UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended March 31, 2004

Commission File Number 000-33009

MEDCATH CORPORATION

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

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

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

Yes [X ] No [   ]

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

Yes [   ] No [X]

As of April 30, 2004, there were 17,985,644 shares of $0.01 par value common stock outstanding.

MEDCATH CORPORATION

FORM 10-Q

TABLE OF CONTENTS

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MEDCATH CORPORATION

See notes to consolidated financial statements.

3

MEDCATH CORPORATION

See notes to consolidated financial statements.

4

MEDCATH CORPORATION

See notes to consolidated financial statements.

5

MEDCATH CORPORATION

See notes to consolidated financial statements.

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MEDCATH CORPORATION

1. Business and Organization

     MedCath Corporation (the Company) is a healthcare provider focused primarily on the diagnosis and treatment of cardiovascular disease. The Company owns and operates hospitals in partnership with physicians whom it believes have established reputations for clinical excellence as well as with community hospital systems. Each of the Company’s majority-owned hospitals (collectively, the Hospital Division) is a freestanding licensed general acute care hospital, that provides a wide range of health services, and the medical staff at each hospital includes qualified physicians in various specialties. The Company opened its first hospital in 1996, and as of March 31, 2004 has ownership interests in and operates 13 hospitals. These hospitals include 12 majority-owned hospitals and one in which the Company owns a minority interest. The Company’s 13 hospitals have a total of 759 licensed beds, of which 648 were staffed and available at March 31, 2004, and are located in nine states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, Texas and Wisconsin.

     The Company accounts for all but one of its owned and operated hospitals as consolidated subsidiaries. The Company owns a minority interest in Heart Hospital of South Dakota and does not have substantive control over the hospital, and therefore is unable to consolidate the hospital’s results of operations and financial position, but rather is required to account for its minority ownership interest in the hospital as an equity investment. The Company has evaluated the accounting for its interest in this hospital under Financial Accounting Standards Board (FASB) Interpretation No. 46-R that was issued in December 2003 regarding consolidation of variable interest entities. The adoption of this interpretation did not require the Company to consolidate this entity. See Note 3 below.

     In addition to its hospitals, the Company owns and/or manages cardiac diagnostic and therapeutic facilities (the Diagnostics Division). The Company began its cardiac diagnostic and therapeutic business in 1989, and as of March 31, 2004 owns and/or manages 25 cardiac diagnostic and therapeutic facilities. Ten of these facilities are located at hospitals operated by other parties and offer invasive diagnostic and sometimes therapeutic procedures. The remaining 15 facilities are not located at hospitals and offer only diagnostic services. The Company also provides consulting and management services (CCM) tailored primarily to cardiologists and cardiovascular surgeons, which is included in the corporate and other division.

2. Summary of Significant Accounting Policies

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

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

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

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

     Pre-opening Expenses – Pre-opening expenses consist of operating expenses incurred during the development of a new venture and prior to its opening for business. Such costs specifically relate to ventures under development and are expensed as incurred. The Company recognized pre-opening expenses of approximately $2.1 million and $2.8 million during the three months ended March 31, 2004 and 2003, respectively, and $5.5 million and $5.2 million during the six months ended March 31, 2004 and 2003, respectively.

     Stock-Based Compensation – As of March 31, 2004, the Company has two stock-based compensation plans, including a stock option plan under which it may grant incentive stock options and nonqualified stock options to officers and other key employees and an outside director’s stock option plan under which it may grant nonqualified stock options to nonemployee directors. The Company accounts for stock options under both of these plans in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, as permitted under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. The Company also provides prominent disclosure of the information required by SFAS No. 148, Accounting for Stock-Based Compensation, in its annual and interim financial statements.

     Under APB Opinion No. 25, compensation cost is determined based on the intrinsic value of the equity instrument award. No stock-based employee compensation cost is reflected in net income for the three months and six months ended March 31, 2004 and 2003, as all options granted during those periods under the Company’s stock option plans had an exercise price equal to the market value of the underlying shares of common stock at the date of grant.

     Had compensation expense for the Company’s stock options been recognized based on the fair value of the option award at the grant date under the methodology prescribed by SFAS No. 123, the Company’s net income for the three months and six months ended March 31, 2004 and 2003 would have been impacted as follows:

     Accounting Changes and Recent Accounting Pronouncements – In December 2003, the SEC released Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, which supercedes SAB No. 101, Revenue Recognition in Financial Statements, in order to make interpretive guidance under the SAB consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The principal changes under SAB No. 104 relate to the rescission of material no longer necessary because of private sector developments in generally accepted accounting principles. The Company’s adoption of SAB No. 104 did not have any impact on its financial position or results of operations and cash flows.

3. Adoption of FASB Interpretation No. 46

     In December 2003 the FASB released a revised version of Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, (hereinafter, FIN 46-R), which provides a new consolidation method of accounting. FIN 46-R established the effective dates for public entities to apply FIN 46 and FIN 46-R based on the nature of the variable interest entity and the date upon which the public company became involved with the variable interest entity. The Company was not required to apply either FIN 46 or FIN 46-R prior to March 31, 2004 as the Company was not involved with variable interest entities created after January 31, 2003 or any variable interest entities created before February 1, 2003 that were special purpose entities, which required early application.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

     Upon application of FIN 46-R the Company determined that one of its majority-owned subsidiaries was the primary beneficiary of a managed entity in the Company’s Diagnostics Division, and accordingly began consolidating this managed entity effective March 31, 2004. The Company does not hold any equity ownership interest in the managed entity, either directly or through its majority-owned subsidiary, but rather has a management relationship with the entity. The managed entity owns a diagnostic and therapeutic facility, which is located at a community hospital, and operates that facility under a services agreement with the hospital. The managed entity receives service fees from the hospital as well as revenue from patients and third party payors for procedures performed in the facility. The Company’s majority-owned subsidiary manages the diagnostic and therapeutic facility in exchange for management fees equal to 100% of the managed entity’s net operating results. As summarized below, the consolidation of this managed entity did not result in a cumulative effect of an accounting change as the managed entity has a $0 equity balance and $0 cumulative earnings. The managed entity operates at breakeven due to the 100% management fee structure with the Company’s majority-owned subsidiary.

     As a result of consolidating this managed entity, the Company recognized the following assets and liabilities, net of intercompany eliminations, in its consolidated balance sheet as of March 31, 2004:

     The managed entity’s long-term debt represents unsecured notes payable relating to the financing of leasehold improvements at the diagnostic and therapeutic facility. These notes payable accrue interest at a fixed rate of 8.00%, with payments of principal and interest due quarterly, and mature September 2007. The managed entity’s creditors, including the note holders, do not have recourse to the general credit of the Company or its majority-owned subsidiary.

