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Article by DailyStocks_admin    (06-23-08 09:23 AM)

The Daily Magic Formula Stock for 06/23/2008 is Dynacq Healthcare Inc. According to the Magic Formula Investing Web Site, the ebit yield is 18% and the EBIT ROIC is 50-75 %.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW

General

Dynacq Healthcare, Inc., a Nevada corporation, is a holding company that through its subsidiaries develops and manages general acute care hospitals that principally provide specialized surgeries. The Company’s business strategy is to develop and operate general acute care hospitals designed to handle specialized surgeries such as bariatric, orthopedic and neuro-spine surgeries. Certain of the Company’s facilities also provide sleep laboratory and pain management services, as well as minor emergency treatment services and ear, nose and throat services. The Company’s hospitals include operating rooms, pre- and post-operative space, intensive care units, nursing units and diagnostic facilities, as well as adjacent medical office buildings that lease space to physicians and other healthcare providers. These hospitals are the Surgery Specialty Hospitals of America – Southeast Houston Campus (formerly Vista Medical Center Hospital) in Pasadena, Texas, near Houston (the “Pasadena Facility”); Vista Hospital of Dallas (the “Garland Facility”); and Vista Surgical Hospital of Baton Rouge (the “Baton Rouge Facility”). During the fiscal year ended August 31, 2007 the Company sold its outpatient surgery center, Vista Surgical Center West (the “West Houston Facility”).

The Company owns a 70% equity interest in Shanghai DeAn Hospital, a joint venture formed under the laws of the People’s Republic of China (the “DeAn Joint Venture”). On May 16, 2005, the DeAn Joint Venture entered into land use agreements with the Chinese Government, under which it leased, for a term of 50 years, approximately 28.88 acres of government-owned land in Shanghai, China on which a hospital will be constructed to be owned and operated by the DeAn Joint Venture. The DeAn Joint Venture is currently negotiating a contract for the construction of the hospital, including obtaining governmental approval of the size and scope of services of the hospital.

Except for emergency room patients, surgeries at our facilities are typically pre-certified or pre-authorized by the insurance carriers. The bulk of the surgeries are either covered by workers’ compensation insurance or by commercial insurers on an out-of-network health plan basis. Through the fiscal year ended August 31, 2005, the Company had not participated in managed care contracts and had not received a substantial amount of reimbursement from Medicare or Medicaid. However, during the first quarter of fiscal 2006, the Company began such participation and currently participates in a small number of managed care contracts. To date these contracts have not resulted in any meaningful patient revenues.

The Company, through its affiliates, owns or leases 100% of the real estate for and equipment in its facilities. The Company maintains a majority ownership and controlling interest in all of its operating entities. As of August 31, 2007, the Company owned the following percentages of its operating entities, with the remaining percentages owned by physicians and other healthcare professionals:

The Company was incorporated in Nevada in February 1992. In November 2003, the Company reincorporated in Delaware and changed its name from Dynacq International, Inc. to Dynacq Healthcare, Inc. In August, 2007, the Company reincorporated back in Nevada. The terms “Company,” “Dynacq,” “our” or “we” are used herein to refer to Dynacq Healthcare, Inc. and its affiliates unless otherwise stated or indicated by context. The term “affiliates” means direct and indirect subsidiaries of Dynacq Healthcare, Inc. and partnerships and joint ventures in which subsidiaries are general or limited partners or members.

Recent Developments

Spinoff

On August 10, 2007, Dynacq’s Board of Directors determined that it would be in the best interests of the shareholders to separate the domestic operations of the Company from its investment in the DeAn Joint Venture. The DeAn Joint Venture is a joint venture project between Dynacq and the People’s Republic of China to design, construct, own and operate Shanghai DeAn Hospital in Shanghai, China, generally referred to as the “China Project”. Management believes the separation of those operations into two distinct public companies will enhance the ability of the Company to obtain financing for the China Project, while allowing the domestic operations to continue without the financial commitments to and significant risks associated with the construction and operation of a new hospital in a foreign country. All the assets of the Company except for its investment in the China Project will be transferred into a newly formed, wholly owned subsidiary corporation, Surgery Specialty Hospitals of America, Inc. (“SSHA”), and all the shares of SSHA will be distributed to the current shareholders of Dynacq as a dividend. The transfer of assets to SSHA and distribution of stock to Dynacq shareholders will be made under the terms and conditions of a Distribution Agreement, and are generally referred to as the “Spinoff”. Dynacq will continue to own the interest in the China Project, will receive $5.5 million from SSHA over a five year term to fund its operations, and will seek additional financing to fulfill its obligations under the DeAn Joint Venture Agreement and to complete the construction and operation of the China Project. The Company will obtain the consent to the Spinoff from the holder of a majority of its outstanding shares and intends to mail an Information Statement to its shareholders in November explaining the Spinoff in more detail. The Company is not obligated to consummate the Spinoff and may determine not to do so if in the judgment of management the Spinoff would not be advisable and in the best interests of the Company and its shareholders.

