SUNLINK HEALTH SYSTEMS INC - Quarter Report: 2004 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2004

OR

For the transition period from                      to                     

Commission File Number 1-12607

SUNLINK HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

900 Circle 75 Parkway, Suite 1300, Atlanta, Georgia 30339

(Address of principal executive offices)

(Zip Code)

(770) 933-7000

(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 filings 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

The number of Common Shares, without par value, outstanding as of May 14, 2004 was 7,072,153.

PART I. FINANCIAL INFORMATION

SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share amounts)

(unaudited)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See notes to condensed consolidated financial statements.

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SUNLINK HEALTH SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTHS ENDED MARCH 31, 2004

(dollars in thousands, except share and per share amounts)

(unaudited)

Note 1. – Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements as of and for the three and nine months ended March 31, 2004 have been prepared in accordance with Rule 10-01 of Regulation S-X of the Securities and Exchange Commission and, as such, do not include all information required by accounting principles generally accepted in the United States of America. These Condensed Consolidated Financial Statements should be read in conjunction with the consolidated financial statements included in the SunLink Health Systems, Inc. (“SunLink” or the “Company”) Annual Report on Form 10-K for the fiscal year ended June 30, 2003, filed on September 26, 2003. In the opinion of management, the Condensed Consolidated Financial Statements, which are unaudited, include all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations for the periods indicated. The results of operations for the three and nine months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the entire fiscal year or any other interim period.

Note 2. – Business Operations and Corporate Strategy

SunLink is a provider of healthcare services through the operation of exurban and rural community hospitals in the United States. In February 2001, SunLink acquired its initial six hospitals and began healthcare operations. On October 3, 2003, SunLink acquired two additional hospitals from HealthMont, Inc. Through its subsidiaries, SunLink currently operates a total of eight community hospitals in four states. Seven of the hospitals are owned and one is leased. SunLink also operates certain related businesses, consisting primarily of nursing homes located adjacent to certain of its hospitals, and home health agencies servicing areas around its hospitals. The healthcare operations comprise a single business segment: community hospitals. SunLink currently does not have operations in other business segments. SunLink’s hospitals are acute care hospitals and have a total of 437 licensed beds.

On April 12, 2004, SunLink announced it had entered into a definitive agreement to sell its Mountainside Medical Center (“Mountainside”) hospital, a 35 bed hospital located in Jasper, GA for approximately $40,000. The transaction, which is subject to various conditions and approvals, is expected to be completed in SunLink’s fourth fiscal quarter ending June 30, 2004. The service area of Mountainside is a fast growing area in the northern Atlanta metropolitan statistical area, which the Company believes is trending toward suburban characteristics which are different from the characteristics of exurban and rural area hospitals on which SunLink’s business strategy is based. Such changing characteristics contributed to SunLink’s decision to sell Mountainside.

SunLink’s business strategy is to focus its efforts on internal growth of its remaining seven hospitals supplemented by growth from selected hospital acquisitions. During the nine months ended March 31, 2004, SunLink concentrated its efforts as discussed in Note 4, on the acquisition of HealthMont, Inc., the sale of Mountainside, as further discussed in Note 3, and the operation and improvement of its existing hospitals. SunLink continues to evaluate certain hospitals which are for sale and monitor selected hospitals which SunLink has determined might become available for purchase.

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Note 3. – Discontinued Operations

All of the businesses discussed below are reported as discontinued operations and the condensed consolidated financial statements for all prior periods have been adjusted to reflect this presentation.

Results for all of the businesses included in discontinued operations are presented in the following table:

Mountainside Medical Center – On April 12, 2004, SunLink announced it has entered into a definitive agreement to sell its Mountainside Medical Center hospital in Jasper, Georgia, for approximately $40,000. SunLink’s Board of Directors approved the plan to sell Mountainside on March 31, 2004. SunLink has agreed to sell the operations of Mountainside which includes the property, plant and equipment and the supplies inventory. SunLink will retain Mountainside’s working capital except for supplies inventory. It is contemplated that the net proceeds of the sale will be used to repay debt and related transaction costs. The transaction, which is subject to various conditions and approvals, is expected to be completed in SunLink’s fourth fiscal quarter ending June 30, 2004. The book value of the property, plant and equipment and the supplies inventory to be sold of $18,697 at March 31, 2004 is included in assets held for sale on the condensed consolidated balance sheet.

