the Hospital Division) is a freestanding licensed general acute care hospital, that provides a wide range of health services, and the medical staff at each hospital includes qualified physicians in various specialities. As of December 31, 2003, the Company owned and operated eleven hospitals, which include ten majority-owned hospitals and one in which the Company owns a minority interest. These hospitals have a total of 667 licensed beds, of which 587 were staffed and available, and are located in nine states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, Texas and Wisconsin.

     On January 13, 2004, the Company opened its twelfth hospital, which is located in San Antonio, Texas. This hospital is designed to accommodate 120 inpatient beds and will initially open with 60 licensed beds that will be staffed and available as the hospital ramps up its operations. The Company is currently completing the development of its thirteenth hospital, which is located in Lafayette, Louisiana and will open with 32 licensed beds in March 2004.

     The Company accounts for all but one of its owned and operated hospitals as consolidated subsidiaries. The Company owns a minority interest in Heart Hospital of South Dakota and does not have substantive control over the hospital, and therefore is unable to consolidate the hospital’s results of operations and financial position, but rather is required to account for its minority ownership interest in the hospital as an equity investment. The Company is currently evaluating the accounting for its interest in this hospital under Financial Accounting Standards Board (FASB) Interpretation No. 46-R that was issued in December 2003 regarding consolidation of variable interest entities. See “Accounting Changes and Recent Accounting Pronouncements” in Note 2 below.

     In addition to its hospitals, the Company provides cardiovascular care services in diagnostic and therapeutic facilities located in various locations and through mobile cardiac catheterization laboratories (the Diagnostics Division). The Company also provides consulting and management services (CCM) tailored primarily to cardiologists and cardiovascular surgeons, which is included in the corporate and other division.

2. Summary of Significant Accounting Policies

     Basis of Presentation - The Company’s unaudited interim consolidated financial statements as of December 31, 2003 and for the three months ended December 31, 2003 and 2002 have been prepared in accordance with accounting principles generally accepted in the United States of America (hereafter, generally accepted accounting principles) and pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). These unaudited interim consolidated financial statements reflect, in the opinion of management, all material adjustments (consisting only of normal recurring adjustments) necessary to fairly state the results of operations and financial position for the periods presented. All intercompany transactions and balances have been eliminated. The results of operations for the three months ended December 31, 2003 are not necessarily indicative of the results expected for the full fiscal year ending September 30, 2004 or future fiscal periods.

     Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by the rules and regulations of the SEC, although the Company believes the disclosure is adequate to make the information presented not misleading. The accompanying unaudited interim consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

     Use of Estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. There is a reasonable possibility that actual results may vary significantly from those estimates.

     Pre-opening Expenses – Pre-opening expenses consist of operating expenses incurred during the development of a new venture and prior to its opening for business. Such costs specifically relate to ventures under development and are

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

expensed as incurred. The Company recognized pre-opening expenses of approximately $3.4 million and $2.4 million during the three months ended December 31, 2003 and 2002, respectively.

     Stock-Based Compensation – As of December 31, 2003, the Company has two stock-based compensation plans, including a stock option plan under which it may grant incentive stock options and nonqualified stock options to officers and other key employees and an outside director’s stock option plan under which it may grant nonqualified stock options to nonemployee directors. The Company accounts for stock options under both of these plans in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, as permitted under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. The Company also provides prominent disclosure of the information required by SFAS No. 148, Accounting for Stock-Based Compensation, in its annual and interim financial statements.

     Under APB Opinion No. 25, compensation cost is determined based on the intrinsic value of the equity instrument award. No stock-based employee compensation cost is reflected in net income for the three months ended December 31, 2003 and 2002, as all options granted during those periods under the Company’s stock option plans had an exercise price equal to the market value of the underlying shares of common stock at the date of grant.