Update on Assets Held for Sale

In 2006, the Company made the decision to sell the assets related to its Baton Rouge and West Houston Facilities and its land in The Woodlands, Texas. During the fiscal year ended August 31, 2007, the Company sold its West Houston Facility. In May 2007, the Company signed an earnest money contract for sale of the land in The Woodlands, Texas, and the sale was subsequently completed in September 2007. The net proceeds and gain on sale of land in The Woodlands, Texas were $1.8 million and $28,000, respectively. The Company entered into a Purchase and Sale Agreement (the “Sale Agreement”) for the sale of assets related to its Baton Rouge Facility on November 8, 2007, and the sale is expected to be completed in the second quarter of fiscal year 2008, subject to the satisfaction of certain closing conditions. The expected sales proceeds and gain on sale of the assets related to the Baton Rouge Facility are $20 million and $6 million, respectively. See Industry Background – Baton Rouge Facility for a description of the terms of the Sale Agreement. The assets related to these facilities have been classified as “Assets held for sale”. None of these assets is encumbered by secured lien or debt, so all proceeds from the sale of any of those assets, net of selling expenses, would be available to the Company to pursue its business plans.

Update on Accounts Receivable related to Medical Dispute Resolutions

The Company, in conjunction with most of the Texas hospital medical providers, continues its efforts to resolve the pending claims regarding payment for the treatment of injured workers under the Texas workers’ compensation laws. The Company exhausts all of its available avenues in collecting its accounts receivable (particularly in the workers’ compensation arena). This includes the appeal to the State Office of Administrative Hearings (“SOAH”) or the District Court for workers’ compensation cases where the insurance carrier failed to reimburse the Company in accordance with the rules of reimbursement mandated by Texas state law.

The Company has recently been successful in its pursuit of collections regarding the stop-loss cases pending before SOAH, receiving positive rulings in over 90% of its claims presented for administrative determination. Further, in a declaratory judgment action before the 353 rd State Judicial District Court of Travis County, Texas, the interpretation of the statute as applied to the stop-loss claims of the Company by SOAH was upheld. It is expected that the ruling of the trial court will be appealed to the State of Texas Third Court of Appeals by the insurance carriers. Claims regarding payment for hospital outpatient services remain pending at the Texas Division of Workers Compensation (“TDWC”) (formerly the Texas Workers’ Compensation Commission). It is expected that these claims will be adjudicated at SOAH and ultimately in the Texas District and Appellate Courts.

Bariatric Program for Pasadena, Garland and Baton Rouge Facilities

New bariatric or weight control programs were implemented at the Pasadena and Baton Rouge Facilities in the first quarter of fiscal 2006 and at the Garland Facility in the second quarter of fiscal 2006, to replace the former bariatric programs at those facilities and to reduce costs associated with outside vendor programs. Our programs provide or contract for marketing, pre-authorization and follow up support services to prospective bariatric patients in areas serviced by the Pasadena, Garland or Baton Rouge Facilities. The new bariatric programs have resulted in an increase in bariatric cases at all our facilities. Each of our Baton Rouge and Pasadena facilities was designated as a Bariatric Center of Excellence by the American Society for Bariatric Surgery (ASBS) in August 2006 and June 2007, respectively. The ASBS Center of Excellence designation recognizes surgical programs and surgeons who have demonstrated a track record of favorable short and long-term outcomes in bariatric surgery and have the resources to perform safe bariatric surgeries.

Industry Background

The development of proprietary general acute care hospital networks occurred during the 1970’s. During the past 20 years, freestanding outpatient surgery centers were developed to compete with these general hospitals for outpatient procedures. Freestanding outpatient surgery centers have allowed physicians to perform outpatient procedures in specialized facilities designed to improve efficiency and enhance patient care. The Company believes that its operational model allows physicians to perform inpatient and outpatient procedures at facilities that provide similar efficiencies as those provided at freestanding outpatient surgery centers.