On September 30, 2002, SunLink entered into a $6,000 secured bank financing facility (the “Mountainside Financing Facility”) to provide financing for the construction of the Mountainside Medical Center replacement hospital in Jasper, Georgia, which replaced an older hospital, also located in Jasper, Georgia. As of March 31, 2004, SunLink had borrowed $5,700 under a construction loan with interest at prime plus 1% per annum, which is included in current liabilities of Mountainside Medical Center on the condensed consolidated balance sheet. Under the Mountainside Financing Facility, the construction loan may be converted to a 20-year mortgage loan, subject to certain conditions, by July 1, 2004. The 20-year mortgage loan option

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would bear interest at prime plus 1% per annum or, at SunLink’s option, interest at the 5-year U.S. Treasury Constant Maturity Yield plus 3 ½%. The actual mortgage loan interest rate is adjustable every 5 years. The Mountainside Financing Facility requires SunLink to comply with certain conditions and covenants including hospital financial and operational covenants, information requirements and limitations on secured debt incurred by the hospital subsidiary. It is anticipated that SunLink will be required to repay the Mountainside Financing Facility upon the closing of the sale of Mountainside.

The retained assets and liabilities of Mountainside are shown as current assets, current liabilities and noncurrent assets of Mountainside on the condensed consolidated balance sheet, including the retained patient receivables and current liabilities.

SunLink opened its new Mountainside Medical Center replacement hospital in Jasper, Georgia in May 2003. At that time, all hospital operations at the old hospital facility ceased. During the nine months ended March 31, 2003, SunLink determined that the carrying value of its old hospital and an adjacent medical office building exceeded their estimated fair value by $1,482 and $80, respectively. An impairment loss of $1,562 was recorded to write the hospital and medical office building down to fair value. Fair value was determined by SunLink based upon management’s determination of the best future use of the facilities and the estimated discounted cash flows generated by these uses. The medical office building is being retained and continues to be leased to medical practitioners. The old hospital facility was sold in March 2004 for $500 at a loss of $8 from the earlier estimated fair value which is included in the results of discontinued operations for the three and nine months ended March 31, 2004.

Life Sciences and Engineering Segment – SunLink retained a defined benefit retirement plan which covered substantially all of the employees of this segment when it was sold in fiscal 1998. Included in discontinued operations for the three and nine months ended March 31, 2004 and 2003, respectively were the following:

Also included in discontinued operations for the nine months ended March 31, 2004 is $30 of partial pension termination expense and a $57 income tax benefit related to the adjustment to the minimum pension liability account. SunLink has contributed $153 to the plan in the nine months ended March 31, 2004 and expects to contribute an additional $43 through the end of the fiscal year ended June 30, 2004, as required by the Employee Retirement Income Security Act of 1974.

Housewares Segment – Non-current liabilities of discontinued operations at March 31, 2004 include $1,247 relating to the former housewares segment which represents a reserve for a portion of a guarantee by a U.K. subsidiary of SunLink with respect to obligations of a former subsidiary under a lease covering a portion of the manufacturing location of the former subsidiary. The reserve for the subsidiary’s obligation under such lease is based upon management’s estimate, after consultation with its property consultants and legal counsel, of the cost, including lease payments, to satisfy the lease obligation. The guarantee runs through March 2019. The U.K. subsidiary of SunLink is currently inactive, and entered into the guarantee for the former subsidiary’s lease obligation when the former subsidiary was owned by the SunLink U.K.

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subsidiary. The maximum potential obligation of SunLink’s U.K. subsidiary under the guarantee would be approximately $9,000. SunLink’s currently inactive U.K. subsidiary has an option to repurchase the capital stock of the disposed subsidiary for nominal consideration if any U.K. subsidiary of SunLink is called upon to perform under the lease guarantee and under certain other conditions. For the nine months ended March 31, 2003, earnings from discontinued operations included $331 relating to a domestic capital loss tax carry-back on the disposal of the Housewares segment subsidiary. It resulted from carrying back capital losses on SunLink’s investment in the subsidiary against capital gains of earlier years.

Child Safety Segment – In January 2001, SunLink sold its European child safety subsidiary Klippan Limited. During the three months ended March 31, 2004, SunLink was notified that a tax loss related to Klippan in the United Kingdom in the fiscal year it was sold was reduced and additional tax of $65 was owed. This expense is included in the results of discontinued operations for the three and nine months ended March 31, 2004.