     The Company’s consolidation of the managed entity’s results of operations beginning April 1,2004 will result in an increase in the Company’s net revenue and operating expenses, but will not have any impact on net income as the managed entity operates at breakeven as a result of the management fee structure, as previously discussed.

     The Company also has a significant variable interest in its one unconsolidated affiliate hospital, Heart Hospital of South Dakota, but has determined that it is not the primary beneficiary under FIN 46-R, and accordingly has continued to account for its investment in this hospital using the equity method of accounting. This hospital, which has 55 licensed beds, 3 catheterization labs, and 3 operating rooms opened in March 2001 as a limited liability corporation. The Company, along with physician partners and a community hospital, each hold an approximately 33.33% ownership interest in the hospital. The Company also guarantees approximately 50% of the real estate debt and 30% of the equipment debt and manages the hospital’s operations pursuant to a management agreement. Historically, the Company has provided senior subordinated working capital loans to this hospital, however, no such loan amounts were outstanding at March 31, 2004. Under the terms of the hospital’s operating agreement, the Company is committed to providing working capital loans up to $12.0 million and additional guarantees of indebtedness as may be required in future periods. The Company’s maximum exposure to loss as a result of its involvement with this hospital includes the Company’s equity investment, performance under the guarantees of indebtedness (see Note 7), annual management fees, and any amounts outstanding under the senior subordinated working capital loans.

     The Company has variable interests in several other entities in its Diagnostics Division, however none of these variable interests were determined to be significant under FIN 46-R as of March 31, 2004.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

4. Goodwill and Other Intangible Assets

     As required by SFAS No. 142, Goodwill and Other Intangibles, the Company has designated September 30, its fiscal year end, as the date it will perform the annual goodwill impairment test for all of its reporting units. Goodwill of a reporting unit will also be tested between annual tests if an event occurs or circumstances change that indicate an impairment may exist. During the three months and six months ended March 31, 2004, no events or circumstances changed that indicated interim impairment testing was necessary and as such, no impairment was recognized during the three months and six months ended March 31, 2004.

     As of March 31, 2004 and September 30, 2003, the Company’s other intangible assets, net, included the following:

     Amortization expense recognized for the management contracts and other intangible assets totaled $290,000 and $437,000 for the three months ended March 31, 2004 and 2003, respectively, and $580,000 and $874,000 for the six months ended March 31, 2004 and 2003, respectively. The Company recognizes amortization expense for loan acquisition costs as a component of interest expense. For the three months ended March 31,2004 and 2003, amortization expense for loan acquisition costs was $495,000 and $342,000, respectively, and for the six months ended March 31, 2004 and 2003, amortization expense for loan acquisition costs was $931,000 and $715,000, respectively.

5. Business Development and Changes in Operations

     New Hospital Development During the Three Months Ended March 31, 2004 – On March 2, 2004, the Company opened Heart Hospital of Lafayette in Lafayette, Louisiana, which focuses primarily on cardiovascular care. On March 26, 2004, Heart Hospital of Lafayette received its accreditation from the Joint Commission on Accreditation of Healthcare Organizations (JCAHO), which permits the hospital to bill for services. Heart Hospital of Lafayette is accounted for as a consolidated subsidiary since the Company, through its wholly-owned subsidiaries, owns an approximate 51.0% interest in the venture, with physician investors owning the remaining 49.0%, and the Company exercises substantive control over the hospital.

     On January 13, 2004, the Company opened Texsan Heart Hospital in San Antonio, Texas, which focuses primarily on cardiovascular care. On January 22, 2004, Texsan Heart Hospital received its accreditation from JCAHO, which permits the hospital to bill for services. Texsan Heart Hospital is accounted for as a consolidated subsidiary since the Company, through its wholly-owned subsidiaries, owns an approximate 51.0% interest in the venture, with physician investors owning the remaining 49.0%, and the Company exercises substantive control over the hospital.

     As of March 31, 2004, the Company’s four most recently opened hospitals were committed (and had paid and accrued amounts) under their construction contracts as set forth in the table below:

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

     The Company capitalized interest expense as part of the capitalized costs of its hospitals under development of approximately $153,000 and $380,000 during the three months ended March 31, 2004 and 2003, respectively, and approximately $616,000 and $694,000, respectively, during the six months ended March 31, 2004 and 2003.

6. Accounts Receivable

     Accounts receivable, net, consists of the following:

7. Long-Term Debt

     Long-term debt consists of the following:

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

     As of March 31, 2004, $130.3 million of the $145.0 million initially available to finance the Company’s hospital development program had been designated to finance the development of Harlingen Medical Center, Louisiana Heart Hospital, Texsan Heart Hospital, The Heart Hospital of Milwaukee and Heart Hospital of Lafayette (see Note 5). Of this $130.3 million of designated financing, $123.8 million was outstanding as of March 31, 2004. The Company may elect to terminate part or all of the remaining $14.7 million undesignated funds if it deems that its development activity is unlikely to result in a need for the funds.

     Each loan under the Master Credit Facility is separately documented and secured by the assets of the borrowing hospital only. Each loan under the Master Credit Facility amortizes based on a 20-year term, matures on July 27, 2006, and accrues interest at variable rates on either a defined base rate plus an applicable margin, or Eurodollar Rate (LIBOR) plus an applicable margin. The weighted average interest rate for the loans under the Master Credit Facility was 4.47% and 4.44% at March 31, 2004 and September 30, 2003, respectively. The Company is required to pay a monthly unused commitment fee at a rate of 0.5%.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

     In accordance with the related hospital operating agreements and as required by the lenders, the Company has guaranteed 100% of the obligations of its subsidiary hospitals for bank mortgage loans made under the Master Credit Facility and REIT loans and 71% of the obligation for another bank mortgage loan at March 31, 2004. The Company receives a fee from the minority partners in the subsidiary hospitals as consideration for providing guarantees in excess of the Company’s ownership percentage in the subsidiary hospitals. These guarantees expire concurrent with the terms of the related real estate loans and would require the Company to perform under the guarantee in the event of the subsidiary hospitals failing to perform under the related loans. The total amount of this real estate debt is secured by the subsidiary hospitals’ underlying real estate, which was financed with the proceeds from the debt. At March 31, 2004, the total amount of real estate debt was approximately $276.1 million, of which $270.5 million was guaranteed by the Company. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets.

