INTEGRATED HEALTHCARE HOLDINGS INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

FORWARD-LOOKING INFORMATION

This Annual Report on Form 10-K contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" herein that may cause our Company's or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results.

As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated.

Unless otherwise indicated, all amounts included in this Item 7 are expressed in thousands (except percentages and per share amounts).

OVERVIEW

On March 8, 2005, we completed our acquisition (the "Acquisition") of four Orange County, California hospitals and associated real estate, including: (i) 282-bed Western Medical Center - Santa Ana, CA; (ii) 188-bed Western Medical Center - Anaheim, CA; (iii) 178-bed Coastal Communities Hospital in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA (collectively, the "Hospitals") from Tenet Healthcare Corporation. The Hospitals were assigned to four of our wholly owned subsidiaries formed for the purpose of completing the Acquisition. We also acquired the following real estate, leases and assets associated with the Hospitals: (i) a fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa Ana, CA, a fee interest in the administration building at 1301 North Tustin Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in the medical office building at 999 North Tustin Avenue, Santa Ana, CA; (ii) a fee interest in the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa Ana, CA, and a fee interest in the medical office building at 1901 North College Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East Chapman Avenue, Orange, CA, and a fee interest in the medical office building at 2617 East Chapman Avenue, Orange, CA; and (v) equipment and contract rights. At the closing of the Acquisition, we transferred all of the fee interests in the acquired real estate (the "Hospital Properties") to Pacific Coast Holdings Investment, LLC ("PCHI"), a company owned 51% by various physician investors and 49% by our largest shareholder.

SIGNIFICANT CHALLENGES

COMPANY - Our Acquisition involved significant cash expenditures, debt incurrence and integration expenses that has seriously strained our consolidated financial condition. If we are required to issue equity securities to raise additional capital or for any other reasons, existing stockholders will likely be substantially diluted, which could affect the market price of our stock. In April 2010 we issued equity securities to existing shareholders and a new lender. (see "WARRANTS").

INDUSTRY - Our Hospitals receive a substantial portion of their revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement and resource utilization group rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services.

Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to have limited, payment increases. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations which may further affect payments.

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Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure and certification of facilities, and reimbursement. These regulations relate, among other things, to the adequacy of physical property and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with these regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Since these regulations are amended from time to time and are subject to interpretation, we cannot predict when and to what extent liability may arise. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including (with respect to inpatient care) fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility or site of service.

We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. Rights and remedies available to these programs include repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. These programs may also impose fines, criminal penalties or program exclusions. Other third-party payer sources also reserve rights to conduct audits and make monetary adjustments in connection with or exclusive of audit activities.

The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently our patients or customers or are otherwise receiving our services.

An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Also, a tightening of the reinsurance market has affected property, vehicle, and excess liability insurance carriers.

We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on our financial position, results of operations, and cash flows.

LIQUIDITY AND CAPITAL RESOURCES

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. We had a total stockholders' deficiency of $11.6 million and a working capital deficit of $14.7 million at March 31, 2012. For the year ended March 31, 2012, we had net income of $7.5 million. As discussed below, the stated maturity date of our $45.0 million Term Note under our Credit Agreements with Silver Point is April 13, 2013. If we are unable to refinance, restructure or extend our obligation to repay the principal amount by the maturity date, such failure would constitute a default under the Credit Agreement with Silver Point and our other loan facilities, which would permit Silver Point and our other lenders to seize our assets and those of our variable interest entity, PCHI. Any actions by Silver Point or our other lenders to enforce their rights by seizing our assets could force us into bankruptcy or liquidation, which would have a material adverse effect on our liquidity and financial position and the value of our common stock.

Key items for the year ended March 31, 2012 included:

   1.  Net service patient revenues (patient service revenues, net of contractual       allowances and discounts, less provision for doubtful accounts) for the       years ended March 31, 2012 and 2011 were $365.3 million and $423.1 million,       respectively, representing a decrease of 13.7%. The Hospitals serve a       disproportionate number of indigent patients and receive governmental       revenues and subsidies in support of care for these patients. Governmental       revenues include payments from Medicaid, Medicaid DSH, and Orange County, CA       (CalOptima). Governmental net revenues decreased $58.5 million for the year       ended March 31, 2012 compared to the year ended March 31, 2011. The primary       reason for the significant decrease in governmental net revenues related to       the Hospital Quality Assurance Fee program ("QAF") payments received from       the State of California. During the year ended March 31, 2012, we received       $31.9 million in QAF payments compared to $87.2 million during the year       ended March 31, 2011 (see "HOSPITAL QUALITY ASSURANCE FEES").   

Inpatient admissions decreased by 7.8% to 21.3 for the year ended March 31, 2012 compared to 23.1 for the year ended March 31, 2011. The decline in admissions is primarily related to reductions in managed care, shifts from inpatient to outpatient observation, and obstetrics admissions.