Industrial Segment – In fiscal 1989, SunLink discontinued the operations of its industrial segment and subsequently disposed of substantially all related net assets. However, obligations may remain relating to product liability claims for products sold prior to the disposal. Liabilities of discontinued operations at March 31, 2004 and June 30, 2003 of $426 and $495, respectively, relate to the industrial segment.

Over the past fifteen years SunLink has discontinued operations carried on by its former industrial, U.K. leisure marine, life sciences and engineering, U.K. child safety and U.K. housewares segments. SunLink’s reserves related to discontinued operations of these segments represent management’s best estimate of the possible liability for property, product liability and other claims for which SunLink may incur liability. These estimates are based on management’s judgments using currently available information as well as, in certain instances, consultation with its insurance carriers and legal counsel. While estimates are based on the evaluation of available information, it is not possible to predict with certainty the ultimate outcome of many contingencies relating to discontinued operations. SunLink intends to adjust its estimates of the reserves as additional information is developed and evaluated. However, management believes that the final resolution of these contingencies will not have a material adverse impact on the financial position, cash flows or results of operations of SunLink.

Note 4. – Acquisition of HealthMont, Inc.

On October 3, 2003, SunLink completed the acquisition with HealthMont, Inc. (“HealthMont”), a privately held operator of community hospitals, through the merger of a wholly-owned subsidiary of SunLink with HealthMont. Upon the consummation of the transaction, SunLink acquired two community hospitals: Memorial Hospital of Adel, a 60-bed acute-care hospital in Adel, Georgia, which includes a 95-bed nursing home, and Callaway Community Hospital, a 49-bed acute-care hospital in Fulton, Missouri. The results of operations of HealthMont are included in the results of operations for the Company from October 3, 2003 through the end of the current fiscal quarter, March 31, 2004. The Company believes that the two HealthMont hospitals it acquired are compatible with its business strategy of operating rural and exurban community hospitals.

Under the terms of the merger agreement, SunLink, among other things, issued to the shareholders of HealthMont 1,135,782 common shares of SunLink in consideration for all issued and outstanding capital stock of HealthMont. SunLink also issued 95,000 shares of SunLink to settle certain contractual obligations of HealthMont to its officers and directors. Additionally SunLink is obligated to issue 19,005 common shares in connection with certain SunLink options issued in replacement of previously outstanding HealthMont options.

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Based on the average market price of SunLink’s common shares of $2.26 per share calculated based on the price two days before, the day of and two days after the amended merger agreement was entered into, plus the amount of senior debt and capital lease obligations assumed, plus transaction costs, the price to SunLink of the transaction was approximately $15,000. For financial reporting purposes, the average market value of SunLink’s common shares was set as of the date of the first amendment of the merger agreement, March 24, 2003. The preliminary balance of the purchase price in excess of the fair value of the assets acquired and liabilities assumed at the date of the acquisition was recorded as goodwill totaling $4,210. The purchase price was established at March 31, 2003 based upon, among other things, the expected future operating results of the two hospitals. The final allocation of the purchase price to the fair value of assets acquired and liabilities assumed must be completed within one year of the merger date.

In connection with the merger, SunLink assumed HealthMont’s debt, which was approximately $8,275 at closing. HealthMont obtained the consent of its senior lender to the merger and the modification of certain terms of HealthMont’s senior debt, including an extension of the maturity date of the debt to August 31, 2005. Certain HealthMont investors arranged letters of credit which support up to $1,650 of HealthMont’s revolving credit loans with HealthMont’s senior lender. SunLink has agreed, in the event the letters of credit are drawn and the proceeds are applied to the outstanding balance of the revolving credit loans, to issue to such letter of credit obligors 350,000 SunLink common shares in full satisfaction of HealthMont’s reimbursement obligations under the letters of credit. Beginning October 3, 2003, SunLink is paying to such letter of credit obligors a 5% annual commitment fee paid monthly through March 31, 2005 in consideration for their obligation to maintain the letters of credit in effect.

Prior to the merger transaction, on March 24, 2003, SunLink assumed management of HealthMont’s Adel, Georgia and Fulton, Missouri hospitals under a management agreement for a fee of $80 per month ($50 per month in cash and $ 30 per month deferred) and extended loans to HealthMont totaling $1,600 at October 3, 2003. SunLink recorded the $50 cash management fee paid as a reduction of other operating expenses for the period prior to the merger. The loan was recorded as part of the purchase price upon consummation of the merger.