     Had compensation expense for the Company’s stock options been recognized based on the fair value of the option award at the grant date under the methodology prescribed by SFAS No. 123, the Company’s net income (loss) for the three months ended December 31, 2003 and 2002 would have been impacted as follows:

     Accounting Changes and Recent Accounting Pronouncements – In December 2003 the FASB released a revised version of Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, (hereinafter, FIN 46-R). This Interpretation established the effective dates for public entities to apply FIN 46 and FIN 46-R based on the nature of the variable interest entity and the date upon which the public company became involved with the variable interest entity. In general, FIN 46-R provides that (i) for variable interest entities created before February 1, 2003, a public entity must apply this Interpretation at the end of the first interim or annual period ending after March 15, 2004, and may be required to apply this Interpretation at the end of the first interim or annual period ending after December 15, 2003 if the variable interest entity is a special purpose entity, and (ii) for variable interest entities created after January 31, 2003, a public entity must apply this Interpretation at the end of the first interim or annual period ending after December 15, 2003, as previously required, and then apply this Interpretation at the end of the first interim or annual period ending after March 15, 2004. The Company is currently evaluating the accounting for its equity investment in one of its hospitals and in a small number of equity investments in its diagnostic services division. FIN 46-R, which will be effective during the three months ended March 31, 2004, provides a new consolidation method of accounting and may require the Company to consolidate certain entities that are not currently consolidated under generally accepted accounting principles. While FIN 46-R may also require certain entities to be accounted for under the equity method of accounting that are currently consolidated, the Company does not expect any such impact on its current consolidated operations.

3. Goodwill and Other Intangible Assets

     As required by SFAS No. 142, Goodwill and Other Intangibles, the Company has designated September 30, its fiscal year end, as the date it will perform the annual goodwill impairment test for all of its reporting units. Goodwill of a reporting unit will also be tested between annual tests if an event occurs or circumstances change that indicate an

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

impairment may exist. During the three months ended December 31, 2003, no events or circumstances changed that indicated interim impairment testing was necessary and as such, no impairment was recognized during the three months ended December 31, 2003.

     As of December 31, 2003 and September 30, 2003, the Company’s other intangible assets, net, included the following:

     Amortization expense recognized for the management contracts and other intangible assets totaled $290,000 and $437,000 for the three months ended December 31, 2003 and 2002, respectively. The Company recognizes amortization expense for loan acquisition costs as a component of interest expense. For the three months ended December 31, 2003 and 2002, amortization expense for loan acquisition costs was $574,000 and $445,000, respectively.

4. Business Development and Changes in Operations

     New Hospital Development During the Three Months Ended December 31, 2003 – On January 13, 2004, the Company opened Texsan Heart Hospital in San Antonio, Texas, which focuses primarily on cardiovascular care. On January 22, 2004, Texsan Heart Hospital received its accreditation from Joint Commission Accreditation for Healthcare Organizations (JCAHO), which initiates the hospital’s patient billing. Texsan Heart Hospital is accounted for as a consolidated subsidiary since the Company, through its wholly-owned subsidiaries, owns an approximate 51% interest in the venture, with physician investors owning the remaining 49%, and the Company exercises substantive control over the hospital.

     On October 14, 2003, the Company opened The Heart Hospital of Milwaukee in Glendale, Wisconsin. This hospital focuses primarily on cardiovascular care. On October 24, 2003, The Heart Hospital of Milwaukee received its accreditation from JCAHO, which initiates the hospital’s patient billing. The Heart Hospital of Milwaukee is accounted for as a consolidated subsidiary because the Company, through its wholly-owned subsidiaries, owns an approximate 60.3% interest in the venture, with physician investors owning the remaining 39.7%, and the Company exercises substantive control over the hospital.

     As of December 31, 2003, the Company’s three most recently opened hospitals, and the one hospital remaining under development were committed (and had paid and accrued amounts) under their construction contracts as set forth in the table below:

     For the three months ended December 31, 2003 and 2002, the Company capitalized approximately $463,000 and $314,000, respectively of interest expense as part of the capitalized costs of its hospitals under development during those periods.

     Closure of Diagnostic and Therapeutic Facilities – Effective May 2003, the Company received notification from its hospital partner of its intent to exercise its option to require the dissolution of Gaston Cardiology Services, LLC, and to

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

terminate all agreements with the hospital, Gaston Cardiology Services, LLC and the Company. The effective date of the dissolution and the termination of the agreements was November 2003.