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Uninsured patients, as a percentage of gross charges (retail charges), were 5.3% for the year ended March 31, 2012 compared to 5.4% for the year ended March 31, 2011.

   2.  Operating expenses: Management is working aggressively to reduce costs       without reduction in service levels. These efforts have in large part been       offset by inflationary pressures. Operating expenses before interest for the       year ended March 31, 2012 were $352.6 million, or 6.8%, lower than during       the year ended March 31, 2011. The most significant factor of this decrease       related to QAF fees paid totaling $15.9 million and $47.8 million during the       years ended March 31, 2012 and 2011, respectively. Without including the QAF       fees in fiscal years 2012 and 2011, operating expenses before interest for       the year ended March 31, 2012 increased by $6.1 million over the same period       in fiscal 2011. The primary reason for this increase related to an increase       in salaries and benefits of $7.2 million, of which $4.7 million related to       increased costs of health insurance for our employees.   

DEBT - On April 13, 2010 (the "Effective Date"), we entered into an Omnibus Credit Agreement Amendment (the "Omnibus Amendment") with SPCP Group IV, LLC and SPCP Group, LLC (together, "Silver Point"), Silver Point Finance, LLC, as the Lender Agent, PCHI, Ganesha Realty LLC ("Ganesha"), Dr. Chaudhuri and KPC Resolution Company ("KPC"). KPC and Ganesha are companies owned and controlled by Dr. Chaudhuri, who is our majority shareholder. Ganesha owns a 49% membership interest in PCHI.

We entered into the Omnibus Amendment in connection with the Loan Purchase and Sale Agreement (the "Loan Purchase Agreement"), dated as of January 13, 2010, as amended, by and between KPC and the previous lender's receiver. Under the Loan Purchase Agreement, and as approved by the Court on April 2, 2010, KPC agreed to purchase all of the Credit Agreements from Medical Capital Corporation's receiver for $70.0 million. Concurrent with the closing of the Loan Purchase Agreement, KPC sold its interest in the Credit Agreements to Silver Point, and KPC purchased from Silver Point a 15% participation interest in the Credit Agreements. On April 13, 2010, concurrent with the effectiveness of the Omnibus Amendment and the closing of the Loan Purchase Agreement, Silver Point acquired all of the Credit Agreements, including the security agreements and other ancillary documents executed by us in connection with the Credit Agreements, and became the "New Lender" under the Credit Agreements.

The following are material terms of the Omnibus Amendment:

      ?    The stated maturity date under each Credit Agreement was changed to           April 13, 2013.       ?    Affirming release of prior claims between us and the previous lender's           receiver, Silver Point agreed to waive any events of default that had           occurred under the Credit Agreements and waived claims to accrued and           unpaid interest and fees of $6.4 million under the Credit Agreements as           of April 13, 2010.       ?    The $80.0 million Credit Agreement was amended so that the $45.0 million           term note (the "$45.0 million Loan") and $35.0 million non-revolving           line of credit note (the "$35.0 million Loan") will each bear a fixed           interest rate of 14.5% per year. These loans previously bore interest           rates of 10.25% and 9.25%, respectively. In addition, we agreed to make           certain mandatory prepayments of the $35.0 million Loan when we received           proceeds from certain new financing of our accounts receivable or           provider fee funds from Medi-Cal under the Hospital Quality Assurance           Fee program (see "HOSPITAL QUALITY ASSURANCE FEES PROGRAM"). The $35.0           million non-revolving line of credit was refinanced on August 30, 2010           (see below).       ?    The $50.0 million Revolving Credit Agreement was amended so that Silver           Point would, subject to the terms and conditions contained therein, make           up to $10.0 million in new revolving funds available to us for working           capital and general corporate purposes. Each advance under the $50.0           million Revolving Credit Agreement would bear interest at an annual rate           of Adjusted LIBOR (calculated as LIBOR subject to certain adjustments,           with a floor of 2% and a cap of 5%) plus 12.5%, compared to an interest           rate of 24.0% that was previously in effect under the $50.0 million           revolving credit agreement. In addition, we agreed to make mandatory           prepayments of the $50.0 million Revolving Credit Agreement under the           conditions described above with respect to the $80.0 million Credit           Agreement. The financial covenants under the $50.0 million Revolving           Credit Agreement were also amended to increase the required levels of           minimum EBITDA (as defined in the Omnibus Amendment) from the levels           previously in effect under the $50.0 million Revolving Credit Agreement.           This $50.0 million revolving line of credit was refinanced on August 30,           2010 (see below).       ?    The $10.7 million Credit Agreement was amended so that the $10.7 million           convertible term note will bear a fixed interest rate of 14.5% per year,           compared to the interest rate of 9.25% previously in effect and to           eliminate the conversion feature of the loan. In addition, we agreed to           make mandatory prepayments of the $10.7 million Credit Agreement under           the conditions described above with respect to the $80.0 million Credit           Agreement. This $10.7 million term note was refinanced on August 30,           2010 (see below).                                            25

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In connection with the sale of the Credit Agreements, all warrants and stock conversion rights issued to the previous lender were cancelled. In connection with the Omnibus Amendment, we issued new warrants (see "WARRANTS").