On October 3, 2003, SunLink’s new HealthMont subsidiary also entered into a three year secured term loan for $2,300 with a third-party lender. The loan is guaranteed by SunLink. The proceeds of the loan were used for certain transaction costs and for working capital needs. The loan bears an interest rate of 15% per annum and requires SunLink to pay certain fees.

SunLink did not acquire HealthMont’s corporate staff and offices in connection with the merger and did not add any corporate staff or significantly increase its overhead as a result of the merger. Upon consummation of the merger, the board of directors of SunLink elected Gene E. Burleson, a former HealthMont director, to serve the remainder of the unexpired term of Ronald J. Vannuki, who stepped down from the Company’s board.

In the nine months ended March 31, 2003, SunLink expensed $411 of capitalized costs relating to the then proposed HealthMont merger because SunLink could not determine at that time that it was probable that the merger would be completed.

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The Company is in the process of obtaining third-party valuations of certain intangible assets; accordingly the allocation of the purchase price is preliminary. The following table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of the acquisition:

The following pro forma statements of earnings for the three and nine months ending March, 31, 2004 and 2003, respectively give effect to SunLink’s acquisition of HealthMont as if it had occurred as of July 1, 2002:

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Note 5. – Stock-Based Compensation

SunLink measures compensation costs for stock options issued to employees and directors using the intrinsic value-based method of accounting. Pro forma net earnings (loss) and net earnings (loss) per share amounts that would have resulted had compensation costs been determined using the fair value-based method are as follows:

Note 6. – Recent Accounting Pronouncements

In April 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. In particular, this statement clarifies the circumstances under which a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. This statement is effective for contracts entered into or modified after June 30, 2003 and is not expected to have a material impact on the Company’s financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both a liability and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of these instruments were previously classified as equity. This statement is effective for financial instruments entered into or modified on or after May 15, 2003 and is not expected to have a material impact on the Company’s financial condition or results of operations.

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In December 2003, the FASB issued SFAS No. 132(R) “Employers’ Disclosures about Pension and Other Postretirement Benefits”. SFAS No. 132(R) revises employers’ disclosures about pension plans and other postretirement benefit plans. It retains the disclosure requirements contained in SFAS No. 132 “Employers’ Disclosures about Pension and Other Postretirement Benefits, which it replaces. It requires additional disclosures to the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. This statement is effective for fiscal years ending after December 15, 2003 and is not expected to have a material impact on the Company’s financial condition or results of operations.

Note 7. – Receivables- net

Net revenues included $385 and $0 for the three months ended March 31, 2004 and 2003, respectively, for the settlements and filings of prior year third-party payor issues. Net revenues included $545 and $953 for the nine months ended March 31, 2004 and 2003, respectively, for the settlements and filings of prior year third-party payor issues. Net revenues for the three and nine months ended March 31, 2004 included $406 and $1,115, respectively, from a state indigent care program.

Note 8. – Long-Term Debt

Seller Financing - In connection with the acquisition of SunLink’s initial six hospitals, SunLink Healthcare Corp. (“SHC”), a wholly-owned subsidiary of the Company, issued an 8.5% senior subordinated note in the face amount of $17,000 and a senior subordinated zero coupon note in the face amount of $2,000, to the seller of the hospitals (collectively the “SHC Notes”).

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The senior subordinated note is due on January 31, 2006. Interest on the note was payable semiannually either in cash or additional promissory notes through August 1, 2003 and currently is payable in cash. Pursuant to the pay in kind feature, additional promissory notes for $3,862 for interest from February 1, 2001 through August 31, 2003 were issued. The accrued interest payable at March 31, 2004 of $291 is due on July 31, 2004. The stated interest rate of 8.5% on the senior subordinated note was considered a below-market interest rate at the date of issuance; therefore, the note was discounted to estimated market value at an effective interest rate of 12.3%. The discount recorded on the senior subordinated note was $2,873.

The senior subordinated zero coupon note matured and was paid on January 31, 2004 in the amount of $1,650. The interest rate on the senior subordinated zero coupon note was considered less than the market rate at the date of issuance, therefore, the note was discounted to an estimated market interest rate of 11.3%. The original issue discount on the senior subordinated zero coupon note was $490.