5. Long-Term Debt

     Long-term debt consists of the following:

     Master Credit Facility and Bank Mortgage Loans – In July 2001, the Company became a party to a $189.6 million master credit facility (the Master Credit Facility), which provided a source of capital to refinance approximately $79.6 million of the real estate indebtedness of three of the Company’s existing hospitals and provided the Company with $110.0 million of available debt capital to finance its hospital development program. In March 2003, the Master Credit Facility was amended to increase available borrowings by $35.0 million thereby providing a total of $145.0 million of available debt to finance the Company’s hospital development program.

     As of December 31, 2003, $130.3 million of the $145.0 million initially available to finance the Company’s hospital development program had been designated to finance the development of Harlingen Medical Center, Louisiana Heart Hospital, Texsan Heart Hospital, The Heart Hospital of Milwaukee and Heart Hospital of Lafayette (see Note 4). Of this $130.3 million of designated financing, $120.4 million had been borrowed as of December 31, 2003. The Company anticipates the $14.7 million of undesignated funds under the $145.0 million initially available will remain available to finance other future projects in the Company’s hospital development program. However, the Company may elect to terminate part or all of the undesignated funds if it deems that its development activity is unlikely to result in a need for the funds.

     Each loan under the Master Credit Facility is separately documented and secured by the assets of the borrowing hospital only. Each loan under the Master Credit Facility amortizes based on a 20-year term, matures on July 27, 2006, and accrues interest at variable rates on either a defined base rate plus an applicable margin, or Eurodollar Rate (LIBOR) plus an applicable margin. The weighted average interest rate for the loans under the Master Credit Facility was 4.5% and 4.4% at December 31, 2003 and September 30, 2003, respectively. The Company is required to pay a monthly unused commitment fee at a rate of 0.5%.

     In December 2003, the Company made a principal prepayment of $11.4 million to the mortgage lender for Bakersfield Heart Hospital. The bank mortgage lender agreed to accept this principal prepayment in exchange for amending certain financial ratio covenants and minimum financial performance covenants, which Bakersfield Heart Hospital was not in compliance with during the preceding fiscal year ended September 30, 2003. The Company had classified this amount as current portion of long-term debt at September 30, 2003.

     At December 31, 2003, the Company classified $16.6 million of real estate mortgage debt for Tucson Heart Hospital as current portion of long-term debt based on the debt’s scheduled maturity in November 2004.

     In accordance with the related hospital operating agreements and as required by the lenders, the Company has guaranteed 100% of the obligations of its subsidiary hospitals for bank mortgage loans made under the Master Credit Facility and REIT loans and 71% of the obligation for another bank mortgage loan at December 31, 2003. The Company receives a fee from the minority partners in the subsidiary hospitals as consideration for providing guarantees in excess of the Company’s ownership percentage in the subsidiary hospitals. These guarantees expire concurrent with the terms of the related real estate loans and would require the Company to perform under the guarantee in the event of the subsidiary hospitals failing to perform under the related loans. The total amount of this real estate debt is secured by the subsidiary hospitals’ underlying real estate, which was financed with the proceeds from the debt. At December 31, 2003, the total amount of real estate debt was approximately $274.3 million, of which $268.5 million was guaranteed by

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

the Company. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets.

     Revolving Credit Facility – Separate from the Master Credit Facility, the Company has a revolving credit facility (the Revolver) that provides $100.0 million in available borrowings, $10.0 million of which is designated as short-term borrowings and $25.0 million of which is available to issue letters of credit. The Revolver expires on January 31, 2005. As of December 30, 2003, no amounts were outstanding under the Revolver, however, the Company had letters of credit outstanding of $24.5 million, which reduced its availability under the Revolver to $75.5 million, subject to limitations on the Company’s total indebtedness as stipulated under its other debt agreements.

     Notes Payable – The Company has acquired substantially all of the medical and other equipment for its hospitals and certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories under installment notes payable to equipment lenders collateralized by the related equipment. Two facilities in the diagnostic division also have leasehold improvements funded through notes payable collateralized by real estate. Amounts borrowed under these notes are payable in monthly installments of principal and interest over 4 to 7 year terms. Interest is at fixed and variable rates ranging from 3.92% to 9.84%. The Company has guaranteed between 50% and 100% of certain of its subsidiary hospitals’ equipment loans. The Company receives a fee from the minority partners in the subsidiary hospitals as consideration for providing guarantees in excess of the Company’s ownership percentage in the subsidiary hospitals. These guarantees expire concurrent with the terms of the related equipment loans and would require the Company to perform under the guarantee in the event of the subsidiaries’ failure to perform under the related loan. At December 31, 2003, the total amount of notes payable was approximately $82.1 million, of which $56.6 million was guaranteed by the Company. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets.