General acute care hospitals specializing in specific complex surgical procedures are designed with the goal of improving both physician and facility efficiency. The surgeries performed are primarily non-emergency procedures that are electively scheduled and, therefore, allow for efficiency available through block time/scheduling. Given the opportunity to utilize multiple operating rooms for pre-determined periods of time, the physicians are able to schedule their time more efficiently and, therefore, increase the number of procedures they can perform within a given amount of time. The facility receives the benefit of consistent staffing patterns and greater facility utilization. In addition, the Company believes that, due to the relatively small size of its facilities, many physicians prefer to perform procedures in the Company’s facilities because their patients prefer the comfort of a more personal atmosphere and the convenience of simplified admission and discharge procedures.

Reference is made to the discussion under the caption “Spinoff” above regarding the Company’s plan to transfer to SSHA its domestic operations and to distribute to its current shareholders the shares of stock of SSHA. The information contained in this Annual Report on Form 10-K regarding the operations of the Company are presented on an historical basis and will not be representative of the Company after the Spinoff is consummated. The Company is not obligated to consummate the Spinoff and may determine not to do so if in the judgment of management the Spinoff would not be advisable and in the best interests of the Company and its shareholders.

Pasadena Facility

At August 31, 2007, the Company owned, through its subsidiaries, a 98.5% partnership interest in the Pasadena Facility operating entity, with the remaining interest owned primarily by physicians and other healthcare professionals. The Pasadena Facility’s areas of practice include orthopedic and general surgery, such as spine and bariatric surgeries, various pain management modalities and other services. The Pasadena Facility represented approximately 38%, 57% and 72% of the Company’s net patient revenues in fiscal years 2007, 2006 and 2005, respectively. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and, in turn, leases the land, hospital facility and equipment to the hospital operating entity.

Garland Facility

As of August 31, 2007, the Company owned, through its subsidiaries, a 99% partnership interest in the Garland Facility operating entity, with the remaining interests owned by physicians. The areas of practice performed at this facility are orthopedic surgery, bariatric surgery, general surgery and pain management procedures. The Garland Facility represented approximately 62%, 43% and 27% of the Company’s net patient revenues in fiscal years 2007, 2006 and 2005, respectively. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and, in turn, leases the land, hospital facility and equipment to the hospital operating entity.

Baton Rouge Facility

At August 31, 2007, the Company owned, through its subsidiaries, a 93% membership interest in the Baton Rouge Facility operating entity, with the remaining interest owned by physicians. The Baton Rouge Facility’s areas of practice include bariatric surgery, general surgery and cosmetic surgery. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and, in turn, leases the land, hospital facility and equipment to the hospital operating entity. The Company has made the decision to sell the assets related to its Baton Rouge Facility, and has included it as part of its discontinued operations.

On November 8, 2007, Vista Holdings, LLC, a wholly owned subsidiary of the Company (“Seller”), entered into the Sale Agreement with the State of Louisiana (“Buyer”) for the sale of substantially all the assets, and the assumption of certain stated liabilities, of the Baton Rouge Facility for $20,000,000 in cash. The Sale Agreement provides for Buyer to purchase all assets of Seller except for the following: accounts receivable; cash; rights under insurance policies and payments; ownership interests in Vista Hospital of Baton Rouge, LLC, Vista Medical Management, LLC and Seller; rights under specified contracts; and certain permits, licenses and records related to the operations of the Baton Rouge Facility prior to the closing date. The Sale Agreement further provides for Buyer to assume all liabilities of Seller arising after the Closing Date and relating to the assets acquired. The Sale Agreement contains customary representations and warranties of the parties regarding the assets sold and liabilities assumed, which representations and warranties will survive the closing. Under the Sale Agreement, the Buyer may elect to assume certain leases of equipment located in the facility.