The discounts on the SHC Notes were determined in consultation with SunLink’s financial advisor based on high-yield debt instruments of similar health care providers and are being amortized over the term of the related debt instrument using the effective interest method. For the three months ended March 31, 2004 and 2003, amortization expense was recognized on the discounts of $177 and $168, respectively, and for the nine months ended March 31, 2004 and 2003, $582 and $497, respectively.

The loan agreement pursuant to which the SHC Notes were issued requires that SHC grant to the lender a security interest in, and mortgage on, collateral consisting of SHC and its subsidiaries’ real and personal property, unless SHC has outstanding senior indebtedness that meets certain conditions. The senior subordinated note presently is not collateralized. Each of the individual hospital subsidiaries of SHC was a guarantor of the senior subordinated zero coupon note and is a guarantor of the senior subordinated note. Further, the senior subordinated note is subordinate in payment and collateral to all defined senior indebtedness of SHC which in the aggregate may not exceed $15,000, other than debt incurred after the issuance of such notes in connection with certain permitted acquisitions. The loan agreement also prohibits the payment of dividends or other distributions in respect of capital stock of SHC or other payments to SunLink.

SunLink Credit Facility - On January 4, 2002, SunLink entered into a $14,000 credit facility comprised of a secured revolving credit facility (which expires December 31, 2005) for loans of up to $8,000 with interest at prime plus 1.25% and a $6,000 secured term loan repayable in monthly installments through June 30, 2007 at an interest rate of 9.78%. The availability of borrowings under the SunLink revolving credit facility is based upon, among other things, a borrowing base keyed to the level of SHC receivables which, based upon the Company’s estimates, provided borrowing capacity of approximately $8,000 at March 31, 2004. Borrowings under the SunLink revolving credit facility were $4,672 at March 31, 2004. The revolving line of credit is secured by the patient accounts receivable of SHC. The SunLink revolving line of credit facility lender filed for bankruptcy on August 25, 2003. Subsequent to the bankruptcy filing and through March 31, 2004, the revolving credit facility lender has funded the line daily by the amount of SHC’s accounts receivable received by the lender to pay down the revolving line of credit plus additional advances of $1,158. The net proceeds from the secured term loan of $5,800 ($6,000 secured term loan less $200 costs and fees) were used for working capital and to fund a portion of SunLink’s hospital capital projects which include the replacement hospital in Jasper, Georgia (which opened in May 2003), and a new emergency room at its hospital in Ellijay, Georgia. The term loan is secured by liens on SHC’s real and personal property, except for the Jasper, Georgia hospital and patient accounts receivables, as well as by the capital stock owned by SHC and its subsidiaries. Also, each of the SHC hospital subsidiaries is a guarantor of the loan.

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HealthMont Term Notes – On March 21, 2003, in connection with the HealthMont merger, SunLink borrowed $700 under a commitment for a $3,000, three-year secured term loan with an interest rate of 15% (the “HealthMont Term Notes I”). SunLink’s new HealthMont subsidiary borrowed the remaining $2,300 under the commitment at the closing of the HealthMont merger on October 3, 2003 through the sale of 15% notes due August 2005 (the “HealthMont Term Notes II”).

HealthMont Mortgage I – In connection with the merger with HealthMont on October 3, 2003, SunLink assumed a mortgage loan of $2,926 which bears interest at prime plus 2% and is payable in quarterly principal installments of $83 plus interest, with the remaining unpaid balance of $2,262 due on August 31, 2005. The mortgage is secured by the real and leased property of the HealthMont subsidiary’s Adel, Georgia facility. The agreement requires the HealthMont subsidiary to comply with certain conditions and covenants including financial and operational covenants. This mortgage is guaranteed by SunLink.

HealthMont Mortgage II– In connection with the merger with HealthMont on October 3, 2003, SunLink assumed a mortgage loan of $1,560 which bears interest at prime plus 2% and is payable in quarterly principal installments of $32 plus interest, with the remaining unpaid balance of $1,304 due on August 31, 2005. The mortgage is secured by the real and leased property of the HealthMont subsidiary’s Fulton, Missouri facility. The agreement requires the HealthMont subsidiary to comply with certain conditions and covenants including financial and operational covenants. This mortgage is guaranteed by SunLink.