On August 30, 2010, we (excluding PCHI) entered into a Credit and Security Agreement (the "New Credit Agreement") with MidCap Financial, LLC, a commercial finance lender specializing in loans to middle market health care companies, and Silicon Valley Bank (collectively, the "AR Lender").

Under the New Credit Agreement, the AR Lender committed to provide up to $40.0 million in loans to us under a secured revolving credit facility (the "New Credit Facility"), which may be increased to up to $45.0 million upon our request, if the AR Lender consents to such increase. Upon execution of the New Credit Agreement, the AR Lender funded approximately $39.7 million of the New Credit Facility, which funds were used primarily to repay approximately $35.0 million in loans outstanding to affiliates of Silver Point ("Term Lender"). Upon such repayment, the remaining balances on our $35.0 million non-revolving line of credit loan, $50.0 million revolving credit agreement and $10.7 million credit agreement with the Term Lender were fully repaid and terminated. The only loan currently outstanding to the Term Lender consists of a $45.0 million Loan issued under our $80.0 million Credit Agreement.

The New Credit Facility is secured by a first priority security interest on substantially all of our assets, including the equity interests in all of our subsidiaries (excluding PCHI). The availability of the AR Lender's commitments under the New Credit Facility is limited by a borrowing base tied to our eligible accounts receivable and certain other availability restrictions.

Loans under the New Credit Facility accrue interest at LIBOR (subject to a 2.5% floor) plus 5.0% per annum, subject to a default rate of interest and other adjustments provided for in the New Credit Agreement. For purposes of calculating interest, all payments we make on the New Credit Facility are subject to a six business day clearance period. We also pay a collateral management fee of .0625% per month on the outstanding balance (or a minimum balance amount equal to 85% of the monthly average borrowing base (the "Minimum Balance Amount"), if such amount is greater than the outstanding balance), a monthly minimum balance fee equal to the highest interest rate applicable to the loans if the Minimum Balance Amount is greater that the outstanding balance, and an unused line fee equal to .042% per month of the average unused portion of the New Credit Facility. We paid to the AR Lender a non-refundable origination fee of 1.0% of the AR Lender's commitments under the New Credit Facility at closing.

The New Credit Agreement contains various affirmative and negative covenants and customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to similar obligations, events of bankruptcy and insolvency, judgment defaults, the invalidity of liens on collateral, and the occurrence of events which have a material adverse effect on us.

Amendment to $80.0 million Credit Agreement - Concurrently with the execution of the New Credit Agreement, on August 30, 2010 we entered into an amendment to its existing $80.0 million Credit Agreement, as amended (the "Original Credit Agreement"), with the Term Lender, PCHI, and Ganesha. Under this amendment, we agreed with the Term Lender to the following material changes to the Original Credit Agreement:

      ?    In the event of a mandatory prepayment of our accounts receivable based           financing facility under the Original Credit Agreement, the outstanding           loans under such agreement shall not be required to be prepaid below           $10.0 million. There is also a floor of $10.0 million below which           commitments under such accounts receivable based facility would not be           mandatorily reduced as a result of such prepayment.       ?    The Original Credit Agreement was amended to add an affirmative covenant           requiring us to deliver financial statements and other financial and           non-financial information to the Term Lender on a regular basis, and a           negative covenant requiring that we maintain a minimum fixed charge           coverage ratio of 1.0 and minimum levels of earnings before interest,           tax, depreciation and amortization.       ?    We agreed to the provisions of an Intercreditor Agreement executed on           August 30, 2010 by and between the AR Lender and the Term Lender with           respect to shared collateral of ours that is being pledged under both           the New Credit Agreement and the Original Credit Agreement. Under the           Intercreditor Agreement, among other things the Term Lender consented to           the AR Lender having a first priority lien on substantially all of the           operating company's assets while the Term Lender retained a second lien           on such assets, in addition to the Term Lender's first priority lien on           our leased properties owned by PCHI.   

On October 29, 2010, we entered into Amendment No. 1 to the New Credit Agreement, dated as of August 30, 2010, by and among us and the AR Lender. Under Amendment No. 1, the AR Lender committed to increase the total revolving loan commitment amount under the New Credit Agreement from $40.0 million to $45.0 million, and we agreed to pay to the AR Lender a non-refundable origination fee of 1.0% of the AR Lender's increased commitment under the amendment, or $50.