The closing of the sale is anticipated to take place on or before December 14, 2007, subject to the satisfaction of the following closing conditions: issuance of a title insurance policy insuring clear title to the real property; Buyer’s satisfaction with the environmental condition of the real estate; satisfactory completion by the Buyer of an inspection of the assets, a physical survey, termite inspection, and other tests deemed necessary by Buyer; receipt of an appraisal of the real property and other assets for not less than the purchase price; the absence of any material adverse change in the assets between signing of the Sale Agreement and the closing; delivery of an officer’s certificate certifying as to the due authorization, execution and delivery of the Sale Agreement by Seller and the Company; delivery of an officer’s certificate certifying as to the due authorization, execution and delivery of the Sale Agreement by Buyer; the good standing of Seller; the receipt of any third party consents; the receipt of all required releases of liens on the assets, the execution and delivery of appropriate transfer documents for the real property and personal assets being sold; the receipt of a certificate from each of the parties regarding the accuracy of each of the representations and warranties contained in the Sale Agreement as of the closing date; delivery of the purchase price, and such other documents or transactions as may be required by either party in order to consummate the sale of the assets to, and the assumption of the stated liabilities by, Buyer. Prior to the closing, the Sale Agreement may be terminated by mutual agreement, or Buyer may terminate the Sale Agreement if Seller has breached a provision of the Sale Agreement or not satisfied any of its obligations prior to closing stated above.

China Project

On May 16, 2005, the DeAn Joint Venture, of which the Company owns a 70% equity interest, entered into land use agreements with the Chinese government to lease for a term of 50 years approximately 28.88 acres of government-owned land in Shanghai, China to be used for the China Project. In accordance with the Land Use Right Agreement, construction of the peripheral walls commenced in October 2005, and the DeAn Joint Venture is currently negotiating a contract for the construction of the hospital, including obtaining governmental approval of the size and scope of services of the hospital. Because the Chinese government has not made certain of the payments due by it under the Joint Venture Agreement, the Company is also negotiating for the sale of the government’s interest in the DeAn Joint Venture to a third party. If the Company is not successful in persuading the Chinese government to sell its interest to a third party and if the Chinese government does not make the payments due by it under the Joint Venture Agreement, Dynacq would contribute $3.3 million to the DeAn Joint Venture and become a 95% owner of the project.

The central government of Beijing has granted to the Company a unique, non-exclusive license to operate and own majority controlling interests in hospitals throughout China. The Company believes that to date it is the only foreign entity which has been granted this license.

West Houston Facility

The West Houston Facility was a satellite ambulatory surgical center to the Pasadena Facility. This facility’s areas of practice included pain management, invitro fertilization and other services. The Company sold the assets related to its West Houston Facility during the fiscal year 2007.

Business Growth Strategy

The Company has focused on developing and expanding its surgical services facilities. The Company’s business strategy involves:


•

Creating and maintaining relationships with quality physicians;


•

Attracting and retaining key management, marketing and operating personnel;


•

Further developing and refining its hospital prototype to, among other things, enhance the facility design of its hospitals to provide efficient, effective, and quality patient care for its current surgical mix as well as additional types of services;


•

Adding new capabilities to its existing hospital campuses; and


•

Constructing and developing the China Project.

Creating and Maintaining Relationships with Quality Physicians

Since physicians provide and influence the direction of healthcare, we have developed our operating model to encourage physicians to affiliate with us and to use our facilities in accordance with their practice needs. Our strategy is to focus on the development of physician partnerships and facilities that will enhance their practices in order to provide quality healthcare in a friendly environment for the patient. We seek to attract new physicians to our facilities in order to grow or to replace physicians who retire or otherwise depart from time to time, as well as to expand the surgical case mix. In order to attract new physicians and maintain existing physician relationships, the Company affords them the opportunity to purchase interests in the operating entities of the facilities. By doing so, the physician becomes more integrally involved in the quality of patient care and the overall efficiency of facility operations.

Attracting and Retaining Key Personnel

We place the utmost importance on attracting and retaining key personnel to be able to provide quality facilities to attract and retain qualified physicians. Attracting and retaining the appropriate personnel at all levels within the organization, including senior executives at the corporate level, are also important goals of management and essential in expanding our operations.

Further Refining Hospital Design

We believe we attract physicians because we design our facilities and adopt staffing, scheduling and clinical systems and protocols to increase physician productivity and promote their professional success. We focus attention on providing physicians with quality facilities designed to improve the physicians’ and their patients’ satisfaction.

Adding New Capabilities to Existing Hospitals

Our overall strategy is to develop and operate hospitals designed to handle complex surgeries. Currently, some of our more complex surgeries include spine and bariatric surgeries for which we have added more surgical equipment. The Company continues to explore the possibility of adding other types of surgical procedures that fit into our business model.