HealthMont Revolving Loan – In connection with the merger with HealthMont, SunLink assumed an $8,000 revolving loan agreement, which SunLink guaranteed, which had borrowings of $2,807 at the merger date. The loan bears interest of prime plus 1.5% and the agreement expires August 31, 2005. All of the receipts of the HealthMont subsidiary are required to be deposited with the lender as payment on the revolving loan and borrowings are made weekly for working capital needs. The amount available is based upon several factors, including liquidity, as defined, of the HealthMont subsidiaries’ patient accounts receivable. As of March 31, 2004, the Company had $3,002 of borrowings outstanding and no unused availability under the HealthMont revolving loan agreement. The HealthMont revolving loan is secured by the personal property of the HealthMont subsidiary and letters of credit guaranteed by certain persons who were shareholders of HealthMont prior to the acquisition and who currently are shareholders of SunLink. The agreement requires SunLink’s HealthMont subsidiary to comply with certain conditions and covenants including financial and operational covenants. This revolving loan is guaranteed by SunLink.

The debt capacity of SunLink’s subsidiaries, SunLink Healthcare Corp. and HealthMont Inc., is limited and is subject to certain financial and other covenants under their debt agreements. Under the most limiting of such covenants, SHC would, at March 31, 2004, have been able to incur up to approximately $703 of additional indebtedness. The HealthMont subsidiary had no additional borrowing capacity at March 31, 2004.

Certain indebtedness with respect to SunLink’s Mountainside Medical Center has been reclassified to current liabilities of Mountainside Medical Center on the condensed consolidated balance sheet. See Note 3.

Note 9. – Income Taxes

Income tax expense of $61 ($20 federal benefit and $81 state taxes) and $70 ($7 federal benefit and $77 state taxes) was recorded for the three months ended March 31, 2004 and 2003, respectively. Income tax expense of $187 ($20 federal benefit and $207 state taxes) and $229

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($61 federal and $168 state taxes) was recorded for the nine months ended March 31, 2004 and 2003, respectively. SunLink had a federal net operating loss carryforward (which expires in 2020, 2021 and 2022) of approximately $8,800 at March 31, 2004. Use of this net operating loss carryforward is subject to the limitations of the provisions of Internal Revenue Code Section 382. As a result, not all of the net operating loss carryforward is useable to offset federal taxable income in the current year. At March 31, 2004, SunLink has provided a valuation allowance for the entire amount of the deferred tax asset (the majority of which is the federal net operating loss carryforward) as it was management’s assessment based upon the criteria identified in SFAS No. 109, that it was currently more likely than not that none of the deferred tax asset will be realized through future taxable earnings or implementation of tax planning strategies.

Note 10. – Comprehensive Earnings

Comprehensive earnings for SunLink include foreign currency translation adjustments. Total comprehensive earnings for the following periods were as follows:

Note 11. – Commitments and Contingencies

As discussed in Note 3 – “Discontinued Operations”, among other things, a U.K. subsidiary of SunLink remains contingently liable as guarantor of obligations under a lease of a former U. K. subsidiary covering a portion of such former subsidiary’s manufacturing location. The maximum potential obligation of SunLink’s U.K. guarantor subsidiary under the guarantee would be approximately $9,000.

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As of March 31, 2004, SunLink had no material future commitments for capital expenditures. Subject to the availability of internally generated funds and other financing, SunLink expects to spend approximately $500 in capital expenditures during the remaining three months of the fiscal year ending June 30, 2004, primarily for new and replacement equipment.

SunLink is a party to claims and litigation incidental to its business, as to which it is not currently possible to determine the ultimate liability, if any. Based on an evaluation of information currently available and consultation with legal counsel, management believes that resolution of such claims and litigation is not likely to have a material effect on the financial position, cash flows or results of operations of SunLink.

On February 20, 2004 and March 3, 2004, two similar class action proceedings, respectively captioned Mary Ross v. Robert M. Thornton, Jr., Dr. Steven J. Baileys, Michael W. Hall, Gene E. Burleson, Karen B. Brenner, C. Michael Ford, Howard E. Turner, and SunLink Health Systems, Inc., Case No. 2004-CV-81871, filed February 20, 2004 (Superior Court of Fulton County, Georgia) (“Ross”) and Roger Barber v. Robert M. Thornton, Jr., Dr. Steven J. Baileys, Michael W. Hall, Gene E. Burleson, Karen B. Brenner, C. Michael Ford, Howard E. Turner, and SunLink Health Systems, Inc., Case No. 2004-CV-82484, filed March 3, 2004 (Superior Court of Fulton County, Georgia) (“Barber”) arose, where plaintiffs, who allege to be shareholders, sued the Company and its directors, with respect to the Company’s response to a putative proposal made by Attentus Healthcare Corporation to acquire all of the Company’s stock. The claims allege that the Company and directors breached common law fiduciary duties owed to the shareholders by adopting a shareholder rights plan and refusing to negotiate with Attentus. They seek, among other things, injunctive relief with respect to these actions. No damages are sought in either complaint. The Ross suit was voluntarily dismissed on April 19, 2004. The defendants have responded to the complaints and intend to vigorously defend the Barber suit.

With the acquisition of HealthMont, the Company assumed a lease guarantee of $500 for a hospital HealthMont formerly operated. The lease had been assumed by a third party in a transaction prior to the Company’s acquisition of HealthMont. The leased hospital has subsequently been closed and SunLink recorded a liability of $500 for the lease guarantee at the acquisition date.

Contractual obligations, commitments and contingencies related to long-term debt, non-cancelable operating leases and physician guarantees from continuing operations at March 31, 2004 were as follows:

Contractual Obligations, Commitments and Contingencies

The Company also has $7,674 of outstanding borrowings under its revolving lines which are classified as current liabilities at March 31, 2004. The Company also has $5,700 outstanding under the Mountainside Financing Facility at March 31, 2004 which is included in current liabilities of Mountainside Medical Center on the condensed consolidated balance sheet.

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At March 31, 2004, SunLink had contracts with 16 physicians (exclusive of contracts with physicians at Mountainside which is included in discontinued operations as discussed in Note 3) which contain guaranteed minimum gross receipts. SunLink expenses physician guarantees as they are determined to be due to the physician on an accrual basis. Each month the physician’s gross receipts are accumulated and the difference between the monthly guarantee and the physician’s actual gross receipts for the month is calculated. If the guarantee is greater than the receipts, the difference is accrued as a liability and an expense. The net guarantee amount is paid to the physician in the succeeding month. If the physician’s monthly receipts exceed the guarantee amount in subsequent months, then the overage is repaid to SunLink to the extent of any prior monthly guarantee payments and the liability and expense is reduced by the amount of the repayment. For the three months ended March 31, 2004 and 2003, SunLink expensed (in continuing operations) physician guarantees of $621 and $230, respectively, and $1,964 and $965 for the nine months ended March 31, 2004 and 2003, respectively. The table above shows the maximum obligations SunLink had at March, 31, 2004 for the non-cancelable commitments under physician guarantee contracts.

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(dollars in thousands, except per share and admissions data)

Recent Developments

On April 12, 2004, SunLink announced it had entered into a definitive agreement to sell its Mountainside Medical Center (“Mountainside”), a 35 bed hospital located in Jasper, GA for approximately $40,000. The transaction, which is subject to various conditions and approvals, is expected to be completed in SunLink’s fourth fiscal quarter ending June 30, 2004. The service area of Mountainside is a fast growing area in the northern Atlanta metropolitan statistical area which the Company believes is trending toward suburban characteristics which are different from the exurban and rural areas characteristics on which SunLink’s business strategy is based. Such changing characteristics contributed to the decision to sell Mountainside.

On October 3, 2003, SunLink completed the acquisition with HealthMont, Inc. (“HealthMont”), a privately held operator of community hospitals through the merger of a wholly owned subsidiary of SunLink with HealthMont. Upon the consummation of the transaction, SunLink acquired two community hospitals: Memorial Hospital of Adel, a 60-bed acute-care hospital in Adel, Georgia, which includes a 95-bed nursing home, and Callaway Community Hospital, a 49-bed acute-care hospital in Fulton, Missouri. The results of operations of HealthMont are included in the results of operations for the Company from October 3, 2003 through the end of the current fiscal quarter, March 31, 2004. The Company believes that the two HealthMont hospitals it acquired are compatible with its business strategy of operating rural and exurban community hospitals.

Financial Summary

The results of continuing operations shown in the financial summary below are of our U.S. community hospital segment which is composed of five SunLink facilities acquired February 1, 2001 and the two HealthMont facilities acquired October 3, 2003. The results of operations for Mountainside, which is now classified as held for sale, are included in the results of discontinued operations.