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Also under Amendment No. 1, the AR Lender agreed to allow the inclusion in Eligible Accounts that are used to determine our Borrowing Base of up to $33.6 million in aggregate federal or state matching payments to us related to the Hospital Quality Assurance Fee program (see "HOSPITAL QUALITY ASSURANCE FEES PROGRAM") which amount was increased from $11.8 million for the first matching payment.

In addition, the optional prepayment and permanent commitment reduction provisions of the New Credit Agreement were amended to change the minimum Revolving Loan Commitment Amount to $20.0 million from $5.0 million. In addition, the prepayment fee calculation under the New Credit Agreement was changed so that the prepayment fee is based on $40.0 million rather than the amount of the permanent revolving loan commitment reduction amount.

Lastly, under Amendment No. 1, in the event we permanently reduce our Revolving Loan Commitment Amount to $20.0 million (and assuming there is no Event of Default at the time), we would be permitted to transfer funds that are swept into the Lender's account from our lockbox accounts to a different bank account designated by us. Effective March 1, 2011, we reduced our Revolving Loan Commitment Amount to $20.0 million. Beginning in April 2011, the funds that were previously swept into the Lender's account were swept directly to our main account.

During the year ended March 31, 2012, we paid down the balance of the $20.0 million revolving line of credit to $14.0 million. On June 8, 2012, we entered into Amendment No. 2 to the New Credit Agreement with the AR Lender. Under Amendment No. 2, the minimum Revolving Loan Commitment Amount under the New Credit Agreement was permanently reduced from $20.0 million to $14.0 million, and the AR Lender agreed that no Prepayment Fee will be payable in connection with such reduction.As of March 31, 2012, we had the following Credit Agreements:

      ?    A $45.0 million Term Note issued under the $80.0 million Credit           Agreement, bearing a fixed interest rate of 14.5% per year ($45.0           million outstanding balance at March 31, 2012). If any event of default           occurs and continues, the lender can increase the interest rate to 19.5%           per year. As of March 31, 2012, we were in compliance with all financial           covenants. The stated maturity date for this Credit Agreement is April           13, 2013.       ?    A $20.0 million Revolving Credit Agreement, bearing an interest rate of           5.0% plus LIBOR, with a 2.5% floor, per year (7.5% at March 31, 2012)           and an unused commitment fee of 0.625% per year ($14.0 million           outstanding balance at March 31, 2012). For purposes of calculating           interest, all payments we make on the New Credit Facility are subject to           a six business day clearance period. As of March 31, 2012, we were in           compliance with all financial covenants. The stated maturity date for           this New Credit Facility is August 30, 2013.   

WARRANTS - On April 13, 2010 we issued warrants (the "Omnibus Warrants") to purchase our common stock for a period of three years at an exercise price of $0.07 per share in the following denominations: 139.0 million shares to KPC or its designees and 96.0 million shares to Silver Point or its designees. The Omnibus Warrants also provide the holders with certain pre-emptive, information and registration rights. As of April 13, 2010, we recorded warrant expense and the related warrant liability of $2.9 million, representing fair value. As of March 31, 2012, the fair value of the Omnibus Warrants was $952.

In addition, on April 13, 2010, we issued a three-year warrant (the "Release Warrant") to acquire up to 170.0 million shares of common stock at $0.07 per share to Dr. Chaudhuri who facilitated the release (see "DEBT") enabling us to recover amounts due from our prior lender and a $1.0 million reduction in principal of our outstanding debt, among other benefits to us. The Release Warrant also provides the holder with certain pre-emptive, information and registration rights. During the year ended March 31, 2010, we recorded the fair value of $2.1 million as an offsetting cost of the recovery. As of March 31, 2012, the fair value of the Release Warrant was $689.

The Omnibus Warrants and the Release Warrant are collectively referred to as the "April Warrants." The net gain (loss) related to the April Warrants for the year ended March 31, 2012 and 2011 was $(1.5) million and $1.9 million, respectively.

HOSPITAL QUALITY ASSURANCE FEES PROGRAM - In October 2009, the Governor of California signed legislation supported by the hospital industry to impose a provider fee on general acute care hospitals that, combined with federal matching funds, would be used to provide supplemental Medi-Cal payments to hospitals. The state submitted the plan to the Centers for Medicare and Medicaid Services ("CMS") for a required review and approval process, and certain changes in the plan were required by CMS. Legislation amending the fee program to reflect the required changes was passed by the legislature and signed by the Governor on September 8, 2010. Among other changes, the legislation leaves distribution of "pass-through" payments received by Medi-Cal managed care plans that will be paid to hospitals under the program to the discretion of the plans.