Constructing and developing the China Project

The Company plans to build a general acute care hospital with up to 150 beds and eight surgical suites to perform general and specialized surgeries. The Company plans to attract various medical specialty treatment centers as anchors to the hospital, such as cancer, cardiac catheterization, organ transplant and specialty obstetrics and gynecology, complemented by research and development facilities where American specialists can train local physicians with advanced medical techniques and knowledge. Our master plan for development of the China Project includes the construction with other venturers of hotels, convention facilities and living quarters to accommodate the needs of physicians, surgeons, scholars, patients and their families in the medical center campus. The Company is negotiating construction contracts with local contractors pending the final approval of both the architect and construction plans by the local government in China.

Marketing

Our marketing efforts are directed primarily at physicians and other healthcare professionals who are principally responsible for referring patients to our facilities. We market our facilities to physicians by emphasizing the high level of patient satisfaction with our hospitals, the quality and responsiveness of our services and the practice efficiencies provided by our facilities. We believe that providing quality facilities creates a positive environment for patients and physicians. The Company, through its subsidiaries, also has agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective orthopedic and/or bariatric patients in areas serviced by the Pasadena and/or Garland Facilities. These facilities receive orthopedic and bariatric referrals from other sources, and such organizations also refer clients to other area hospitals.

In addition to our arrangements with outside organizations regarding marketing, new bariatric or weight control programs were implemented at the Pasadena and Baton Rouge Facilities in the first quarter of fiscal 2006 and at the Garland Facility in the second quarter of fiscal 2006, to replace the former bariatric programs at those facilities and to reduce costs associated with outside vendor programs. Our programs provide or contract for marketing, pre-authorization and follow up support services to prospective bariatric patients in areas serviced by the Pasadena, Garland or Baton Rouge Facilities.

Competition

Presently, the Company operates in the greater Houston, Texas, Baton Rouge, Louisiana, and Dallas-Fort Worth, Texas metropolitan markets. In each market, the Company competes with other providers, including major acute care hospitals. These entities may have various competitive advantages over the Company, including their community position, capital resources, physician partnerships and proximity to physician office buildings. The Company also encounters competition with other companies for strategic relationships with physicians.

There are several large publicly-held companies, and numerous privately-held companies, that acquire and develop freestanding private hospitals and outpatient surgery centers. Many of these competitors have greater financial and other resources than the Company. The principal competitive factors that affect the Company’s ability and the ability of its competitors to acquire or develop private hospitals are experience, reputation, relationships with physicians and other medical providers, as well as access to capital. Further, some surgeon groups develop surgical facilities without a corporate partner. The Company can provide no assurance that it will be able to compete successfully in these markets.

Government Regulation

Overview

All participants in the healthcare industry are required to comply with extensive government regulation at the federal, state and local levels. Under these laws and regulations, hospitals must meet requirements for licensure and qualify to participate in government programs, including Medicare and Medicaid. These requirements relate to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, hospital use, rate-setting, compliance with building codes and environmental protection laws, as well as patient confidentiality requirements. There are also extensive regulations governing a hospital’s participation in government programs and payment for services provided to program beneficiaries. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial interpretation. Some of the laws applicable to us are subject to limited or evolving interpretations; therefore, a review of our operations by a court or law enforcement or regulatory authority may result in a determination that could have a material adverse effect on us. Furthermore, the laws applicable to us may be amended or interpreted in a manner that could have a material adverse effect on us.

We believe that our facilities are in substantial compliance with current applicable federal, state and local regulations and standards. In the event of a determination that we violated applicable laws, rules or regulations or if changes in the regulatory framework occur, we may be subject to criminal penalties and/or civil sanctions and our facilities could lose their licenses and/or their ability to participate in government programs. In addition, government regulations frequently change, and when regulations change we may be required to make changes in our facilities, equipment, personnel and services so that our facilities remain licensed and qualified to participate in these programs. One or more of these outcomes could be material to our operations.

Texas and Louisiana Workers’ Compensation Systems

A significant amount of our net revenue results from Texas workers’ compensation claims and to a significantly lesser extent from Louisiana workers’ compensation claims. As such, we are subject to the rules and regulations of the TDWC and the Louisiana Workers’ Compensation Commission.

The 2005 Texas Legislature substantially revised the workers’ compensation system by implementing workers’ compensation healthcare networks. Regulations governing workers’ compensation healthcare networks have recently been adopted. If one of our hospitals chooses to participate in a network, the amount of revenue that will be generated from workers’ compensation claims will be governed by a network contract.