     In July 2003, Texsan Heart Hospital obtained a debt commitment of up to $20.0 million to finance its equipment purchases. Until March 2004, interest on borrowings made under this commitment shall accrue at Prime, plus a margin. Beginning in March 2004, borrowings shall bear interest at a fixed rate of interest equal to a specific Treasury Note yield, plus a margin. Principal shall be payable in 78 months beginning in September 2004. As of December 31, 2003, no borrowings were outstanding under the commitment.

     In November 2003, The Heart Hospital of Milwaukee, obtained a $15.0 million debt commitment to finance its equipment purchases. Amounts borrowed under this commitment shall accrue at a base rate, plus a margin, or LIBOR plus a margin (4.39% at December 31, 2003). Principal amounts borrowed under this commitment are due March 2004. As of December 31, 2003, The Heart Hospital of Milwaukee had borrowed $10.1 million of the $15.0 million available. In February 2004, The Heart Hospital of Milwaukee obtained a $15.0 million debt commitment to refinance borrowings owed under the above debt commitment, and finance other equipment purchases. Final documentation of the loan facility is anticipated to close in March 2004. The loan commitment shall be interest only for one year following the date of the loan’s final documentation, during which time interest shall accrue at 90-day LIBOR, plus a margin. Following the one year interest only period, the loan’s principal amount shall amortize based on a seven-year term, with interest fixed at a Treasury Yield, plus a margin. The loan will mature three years after the date of loan’s final documentation, with all principal plus accrued interest being due at that time.

     Debt Covenants – Covenants related to the Company’s long-term debt restrict the payment of dividends and require the maintenance of specific financial ratios and amounts and periodic financial reporting. At December 31, 2003, the Company was in violation of certain financial ratio covenants related to the equipment loans at Arizona Heart Hospital and the real estate mortgage loan at Heart Hospital of New Mexico. The Company was also not in compliance with certain guarantor financial ratio covenants related to the real estate mortgage loans at Heart Hospital of Austin and Heart Hospital of New Mexico. These guarantor covenants related to the Company’s maintenance of a minimum current ratio, which the Company failed to meet due to the classification of real estate mortgage debt at one its hospitals as a current obligation at December 31, 2003, as previously discussed. The equipment lender at Arizona Heart Hospital has not granted a waiver for the breach and the obligation of approximately $902,000 million has been classified as a current liability in the Company’s consolidated balance sheet at December 31, 2003. The real estate lender granted a waiver of the financial covenant violation at Heart Hospital of New Mexico and provided a waiver and amendment for the guarantor covenant violations at Heart Hospital of Austin and Heart Hospital of New Mexico. The guarantor financial ratio was amended through November 30, 2004, during which time the Company agreed to certain limitations of indebtedness. The Company was in compliance with all other covenants in the instruments governing its outstanding debt at December 31, 2003 except as noted above.

11

MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

     Guarantees of Unconsolidated Affiliate’s Debt – The Company has guaranteed approximately 50% of the real estate debt and 40% of the equipment debt of the one affiliate hospital in which the Company has a minority ownership interest and therefore does not consolidate the hospital’s results of operations and financial position. The Company provides these guarantees in exchange for a fee from that affiliate hospital. At December 31, 2003, the affiliate hospital was in compliance with all covenants in the instruments governing its debt. The total amount of the affiliate hospital’s real estate and equipment debt was approximately $27.9 million and $10.7 million, respectively, at December 31, 2003. Accordingly, the real estate debt and the equipment debt guaranteed by the Company was approximately $13.9 million and $4.3 million, respectively, at December 31, 2003. These guarantees expire concurrent with the terms of the related estate and equipment loans and would require the Company to perform under the guarantee in the event of the affiliate hospital’s failure to perform under the related loans. The total amount of this affiliate hospital’s debt is secured by the hospital’s underlying real estate and equipment, which were financed with the proceeds from the debt. Because the Company does not consolidate the affiliate hospital’s results of operations and financial position, neither the assets nor the accompanying liabilities are included in the value of the assets and liabilities on the Company’s balance sheets.