The hospital quality assurance fee program ("QAF") created by this legislation initially provided payments for up to 21 months retroactive to April 2009 and expiring on December 31, 2010 ("2010 QAF"). In February 2011, CMS gave final approval for the 2010 QAF. In December 2011, CMS gave final approval for the extension of the QAF for the six month period from January 1 through June 30, 2011 ("2011 QAF").

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During the year ended March 31, 2012, we recognized $31.9 million in revenue from the state for the 2011 QAF ($18.4 million from the fee-for-service portion and $13.5 million from the supplemental managed care portion). During the year ended March 31, 2012, we recorded expenses of $15.1 million for the 2011 QAF fees paid to the state and $0.8 million in other expenses relating to the 2011 QAF.

During the year ended March 31, 2011, we recognized $87.2 million in revenue from the state for the 2010 QAF ($44.4 million from the fee-for-service portion and $42.8 million from the supplemental managed care portion). During the year ended March 31, 2011, we recorded expenses of $44.7 million for the 2010 QAF fees paid to the state and $3.1 million in other expenses relating to the 2010 QAF.

We cannot provide any assurances or estimates in connection with a possible continuation of the QAF program beyond June 30, 2011.

ELECTRONIC HEALTH RECORDS INCENTIVE PROGRAM - Provisions of the American Recovery and Reinvestment Act of 2009 provide incentive payments for the adoption and meaningful use of certified electronic health record (EHR) technology. The Medicare EHR incentive program provides incentive payments to eligible hospitals (and certain other providers) that are meaningful users of certified EHRs. The Medicaid EHR incentive program provides incentive payments to eligible hospitals (and certain other providers) for efforts to adopt, implement, upgrade, or meaningfully use of certified EHR technology.

CMS has established the final rule which requires eligible providers in their first year of participation in the Medicaid incentive payment program to demonstrate that they have adopted (acquired, purchased, or secured access to), or implemented, or upgraded to certified EHR technology in order to qualify for an incentive payment. During the second and subsequent years of the program, eligible providers are required to meet other criteria, including meaningful use, to receive additional funds. We have been awarded a total amount of $13.6 million under the Medicaid EHR incentive program, which will be earned and received over a four year period.

We adopted certified EHR technology and we recognized income of $6.8 million relative to the first year under the Medicaid EHR incentive program during the year ended March 31, 2012.

LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY - On April 13, 2010, we and PCHI entered into a Second Amendment to Amended and Restated Triple Net Hospital Building Lease (the "2010 Lease Amendment"). Under the 2010 Lease Amendment, the annual base rent to be paid to PCHI was increased from $5.4 million to $7.3 million, but if PCHI refinances the $45.0 million Loan, the annual base rent may increase to $8.3 million. This lease commitment with PCHI is eliminated in consolidation.

COMMITMENTS AND CONTINGENCIES - The State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future. In addition, there could be other remediation costs pursuant to this seismic retrofit.

The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. All four Hospitals requested HAZUS review and received a favorable notice pertaining to structural reclassification. All Hospital buildings, with the exception of one (an administrative building), have been deemed compliant until January 1, 2030 for both structural and nonstructural retrofit. We do not have an estimate of the cost to remediate the seismic requirements for the administrative building as of March 31, 2012.

There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be costly and could have a material adverse effect on our cash flow. In addition, remediation could possible result in certain environmental liabilities, such as asbestos abatement.

On July 1, 2011, we entered into software and services agreements with McKesson Technologies Inc. ("McKesson") to upgrade our information technology systems.

Under the agreements, McKesson will provide us with a variety of services, including new software implementation and education/training services for our personnel, software maintenance services and professional services related to movement and migration of data from legacy systems. McKesson will also furnish to us and maintain new hardware to accommodate the upgraded software and systems. The new hardware will include computers and servers, among other things, and will include installation, testing, and ongoing maintenance. We have entered into the arrangement to enhance our clinical information systems and upgrade our billing and revenue management information systems.

The agreements will initially run for a period of five years, and the recurring services may be renewed by us for successive periods. The agreements do not provide that they may be terminated by us prior to the initial expiration date. The agreements provide for one-time fees and recurring fees which aggregate a total of $22.0 million. Approximately 60% of the fees are for one-time charges, while the balance is for recurring services.

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CASH FLOW - Net cash provided by operating activities for the years ended March 31, 2012 and 2011 was $4.5 million and $32.5 million, respectively. Net income, adjusted for depreciation and other non-cash items, excluding the provision for doubtful accounts and net income from non-controlling interests (not a measurement under accounting principles generally accepted in the United States of America ("GAAP"), totaled $14.2 million and $23.1 million for the years ended March 31, 2012 and 2011, respectively. We used $9.1 million and provided $9.8 million in working capital for the years ended March 31, 2012 and 2011, respectively. Net cash provided in payment of accounts payable, accrued compensation and benefits and other current liabilities was $4.3 million and $0.1 million for the years ended March 31, 2012 and 2011, respectively. Cash provided by accounts receivable, net of provision for doubtful accounts, was $1.1 million and $0.6 million for the years ended March 31, 2012 and 2011, respectively.