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

     At March 31, 2004, the Company classified $16.5 million of real estate mortgage debt for Tucson Heart Hospital as current portion of long-term debt based on the debt’s scheduled maturity in November 2004.

     Revolving Credit Facility – Separate from the Master Credit Facility, the Company has a revolving credit facility (the Revolver) that provides $100.0 million in available borrowings, $10.0 million of which is designated as short-term borrowings and $25.0 million of which is available to issue letters of credit. The Revolver expires on January 31, 2005. As of March 31, 2004, no amounts were outstanding under the Revolver, however, the Company had letters of credit outstanding of $9.5 million, which reduced its availability under the Revolver to $90.5 million. The $90.5 million available under the revolving credit facility is subject to limitations on the Company’s total indebtedness as stipulated by other Company debt agreements.

     Notes Payable – The Company has acquired substantially all of the medical and other equipment for its hospitals and certain diagnostic and therapeutic facilities and mobile cardiac catheterization laboratories under installment notes payable to equipment lenders collateralized by the related equipment. Two facilities in the diagnostic division also have leasehold improvements funded through notes payable collateralized by real estate. Amounts borrowed under these notes are payable in monthly installments of principal and interest over 4 to 7 year terms. Interest is at fixed and variable rates ranging from 3.85% to 9.84%. The Company has guaranteed between 50% and 100% of certain of its subsidiary hospitals’ equipment loans. The Company receives a fee from the minority partners in the subsidiary hospitals as consideration for providing guarantees in excess of the Company’s ownership percentage in the subsidiary hospitals. These guarantees expire concurrent with the terms of the related equipment loans and would require the Company to perform under the guarantee in the event of the subsidiaries’ failure to perform under the related loan. At March 31, 2004, the total amount of notes payable was approximately $89.8 million, of which $59.4 million was guaranteed by the Company. Because the Company consolidates the subsidiary hospitals’ results of operations and financial position, both the assets and the accompanying liabilities are included in the assets and long-term debt on the Company’s consolidated balance sheets.

     In July 2003, Texsan Heart Hospital obtained a debt commitment of up to $20.0 million to finance its equipment purchases. Beginning in March 2004, borrowings bear interest at a fixed rate of interest equal to a specific Treasury Note yield, plus a margin. Prior to March 2004, interest on borrowings made under this commitment accrued at Prime, plus a margin. Principal shall be payable in 78 months beginning in September 2004. As of March 31, 2004, $10.1 million of the $20.0 million was outstanding under the commitment.

     In March 2004, The Heart Hospital of Milwaukee obtained a debt commitment in the amount of $15.0 million to refinance borrowings previously incurred to fund equipment purchases, and to provide additional borrowings for the hospital’s equipment needs. Interest on amounts borrowed under this facility shall accrue at Prime, plus a margin, until March 2005. Beginning in March 2005, borrowings shall bear interest at a fixed rate equal to a specific Treasury Note yield, plus a margin. Principal amounts shall begin to amortize in March 2005 based on a 7-year amortization schedule,

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

with all outstanding principal amounts due in March 2007. At March 31, 2004, $12.3 million of the $15.0 million available was outstanding under this commitment.

     In March 2004, Heart Hospital of Lafayette began submitting funding requests to the lender under a loan that previously had been the subject of a binding commitment in September 2003 in the amount of $12.0 million to fund equipment purchases. Interest on borrowings under the facility will accrue at prime, plus a margin, until July 1, 2004, at which time interest becomes fixed based on a specific Treasury Note yield, plus a margin. Principal amounts on borrowings incurred after April 1, 2004 and before July 1, 2004 will be repaid over a 78-month period beginning February 1, 2005. Interest on borrowings incurred after July 1, 2004 shall accrue at Prime, plus a margin, until December 31, 2004, at which time interest becomes fixed based on a specific Treasury Note yield, plus a margin. Principal amounts on borrowings incurred after July 1, 2004 and before December 31, 2004 shall be repaid over a 78-month period beginning July 31, 2005. Funding requests under the facility are not allowed after December 31, 2004. As of March 31, 2004, no borrowings were outstanding under this facility.

     Other Long Term Debt – Other long-term debt includes Arizona Heart Hospital’s revolving credit note. The note is collateralized by a pledge of the hospital’s accounts receivable. As of March 31, 2004, $4.3 million of the $5.0 million available was outstanding under the commitment. In April 2004, the maturity date of March 1, 2004 was extended to April 15, 2005. Based on the debt’s scheduled maturity in April 2005, the Company classified the debt as long-term debt at March 31, 2004.

     Debt Covenants – Covenants related to the Company’s long-term debt restrict the payment of dividends and require the maintenance of specific financial ratios and amounts and periodic financial reporting. At March 31, 2004, the Company was in violation of a certain financial ratio related to an equipment loan at Arizona Heart Hospital. The hospital was also not in compliance with this ratio at December 31, 2003. The equipment lender at Arizona Heart Hospital has not granted a waiver for the breach and the total obligation of approximately $3.5 million is recorded as current portion of long-term debt in the Company’s consolidated balance sheet as of March 31, 2004. In addition, the Company was in violation of a guarantor financial ratio covenant related to the equipment loan at Dayton Heart Hospital. Although the equipment lender at Dayton Heart Hospital has granted a waiver for the breach at March 31, 2004, the Company anticipates that it will require an amendment of the loan terms in order to meet compliance with the guarantor financial ratio covenant over the next 12 months. The Company is seeking an amendment to the loan terms from the equipment lender, but has not yet obtained such amendment. Accordingly, the Company has classified the total obligation of approximately $4.2 million to current portion of long-term debt in its consolidated balance sheet at March 31, 2004. The Company was in compliance with all other covenants in the instruments governing its outstanding debt at March 31, 2004 except as noted above.

     Guarantees of Unconsolidated Affiliate’s Debt – The Company has guaranteed approximately 50% of the real estate debt and 30% of the equipment debt of the one affiliate hospital in which the Company has a minority ownership interest and therefore does not consolidate the hospital’s results of operations and financial position. The Company provides these guarantees in exchange for a fee from that affiliate hospital. At March 31, 2004, the affiliate hospital was in compliance with all covenants in the instruments governing its debt. The total amount of the affiliate hospital’s real estate and equipment debt was approximately $27.5 million and $9.9 million, respectively, at March 31, 2004. Accordingly, the real estate debt and the equipment debt guaranteed by the Company was approximately $13.7 million and $3.0 million, respectively, at March 31, 2004. These guarantees expire concurrent with the terms of the related real estate and equipment loans and would require the Company to perform under the guarantee in the event of the affiliate hospital’s failure to perform under the related loans. The total amount of this affiliate hospital’s debt is secured by the hospital’s underlying real estate and equipment, which were financed with the proceeds from the debt. Because the Company does not consolidate the affiliate hospital’s results of operations and financial position, neither the assets nor the accompanying liabilities are included in the value of the assets and liabilities on the Company’s balance sheets.