6. Liability Insurance Coverage

     Since June 1, 2002, the Company has been partially self-insured under claims-made insurance policies that provide coverage for claim amounts in excess of specified amounts of retained liability per claim. These specified amounts of retained liability per claim range from $2.0 million to $5.0 million depending on the applicable policy year and hospital. As of December 31, 2003 and September 30, 2003, the total estimated liability for the Company’s self-insured retention on medical malpractice claims, including an estimated amount for incurred but not reported claims, was approximately $3.9 million and $3.7 million, respectively, which is included in current liabilities in the Company’s consolidated balance sheet.

7. Commitments and Contingencies

     Resolution of Contingency – CMS change in Medicare capital cost reimbursement - Medicare reimburses hospitals for capital-related costs using one of two alternative methodologies based upon whether the hospital is categorized as “new” under CMS regulations. As previously discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003, one of the Company’s Medicare fiscal intermediaries notified the Company on August 11, 2003 that it had been directed by CMS to change, on a retroactive and prospective basis, the capital cost reimbursement methodology applicable to four of its hospitals. This position was contrary to a previous written determination the Company had received from that fiscal intermediary on October 11, 2002 that confirmed the methodology being applied by those hospitals. Consistent with the belief that the position taken by the fiscal intermediary in October 2002 was based upon a correct interpretation of applicable CMS regulations, the Company began during the fourth quarter of fiscal 2003 to vigorously pursue its administrative, judicial and other remedies to challenge the matter with the fiscal intermediary and CMS.

     Since August 2003, the Company has been in active conversations with CMS regarding the change in interpretation as to how capital reimbursement is paid for new hospitals. In early-February 2004, the Company learned that CMS has determined that the change in capital reimbursement methodology would be effective August 11, 2003, and that the change would not be applied retroactively to any periods prior to that effective date. Accordingly, this change in methodology will not have any impact on a retroactive basis to the Company’s consolidated financial position, results of operations and cash flows, as the four affected hospitals will not be required to repay the Medicare program for the reimbursed capital costs prior to August 11, 2003.

     CMS’s recent determination did not result in any changes in accounting estimates to the Company’s previously reported financial position, results of operations and cash flows for the most recent fiscal year ended September 30, 2003. During fiscal 2003 and the first quarter of fiscal 2004, the Company accounted for the retroactive component as a contingency that did not meet the criteria for recognition under SFAS No. 5, Accounting for Contingencies, and recognized capital reimbursement subsequent to August 11, 2003 consistent with the payments received under that new methodology beginning on that date.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

8. Income Taxes

     Income tax benefit was $627,000 million for the three months ended December 31, 2003 and income tax expense was $259,000 for the three months ended December 31, 2002, which represented an effective tax rate of approximately 40% for both periods. Because the Company continues to have federal and state net operating loss carryforwards available from prior periods to offset its current tax liabilities, it has no material current cash income tax liability and the majority of its income tax expense is deferred.

9. Per Share Data

     The calculation of diluted net income (loss) per share considers the potentially dilutive effect of options to purchase 3,049,266 and 2,705,095 shares of common stock outstanding at December 31, 2003 and 2002, respectively, at prices ranging from $4.75 to $25.00. Of these options, 3,049,266 and 2,573,623 were not included in the calculation of diluted earnings (loss) per share at December 31, 2003 and 2002, respectively, as such shares were anti-dilutive for the periods.

10. Comprehensive Income (Loss)

     The components of comprehensive income (loss) are as follows:

11. Litigation

     Litigation – The Company is involved in various claims and legal actions in the ordinary course of business, including malpractice claims arising from services provided to patients that have been asserted against the Company by various claimants, and additional claims that may be asserted for known incidents through December 31, 2003. These claims and legal actions are in various stages, and some may ultimately be brought to trial. Moreover, additional claims arising from services provided to patients in the past and other legal actions may be asserted in the future. The Company is protecting its interests in all such claims and actions.