For claims arising prior to the implementation of workers’ compensation networks and out of network claims, the Texas Administrative Code provides the specific methodology and procedure for the payment and denial of medical bills by third-party payers for medical services to injured workers in Texas. Specifically, inpatient and outpatient surgical services are either reimbursed pursuant to the Acute In-Patient Hospital Fee Guideline (“AIHFG”) or at a “fair and reasonable” rate for services in which the fee guideline is not applicable. Should our facility disagree with the amount of reimbursement provided by a third-party payer, we are required to pursue the MDR process at the TDWC to request proper reimbursement for services pursuant to the Texas Labor Code and the Texas Administrative Code. The Company has recently been successful in its pursuit of collections regarding the stop-loss cases pending before SOAH, receiving positive rulings in over 90% of its claims presented for administrative determination. Further, in a declaratory judgment action before the 353 rd State Judicial District Court of Travis County, Texas, the interpretation of the statute as applied to the stop-loss claims of the Company by SOAH was upheld. It is expected that the ruling of the trial court will be appealed to the State of Texas Third Court Appeals by the insurance carriers. Claims regarding payment for hospital outpatient services remain pending at the TDWC. It is expected that these claims will be adjudicated at SOAH and ultimately in the Texas District and Appellate Courts.

The Louisiana Administrative Code provides the specific methodology and procedure for the payment and denial of medical bills by third-party payers for medical services to injured workers. Specifically, for inpatient surgical services, reimbursement is predicated upon the hospital reimbursement schedule. In addition, there is also a reimbursement guideline for outpatient services.

We cannot predict the course of future legislation or changes in current administration of the Texas Labor Code and/or Texas Administrative Code or the Louisiana Administrative Code. We expect that there may be changes in the future, but we are unable to predict their impact on our operations.

Licensure, Certification and Accreditation

Our healthcare facilities are subject to state and local licensing regulations ranging from the adequacy of medical care to compliance with building codes and environmental protection laws. The failure to comply with these regulations could result in the suspension or revocation of a healthcare facility’s license. To assure continued compliance with these regulations, our facilities are subject to periodic inspection by governmental and other authorities. Moreover, in order to participate in the Medicare and Medicaid programs, each of our hospitals must comply with the applicable regulations of the United States Department of Health and Human Services (“DHHS”) relating to, among other things, equipment, personnel and standards of medical care, as well as comply with all applicable state and local laws and regulations. If a hospital fails to substantially comply with the numerous conditions of participation in the Medicare and Medicaid programs or performs certain prohibited acts, the hospital’s participation in the federal or state healthcare programs may be terminated, civil or criminal penalties may be imposed under certain provisions of the Social Security Act, or both.

We believe that our hospitals are in substantial compliance with current applicable federal, state and local regulations and standards. However, the requirements for licensure and certification are subject to change. Effective August 2007, the Texas licensing rules for hospitals underwent significant revisions. Consequently, in order for our hospitals to remain licensed and certified, it may be necessary from time to time for us to make material changes in our facilities, equipment, personnel and/or services. Additionally, the revisions to the Texas hospital licensing rules may have an impact on any future expansions or renovations to our healthcare facilities in that state.

Professional Licensure

Healthcare professionals at our facilities are required to be individually and currently licensed or certified under applicable state law and may be subject to numerous Medicare and Medicaid participation and reimbursement regulations. We take steps to ensure that all independent physicians and our employees and agents have the necessary licenses and certifications with their respective licensing agency. We believe that our employees and agents as well as all independent physicians on staff comply with all applicable state licensure laws.

Corporate Practice of Medicine and Fee-splitting

Some states, such as Texas, have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that prohibit direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of license, civil and criminal penalties, and rescission of the business arrangements. These laws vary from state to state, are often vague and in most states have seldom been interpreted by the courts or regulatory agencies. We have structured our arrangements with healthcare providers to avoid the exercise of any responsibility on behalf of the physicians utilizing our hospitals that could be construed as affecting the practice of medicine and to comply with all such applicable state laws. However, we cannot assure you that governmental officials charged with the responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws also may be interpreted by courts in a manner inconsistent with our interpretations.