8. Liability Insurance Coverage

     Since June 1, 2002, the Company has been partially self-insured under claims-made insurance policies that provide coverage for claim amounts in excess of specified amounts of retained liability per claim. These specified amounts of retained liability per claim range from $2.0 million to $5.0 million depending on the applicable policy year and hospital. As of March 31, 2004 and September 30, 2003, the total estimated liability for the Company’s self-insured retention on medical malpractice claims, including an estimated amount for incurred but not reported claims, was approximately $4.9 million and $3.7 million, respectively, which is included in current liabilities in the Company’s consolidated balance sheets.

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

9. Commitments and Contingencies

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

     In February 2004, the Company learned that CMS, after considering its position, has determined that the change in capital reimbursement methodology would be effective August 11, 2003, and that the change would not be applied retroactively to any periods prior to that effective date. Accordingly, this change in methodology will not have any impact on a retroactive basis to the Company’s consolidated financial position, results of operations and cash flows, as the four affected hospitals will not be required to repay the Medicare program for the reimbursed capital costs prior to August 11, 2003.

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

10. Income Taxes

     Income tax expense for the three months ended March 31, 2004 and 2003 was $1.6 million and $393,000, respectively, resulting in an effective tax rate of approximately 38.2% and 40.1%, respectively. Income tax expense for the six months ended March 31, 2004 and 2003 was $1.0 million and $652,000, respectively, resulting in an effective tax rate of approximately 37.0% and 40.0%, respectively. The Company’s effective tax rate for the first six months of fiscal 2004 is estimated based on projected earnings for the full fiscal year and may change in future interim periods if actual results are materially different from current expectations. The Company continues to have federal and state net operating loss carryforwards available from prior periods to offset its current tax liabilities, and thus it has no material current income tax liability.

11. Per Share Data

     The calculation of diluted earnings per share considers the potentially dilutive effect of options to purchase 3,149,550 and 2,708,595 shares of common stock outstanding at March 31, 2004 and 2003, respectively, at prices ranging from $4.75 to $25.00. Of these options, 1,374,300 and 2,577,123 were not included in the calculation of diluted earnings per share for the three months ended March 31, 2004 and 2003, respectively, and 1,390,300 and 2,577,123 were not included for the six months ended March 31, 2004 and 2003, respectively, as such shares were anti-dilutive for the periods.

12. Comprehensive Income

     The components of comprehensive income are as follows:

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

13. Litigation

     Litigation – The Company is involved in various claims and legal actions in the ordinary course of business, including malpractice claims arising from services provided to patients that have been asserted against the Company by various claimants, and additional claims that may be asserted for known incidents through March 31, 2004. These claims and legal actions are in various stages, and some may ultimately be brought to trial. Moreover, additional claims arising from services provided to patients in the past and other legal actions may be asserted in the future. The Company is attempting to protect its interests in all such claims and actions.

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

     In October 2003, the Company made a written demand of its former chief executive officer, David Crane, to exercise options to purchase 175,000 shares of its common stock at a price of $19 per share which the Company believes Mr. Crane was obligated to do upon the termination of his employment in accordance with the terms of a contract to purchase stock Mr. Crane entered into with the Company in 2001. Mr. Crane does not believe the contract is enforceable and has refused to exercise the options in question. The Company filed a lawsuit against Mr. Crane on March 11, 2004 in the Superior Court of Mecklenburg County, North Carolina seeking damages for the breach of contract and a declaratory judgment that his obligation to exercise the options under the contract is enforceable.

14. Reportable Segment Information

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

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MEDCATH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — Continued

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

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

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

Overview

     General

     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 13 hospitals. We have majority ownership of 12 of these 13 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 759 licensed beds and are located in nine states: Arizona, Arkansas, California, Louisiana, New Mexico, Ohio, South Dakota, Texas and Wisconsin.

     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 25 cardiac diagnostic and therapeutic facilities. Ten of these facilities are located at hospitals operated by other parties and offer invasive diagnostic and sometimes therapeutic procedures. The remaining 15 facilities are not located at hospitals and offer only diagnostic services. We also provide consulting and management services tailored primarily to cardiologists and cardiovascular surgeons.

     Our Strengths

     Leading Local Market Positions in Growing Markets. Each of our seven majority-owned hospitals that was open for all of fiscal 2002 has achieved a number one or two ranking in the local market position for cardiovascular care, as measured by the number of Medicare procedure-oriented cardiovascular diagnosis related groups performed. We have included the following in determining our market share: cardiac catheterization; by-pass and valves; cardiovascular implantables and angioplasty; and vascular procedures. These hospitals are located in markets where the population of those 55 years and older, the primary recipients of cardiac care services, is anticipated to increase between 8.6% and 40.0% over the next five years.

     Geographically Diversified Portfolio of Facilities. We currently have ownership interests in and operate 13 hospitals in nine states and own or manage 25 cardiac diagnostic and therapeutic facilities in 12 states. This diversifies our earnings base and reduces our exposure to any one geographic market.

     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. The most recent Lewin study, based on 2002 Medicare reimbursement data, concluded that our hospitals, on average, exhibited a 16.0% lower mortality rate for Medicare cardiac cases compared to peer community hospitals.

     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 2003, 98% of patients who completed discharge surveys indicated that they would return to our hospital for any future procedures. Additionally, more than 98% indicated they were satisfied with the physical comfort of our hospital and the patient education we provided.

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     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, hospital marketing plans, 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 partner 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 chief executive officer and chief operating officer each has over 18 years of experience in the healthcare industry, including extensive experience managing community hospital systems. John T. Casey was named our president and chief executive officer in September 2003 and has been a director since 2000. Charles R. Slaton was named our executive vice president and chief operating officer in September 2003. 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. As of March 31, 2004, private investment partnerships sponsored by Kohlberg Kravis Roberts & Co., L.P. (“KKR”) and Welsh, Carson, Anderson & Stowe VII, L.P. (“WCAS”) owned approximately 31.0% and 30.0%, respectively, of our outstanding common stock.