     Management believes, based on advice of counsel and the Company’s experience with past lawsuits and claims, that, taking into account the applicable liability insurance coverage and recorded reserves, the results of those lawsuits and potential lawsuits will not have a materially adverse effect on the Company’s financial position or future results of operations and cash flows.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued

12. Reportable Segment Information

     The Company’s reportable segments consist of the Hospital Division and the Diagnostics Division. Financial information concerning the Company’s operations by each of the reportable segments as of and for the periods indicated is as follows:

     Substantially all of the Company’s net revenue in its Hospital Division and Diagnostics Division is derived directly or indirectly from patient services. The amounts presented for Corporate and other primarily include general overhead and administrative expenses, cash and cash equivalents, other assets and operations of the Company not subject to separate segment reporting.

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

     The following discussion and analysis of our results of operations and financial condition should be read in conjunction with the interim unaudited consolidated financial statements and related notes included elsewhere in this report, as well as the audited consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003.

Overview

     The Company. We are a healthcare provider primarily focused on the diagnosis and treatment of cardiovascular disease. We design, develop, own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence. Each of our majority-owned hospitals is a freestanding, licensed general acute care hospital that provides a wide range of health services, and the medical staff at each of our hospitals includes qualified physicians in various specialties. As of December 31, 2003, we owned and operated eleven hospitals, which include ten majority-own hospitals and one in which we own a minority interest. These hospitals have a total of 667 licensed beds, of which 587 were staffed and available, and are located in nine states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, Texas and Wisconsin.

     On January 13, 2004, we opened our twelfth hospital in San Antonio, Texas, which obtained its accreditation from Joint Commission Accreditation for Healthcare Organizations (JCAHO) on January 22, 2004. This hospital is designed to accommodate 120 inpatient beds and opened initially with 60 licensed beds that will be staffed and available as the hospital ramps up its operations. We are currently in the process of completing the development of our thirteenth hospital, which is located in Lafayette, Louisiana and will open with 32 licensed beds in March 2004. The opening of this hospital will mark our fifth hospital opened since October 2002, during which time we will have increased our portfolio of owned and operated hospitals from eight hospitals having a total of 465 licensed beds in September 2002 to thirteen hospitals having a total of 759 licensed beds by March 2004.

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

     Basis of Consolidated Results of Operations. We have included 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 have used 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. Accordingly, the one hospital in which we hold a minority interest at December 31, 2003, Heart Hospital of South Dakota, is excluded from the net revenue and operating expenses of our consolidated company and our consolidated hospital division. Our minority interest in this hospital’s results of operations for the periods discussed is recognized as part of the equity in net earnings of unconsolidated affiliates in our statements of operations in accordance with the equity method of accounting. We are currently evaluating the accounting for our interest in this hospital under the new accounting rules that were issued in December 2003 regarding consolidation of variable interest entities. In addition to this hospital, we are also evaluating the impact of these new accounting rules on a small number of equity investments in our diagnostic services division. These new rules, which will be effective during the three months ended March 31, 2004, provide a new consolidation method of accounting and may require us to consolidate certain entities that are not currently consolidated under the generally accepted accounting principles. While these new rules may also require certain entities to be accounted for under the equity method of accounting that are currently consolidated, we do not expect any such impact on our current consolidated operations.

     Same Facility Hospital Division. On a same facility basis for our consolidated hospital division, we exclude the results of operations of Louisiana Heart Hospital and The Heart Hospital of Milwaukee, which opened in February 2003 and October 2003, respectively.

     Revenue Sources. The largest percentage of our net revenue is attributable to our hospital division. Based on our recent 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 below.

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     We receive payments for services rendered to patients from the Medicare and Medicaid programs, commercial insurers, health maintenance organizations, and directly from our patients. The following table sets forth the percentage of consolidated net revenue we earned by category of payor in the periods indicated below.