Federal Anti-kickback Statute

The Medicaid/Medicare Anti-kickback Statute prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Courts have interpreted this statute broadly. A violation of the Anti-kickback Statute constitutes a felony and may be punished by a criminal fine of up to $25,000 for each violation, imprisonment up to five years, or both, civil money penalties of up to $50,000 per violation and damages of up to three times the amount of the illegal kickback and/or exclusion from participation in federal healthcare programs, including Medicare and Medicaid.

The Office of Inspector General at the DHHS (the “OIG”), among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste in federal healthcare programs. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. The OIG has published final safe harbor regulations that outline categories of activities that are deemed protected from prosecution under the Anti-kickback Statute. Currently there are statutory exceptions and safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, freestanding surgery centers and referral agreements for specialty services. Compliance with a safe harbor is not mandatory. The fact that a particular conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the Anti-kickback Statute. Such conduct and business arrangements, however, may lead to increased scrutiny by government enforcement authorities. The determination as to compliance with the Anti-kickback statute outside of a safe harbor rests on the particular facts and circumstances and on the parties’ intent in entering into the transaction or arrangement.

The safe harbor regulations with respect to investment interests establish two instances in which payments to an investor in a venture will not be treated as a violation of the Anti-kickback Statute. The first safe harbor is for investment interests in public companies that have total assets exceeding $50 million and whose investment securities are registered pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The second safe harbor or “small entity” safe harbor is for investments in entities when certain criteria are met. Two significant criteria for this safe harbor are (1) that no more than 40% of the value of the investment interests of each class of investments may be held in the previous fiscal year or previous twelve-month period by investors who are in a position to make or influence referrals to, furnish items or services to, or otherwise generate business, for the entity, and (2) that no more than 40% of the gross revenue of the entity in the previous fiscal year or previous twelve-month period may come from referrals or business otherwise generated from investors. In addition to promulgating safe harbor regulations, to further assist providers, the OIG has established a process to enable healthcare providers to request advisory opinions on whether individual transactions might violate the Anti-kickback and certain other statutes. The OIG also provides insight into its views on the application of the Anti-kickback Statute through various documents including Special Fraud Alerts, Special Advisory Bulletins, Medicare Fraud Alerts and Medicare Advisory Bulletins.

We have a variety of financial relationships with physicians who refer patients to our hospitals. Physicians own interests in certain of our hospitals and may also own our stock. We also have medical directorship agreements with some physicians. Although we believe that our arrangements with physicians have been structured to comply with the current law and available interpretations, we cannot assure you that regulatory authorities will not determine that these arrangements violate the Anti-kickback Statute or other applicable laws. Also, the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payers, not just to federal healthcare programs. Many of these state laws do not have safe harbor regulations comparable to the federal Anti-kickback Statute and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these anti-kickback laws, we could be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid or other governmental healthcare programs such as workers’ compensation programs. Exclusion from these programs could result in significant reductions in revenue and could have a material adverse effect on our business.

CEO BACKGROUND

Mr. Chiu Chan has served as our president and chief executive officer since July 1992. Mr. Chan is a registered pharmacist and during the period from May 1978 to July 1992 was employed by various healthcare service organizations in Houston, Texas. Mr. Chan earned a Bachelor of Science degree in Pharmacy from the University of Houston. Chiu M. Chan is not related to Philip S. Chan.

Mr. Philip Chan has served as our vice president of finance, chief financial officer, and treasurer since July 1992. Mr. Chan earned advanced accounting degrees from the University of Houston and is a certified public accountant in the State of Texas. Philip S. Chan is not related to Chiu M. Chan.

Mr. Huber is a registered pharmacist and earned a Bachelor of Science degree in Pharmacy and a Masters of Science in Hospital Pharmacy, both from the University of Houston. From 1991 to 1999, Mr. Huber served as the Deputy Division Head for patient care services at the University of Texas M.D. Anderson Cancer Center. In 1999, Mr. Huber joined Cortex Communications, Inc., a medical education company, as president and chief operating officer. In 2001, Mr. Huber joined Medicus International, now known as Publicis Healthcare Communications Group, a global medical communications company, as its senior vice president and currently is the president of Medical and Scientific Affairs. Mr. Huber continues to serve as a research consultant to M.D. Anderson Cancer Center.

Mr. Votaw earned a Bachelor of Arts degree from the University of the Americas in Mexico City and a certificate of graduation from the Graduate School of Mortgage Banking from Northwestern University of Chicago. Prior to his retirement in December 1993, Mr. Votaw served as a director and as the president and chief executive officer of Capital Bank, a Texas chartered bank located in Houston, Texas, where he continues to serve as a director.