     Our Strategy

     Under the leadership of our senior management, we recently conducted an in-depth, strategic review of our company to develop strategies to better enable us to leverage our strengths. Key components of our strategy include to:

     Enhance Operating Performance. In markets where we have well-established hospitals, we intend to focus on improving operating performance and increasing our leading market shares. At these hospitals and our cardiac diagnostic and therapeutic facilities, we intend to improve management processes and systems, improve labor efficiencies by staffing to patient volume and clinical needs and control supply expense through more favorable group purchasing arrangements and inventory management. In our five newer hospitals, those that have been opened for less than 18 months, we will focus on controlling costs and establishing ourselves as a leading provider of healthcare services. In addition, we intend to increase revenue from all of our facilities, primarily through growth in patient volume. We plan to increase patient volume by seeking new or more favorable managed care contracts, as a result of the growth in the practices of our physicians and by attempting to increase the number of physicians who practice at our facilities.

     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 recently enacted federal law 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 employ 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.

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     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 may 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.

Results of Operations

     General

     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 March 31, 2004, 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 diagnostic services 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.

     Effective March 31, 2004, we began consolidating in our diagnostics services division a managed entity in which we do not hold any equity ownership interest and have not historically consolidated. Upon applying the new accounting principles set forth by Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, we determined that this entity was a variable interest entity and that one of our majority-owned and consolidated subsidiaries was the primary beneficiary. This majority-owned subsidiary receives 100% of the net earnings of the variable interest entity as a management fee. The consolidation of this variable interest entity did not have any impact on our results of operations or cash flows, and there was no cumulative effect in our balance sheet as a result of the consolidation as of March 31, 2004. Also, as part of applying the new accounting principles, we identified a number of other variable interest entities in which we hold variable interests, but concluded we are not the primary beneficiary and therefore are not required to change our method of accounting.

     Same Facility Hospitals. On a same facility basis for our consolidated hospital division, we exclude the results of operations of 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. 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.

     Newly Opened Hospitals During the Three Months Ended March 31, 2004. On January 13, 2004, we opened our twelfth hospital in San Antonio, Texas, which obtained its accreditation from the Joint Commission on Accreditation of Healthcare Organizations (JCAHO) on January 22, 2004. This hospital is designed to accommodate 120 inpatient beds and opened initially with 60 licensed beds that will be staffed and available as the hospital ramps up its operations.

     On March 2, 2004, we opened our thirteenth hospital 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.

     Revenue Sources. The largest percentage of our net revenue is attributable to our hospital division. Based on our recent investment in the development of hospitals, we believe our hospital division’s percentage of consolidated net revenue will continue to increase in future periods.

     The following table sets forth the percentage contribution of each of our consolidating divisions to consolidated net revenue in the periods indicated below.

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

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

     Medicare Reimbursement Changes. As previously disclosed, the Centers for Medicare and Medicaid Services (CMS) increased payment rates for inpatient services by 3.4% in fiscal year 2004 and enacted a new rule governing the calculation of outlier payments. Since the changes to the outlier formula became effective in August 2003, we have been recognizing net revenue from outlier payments at estimated amounts determined under the new calculation formula. However, one of our Medicare fiscal intermediaries has continued to pay us at amounts

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calculated under the historical formula since August 2003. As such, our cash and cash equivalents at March 31, 2004 includes approximately $7.6 million, of which $2.8 million and $5.7 million was received during the second quarter and six months of fiscal year 2004, respectively, that we may be required to repay the Medicare program. The $7.6 million is also reflected as a reduction to our accounts receivable, net at March 31, 2004, consistent with our other estimated reimbursement settlements. The Medicare fiscal intermediary notified us in April 2004 that it would begin to pay us at rates consistent with the new calculation formula effective May 1, 2004 for our Medicare cost report year ending September 30, 2004. Accordingly, our cash and cash equivalents and our cash provided by operating activities will be positively impacted as we receive and reserve these payments through April 30, 2004; and our cash and cash equivalents and our cash provided by operating activities will be negatively impacted in the period during which we repay the amounts. Any changes in these new rules or other regulations governing the Medicare and Medicaid programs, or the manner in which they are interpreted, may result in a material change in our net revenue in future periods.

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

     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. Accordingly, this change in methodology will not have any impact on a retroactive basis to our consolidated financial position, results of operations and cash flows, as our four affected hospitals will not be required to repay the Medicare program for the reimbursed capital costs prior to August 11, 2003. On a prospective basis, the fiscal intermediary began making payments for capital cost reimbursement under the new methodology for all claims submitted after August 11, 2003. The impact of this change for fiscal 2003 was a $1.2 million reduction in our net revenue, and for the second quarter of fiscal 2004 was a $1.7 million reduction in our net revenue from the amount that would have been recognized under the previous reimbursement method. In addition, we estimate the impact of this change in reimbursement will be approximately $7.2 million for the full fiscal year 2004. 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 2004 through 2009 will be from $15.0 million to $16.0 million. As disclosed in our Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2003, CMS’s determination did not result in any changes to accounting estimates to our previously reported financial position, results of operations and cash flows for the fiscal year ended September 30, 2003.

     Critical Accounting Policies. During the six months ended March 31, 2004, we have made no material changes in the application of our critical accounting policies as set forth in our Annual Report on Form 10-K for the year ended September 30, 2003.

     Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

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

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          The following tables present, for the periods indicated, selected operating data on a consolidated basis and same facility basis.

(a)		Licensed beds represent the number of beds for which the appropriate state agency licenses a facility regardless of whether the beds are actually available for patient use.
(b)		Staffed and available beds represent the weighted average number of beds that are readily available for patient use during the period.
(c)		Admissions represent the number of patients admitted for inpatient treatment.
(d)		Adjusted admissions is a general measure of combined inpatient and outpatient volume. We computed adjusted admissions by dividing gross patient revenue by gross inpatient revenue and then multiplying the quotient by admissions.
(e)		Patient days represent the total number of days of care provided to inpatients.
(f)		Average length of stay (days) represents the average number of days inpatients stay in our hospital.
(g)		We computed occupancy by dividing patient days by the number of days in the period and then dividing the quotient by the number of staffed and available beds.

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     Net Revenue. Net revenue increased 28.2% to $173.3 million for the three months ended March 31, 2004, the second quarter of our fiscal year 2004, from $135.2 million for the three months ended March 31, 2003, the second quarter of our fiscal year 2003. Of this $38.1 million increase in net revenue, our hospital division generated a $42.1 million increase, which was offset in part by a $700,000 decrease in our diagnostics division and a $3.3 million decrease in our corporate and other division.