Net cash used in investing activities during the years ended March 31, 2012 and 2011 was $5.5 million and $1.7 million, respectively. In the years ended March 31, 2012 and 2011, we invested $5.5 million and $1.7 million in cash, respectively, in new property and equipment.

Net cash used in financing activities for the years ended March 31, 2012 and 2011 was $7.8 million and $20.4 million, respectively.

RESULTS OF OPERATIONS AND FINANCIAL CONDITIONThe following table sets forth, for the years ended March 31, 2012 and 2011, our consolidated statements of operations expressed as a percentage of net patient services revenues.

                                                                Year ended March 31,                                                                2012             2011  Net patient service revenues                                     100.0%          100.0%  Operating expenses: Salaries and benefits                                             59.9%           50.0% Supplies                                                          15.1%           12.5% Other operating expenses                                          20.4%           26.0% Depreciation and amortization                                      1.1%            1.0%                                                                   96.5%           89.5%  Operating income                                                   3.5%           10.5%  Other income (expense): Income from electronic health records incentive program            1.9%            0.0% Interest expense, net                                             (2.8% )         (2.9% )      Gain (loss) on warrants                                      (0.4% )          0.5%                                                                   (1.3% )         (2.4% )  Income before income tax provision (benefit)                       2.2%            8.1% Income tax provision (benefit)                                    (0.0% )          3.3% Net income                                                         2.2%            4.8% Net income attributable to noncontrolling interests               (0.1% )         (0.1% ) Net income attributable to Integrated Healthcare Holdings, Inc.                                                     2.1%            4.7%                                            29

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FISCAL YEAR ENDED MARCH 31, 2012 COMPARED TO FISCAL YEAR ENDED MARCH 31, 2011

NET PATIENT SERVICE REVENUES - Net patient service revenues for the year ended March 31, 2012 decreased 13.7% compared to fiscal year 2011, from $423.1 million to $365.3 million. Net patient service revenues for the year ended March 31, 2012 included QAF payments received from the State of California totaling $31.9 million and a lump sum distressed hospital fund payment of $50. Net patient service revenues for the year ended March 31, 2011 included QAF payments received from the State of California totaling $87.2 million and a lump sum distressed hospital fund payment of $450. If the QAF payments and one-time lump sum payments noted above are excluded, net patient service revenues for fiscal year 2012 were $2.1 million, or 0.6%, lower than fiscal year 2011 primarily due to a decline in admissions. The provision for doubtful accounts for the year ended March 31, 2012 was $40.4 million compared to $34.8 million for the year ended March 31, 2011, representing a 16.1% increase. The primary reason for the increase in the provision for doubtful accounts was related to the write off of receivables of $4.0 million due to the termination of Section 1011 of the Medicare Modernization Act of 2003 program which provided federal funding of emergency health services for "eligible aliens."

Admissions for the year ended March 31, 2012 decreased 8.0% compared to fiscal year 2011. The decline in admissions is the combined result of lower obstetrical deliveries, psychiatric admissions, and managed care contracts that have reached term and are pending renegotiation. Net patient service revenues per admission declined 6.2% during the year ended March 31, 2012 primarily due to the decrease in QAF payments received from the state.

Essentially all patient service revenues come from external customers. The largest payers are the Medicare and Medicaid (including Medicare and Medicaid managed care plans) programs accounting for 59.4% and 65.5% of the patient service revenues for the years ended March 31, 2012 and 2011, respectively.

Uninsured patients, as a percentage of gross charges, decreased to 5.3% from 5.4% for the year ended March 31, 2012 compared to the year ended March 31, 2011.

The Hospitals serve a disproportionate number of indigent patients and receive governmental revenues and subsidies in support of care for these patients. Governmental revenues include payments from Medicaid, Medicaid DSH, and Orange County, CA (CalOptima). Governmental net revenues decreased $58.5 million for the year ended March 31, 2012 compared to the year ended March 31, 2011. The primary reason for the significant decrease in governmental net revenues was related to a $55.3 million decrease in QAF payments received ($31.9 million) during the year ended March 31, 2012 compared to the QAF payments received ($87.2 million) during the year ended March 31, 2011.

OPERATING EXPENSES - Operating expenses for the year ended March 31, 2012 decreased to $352.6 million from $378.4 million, a decrease of $25.8 million, or 6.8%, compared to fiscal year 2011. The primary reason for decrease in operating expenses was related to a $31.9 million decrease in QAF fees paid during the year ended March 31, 2012 ($15.9 million) compared to the QAF fees paid during the year ended March 31, 2011 ($47.8 million). Operating expenses expressed as a percentage of net patient services revenues for the years ended March 31, 2012 and 2011 were 96.5% and 89.5%, respectively. On a per admission basis, operating expenses increased 1.3%.