     A significant portion of our net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid. Although Medicare and Medicaid remain a significant payor, we experienced a significant change in payor mix comparing the first quarter of fiscal 2004 with the first quarter of fiscal 2003, as illustrated in the above table. One reason for this change in payor mix was Harlingen Medical Center, which is a full-serviceversus the cardiovascular focus of our other hospitals. This hospital’s different payor mix stems from its focus on a number of specialties, rather than only cardiovascular, and a higher concentration of self-pay patients than our typical hospital which is consistent with trend in that hospital’s market demographics. A second reason for this change in payor mix is an overall higher percentage of self-pay patients in our other hospitals during the current fiscal quarter than in the prior year. We believe this change in self-pay patients is consistent with the industry trend. A third reason for this change in payor mix is recent changes in Medicare outlier payment and capital cost reimbursement formulas affecting several of our hospitals, as discussed more fully below. We expect the net revenue that we receive from the Medicare program as a percentage of total consolidated net revenue to remain significant in future periods because the percentage of our total consolidated net revenue generated by our hospital division will continue to increase as we open and ramp up the operations of our new hospitals. We also expect our payor mix may continue to fluctuate in future periods due to changes in reimbursement, market and industry trends with self-pay patients and other similar factors.

     Medicare Reimbursement Changes. In recent months, CMS has issued and enacted several new rules and changes that significantly affect our net revenue. First, CMS increased the payment rates for inpatient services by 3.4% in fiscal 2004, resulting in higher Medicare payments for most hospitals. As part of this increase, which went into effect on October 1, 2003, CMS expects to pay approximately $98 billion to 4,087 acute care hospitals in 2004, a $4.1 billion increase over payments in fiscal 2003. Second, CMS enacted a new rule governing the calculation of outlier payments to hospitals that included, among other things:

	•		reducing the threshold for outlier payments;
	•		requiring the use of the latest of either the most recently submitted or most recently filed cost report to calculate a hospital’s cost-to-charge ratio;
	•		eliminating the use of statewide average cost-to-charge ratios to determine a hospital’s cost when the hospital’s own cost-to-charge ratio falls below established parameters; and
	•		adjusting the Medicare wage index for several states where we have operations.

     We expect that the increase in payment rates and revised wage indexes in fiscal 2004 will increase our net revenue by approximately $12.0 million to $13.0 million; and we expect that the changes in the outlier payment formula will decrease our outlier payments in fiscal 2004 by approximately $10.0 and $11.0 million. Since the changes to the outlier formula became effective in August 2003, we have been recognizing net revenue from outlier payments at amounts determined under the new calculation formula. However one of our Medicare fiscal intermediaries has continued to pay us at amounts calculated under the historical formula. As such, our cash and cash equivalents at December 31, 2003 includes approximately $4.7 million, of which $2.9 million was received during the first quarter of fiscal year 2004, that we may have to repay to the Medicare program. This amount is also reflected as a reduction to our accounts receivable,

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net at December 31, 2003, consistent with our other estimated reimbursement settlements. We expect our cash and cash equivalents and our cash flows from operations will be positively impacted in future periods in which we continue to receive and reserve these payments; and our cash and cash equivalents and our cash flows from operations will be negatively impacted in the future period in which we may be required to prepay these amounts. Any changes in these new rules or other regulations governing the Medicare and Medicaid programs, or the manner in which they are interpreted, may result in a material change in our net revenue in the near future.

     Medicare reimburses hospitals for capital-related costs using one of two alternative methodologies based upon whether the hospital is categorized as “new” under CMS regulations. As we previously discussed in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003, one of our Medicare fiscal intermediaries notified us on August 11, 2003 that it had been directed by CMS to change, on a retroactive and prospective basis, the capital cost reimbursement methodology applicable to four of our hospitals. This position was contrary to a previous written determination we had received from that fiscal intermediary on October 11, 2002 that confirmed the methodology being applied by those hospitals. Consistent with our belief that the position taken by the fiscal intermediary in October 2002 was based upon a correct interpretation of applicable CMS regulations, we began during the fourth quarter of fiscal 2003 to vigorously pursue our administrative, judicial and other remedies to challenge the matter with the fiscal intermediary and CMS.