     The $42.1 million increase in hospital division net revenue was attributable to $20.8 million of net revenue growth from our four new hospitals, including Louisiana Heart Hospital which opened on February 28, 2003, The Heart Hospital of Milwaukee which opened on October 14, 2003, Texsan Heart Hospital which opened January 13, 2004 and Heart Hospital of Lafayette which opened March 2, 2004 and growth among our same facility hospitals, which accounted for the remaining $21.3 million increase. During the second quarter of fiscal 2004, we filed Medicare cost reports for fiscal year 2003 and as a result of changes in our estimates of final settlements based on additional information, we recognized contractual allowance adjustments that increased net revenue by approximately $1.4 million, of which approximately $1.1 million related to same facility hospitals. Similarly, during the second quarter of fiscal 2003 we filed Medicare cost reports for fiscal year 2002 and recognized adjustments that increased net revenue by approximately $800,000. On a consolidated basis, hospital admissions increased 29.5% and adjusted admissions increased 32.3% for the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. Also on a consolidated basis, inpatient catheterization procedures increased 27.8% and inpatient surgical procedures increased 19.8% for the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003, while average length of stay decreased 4.1% to 3.53 days for the current fiscal quarter compared to 3.68 days for the same prior fiscal quarter.

     The $21.3 million increase in net revenue contributed by our same facility hospitals, along with the increases in admissions of 19.2%, adjusted admissions of 21.5%, inpatient catheterization procedures of 14.8%, and inpatient surgical procedures of 7.7% within our same facility hospitals was largely due to the following factors:

•		the growth in operations of Harlingen Medical Center, which was newly opened during the first quarter of fiscal 2003;
•		the reopening of Bakersfield Heart Hospital’s emergency department in February 2003 after it was closed in the third quarter of fiscal 2002; and
•		the return to use of beds at one of our hospitals that were out of service during the second quarter of fiscal 2003.

     Excluding these three hospitals from our same facility comparison, our admissions increased 8.9% and our adjusted admissions increased 8.5% for our other same facility hospitals. Lastly, the increased reimbursement under the Medicare program associated with procedures utilizing drug-eluting stents contributed approximately $1.2 million to the increase in our net revenue during the second quarter of fiscal 2004.

     The $700,000 decrease in our diagnostics division net revenue was the net result of several key changes in this division. New diagnostic and therapeutic businesses developed and opened since the second quarter of fiscal 2003 contributed an increase of $900,000 and same facility diagnostic services contributed a $400,000 increase, which were offset by a $2.0 million decrease resulting from the dissolution of one of our hospital-based facilities, Gaston Cardiology Services, LLC, in November 2003. The $400,000 increase in our same facility diagnostic division net revenue was primarily the net result of growth in the number of procedures performed, including new services added, in one of our joint ventures, offset in part by a decline in the number of procedures performed in our mobile cardiac catheterization laboratories during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. Our mobile cardiac catheterization business has generally been declining in recent years as a result of a maturing market for such services. In response to this trend and consistent with our strategy, we have been, and will continue to be, focused on transitioning certain of our mobile business relationships into other businesses, such as interim leases or joint venture diagnostic and therapeutic facilities. As we continue to pursue business development opportunities with physicians and community hospital systems, the diagnostics division may become more significant to our net revenue and results of operations in future periods.

     The $3.3 million decrease in our corporate and other division net revenue during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003 was primarily due to a decrease in our cardiology consulting and management operations attributable to two key changes in that business. In the third quarter of fiscal 2003, we restructured one of our two physician management contracts, which reduced management fee revenue, but more significantly eliminated a pass-through cost reimbursement arrangement. In the first quarter of fiscal 2004, we changed certain vendor relationships associated with our second physician management contract to eliminate a substantial amount of pass-through cost reimbursement revenue. The cost reimbursement changes under these two contracts reduced both our net revenue and certain of our operating expenses by corresponding amounts, and therefore had no impact on our consolidated income from

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operations or our consolidated net loss for the second quarter of fiscal 2004. While we continue to receive pass-through cost reimbursement of certain personnel expenses under the terms of the second physician management contract, we may restructure this contract in the future, which could result in a similar decline in our net revenue and operating expenses in our corporate and other division in future periods.

     Personnel expense. Personnel expense increased 25.8% to $54.6 million for the second quarter of fiscal 2004 from $43.4 million for the second quarter of fiscal 2003. This $11.2 million increase in personnel expense was primarily due to a $12.4 million increase generated by our hospital division, offset in part by a $1.2 million decrease in our corporate and other division. Of the $12.4 million increase in hospital division personnel expense, our four new hospitals accounted for $8.3 million and our same facility hospitals accounted for the remaining $4.1 million. This increase in our same facility hospitals’ personnel expense was primarily attributable to the increase in admissions, inpatient catheterization and surgical procedures and net revenue for the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003, as previously discussed. The $1.2 million decrease in our corporate and other division’s personnel expense was due to the change in the physician management contracts in our cardiology consulting and management operations whereby certain reimbursed costs are no longer being passed through our operations, as previously discussed. As a percentage of net revenue, personnel expense decreased to 31.5% for the second quarter of fiscal 2004 from 32.1% for the second quarter of fiscal 2003. This decrease was primarily attributable to higher same facility hospital net revenue and the continued ramp up of Harlingen Medical Center, which opened in the first quarter of fiscal 2003, and Louisiana Heart Hospital, which opened in the second quarter of fiscal 2003, offset in part by the high personnel costs relative to net revenue associated with the ramp up of The Heart Hospital of Milwaukee, which opened in the first quarter of fiscal 2004, and Heart Hospital of Lafayette, which opened in the second quarter of fiscal 2004. On an adjusted patient day basis, which is another trend we monitor for this expense category, personnel expense for our consolidated hospitals increased by 4.0% to $1,076 per adjusted patient day for the second quarter of fiscal 2004 from $1,034 per adjusted patient day for the second quarter of fiscal 2003. However, personnel expense on an adjusted patient day basis for our same facility hospitals actually declined 5.5% to $960 from $1,016 for these same comparable quarters, which we believe is the result of our concentration on staffing levels, and recruiting and retention of nurses in our hospitals.

     Medical supplies expense. Medical supplies expense increased 44.2% to $47.0 million for the second quarter of fiscal 2004 from $32.6 million for the second quarter of fiscal 2003. This $14.4 million increase in medical supplies expense was due to a $13.7 million increase in our hospital division and a $700,000 increase in our diagnostics division. Of the $13.7 million increase in hospital division medical supplies expense, our four new hospitals accounted for $5.5 million and our same facility hospitals accounted for the remaining $8.2 million. This increase in same facility hospitals’ medical supplies expense was attributable to the increases in catheterization and surgical procedures performed during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. In addition, the increase in surgical procedures during 2004 was disproportionately comprised of cardiac procedures that use high-cost medical devices and supplies, such as automatic interior cardiac devices (AICD) and pacemaker procedures. During the second quarter of fiscal 2004, we experienced a 57.5% increase in the number of AICD procedures compared to the second quarter of fiscal 2003. We have experienced a general trend over the past few fiscal quarters in which the number of surgical procedures involving AICD and other higher cost medical devices and supplies has increased as a component of our mix of procedures. In addition, the introduction of drug-eluting stents in April 2003 contributed to higher medical supplies expense during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. We estimate in our hospital division that during the second quarter of fiscal 2004, approximately 39.9% of our cardiac procedures involving stents utilized drug-eluting stents and that the average utilization rate for drug-eluting stents in this division was 1.2 stents per case. The $700,000 increase in our diagnostic services division’s medical supplies expense was primarily attributable to the net revenue growth arising from the new services added at one of our joint ventures, as previously discussed, and the increased costs associated with drug-eluting stents during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. As a percentage of net revenue, medical supplies expense increased to 27.1% for the second quarter of fiscal 2004 from 24.1% for the second quarter of fiscal 2003. Similarly, hospital division medical supplies expense per adjusted patient day increased 15.2% for the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003, reflecting the increase in procedures that use high-cost devices and drug-eluting stents.

     We expect our same facilities’ medical supplies expense to continue to increase in future periods as new technologies are introduced into the cardiovascular care market and as we continue to experience increased utilization of AICD and pacemaker procedures that use high-cost devices. The amount of increase in our medical supplies expense, and the relationship to net revenue, in future periods will depend on many factors such as the introduction, availability, cost and utilization of the specific new technology by physicians in providing patient care, as well as any changes in reimbursement amounts we may receive from Medicare and other payors. We also expect our medical supplies expense in future periods will remain sensitive to changes in case mix of procedures at our hospitals as surgical procedures typically involve higher cost medical supplies than catheterization procedures. Given the significance of our medical supplies expense and the

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recent trends facing our business, management is very focused on this expense category. We recently completed a review of our supply chain and a bid process from which we selected MedAssets Inc. as our new group purchasing organization. We have executed a five-year agreement whereby MedAssets Inc. will assist us in our supply chain logistics, optimization, information technology related to supplies and product sourcing. Our goals include improving our purchasing economics and optimizing our inventory costs by improving our purchasing logistics.

     Bad debt expense. Bad debt expense increased 95.9% to $9.6 million for the second quarter of fiscal 2004 from $4.9 million for the second quarter of fiscal 2003. This $4.7 million increase in bad debt expense was primarily incurred by our same facilities hospitals, which accounted for $3.8 million of the increase. Our four new hospitals accounted for the remaining $900,000 increase for the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. The $3.8 million increase in our same facility hospitals’ bad debt expense was primarily attributable to growth in net revenue, as previously discussed. In addition, Harlingen Medical Center, which continues to ramp up, operates in a market with a historically higher percentage of self-pay patients than our other hospitals. Excluding the increase in net revenue related to our Medicare cost report estimates for the period and the amounts due to third party payors for estimated settlements under reimbursement programs from our accounts receivable, our same facility hospitals’ days of net revenue in accounts receivable, based on second fiscal quarter net revenue, was 56 days as of March 31, 2004 compared to 60 days as of March 31, 2003.

     As a percentage of net revenue, bad debt expense increased to 5.5% for the second quarter of fiscal 2004 from 3.6% for the second quarter of fiscal 2003. In our management discussion and analysis of results of operations for the first quarter of fiscal 2004, we estimated that our bad debt expense as a percentage of net revenue would, on average, range between 7.5% and 8.5% during the remainder of fiscal 2004. Our bad debt expense ratio was below this range during the current quarter primarily due to three factors:

•		strong cash collections — our hospital division collected 103% of its net revenue during the second quarter of fiscal 2004 compared to 98.5% during the first quarter of fiscal 2004.
•		improved Medicaid qualification – we qualified more eligible patients for Medicaid during the second quarter of fiscal 2004 than during the first quarter of fiscal 2004, which resulted in less self-pay receivables requiring bad debt allowances.
•		point of service collections – we improved collections of deductibles and co-payments at the time of service through implementing additional procedures in our admissions process during the second quarter of fiscal 2004.

     While we continue to focus efforts on our receivables collection procedures and other processes in our business offices and our hospitals admissions, we do not expect to realize significant sustainable decreases in our days of net revenue in accounts receivable in future periods as we may have realized in current and prior periods. We also expect our bad debt expense to increase in fiscal 2004 compared to fiscal 2003 due to an increase in operating activity related to the opening and ramp up of our new hospitals.

     Lastly, we believe our payor mix has a favorable impact on bad debt expense. Our hospital division derives approximately 50% of its net revenue from the Medicare program which, absent any billing process errors, typically remits payment to us within 14 to 21 days of submitting the bills. Our hospital division also derives slightly less than 5% of its net revenue from the Medicaid program which, absent any billing process errors, also remits timely payment to us. We believe our hospital division has a low denial rate with commercial payors and a high collection rate on net revenue from these payors. Self-pay accounts are our primary source of bad debts, and we have historically collected approximately 15% of such amounts. As of March 31, 2004, our allowance for bad debts represented approximately 88% of our self-pay accounts receivable.

     Other operating expenses. Other operating expenses increased 14.9% to $38.6 million for the second quarter of fiscal 2004 from $33.6 million for the second quarter of fiscal 2003. This $5.0 million increase in other operating expense was primarily due to a $7.5 million increase generated by our hospital division, offset in part by a $300,000 decrease in our diagnostics division and a $2.2 million decrease in our corporate and other division. Of the $7.5 million increase in our hospital division’s other operating expense, our four new hospitals accounted for $6.0 million and our same facility hospitals accounted for the remaining $1.5 million. This increase in our same facility hospitals’ other operating expense was primarily attributable to the growth in our same facility hospitals’ operations, including Harlingen Medical Center that was newly opened during the first quarter of fiscal 2003, and an overall increase in our insurance costs, including our medical malpractice insurance. These increases in other operating expenses were offset in part by decreases resulting from company-wide cost control initiatives. The $300,000 decrease in our diagnostics division was primarily attributable to the corresponding decrease in net revenue, as previously discussed. The $2.2 million decrease in our corporate and other division’s other operating expense was due to the change in the physician management contracts in our cardiology consulting and management operations whereby certain reimbursed costs are no longer being passed through our operations, as previously discussed. As a percentage of net revenue, other operating expenses decreased to 22.3% for the second

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quarter of fiscal 2004 from 24.9% for the second quarter of fiscal 2003. This decrease was primarily attributable to higher same facility hospital net revenue and the certain economies of scale achieved on the fixed cost components of our other operating expenses combined with the benefits realized from our company-wide cost control initiatives.

     Pre-opening expenses. Pre-opening expenses decreased 25% to $2.1 million for the second quarter of fiscal 2004 from $2.8 million for the second quarter of fiscal 2003. Pre-opening expenses represent expenses specifically related to projects under development, primarily new hospitals. Upon opening Heart Hospital of Lafayette on March 2, 2004, we have completed our hospital expansion plans that commenced three years ago, and we do not currently have any other hospitals under development. Accordingly, we are no longer incurring pre-opening expenses. The amount of pre-opening expenses, if any, we may incur in future periods will depend on the nature, timing and size of our development activities.

     Depreciation. Depreciation increased 11.1% to $11.0 million for the second quarter of fiscal 2004 from $9.9 million for the second quarter of fiscal 2003. This increase in depreciation primarily occurred in our hospital division and was due to the depreciation of assets placed in service upon the opening of our four new hospitals, offset in part by a decrease related to equipment that became fully depreciated during fiscal 2003 in certain of our same facility hospitals. We expect depreciation expense to increase for future periods in fiscal 2004 compared to fiscal 2003 due to our new hospitals opened during fiscal 2003 and fiscal 2004.

     Interest expense. Interest expense increased 16.1% to $7.2 million for the second quarter of fiscal 2004 compared to $6.2 million for the second quarter of fiscal 2003. This $1.0 million increase in interest expense was primarily attributable to an approximately $1.4 million increase from our four new hospitals, offset in part by a $400,000 decrease in our same facility hospitals. This decrease in interest expense in our same facility hospitals resulted from a decrease in outstanding debt through scheduled principal payments and prepayment reductions, and slightly lower interest rates on our variable rate debt during the second quarter of fiscal 2004 compared to the second quarter of fiscal 2003. In addition, we capitalized approximately $153,000 and $380,000 of interest expense as part of the capitalized construction costs of our hospitals that were under development during the second quarter of fiscal 2004 and 2003, respectively. We expect the total amount of our outstanding indebtedness will increase in future periods as a result of the debt we will primarily incur to complete the financing of additional equipment in our recently opened hospitals. We also expect the total of our outstanding indebtedness will increase for any debt we may incur to finance other growth opportunities that we may pursue as part of our business development efforts in fiscal 2004. Accordingly, we expect our interest expense to increase in future periods consistent with any increases in our indebtedness and changes in market interest rates.

     Equity in earnings of unconsolidated affiliates. Equity in earnings of unconsolidated affiliates remained flat at $1.1 million for the second quarter of fiscal 2004 compared to the prior year. The $1.1 million of equity in net earnings of unconsolidated affiliates for this quarter included $442,000 associated with a gain on sale of land by an unconsolidated affiliate of one of our hospitals. Excluding this gain, our equity in earnings of unconsolidated affiliates decreased approximately $359,000. This decrease was attributable to a decline in the operating results of our unconsolidated affiliate hospital primarily due to the reduction in that hospital’s capital cost reimbursement under the Medicare program as the hospital transitioned to the full federal payment methodology following its second full year of operations on October 1, 2003. We have only one hospital in which we hold less than a 50.0% equity interest and which we were required to account for as an equity investment during the second quarter of fiscal 2004 and 2003. We also continue to hold a small number of additional equity investments in our diagnostics division, our corporate and other division, and in one of our hospitals.

     Earnings allocated to minority interests. Earnings allocated to minority interests decreased to a loss allocation of $65,000 for the second quarter of fiscal 2004 from an income allocation of $1.8 million for the second quarter of fiscal 2003. This $1.9 million decrease was primarily due to changes in the operating results of our individual hospitals and the respective basis for allocating such earnings or losses among us and our partners on either a pro rata basis or disproportionate basis during the second quarter of fiscal 2004 compared to the same period of fiscal 2003. In general, our earnings allocated to minority interests decreased due to an increase in ramp up losses incurred by our new hospitals which were allocated to our minority partners on a pro rata basis combined with a decrease in earnings of certain of our same facility hospitals which were allocated to our minority partners on a pro rata basis. These reductions to our earnings allocated to minority interests were offset in part by a change from pro rata to disproportionate recognition of losses at one of our new hospitals that continues to ramp up combined with a change from pro rata recognition of losses to disproportionate recognition of earnings at one of our same facility hospitals during the second quarter of fiscal 2004 compared to the prior year. For a more complete discussion of our accounting for minority interests, including the basis for the disproportionate allocation accounting, see “Critical Accounting Policies” in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003. As evidenced this fiscal quarter, disproportionate recognition makes our earnings allocated to minority interests highly dependent on our mix of operating results among our individual hospitals and may cause the balance to vary significantly among periods and not remain proportional to our consolidated earnings before minority interest and taxes. During the second quarter of fiscal 2004, the disproportionate recognition of losses allocated to our minority interests had a positive impact of $1.1 million on our reported income before income taxes. During the second quarter of fiscal 2003, the disproportionate recognition of earnings allocated to our minority interests had a negative impact of $1.4 million on our reported income before income taxes.

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     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 profit recognition. As of March 31, 2004, we had remaining cumulative disproportionate loss allocations of approximately $21.0 million that we may recover in future periods. However, we may 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 tax expense was $1.6 million for the second quarter of fiscal 2004 compared to $393,000 for the second quarter of fiscal 2003, which represented an effective tax rate of approximately 38% and 40%, respectively. Because we continue to have federal and state net operating loss carryforwards available from prior periods to offset our current tax liability, we have no material current income tax liability.

     Six Months Ended March 31, 2004 Compared to Six Months Ended March 31, 2003

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

     The following tables present, for the periods indicated, selected operating data on a consolidated basis and same facility basis.

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