Salaries and benefits increased $7.2 million (3.4%) for the year ended March 31, 2012 compared to fiscal year 2011. The increase is primarily due to an increase in health insurance ($4.7 million).

Other operating expenses during the year ended March 31, 2012 decreased to $74.5 million from $109.8 million, a decrease of $35.3 million, or 32.1%, compared to fiscal 2011, primarily due to the decrease in QAF fees paid, as described above.

OPERATING INCOME - The operating income for the years ended March 31, 2012 and 2011 was $12.7 million and $44.7 million, respectively. Of the $32.0 million decrease in operating income, $23.4 million related to the decrease in net QAF payments received.

OTHER INCOME (EXPENSE) - We adopted certified EHR technology and recognized other income of $6.8 million under the Medicaid EHR incentive program during the year ended March 31, 2012.

Interest expense for the year ended March 31, 2012 was $10.2 million compared to $12.0 million for the same period in fiscal year 2011. The decrease primarily related to the paydown of our revolving line of credit (see "DEBT").

On April 13, 2010, we issued warrants which had a fair value at the date of issuance of $5.0 million. Of the fair value on April 13, 2010, $2.1 million was related to the warrants issued to Dr. Chaudhuri and were a component of the recovery of overswept funds by our previous lender that was recorded during fiscal year 2010. The remaining $2.9 million was recorded as warrant expense during the year ended March 31, 2011. As of March 31, 2012, the fair value of the warrants aggregated $1.64 million compared to $167 as of March 31, 2011. Accordingly, a gain (loss) relating to the change in fair value of the April Warrants of $(1.5) million and $1.9 million was recorded during the years ended March 31, 2012 and 2011, respectively. See "WARRANTS."

NET INCOME - Net income for the years ended March 31, 2012 and 2011 was $7.5 million and $20.2 million, respectively.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

PATIENT SERVICE REVENUES - Patient service revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less contractual allowances and discounts, principally for patients covered by Medicare, Medicaid, managed care, and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Since Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what the Hospitals charge all other patients prior to the application of discounts and allowances.

Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Estimates of settlement receivables or payables related to a specific year are updated periodically and at year end and at the time the cost report is filed with the fiscal intermediary. Typically no further updates are made to the estimates until the final Notice of Program Reimbursement is received, at which time the cost report for that year has been audited by the fiscal intermediary. There could be a time lag of several years between the submission of a cost report and receipt of the Final Notice of Program Reimbursement. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. We have established settlement receivables of $190 and $456 as of March 31, 2012 and 2011, respectively.

The Hospitals receive supplemental payments from the State of California to support indigent care (Medi-Cal Disproportionate Share Hospital payments or "DSH") and from the California Medical Assistance Commission ("CMAC") under the SB 1100 and SB 1255 programs. The Hospitals received supplemental payments of $14.3 million and $21.4 million during the years ended March 31, 2012 and 2011, respectively. The related revenue recorded for the years ended March 31, 2012 and 2011, was $15.4 million and $20.6 million, respectively. As of March 31, 2012 and 2011, estimated DSH receivables were $5.0 million and $3.9 million, respectively, which are included as due from government payers in the accompanying consolidated balance sheets.

Revenues under managed care plans are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. Management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. We do not believe there were any adjustments to estimates of individual patient bills that were material to our patient service revenues.

The Hospitals provide charity care to patients whose income level is below 300% of the Federal Poverty Level. Patients with income levels between 300% and 350% of the Federal Poverty Level qualify to pay a discounted rate under AB 774 based on various government program reimbursement levels. Patients without insurance are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program ("MEP") screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. The estimated costs (based on direct and indirect costs as a ratio of gross uncompensated charges associated with providing care to charity patients) for the years ended March 31, 2012 and 2011 were approximately $7.0 million and $8.7 million, respectively.

Receivables from patients who are potentially eligible for Medicaid are classified as Medicaid pending under the MEP, with appropriate contractual allowances recorded. If the patient does not qualify for Medicaid, the receivables are reclassified to charity care and written off, or they are reclassified to self-pay and adjusted to their net realizable value through the provision for doubtful accounts. Reclassifications of pending Medicaid accounts to self-pay do not typically have a material impact on the results of operations as the estimated Medicaid contractual allowances initially recorded are not materially different than the estimated provision for doubtful accounts recorded when the accounts are reclassified. All accounts classified as pending Medicaid, as well as certain other governmental receivables, over the age of 90 days were reserved in contractual allowances as of March 31, 2012 and 2011 based on historical collections experience.