     Since August 2003, we have been in active conversations with CMS regarding the change in interpretation as to how capital reimbursement is paid for new hospitals. In early-February 2004, we learned that CMS had determined that the change in capital reimbursement methodology would be effective August 11, 2003, and that the change would not be applied retroactively to any periods prior to that effective date. Accordingly, this change in methodology will not have any impact on a retroactive basis to our consolidated financial position, results of operations and cash flows, as our four affected hospitals will not be required to repay the Medicare program for the reimbursed capital costs prior to August 11, 2003. On a prospective basis, the fiscal intermediary began making payments for capital cost reimbursement under the new methodology for all claims submitted after August 11, 2003. The impact of this change for fiscal 2003 was a $1.2 million reduction in our net revenue, and for the first quarter of fiscal 2004 was a $1.7 million reduction in our net revenue from the amount that would have been recognized under the previous reimbursement method. In addition, we estimate the impact of this change in reimbursement will be approximately $7.2 million for the full fiscal year 2004. The impact will diminish rapidly in future years, based on how reimbursement is calculated, and we estimate that the cumulative negative impact for fiscal years 2004 through 2009 will be from $15.0 million to $16.0 million.

     CMS’s recent determination did not result in any changes in accounting estimates to our previously reported financial position, results of operations and cash flows for our most recent fiscal year ended September 30, 2003. During fiscal 2003 and the first quarter of fiscal 2004, we accounted for the retroactive component as a contingency that did not meet the criteria for recognition under SFAS No. 5, Accounting for Contingencies, and we recognized capital reimbursement subsequent to August 11, 2003 consistent with the payments received under that new methodology beginning on that date.

     Strategic Outlook and Operational Focus. The United States Congress recently passed and President Bush signed into law the Medicare Modernization Act, which imposes an 18-month moratorium on the development of new physician-owned “specialty hospitals,” as such hospitals are defined in the statute, and in regulations we expect to be issued by the Department of Health and Human Services. Although the Medicare Modernization Act will not affect our ability to open the hospital we currently have under development, it is expected to prohibit our hospital development activities as currently configured through June 18, 2005, the expiration date of the moratorium. We believe the short-term impact of the Medicare Modernization Act on our business is negligible as all of our hospitals, including the one remaining under development, are grandfathered under the legislation, and we have not planned any new hospital projects during this period as our focus is on opening and ramping up our new hospitals. We cannot predict the long-term impact of this legislation, or future legislation, on our business given the uncertainty involved with regulatory changes.

     Management is currently conducting an in-depth strategic review of the Company’s business model and development program. We are performing this strategic review partly in response to the temporary moratorium imposed by the Medicare Modernization Act and partly to address less than acceptable financial performance in certain areas of our business. Management will present this strategic review to the board of directors at the end of February 2004. We will provide additional information in future periods as decisions are made that will affect our business outlook. Currently, we do not anticipate an overhaul of our business model. In fact, in many of our markets, our hospital model has proven quite successful in producing favorable clinical outcomes and acceptable financial returns, and in gaining market share. However, we are aggressively reviewing our hospital portfolio and potentially may divest hospitals that we conclude have limited growth potential. If we divest any of our hospitals, we will then seek ways to redeploy the capital generated from such divestitures into new investments that meet the following criteria:

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	•		provide a return on capital consistent with our business objectives;
	•		involve healthcare services that build on our core competencies of involving physicians and other healthcare providers in the governance and strategic decision making processes;
	•		include partners that share our commitment to delivering superior quality care; and
	•		are done on a more collaborative, and less confrontational, manner.

     One area in which we have already begun to focus our business development efforts in fiscal 2004 is our diagnostics division. Our business model in this division involves joint ventures with physicians and hospitals to own and operate catheterization labs and facilities that provide other outpatient cardiovascular services. These new business ventures are generally expected to produce acceptable financial returns and require limited capital investment, which we believe makes them attractive new business opportunities.

     Operationally, management has been, and will continue to be, focused on several key objectives during fiscal 2004, including:

	•		ramping up the operations of our newest hospitals;
	•		improving quality outcomes in our facilities;
	•		aggressively managing our controllable costs;
	•		working to ensure operating fundamentals are being met; and
	•		making sure that the systems and policies are positioned for long-term growth.

Results of Operations

     Statement of Operations Data. The following table presents, for the periods indicated, our results of operations in dollars and as a percentage of net revenue: