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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.     Yes þ          No o

      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

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).     Yes þ          No o

      As of December 3, 2004, there were 18,107,186 shares of the Registrant’s Common Stock outstanding. The aggregate market value of the Registrant’s common stock held by non-affiliates as of March 31, 2004 was approximately $95.8 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 1, 2005 are incorporated by reference into Part III of this Report.

MEDCATH CORPORATION

FORM 10-K

TABLE OF CONTENTS

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MARKET, RANKING AND OTHER DATA

      The data included in this report regarding markets and ranking, including the size of certain markets and our position and the position of our competitors within these markets, are based on independent industry publications, reports of government agencies or other published industry sources and estimates based on management’s knowledge and experience in the markets in which we operate. Our estimates have been based on information obtained from our customers, suppliers, trade and business organizations and other contacts in the markets in which we operate. We believe these estimates to be accurate as of the date of this report. However, this information may prove to be inaccurate because of the method by which we obtained some of the data for our estimates or because this information cannot always be verified with complete certainty due to the limits on the availability and reliability of raw data, the voluntary nature of the data gathering process and other limitations and uncertainties. As a result, you should be aware that market, ranking and other similar data included in this report, and estimates and beliefs based on that data, may not be reliable.

      In particular, we make reference in this report to reports prepared by The Lewin Group, a nationally recognized consultant to the health and human services industries. In 1999, we engaged The Lewin Group to determine how cardiac care services provided in seven of our hospitals compared on measures of patient severity, quality and community impact to cardiac services provided in 1,192 peer community hospitals across the United States that perform open-heart surgery. The study, which has been updated annually, analyzed publicly available Medicare data for federal fiscal years 2000, 2001 and 2002 using an all procedures defined-diagnosis related group cardiac mix index. Cardiac case mix index calculations were based on Medicare discharges and were calculated using the general approach used by the Centers for Medicare and Medicaid Services. Quality of care was measured through an analysis of in-hospital mortality, average length of stay, discharge destination and patient complications.

FORWARD-LOOKING STATEMENTS

      Some of the statements and matters discussed in this report 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 include, among others, statements about the following:

	•	the impact of the Medicare Prescription Drug Improvement and Modernization Act of 2003 and other healthcare reform initiatives,
	•	changes in Medicare and Medicaid reimbursement levels,
	•	unanticipated delays in achieving expected operating results at our recently opened hospitals,
	•	difficulties in executing our strategy,
	•	our relationships with physicians who use our facilities,
	•	competition from other healthcare providers,
	•	our ability to attract and retain nurses and other qualified personnel to provide quality services to patients in our facilities,
	•	our information systems,
	•	existing governmental regulations and changes in, or failure to comply with, governmental regulations,
	•	liability and other claims asserted against us,

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	•	changes in medical devices or other technologies, and
	•	market-specific or general economic downturns.

      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 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. We urge you to review carefully all of the information in this report and the discussion of risk factors filed as Exhibit 99.1 to this report, before making an investment decision with respect to our common stock.

      Unless otherwise noted, the following references in this report will have the meanings below:

	•	For periods subsequent to July 27, 2001, the terms the “Company,” “MedCath,” “we,” “us” and “our” refer to MedCath Corporation and its consolidated subsidiaries;
	•	for the period from July 31, 1998 to July 27, 2001, such terms refer to MedCath Corporation’s predecessor company, MedCath Holdings, Inc., and its consolidated subsidiaries and unconsolidated affiliates; and
	•	references to fiscal years are to our fiscal years ending September 30. For example, “fiscal 2004” refers to our fiscal year ended September 30, 2004.

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PART I

Overview

      We are a healthcare provider focused primarily on the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence as well as with community hospital systems. We opened our first hospital in 1996, and currently have ownership interests in and operate 12 hospitals, excluding The Heart Hospital of Milwaukee, which was sold on December 1, 2004. We have majority ownership in 11 of these 12 hospitals and a minority interest in one. 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. Our hospitals have a total of 727 licensed beds and are located in eight states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, and Texas.

      In addition to our hospitals, we own and/or manage cardiac diagnostic and therapeutic facilities. We began our cardiac diagnostic and therapeutic business in 1989. We currently own and/or manage 27 cardiac diagnostic and therapeutic facilities. Twelve of these facilities are located at hospitals operated by other parties and offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining 15 facilities are not located at hospitals and offer only diagnostics services.

      We are subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act) and therefore, we file periodic reports, proxy statements and other information with the Securities and Exchange Commission (SEC). Such reports may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street NW, Washington, D.C. 20549, or by calling the SEC at (800) SEC-0330. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.

      We maintain an Internet website at: www.medcath.com that investors and interested parties can access, free-of-charge, to obtain copies of all reports, proxy and information statements and other information that the Company submits to the SEC. This information includes copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.

      Investors and interested parties can also submit electronic requests for information directly to the Company at the following e-mail address: ir@medcath.com. Alternatively, communications can be mailed to the attention of “Investor Relations” at the Company’s executive offices.

      Information on our website is not incorporated into this Form 10-K or our other securities filings and is not a part of them.

Our Strengths

      Leading Local Market Positions in Growing Markets. Each of our nine majority-owned hospitals that was open for all of fiscal 2004 has achieved a number one or two ranking in the local market position for core business diagnosis-related group (DRG) procedures performed, as reported by Solucient, a leading source of healthcare business intelligence. We have included the following DRGs in determining our market share: cardiac catheterization; by-pass and valves; cardiovascular implantables and angioplasty; and vascular procedures. Historically, 90% to 95% of patients treated in our hospitals reside in markets where the population of those 55 years and older, the primary recipients of cardiac care services, is anticipated to increase, from 2003 to 2008, between 4.1% and 19.7%, versus the national average of 10.8%.

      Geographically Diversified Portfolio of Facilities. We currently have ownership interests in and operate 12 hospitals in eight states and own and/or manage 27 cardiac diagnostic and therapeutic facilities in 13 states. This diversifies our earnings base and reduces our exposure to any one geographic market.

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      Superior Clinical Outcomes. We believe our hospitals, on average, provide more complex cardiac care, achieve lower mortality rates and a shorter average length of stay, adjusted for patient severity of illness, as compared to our competitors. Since 1999, we have engaged The Lewin Group, a national health and human services consulting group, to conduct a study on cardiovascular patient outcomes based on Medicare hospital inpatient discharge data. The Lewin study, which is updated annually, has consistently concluded that, on average, we treat a more complex mix of cardiac cases and our hospitals have lower mortality rates and shorter length of stay, adjusted for severity, for cardiac cases, than peer community hospitals. Specifically, the most recent Lewin study, which is based on 2002 Medicare reimbursement data, concluded that when compared to peer community hospitals, our hospitals, on average, had a 20.6 higher case mix severity for cardiac patients; exhibited a 16.0% lower mortality rate for Medicare cardiac cases, and had a shorter length of stay for cardiac cases at 3.81 days as compared to 4.88 days, after adjusting for severity.