We previously received payments for "eligible alien" care under Section 1011 of the Medicare Modernization Act of 2003. During the year ended March 31, 2012, the federal funds available under Section 1011 were exhausted by the state and, as a result, we wrote-off $1.3 million in related receivables, net of previously accrued discount allowances. As of March 31, 2012 and 2011, we established a receivable in the amount of $0 and $1.6 million, respectively, related to discharges deemed eligible to meet program criteria.

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We are not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in our consolidated financial statements.

PROVISION FOR DOUBTFUL ACCOUNTS - We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of copayments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process.

Our policy is to attempt to collect amounts due from patients, including copayments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act ("EMTALA"). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In nonemergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated.

Effective March 31, 2012, we adopted Accounting Standards Update ("ASU") 2011-07, "Health Care Entities (Topic 954): Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities," which requires health care entities to present the provision for doubtful accounts relating to patient service revenue as a deduction from patient service revenue in the statement of operations rather than as an operating expense. All periods presented have been reclassified in accordance with the provisions of ASU 2011-07.

INCOME TAXES - Deferred income tax assets and liabilities are determined based on the differences between the book and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws using the asset and liability method. We assess the realization of deferred tax assets to determine whether an income tax valuation allowance is required. We have recorded a 100% valuation allowance on its deferred tax assets.

There is a recognition threshold and measurement attribute for recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction and California. Certain tax attributes carried over from prior years continue to be subject to adjustment by taxing authorities. Any penalties or interest arising from federal or state taxes are recorded as a component of our income tax provision.

INSURANCE - We accrue for estimated general and professional liability claims, to the extent not covered by insurance, when they are probable and reasonably estimable. We have purchased as primary coverage a claims-made form insurance policy for general and professional liability risks. Estimated losses within general and professional liability retentions from claims incurred and reported, along with incurred but not reported ("IBNR") claims, are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2012 and 2011, we had accrued $11.5 million and $11.3 million, respectively, which is comprised of $4.5 million and $6.6 million, respectively, in incurred and reported claims, along with $7.0 million and $4.7 million, respectively, in estimated IBNR. Estimated insurance recoveries of $3.0 million and $2.7 million are included in other prepaid expenses and current assets as of March 31, 2012 and 2011, respectively.

We have also purchased occurrence coverage insurance to fund our obligations under our workers compensation program. We have a "guaranteed cost" policy, under which the carrier pays all workers compensation claims, with no deductible or reimbursement required of us. We accrue for estimated workers compensation claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The ultimate costs related to this program include expenses for deductible amounts associated with claims incurred and reported in addition to an accrual for the estimated expenses incurred in connection with IBNR claims. Claims are accrued based upon projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2012 and 2011, we had accrued $673 and $836, respectively, comprised of $338 and $434, respectively, in incurred and reported claims, along with $335 and $402, respectively, in estimated IBNR.

In addition, we have a self-insured health benefits plan for our employees. As a result, we have established and maintain an accrual for IBNR claims arising from self-insured health benefits provided to employees. Our IBNR accruals at March 31, 2012 and 2011 were based upon projections. We determine the adequacy of this accrual by evaluating our historical experience and trends related to both health insurance claims and payments, information provided by our insurance broker and third party administrator and industry experience and trends. The accrual is an estimate and is subject to change. Such change could be material to our consolidated financial statements. As of March 31, 2012 and 2011, we had accrued $2.2 million and $1.8 million, respectively, in estimated IBNR.

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We have also purchased umbrella liability policies with aggregate limits of $25 million. The umbrella policies provide coverage in excess of the primary layer and applicable retentions for insured liability risks such as general and professional liability, auto liability, and workers compensation (employer's liability).

NEW ACCOUNTING STANDARDS

In August 2010, the FASB approved certain modifications to existing accounting standards that will directly affect health care entities in the future. The first change provides clarification to companies in the healthcare industry on the accounting for professional liability insurance. Specifically, it states that receivables related to insurance recoveries should not be netted against the related claim liability and such claim liabilities should be determined without considering insurance recoveries. The second change clarifies that disclosures regarding the level of charity care provided by a health care entity must (i) represent the direct and indirect costs of providing such services, and (ii) include a description of the method used to determine those costs. Additionally, disclosures about charity care must now include information regarding any related reimbursements received by a health care entity. The modified accounting standards are required to be adopted for fiscal years that begin after December 15, 2010. The charity care disclosure change must be applied on a retrospective basis; however, the accounting change for insurance recoveries may be applied on either a prospective or retrospective basis (the Company has applied the accounting change for insurance recoveries on a retrospective basis). The Company adopted the modified accounting standards during the yeard ended March 31, 2012, which did not have a material impact on the consolidated financial statements.

OFF BALANCE SHEET ARRANGEMENTS

As of March 31, 2012 we had no off-balance sheet arrangements.