      Efficient Quality Care Delivery Model. Our hospitals have innovative facility designs and operating characteristics that we believe enhance the quality of patient care and service and improve physician and staff productivity. The innovative characteristics of our hospital designs include: fully-equipped patient rooms capable of providing the majority of services needed during a patient’s entire length of stay; centrally located inpatient services that reduce the amount of transportation patients must endure; strategically located nursing stations that enable the same nursing rotation to serve the patient from admittance to discharge; and efficiently arranged departments and services that interact frequently. We believe our care delivery model leads to a high level of patient satisfaction. During fiscal 2004, 98% of patients who completed discharge surveys indicated that they would return to our hospital for any future procedures.

      Proven Ability to Partner with Physicians. Physicians are currently partners in all of our hospitals and many of our cardiac diagnostic and therapeutic facilities. Physicians practicing at our hospitals participate in decisions on a wide range of strategic and operational matters, such as development of clinical care protocols, patient procedure scheduling, annual operating budgets and large capital expenditures. The opportunity to have a role in how our hospitals are managed empowers physicians and encourages them to share new ideas, concepts and practices. We attribute our success in partnering with physicians to our ability to develop and effectively manage facilities in a manner that promotes physician productivity, satisfaction and professional success while enhancing the quality of patient care.

      Established Relationships with Community Hospital Systems. Community hospital systems are currently partners in two of our hospitals. In addition, we have management and partnership arrangements with community hospital systems in many of our cardiac diagnostic and therapeutic facilities. We attribute our success in establishing relationships with community hospital systems to our proven ability to work effectively with physicians and deliver quality cardiovascular care. Additionally, we believe many community hospital systems have found that forming a relationship with us is a more cost-effective means of providing cardiovascular care services and/or managing their cardiovascular programs than providing and/or managing these services or programs themselves.

      Strong Management Team and Financial Sponsor Support. Our management team has extensive experience and relationships in the healthcare industry. Our chairman of the board and chief executive officer, John T. Casey, and president and chief operating officer, Charles R. Slaton, each have over 19 years of experience in the healthcare industry, including extensive experience managing community hospital systems. In addition, James E. Harris has been our executive vice president and chief financial officer since 1999 and Thomas K. Hearn has been the president of our diagnostics division since 1995 and chief development officer since November 2004. As of September 30, 2004, private investment partnerships sponsored by Kohlberg Kravis Roberts & Co., L.P. (KKR) and Welsh, Carson, Anderson & Stowe (WCAS) owned approximately 31.0% and 30.0%, respectively, of our outstanding common stock.

Our Strategy

      Key components of our strategy include to:

      Enhance Operating Performance. In markets where we have well-established hospitals, we intend to continue to focus on improving operating performance and increasing our leading market shares. At these

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      Proactively Manage Patient Length of Stay and Throughput. We are continuing to focus on improving productivity and operating efficiency. The Lewin Study noted that our overall length of stay is 22% less than our competition in our markets. With a significant percentage of our reimbursement being fixed, the lower we can drive our length of stay, while maintaining a high level of quality care, the less resources we consume. With a focus on throughput, we can continue to serve more patients and perform more procedures though our existing assets and personnel resources.

      Partner with Physicians. We intend to continue to pursue partnership opportunities with physicians. We believe allowing physicians to partner in the operations and management of our facilities provides further motivation for them to provide quality, cost-effective healthcare. Despite a federal law currently imposing a moratorium on physician ownership in new specialty hospitals through June 8, 2005, we believe meaningful opportunities continue to exist to partner with physicians.

      Focus on Cardiovascular Disease. We operate most of our facilities with a focus on serving the unique needs of patients suffering from cardiovascular disease. By focusing on a single disease category, physicians, nurses, medical technicians and other staff members are able to concentrate on and enhance their professional cardiovascular care skills, thereby enabling us to better serve the needs of cardiovascular patients. We believe our focused approach increases patient, physician and staff satisfaction and enables us to provide quality, cost-effective patient care. We plan to continue to pursue growth opportunities relating to cardiovascular care.

      Provide a Differentiated Standard of Care. We plan to continue to utilize innovative facility designs around the requirements of our patients and invest in leading-edge equipment and technology to achieve a differentiated standard of care. We monitor the quality of cardiovascular care — that is, the degree to which our services increase the likelihood of desired patient outcomes — by measuring key quality criteria, including mortality rates, patient acuity, average length of stay and patient satisfaction. We operate all of our facilities under a quality improvement program to provide a comprehensive assessment of the quality of the services we provide.

      Pursue Growth Opportunities with Community Hospital Systems. We will pursue growth opportunities with community hospital systems in our current and selected new markets. These opportunities are expected to continue our historic focus on providing inpatient and outpatient cardiovascular care. Community hospital systems often have limited access to the resources needed to invest in specialty areas, including cardiology. We believe, as a result of these limitations and our record of success in providing quality cardiovascular care, many community hospital systems would be interested in partnering with us to provide cardiovascular care services and/or to manage their cardiovascular programs. The nature of these partnerships will vary depending upon market and regulatory considerations.

      Selectively Evaluate Acquisitions. We intend to selectively evaluate acquisitions of specialty and general acute care facilities in attractive markets throughout the United States and will also consider opportunistic acquisitions of facilities where we believe we can improve clinical outcomes and operating performance. We will employ a disciplined approach to evaluating and qualifying acquisition opportunities.

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Our Hospitals

      We currently have ownership interests in and operate 12 hospitals. The following table identifies key characteristics of these hospitals.

(1)	On December 1, 2004 we sold the assets of The Heart Hospital of Milwaukee. Prior to completion of the sale, we also closed the facility. As of September 30, 2004 we owned 60.3% of The Heart Hospital of Milwaukee.
(2)	Avera 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. Avera Heart Hospital of South Dakota is licensed as a specialized hospital under state law.

      Before designing and constructing our first hospital in 1994, we consulted 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 patient-focused care. Using subsequent operating experience and further input from physicians at our other hospitals, we refined our basic hospital layout to enable us to combine site selection, facility size and layout, staff and equipment to deliver quality cardiovascular care.

      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 their recovery. This approach differs from the general acute care hospital model of moving patients, potentially several times, as they recover from surgical procedures.

      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.

      Strategically Placed 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

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      Efficient Workflow. We have designed and constructed our various procedure areas in close proximity to each other allowing for both patient safety and efficient staff workflow. For example, our cardiac catheterization laboratories are located in close proximity to our 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.

      Additional 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 and we believe this increases physician productivity and patient satisfaction. 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 enable them to be used more efficiently by physicians and staff.

Diagnostic and Therapeutic Facilities

      We have participated in the development of or have acquired interests in, and provide management services to facilities where physicians diagnose and treat cardiovascular disease and manage hospital-based cardiac catheterization laboratories. We also own and operate mobile cardiac catheterization laboratories serving hospital networks and maintain a number of mobile and modular cardiac catheterization laboratories 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.

      Managed Diagnostic and Therapeutic Facilities. We currently own and/or manage the operations of 27 cardiac diagnostic and therapeutic facilities. The following table provides information about these facilities.

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(1)	Our management agreement with each of these facilities includes an option for us to extend the initial term at increments ranging from one to 10 years, through an aggregate of up to an additional 40 years for some of the facilities.
(2)	The ownership interest refers to our ownership in the entities that have entered into, and provided services to, the facilities under management services agreements or professional services agreements.
(3)	Calendar year.

      We also owned and managed the operations of Gaston Cardiology Services during the first quarter of fiscal 2004. Effective May 2003, we received notification from our hospital partner of its intent to exercise its option to require the dissolution of Gaston Cardiology Services, LLC and to terminate all agreements with the hospital, Gaston Cardiology Services, LLC and us. The effective date of the dissolution and the termination of the agreements was November 2003.

      Our management services generally include providing all non-physician personnel required to deliver 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 facilities. We intend to develop with hospitals and physician groups, or acquire contracts to manage, additional diagnostic and therapeutic facilities in the future.

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      Interim Mobile Catheterization Labs. 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 enable us to be responsive to immediate demand and create flexibility in our operations.

      In August 2004, we entered into a mobile catheterization lab management agreement with a health care system located in Winston-Salem, North Carolina.

Cardiology Consulting and Management Services

      We provide business consulting and management services to primarily cardiovascular physician group practices. 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.

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, including the following:

	•	Atherectomy: a technique using a cutting device to remove plaque from an artery. This technique can be used for coronary and non-coronary arteries.
	•	Angioplasty: a method of treating narrowing of a vessel using a balloon catheter to dilate the narrowed vessel. If the procedure is performed on a coronary vessel, it is commonly referred to as a percutaneous transluminal coronary angioplasty or PTCA.
	•	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 or restenosis. Stents can be placed in coronary arteries as well as renal, aortic and other peripheral arteries. A drug-eluting stent is coated with a drug that is intended to prevent the stent from reclogging with scar tissue after a procedure.

      Brachytherapy: a radiation therapy using implants of radioactive material placed inside a coronary stent with restenosis.

      Electrophysiology 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.

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	•	Automatic Internal Cardiac Defibrillator: cardioverter implanted in patients at high risk for sudden death from ventricular arrhythmias.
	•	Cardiac assist devices: a mechanical device 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.

      Valve Replacement Surgery: 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: a test using 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: a test which 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: a test which involves the injection of a low level radioactive tracer isotope into the patient’s bloodstream during exercise on a motorized treadmill, which is frequently 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: a 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: a test which detects the buildup of calcified plaque in coronary arteries before the patient experiences any symptoms.

Employees

      As of September 30, 2004, we employed 4,374 persons, including 3,313 full-time and 1,061 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. 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 hospitals, but admission to the staff must be approved by the hospital’s medical staff and governing board in accordance with established credentialing criteria.

Environmental Matters

      We are subject to various federal, state and local laws and regulations governing the use, storage, 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.

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Insurance

      Like most health care providers, we are subject to claims and legal actions in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance 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. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies — General and Professional Liability Risk.”

      In recent years, the cost of commercial professional and general liability insurance coverage has risen significantly. However, due to favorable pricing and availability trends in the general and professional liability insurance markets during fiscal 2004, we expect our total insurance premiums, including professional and general liability, property, business, auto, directors and officers, workers compensation and other coverages to remain consistent at $9.5 million in fiscal 2005 compared to fiscal 2004.

      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 hospital. In some of our markets, such as Sioux Falls, South Dakota, we may have only one competitor. In other markets, such as Tucson, 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 two to three hospitals. 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

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Reimbursement

      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 therapeutic facilities.

      Medicare payments for inpatient acute services are generally made pursuant to a prospective payment system. Under this system, hospitals are paid a prospectively determined fixed amount for each hospital discharge based on the patient’s diagnosis. Specifically, each discharge is assigned to a diagnosis-related group or DRG. Based upon the patient’s condition and treatment during the relevant inpatient stay, each DRG is assigned a fixed payment rate that is prospectively set using national average costs per case for treating a patient for a particular diagnosis. The DRG 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. DRG payments do not consider the actual costs incurred by a hospital in providing a particular inpatient service; however, such 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 payments in addition to a DRG payment, hospitals may qualify for an outlier payment when the relevant patient’s treatment costs are extraordinarily high and exceed a specified threshold. Outlier payments, which were established by Congress as part of the DRG prospective payment system, are additional payments made to hospitals for treating patients who are costlier to treat than the average patient. In general, a hospital receives outlier payments when its costs, as determined by using gross

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      CMS has announced that payment rates for inpatient services will rise 3.3% in 2005, resulting in higher Medicare payments for most hospitals. As part of the increase, which went into effect on October 1, 2004, CMS expects to pay approximately $103 billion to acute care hospitals in 2005, a $5.0 billion increase over this year’s payments. The CMS rules for fiscal 2005 also include, among other things: (1) reducing the threshold for outlier payments from $31,000 to $25,800; (2) changing the labor market basket from Metropolitan Statistical Areas to Core Based Statistical Areas; (3) increasing the prospective payment system (PPS) standardized amounts by the market basket, which is 3.3% for hospitals that submit quality data, which currently includes all MedCath hospitals and 2.9% for hospitals that fail to submit quality data; (4) approving new technology add-ons including a device that provides cardiac resynchronization therapy, which could add up to $16,000 per case. For a discussion of the expected impact of outlier and other reimbursement changes on our net revenue in fiscal 2005, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview — Revenue Sources by Payor.”

      Outpatient services are also subject to a prospective payment system. 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 and geographic practice cost indices.

      The Medicare Modernization Act reduces the prospective payment update by 0.4% in fiscal years 2005, 2006, or 2007 for hospitals that fail to furnish certain quality data to CMS. Other provisions will, among other things, increase payments to hospitals for indirect medical education, improve the treatment of new technologies under the inpatient prospective payment system, establish a commuting wage adjustment, allow hospitals to appeal their wage index classification and temporarily increase disproportionate share hospital allotments. Many of these provisions will be clarified and implemented through the subsequent issuance of regulations. Therefore, we cannot predict with certainty how implementation of the reimbursement provisions of the Medicare Modernization Act will impact our operations at this time.

      Future legislation may modify Medicare reimbursement for inpatient and outpatient services provided at our hospitals or services provided at our diagnostic and therapeutic facilities, but we are not able to predict the method or amount of any such reimbursement changes or the effect that such changes will have on us.

      For periods ending prior to October 1, 1991, Medicare reimbursed hospitals for the Programs portion of capital costs as calculated through the cost report. For periods between October 1, 1991 and October 1, 2001, Medicare transitioned hospitals from cost based reimbursement to a prospective payment system that employed a per discharge payment methodology for capital costs related to inpatient hospital care. The 1991 regulations included a separate methodology for hospitals constructed during this ten year transition period. A new hospital was paid 85% of Medicare inpatient capital related costs through the cost reporting periods ending at least two years after the hospital accepts its first patient. New hospitals would transition from cost reimbursement to the prospective payment system over the subsequent eight year period. This methodology for newly constructed hospitals was made available only for hospitals that transitioned from cost reimbursement prior to October 1, 2001. If a new hospital did not receive transitional payments prior to October 1, 2001 then the hospital’s third year reimbursement would be paid under the prospective payment method without deference to cost. Currently, three of our hospitals qualify for transitional capital payments, five hospitals qualify for fully prospective payments, and four hospitals qualify for payments based on 85% of program capital cost. For discussion of a

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      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. Medicaid reimbursement is often less than a hospital’s cost of services. States periodically consider 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 Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care provided, validity of DRG classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department of Health and Human Services (HHS) that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.

      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 and result in a recoupment of monies paid. Finalization of these audits and determination of amounts earned under these programs often takes several years. Providers can appeal any final determination made in connection with an audit.

      Program Adjustments. The Medicare, Medicaid and other federal health care programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations, and requirements for utilization review and new governmental funding restrictions, all of which may materially increase or decrease program payments as well as affect the cost of providing services and the timing of payment to facilities. The final determination of amounts earned under the programs often requires many years, because of audits by the program representatives, providers’ rights of appeal and the application of numerous technical reimbursement provisions. We believe that we have made adequate provision for such adjustments. Until final adjustment, however, previously determined allowances could become either inadequate or more than ultimately required.

      Managed Care. The percentage of admissions and net revenue attributable at our hospitals and other facilities 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.

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      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. We cannot predict whether or how payment by third party payors for the services provided by all hospitals and other facilities may change. Modifications in methodology or reductions in payment could adversely affect us.

Regulation

      Overview. 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 and other facilities could lose their licenses and 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.

      The Medicare Modernization Act makes significant changes to the Medicare program, particularly with respect to the coverage of prescription drugs. These modifications also include provisions affecting Medicare coverage and reimbursement to general acute care hospitals, as well as other types of providers. In addition, the Medicare Modernization Act contains provisions that restrict reliance upon an exception to the federal physician self-referral law for an 18-month period that will have a significant impact on our development activities. See “— Fraud and Abuse Laws — Physician Self-Referral Law.”

      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, like the Medicare Modernization Act, would effect major changes in the healthcare system. Proposals that have been considered include changes in Medicare, Medicaid, and other state and federal programs, cost controls on hospitals and mandatory health insurance coverage for employees. We cannot predict the course of future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs and the effect that any legislation, interpretation, or change may have on us.

      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 majority-owned hospitals are licensed as general acute care hospitals under applicable state law. In addition, our hospitals are accredited by the Joint Commission for Accreditation of Health Organization (JCAHO), a nationwide commission which establishes standards relating to physical plant, administration, quality of patient care and operation of hospital medical staffs.

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      Certification. In order to participate in the Medicare program, each provider must meet applicable regulations of HHS relating to, among other things, the type of facility, equipment, personnel, standards of medical care and compliance with applicable federal, 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 (EMTALA) imposes requirements as to the care that must be provided to anyone who seeks care at facilities providing emergency medical services. In addition, CMS has issued final regulations clarifying those areas within a hospital system that must provide emergency treatment, procedures to meet on-call requirements, as well as other requirements under EMTALA. Sanctions for failing to fulfill these requirements include exclusion from participation in the Medicare and Medicaid programs and civil monetary 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 and applicable regulations, 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 nor what obligations may be imposed by regulations to be issued in the future.

      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 or are exempt from such requirements. However, we cannot assure you that government officials will agree with our interpretation of these laws.

      Professional Licensure. Healthcare professionals who perform services at our hospitals and diagnostic and therapeutic facilities are required to be individually licensed or certified under applicable state law. Our facilities are required to have by-laws relating to the credentialing process, or otherwise document appropriate medical staff credentialing. We take steps to ensure that our employees and agents and physicians on each hospital’s medical staff have all necessary licenses and certifications, and we believe that the medical staff members, as well as our employees and agents comply with all applicable state licensure laws as well as any hospital by-laws applicable to credentialing activities. However, we cannot assure you that government officials will agree with our position.

      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.

      Overview. 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 (HIPAA) broadened the scope of certain fraud and abuse laws by

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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 HHS (OIG) has published safe harbor regulations that describe 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 securities exchange.

      The OIG 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 OIG 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 OIG 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,
	•	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 and our other facilities. 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

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      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 entities in which they or any of their immediate family members have a direct or indirect ownership or compensation arrangement unless an exception applies. The initial Stark Law applied only to referrals of clinical laboratory services. The statute was expanded in Stark II to apply to ten additional “designated health services,” including inpatient and outpatient hospital services, and some radiology services. Sanctions for violating the Stark Law include civil monetary penalties, including up to $15,000 for each improper claim and $100,000 for any circumvention scheme, and exclusion from the Medicare or Medicaid programs. There are various ownership and compensation arrangement exceptions to the self-referral prohibition, including an exception for a physician’s ownership in an entire hospital — as opposed to an ownership interest in a hospital department — if the physician is authorized to perform services at the hospital. This exception is commonly referred to as the “whole hospital exception.” There is also an exception for ownership of publicly traded securities in a company that has stockholder equity exceeding $75 million at the end of its most recent fiscal year or on average during the three previous fiscal years, as long as the physician acquired the securities on terms generally available to the public and the securities are traded on one of the major exchanges. Exceptions are also provided for many of the customary financial arrangements between physicians and providers, including employment contracts, personal service arrangements, isolated financial transactions, payments by physicians, leases, and recruitment agreements, as long as these arrangements meet certain conditions.

      Through June 8, 2005, the Medicare Modernization Act prohibits reliance upon the whole hospital exception by new “specialty hospitals,” as defined by the Medicare Modernization Act, and imposes limitations on the activities of specialty hospitals in operation or under development as of November 18, 2003. Absent further congressional action, the provisions of the Medicare Modernization Act pertaining to specialty hospitals will lapse automatically on June 8, 2005.

      The Medicare Modernization Act defines the term “specialty hospital” as a hospital primarily or exclusively engaged in the care and treatment of certain specified patients, including those with a cardiac condition, and allows the Secretary of HHS to issue regulations or other guidance interpreting this provision of the Medicare Modernization Act. Based upon our understanding of the statute and guidance recently issued by CMS, we believe that all but one of our hospitals are likely to fall within the final definition of specialty hospital.

      CMS has announced an advisory opinion process whereby interested parties may obtain a determination regarding whether a specialty hospital was under development as of November 18, 2003. We are utilizing the advisory opinion process to confirm that our two most recently opened hospitals, Texsan Heart Hospital and Heart Hospital of Lafayette, were under development as of November 18, 2003. While we believe there is compelling evidence that both of these hospitals were under development on this date, we cannot assure you that CMS would agree with our conclusion.

      Assuming all of our hospitals are categorized as grandfathered specialty hospitals, the moratorium imposed by the Medicare Modernization Act will nonetheless prohibit each of them from taking any of the following actions prior to June 8, 2005:

	•	increasing the number of physician investors existing as of November 18, 2003,
	•	increasing the number of beds on the hospital’s main campus by more than 50% of the total number of beds in the hospital as of November 18, 2003 and
	•	changing or adding to the hospital’s area of specialization as of November 18, 2003.

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      During the moratorium period, MedPac, in consultation with the Comptroller General of the United States and the Secretary of HHS, is conducting studies relating to various aspects of specialty hospital operations and their relationship to full-service community hospitals. MedPac recently released a series of draft staff recommendations, one of which was to eliminate the “whole hospital” exception while establishing criteria to grandfather existing physician owned hospitals. The MedPac commissioners are scheduled to vote on these and other recommendations in January 2005. Any such recommendations would require consideration and approval by Congress before they are enacted as law.

      The final recommendations on specialty hospitals to be issued by MedPac may contain findings which will influence future legislative and regulatory developments. Moreover, the regulations to be promulgated by HHS interpreting the Medicare Modernization Act, amendments to the Medicare Modernization Act, the Stark Law or other legislation could require us to modify the manner in which we establish relationships with physicians and operate or develop our hospitals. Even without further legislative or regulatory developments, the moratorium on the development of new physician-owned specialty hospitals and the limitation on bringing additional physician investors into existing specialty hospitals may adversely affect our operations by curtailing some of our hospital development activities and potentially restricting our ability to attract new physician investors.

      As noted above, the Stark Law prohibits a physician who has a financial relationship with an entity from referring Medicare or Medicaid patients to that entity for certain designated health services. On January 4, 2001, CMS issued Phase I of the final regulations to partially implement the Stark Law (Phase I regulations). The regulations largely went into effect on January 4, 2002. On March 26, 2004, and effective July 26, 2004, CMS issued the final regulations to implement the majority of the Stark Law (Phase II regulations). The Phase II regulations largely retain, clarify, and expand upon many of the fundamental concepts adopted in the Phase I regulations.

      The Phase II regulations clarify that, with respect to indirect ownership interests, common ownership in an entity does not create an indirect ownership interest by one common owner in another common owner. The Phase II regulations reiterate the Phase I concept that there is no affirmative duty to investigate whether an indirect financial relationship with a referring physician exists, absent information that puts one on notice of such a relationship.

      As noted above, there are various ownership and compensation arrangement exceptions to the Stark Law. In addressing the whole hospital exception, the Phase II regulations specifically reiterate the statutory requirements for the exception. Additionally, the exception requires that the hospital qualify as a “hospital” under the Medicare program. With respect to the personal services arrangement exception, the Phase II regulations confirm that the exception broadly covers business-oriented services in general, and not just Medicare services. Importantly, the Phase II regulations eliminate a sentence in Phase I prohibiting percentage compensation arrangements based upon fluctuating or indeterminate measures from being considered “set in advance.” Before Phase I became effective and prior to issuance of Phase II, CMS suspended the effective date of this sentence. As a result of the Phase II regulations, hospitals expressly may compensate physicians based upon a percentage of their personally performed services and still meet the requirements of the personal services arrangements exception. The Phase II regulations also provide that physicians may have personal service arrangements with several entities.

      There have been few enforcement actions taken and relatively few cases interpreting the Stark Law to date, although one case struck down an 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 and Phase II of the final regulations. In particular, we believe that our physician ownership arrangements meet the 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 on our arrangements with physicians.

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      States in which we operate periodically consider adopting physician self-referral laws, which may prohibit certain physician referrals or require certain disclosures. Some of these state laws would 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 believe we have structured our financial relationships with physicians and others to comply with applicable state laws. In addition, existing state self-referral laws may be amended. We cannot predict whether new state self-referral laws or amendments to existing laws will be enacted or, once enacted, their effect on us, and we have not researched pending legislation in all the states in which our hospitals are located.

      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 OIG 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 hospital, and structured to take advantage of the whole hospital exception. Hospitals specializing in heart, orthopedic, and maternity care are mentioned, and the bulletin states that these hospitals 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 OIG 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 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 False Claims Act include substantial civil and criminal fines, including treble damages, imprisonment, and exclusion from participation in federal health care programs. In addition, the 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

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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 OIG and the United States Department of Justice (DOJ), are also increasing scrutiny of various types of arrangements between healthcare providers and potential referral sources, including so-called contractual joint ventures, to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and business opportunities. Investigators have also 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. Recently, the OIG has also begun to investigate certain hospitals with a particularly high proportion of Medicare reimbursement resulting from outlier payments. The OIG’s workplan has indicated its intention to review hospital privileging activities within the context of Medicare conditions of participation.

      It is possible that governmental or regulatory authorities could initiate investigations on these or other subjects 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 hospital 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. The positions taken by authorities in any investigations of us, our executives, managers, hospital 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 (IRB), which has the responsibility to review and monitor each study pursuant to applicable law and regulations. Such clinical trials are subject to numerous regulatory requirements.

      The industry standard for conducting preclinical testing is embodied in the investigational new drug regulations administered by the federal Food and Drug Administration (the FDA). 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 FDA and have been adopted by similar regulatory authorities in other countries. These regulations contain requirements for research, sponsors, investigators, IRBs, 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. CMS also imposes certain requirements for billing of services provided in connection with clinical trials.

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      The FDA 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,
	•	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 FDA 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 debarment of an investigator or institution or False Claims Act allegations if fraud or substantial non-compliance is detected, and subject a hospital to a recoupment of payments for services that are not covered by federal health care programs. 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 clinical trial 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 HHS related to the responsibilities of healthcare entities to maintain the privacy of patient identifiable medical information. See “— Privacy and Security Requirements.” We have implemented new policies in an attempt to comply with these rules as they apply to clinical research, including procedures to obtain all required patient authorizations. However, there is little or no guidance available as to how these rules will be enforced.

      HIPAA requires 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, HHS 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 was required by October 16, 2003 for our healthcare facilities. We believe we have complied with the electronic data transmission standards.

      HIPAA also requires HHS to adopt standards to protect the security and privacy of health-related information. HHS released final regulations containing privacy standards on December 28, 2000. These privacy regulations were effective April 14, 2001, but compliance with these regulations was not required until April 14, 2003. The government issued further modifications to these regulations on August 14, 2002. The privacy regulations extensively regulate the use and disclosure of individually identifiable health-related information. We have taken extensive measures to comply with the final privacy regulations, but since there is little guidance about how these regulations will be enforced by the government, we cannot predict whether the government will agree that our healthcare facilities are in compliance.

      HHS issued final regulations adopting security standards on February 20, 2003. These security regulations require healthcare providers to implement organizational and technical practices to protect the security of electronically maintained or transmitted health-related information and will be enforced as to our healthcare facilities on and after April 21, 2005. At this time, we cannot predict the full impact that the security regulations will have on our operations.

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      Violations of the Administrative Simplification Provisions of HIPAA 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 state laws that may be more restrictive than the regulations issued under HIPAA. These statutes vary by state and could impose additional penalties.

      The OIG has issued guidelines to promote voluntarily developed and implemented compliance programs for the healthcare industry. In February 1998, the OIG issued compliance program guidance for hospitals. In response to the original 1998 guidelines, we adopted a code of ethics, designated compliance officers at the parent company level 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.

      We have 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.

      Our policy is 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 former chief counsel for the Health Care Financing Administration (now known as CMS), 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 compliance committee of the board of directors assesses each hospital’s compliance program at least annually. The corporate compliance officer annually assesses 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 has announced 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.

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EXECUTIVE OFFICERS OF THE REGISTRANT

Directors and Executive Officers of MedCath Corporation

      The following table sets forth information regarding MedCath’s directors and executive officers.

      John T. Casey has served as MedCath’s chairman of the board since August 2004. He has served as Chief Executive Officer since September 2003 and as a director since May 2000. From 1997 to 1999, Mr. Casey served as chairman and chief executive officer of Physician Reliance Network, Inc., a publicly traded company that was, prior to its merger with US Oncology, Inc., the largest oncology practice management company in the United States. From 1995 to 1997, Mr. Casey was the chief executive officer of Intecare, LLC, a company formed for the purpose of developing joint venture partnerships with hospitals and integrated healthcare systems. From 1991 to 1995, he served as president and chief operating officer of American Medical International (American Medical), which, at that time, was the third largest publicly held owner and operator of hospitals in the country. In 1995, American Medical merged with National Medical Enterprises to create Tenet Healthcare Corporation (Tenet), where Mr. Casey served as vice-chairman until 1997. He received an undergraduate degree in economics from Auburn University and a masters’ degree in hospital and health care administration from the University of Alabama at Birmingham.

      Charles R. Slaton has served as MedCath’s Executive Vice President and Chief Operating Officer since September 2003 and President since November 2004. Prior to joining MedCath, Mr. Slaton was a senior manager for nine years at Tenet, where he most recently served as senior vice president, with financial and operational responsibilities for 15 acute and rehabilitation hospitals in Texas. Before joining Tenet, Mr. Slaton was part of an executive management team turnaround of Santa Rosa Memorial Hospital in Santa Rosa, California. He began his career as vice president of imaging and surgery centers for Saint Mary’s Hospital in Lubbock, Texas. Mr. Slaton received his bachelor’s degree and a masters degree in business administration from Texas Tech University. In addition, Mr. Slaton completed post-graduate studies in the advanced management program at Harvard Business School in 2001.

      James E. Harris has served as MedCath’s Executive Vice President and Chief Financial Officer since December 1999. From 1998 to 1999, Mr. Harris was chief financial officer of 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, Inc., a private investment company. Prior to joining The Shelton Companies, Inc., Mr. Harris spent two years with Ernst & Young LLP as a senior accountant. Mr. Harris received his undergraduate degree from Appalachian State University and a masters degree in business administration from Wake Forest University’s Babcock School of Management. Mr. Harris is a director of Coca-Cola Bottling Co. Consolidated.

      Thomas K. Hearn III has served as MedCath’s President of the Diagnostics Division since November 1995 and Chief Development Officer since November 2004. 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-

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      Joan McCanless has served as MedCath’s 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 that, 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 undergraduate degree in nursing from the University of North Carolina at Charlotte.

      Grant Wicklund has served as MedCath’s Senior Vice President and Chief Administrative Officer since April 2004 and is responsible for human resources, managed care, materials management/purchasing, administration and cardiology consulting and management operations. From June 2000 to March 2004, Mr. Wicklund was responsible for recruitment, retention, human resources information systems and leadership development at Tenet. From 1995 to 2000, he served as a senior partner of Heidrick & Struggles International, Inc., an executive search firm. From 1992 to 1995, Mr. Wicklund served as a senior partner of Ray & Bernsten, an international executive search firm. Prior to that, he served as a human resources executive of American Medical and PepsiCo and as a senior consultant with Ernst & Young. Mr. Wicklund received an undergraduate degree in business administration from the University of Memphis.

      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 hospital has pledged its interest in the land and hospital building to secure the long-term debt incurred to develop the hospital, and substantially all the equipment located at these hospitals is pledged as collateral to secure long-term debt. Each entity formed to own and operate a diagnostic and therapeutic facility leases its facility.

      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.

      None.

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PART II

      Our common stock began trading on July 24, 2001, on the Nasdaq National Market® under the symbol “MDTH.” At December 3, 2004, there were 18,107,186 shares of common stock outstanding, the sale price of our common stock per share was $22.12, and there were 68 holders of record. 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 or 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 Securities and Exchange Commission on July 23, 2001. Our net proceeds from the offering were approximately $137.0 million. From the effective date through September 30, 2004, we used approximately $43.6 million to increase our ownership interest in six of our heart hospitals, approximately $64.2 million to repay amounts outstanding under various debt instruments and approximately $14.1 million for our hospital development program. We expect to use the remaining approximate $15.1 million of net proceeds from the offering for development activities, working capital and other corporate purposes. 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 included in cash and cash equivalents in our consolidated balance sheet.

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      The selected consolidated financial data have been derived from our audited consolidated financial statements. The selected consolidated financial data should be read in conjunction with “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.

      The following table sets forth our selected consolidated financial data as of and for the years ended September 30, 2004, 2003, 2002, 2001 and 2000.

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      The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.

Overview

      We are a healthcare provider focused primarily on the diagnosis and treatment of cardiovascular disease. We own and operate hospitals in partnership with physicians whom we believe have established reputations for clinical excellence as well as with community hospital systems. We opened our first hospital in 1996, and currently have ownership interest in and operate 12 hospitals, excluding The Heart Hospital of Milwaukee, which was sold on December 1, 2004. We have majority ownership of 11 of these 12 hospitals and a minority interest in one. 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. Our hospitals have a total of 727 licensed beds and are located in eight states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, and Texas.

      In addition to our hospitals, we own and/or manage cardiac diagnostic and therapeutic facilities. We began our cardiac diagnostic and therapeutic business in 1989. We currently own and/or manage 27 cardiac diagnostic and therapeutic facilities. Twelve of these facilities are located at hospitals operated by other parties and offer invasive diagnostic and, in some cases, therapeutic procedures. The remaining 15 facilities are not located at hospitals and offer only diagnostic procedures.

      Basis of Consolidation. We have included in our consolidated financial statements hospitals and cardiac diagnostic and therapeutic facilities over which we exercise substantive control, including all entities in which we own more than a 50% interest, as well as variable interest entities in which we are the primary beneficiary. We have used the equity method of accounting for entities, including variable interest entities, in which we hold less than a 50% interest and over which we do not exercise substantive control, and are not the primary beneficiary. Accordingly, the one hospital in which we hold a minority interest at September 30, 2004, Avera Heart Hospital of South Dakota, is excluded from the net revenue and operating expenses of our consolidated company and our consolidated hospital division. Similarly, a number of our diagnostic and therapeutic facilities are excluded from the net revenue and operating results of our consolidated company and our consolidated diagnostics division. Our minority interest in these entities’ 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.

      Upon applying the new accounting principles set forth by Interpretation No. 46, effective March 31, 2004, we began consolidating in our diagnostics division, a managed entity in which we do not hold any equity ownership interest and have not historically consolidated. The consolidation of this managed entity’s results of operations began April 1, 2004 and resulted in an increase in our net revenue of $7.6 million and an increase in our operating expenses of $7.6 million, for the year ended September 30, 2004, but did not have any impact on our net income since the managed entity operates at breakeven as a result of our management fee structure.

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      Same Facility Hospitals. Our policy is to include in our same facility basis only those facilities that were open and operational during the full current and prior fiscal year comparable periods. For example, on a same facility basis for our consolidated hospital division for the fiscal year ended September 30, 2004, we exclude the results of operations of our four newest hospitals, Louisiana Heart Hospital, The Heart Hospital of Milwaukee, Texsan Heart Hospital, and Heart Hospital of Lafayette, which opened in February 2003, October 2003, January 2004 and March 2004, respectively.

      Hospital Ownership and Capital Structure. Each of our consolidated 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 72% 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 two of our hospitals, there currently are hospital partners that hold ownership interests of 20% and 33%, respectively.

      Newly Opened Hospitals During Fiscal 2004. On October 14, 2003, we opened our eleventh hospital, which is located in Glendale, Wisconsin. This hospital obtained its accreditation from JCAHO on October 24, 2003. The Heart Hospital of Milwaukee opened with 32 inpatient beds. On January 13, 2004, we opened our twelfth hospital, which is located in San Antonio, Texas, and obtained its accreditation from 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. On March 2, 2004, we opened our thirteenth hospital, which is located in Lafayette, Louisiana. This hospital obtained its accreditation from JCAHO on March 26, 2004. Heart Hospital of Lafayette opened with 32 inpatient beds that will be staffed and available as the hospital ramps up its operations. Upon opening Heart Hospital of Lafayette, we have completed our hospital expansion plans that commenced three years ago, and we do not currently have any other hospitals under development.

      New Hospital Development. Once the entity that will own a new hospital is formed and the partners have contributed their capital, it typically takes approximately 18 to 24 months to develop the hospital. As of September 30, 2004 the development costs for our six most recently opened hospitals, including the cost of equipment and capitalized construction period interest, have ranged from $26.1 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 51% 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 hospital. Pre-opening expenses for our nine most recently opened hospitals have ranged between $3.3 million and $6.5 million per hospital. Approximately 54% of these pre-opening expenses were for personnel and 7% for marketing and advertising. The balance was distributed among several categories including staff recruitment and relocation, office and equipment rentals, travel and meals for the staff and other operating expenses such as property taxes, legal expenses, insurance and utilities.

      The Medicare Modernization Act imposes a moratorium on the development of new physician-owned “specialty hospitals,” as such hospitals are defined in the statute and in regulations that may be issued by HHS. This moratorium is expected to end on June 8, 2005 absent further Congressional action.

      Hospital Closure and Asset Sale. On November 5, 2004, we entered into an agreement to sell the assets, excluding accounts receivable and certain computer equipment, of The Heart Hospital of Milwaukee for a purchase price of $42.5 million. As a condition of the sale, which was completed on December 1, 2004, we closed the facility in late November. For a detailed discussion of transaction and selected financial information related to The Heart Hospital of Milwaukee, see Note 23 to the consolidated financial statements included elsewhere in this report.

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      Revenue Sources by Division. The largest percentage of our net revenue is attributable to our hospital division. The following table sets forth the percentage contribution of each of our consolidating divisions to consolidated net revenue in the periods indicated below.

      Revenue Sources 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 those age 55 and older, 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 consolidated net revenue we earned by category of payor in each of our last three fiscal years.

      We are reimbursed by non-governmental payors using a variety of payment methodologies, such as fee-for-service charges and rates based on diagnosis related groups. 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.

      A significant portion of our net revenue is derived from federal and state governmental healthcare programs, including Medicare and Medicaid. We expect the net revenue that we receive from the Medicare program as a percentage of total consolidated net revenue will 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 ramp up operations of our new hospitals. Our payor mix may fluctuate in future periods due to changes in reimbursement, market and industry trends with self-pay patients and other similar factors.

      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 significantly affect our business. In addition, reimbursement is generally subject to adjustment following audit by third party payors, including the fiscal intermediaries who administer the Medicare program for CMS. Final determination of amounts due providers under the Medicare program often takes several years because of such audits, as well as resulting provider appeals and the application of technical reimbursement provisions. We believe that adequate provision has been made for any adjustments that might result from these programs; however, 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 possibility that recorded estimates will change by a material amount in the near term. See “Business — Reimbursement” and “— Regulation.”

      We do not expect changes in the outlier formula for fiscal 2005 to have a material effect on our outlier payments in fiscal 2005. However, we do expect that the increase in payment rates and revised wage indexes in fiscal 2005 will increase our net revenue by approximately $15.0 million to $16.0 million. However, because the regulations are subject to change, and due to the complexity of laws and regulations governing the Medicare and

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      Medicare reimburses hospitals for capital-related costs using one of two alternative methodologies based upon whether the hospital is categorized as “new” under the regulations of CMS. On August 11, 2003, one of the Company’s Medicare fiscal intermediaries notified the Company 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 previously 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 management’s 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. However, the Company has recognized capital reimbursement subsequent to August 11, 2003 consistent with the payments received under the new methodology beginning on that date. During February 2004, we learned that CMS, after considering its position, 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. The impact of this change for fiscal 2003 was a $1.2 million reduction in our net revenue and for fiscal 2004 was a $7.2 million reduction in our net revenue from the amount that would have been recognized under the previous reimbursement method. We believe 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 2005 through 2009 will be from $15.0 million to $16.0 million.

Critical Accounting Policies

      General. The discussion and analysis of our financial condition and results of operations are based on our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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.

      Revenue Recognition. 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, health maintenance organizations and preferred provider 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

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      We also provide care to patients who meet certain criteria under our charity care policy without charge or at amounts less than our established rates. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported as net revenue.

      Our managed diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories operate under various contracts where management fee revenue is recognized under fixed-rate and percentage-of-income arrangements as services are rendered. In addition, certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories recognize additional revenue under cost reimbursement and equipment lease arrangements. Net revenue from our owned diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories is reported at the estimated net realizable amounts due from patients, third party payors, and others as services are rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors.

      Our consulting and management operations, which are included in our corporate and other division, operate under various contracts where management fee revenue is recognized under various percentage-of-income and cost-reimbursement arrangements and consulting and other revenue under service contractual arrangements as services are rendered.

      Allowance for Doubtful Accounts. Accounts receivable primarily consist of amounts due from third-party payors and patients in our hospital division. The remainder of our accounts receivable principally 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 operations. 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. 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.

      General and Professional Liability Risk. 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 entered into a new partially self-insured coverage program. At that time, we purchased a tail insurance policy to provide first-dollar coverage for claims incurred prior to June 1, 2002, but not reported as of that date under the expired claims-made policy. We recognized the full cost of the tail insurance policy as an operating expense in the third quarter of fiscal 2002 as required by generally accepted accounting principles in the United States. From June 1, 2002 through June 6, 2003, we were partially self-insured under a claims-made policy providing coverage for claim amounts in excess of $2.0 million of retained liability per claim. Effective June 7, 2003, we entered into a new one-year claims-made policy providing coverage for claim amounts in excess of $3.0 million of retained liability per claim, subject to $5.0 million of retained liability per claim for the first two claims reported during the policy year at one of our hospitals On June 7, 2004, we extended this claims-made policy through June 29, 2004. On June 30, 2004, we entered into a new one-year claims-made policy providing coverage at the same amounts as were in effect during the 2003-2004 policy year. Because of our self-insured retention levels, we are required to recognize an estimated expense/ liability for the amount of our retained liability applicable to each malpractice claim. As of September 30, 2004 and September 30, 2003, the total estimated liability for our self-insured retention on medical malpractice claims, including an estimated amount for incurred but not reported claims, was approximately $5.4 million and $3.7 million, respectively, which is included in current liabilities in

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      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, 2004 and September 30, 2003, our total estimated reserve for self-insured liabilities on employee health and dental claims was $3.2 million and $2.3 million, respectively, which is included in current liabilities in our consolidated balance sheet. We maintain this reserve based on our historical experience with claims. We also maintain commercial stop loss coverage for our health and dental insurance program of $100,000 per plan participant.

      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.

      Goodwill and Intangible Assets. Goodwill represents acquisition costs in excess of the fair value of net tangible and intangible assets of businesses purchased. Other intangible assets primarily consist of the value of management contracts. With the exception of goodwill, intangible assets are being amortized over periods ranging from 8 to 27 years. In accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS 142), we evaluate goodwill annually on September 30 for impairment, or earlier if indicators of potential impairment exist. The determination of whether or not goodwill has become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the value of our reporting units. Changes in our strategy and or market conditions could significantly impact these judgments and require adjustments to recorded amounts of intangible assets.

      In September 2003, we performed a goodwill impairment test, the results of which concluded our goodwill was impaired. Based on the hypothetical purchase price methodology required under SFAS No. 142, we determined the amount of the goodwill impairment to be approximately $58.9 million at September 30, 2003. The $58.9 million impairment charge consisted of $43.5 million related to our hospital division reporting unit, which reduced its remaining goodwill to $75.0 million at September 30, 2003, and $15.4 million related to our diagnostics division reporting unit, which reduced its remaining goodwill to $0 at September 30, 2003. The testing performed in September 2004 indicated that no additional impairment was required in fiscal 2004.

      Long-Lived Assets. Long-lived assets, other than goodwill, are evaluated for impairment when events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of these assets and its eventual disposition is less than its carrying amount. Impairment, if any, is assessed using discounted cash flows as an estimate of fair value. The determination of whether or not long-lived assets have become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the estimated future cash flows expected to result from the use of those assets. Changes in the our strategy, assumptions and/or market conditions could significantly impact these judgments and require adjustments to recorded amounts of long-lived assets.

      During the year ended September 30, 2004, we recorded a $7.2 million impairment charge relating to certain software costs associated with the purchase of an enterprise wide healthcare information system, which had been installed in two of our hospitals. Due to a number of functionality and integration issues experienced with this system, we determined that the system is not performing to its original specifications and thus will be replaced at the two hospitals where it has been installed and will not be installed in any additional hospitals as stated in the original license. The impairment charge reflects unamortized costs associated with the acquisition, development and implementation of the system.

      Earnings Allocated to Minority Interests. Earnings allocated to minority interests represent the allocation of profits and losses to minority owners in our consolidated subsidiaries. Because our hospitals are owned as joint

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      The determination of at-risk capital position is based on the specific terms of each hospital’s operating agreement, including each partner’s contributed capital, obligation to contribute additional capital to provide working capital loans, or to guarantee the outstanding obligations of the hospital. During each of our fiscal years 2004, 2003 and 2002, our disproportionate recognition of earnings (losses) in our hospitals had a positive (negative) impact of $(7.8) million, $(5.0) million, and $2.0 million, respectively, on our reported income (loss) before income taxes.

      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, 2004, we had remaining cumulative disproportionate loss allocations of approximately $29.3 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.

      Income Taxes. Income taxes are computed on the pretax income (loss) based on current tax law. Deferred income taxes are recognized 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 their 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.

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Results of Operations

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