Dr. Chu received his Ph.D. degree in chemistry from Massachusetts Institute of Technology before he attended medical school at the University of Miami, Florida. Dr. Chu finished his oncology training at M.D. Anderson Cancer Center in 1989 and has been in solo private practice since completion. Dr. Chu is board certified in internal medicine and medical oncology.

Mr. Gerace received his degree in Business Administration with a major in accounting from Texas A & M University in 1961. He is a Certified Public Accountant and mediator with professional experience at public accounting firms, performing audits, tax planning and related services. He has served on the Board of Directors of several banks and savings and loan associations and has maintained his own CPA firm for approximately the last thirty-seven years. Mr. Beauchamp has served as an Executive Vice President and our Chief Operating Officer since January 17, 2005. From 2004 until his employment with the Company, Mr. Beauchamp was a consultant to HealthPlus+ at Doctors Hospital Parkway and Doctors Hospital Tidwell in Houston, Texas; from 2003 to 2004, a partner with Medical Links International; and from 1997 to 2002, the President and Chief Executive Officer of four private software companies (Public Software Library, Digital Tome, Little Shop of Game Makers and Amazing Games). From 1984 to 1997, Mr. Beauchamp accumulated significant experience in an administrative and executive capacity for several healthcare organizations, including Premier Analytical Laboratories and Mid-America Healthcare Group, a private company owning four hospitals. Mr. Beauchamp graduated from Texas A&M University in 1975 with a Bachelors of Business Administration degree in accounting.

MANAGEMENT DISCUSSION FROM LATEST 10K

Executive Summary

Spinoff

On August 10, 2007, Dynacq’s Board of Directors determined that it would be in the best interests of the shareholders to separate the domestic operations of the Company from its investment in the DeAn Joint Venture to design, construct, own and operate the China Project. Management believes the separation of those operations into two distinct public companies will enhance the ability of the Company to obtain financing for the China Project, while allowing the domestic operations to continue without the financial commitments to and significant risks associated with the construction and operation of a new hospital in a foreign country. All the assets of the Company except for its investment in the China Project will be transferred into a newly formed, wholly owned subsidiary corporation, SSHA, and all the shares of SSHA will be distributed to the current shareholders of Dynacq as a dividend in the Spinoff. Dynacq will continue to own the interest in the China Project, will receive $5.5 million from SSHA over a five year term to fund its operations, and will seek additional financing to fulfill its obligations under the DeAn Joint Venture Agreement and to complete the construction and operation of the China Project. The Company will obtain the consent to the Spinoff from the holder of a majority of its outstanding shares and intends to mail an Information Statement to its shareholders in November explaining the Spinoff in more detail. The Spinoff and the results thereof are not discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company is not obligated to consummate the Spinoff and may determine not to do so if in the judgment of management the Spinoff would not be advisable and in the best interests of the Company and its shareholders.

Update on Assets Held for Sale

In 2006, the Company made the decision to sell the assets related to its Baton Rouge and West Houston Facilities and its land in The Woodlands, Texas. During the fiscal year ended August 31, 2007, the Company sold its West Houston Facility. In May 2007, the Company signed an earnest money contract for sale of the land in The Woodlands, Texas, and the sale was subsequently completed in September 2007. The net proceeds and gain on sale of land in The Woodlands, Texas were $1.8 million and $28,000, respectively. The Company entered into the Sale Agreement for the sale of assets related to its Baton Rouge Facility on November 8, 2007, and the sale is expected to be completed in the second quarter of fiscal year 2008, subject to the satisfaction of certain closing conditions. The expected sales proceeds and gain on sale of the assets related to the Baton Rouge Facility are $20 million and $6 million, respectively. See Business—Industry Background – Baton Rouge Facility for a description of the terms of the Sale Agreement. The assets related to these facilities have been classified as “Assets held for sale”. None of these assets is encumbered by secured lien or debt, so all proceeds from the sale of any of those assets, net of selling expenses, would be available to the Company to pursue its business plans.

Update on Accounts Receivable related to Medical Dispute Resolutions

The Company, in conjunction with most of the Texas hospital medical providers, continues its efforts to resolve the pending claims regarding payment for the treatment of injured workers under the Texas workers’ compensation laws. The Company exhausts all of its available avenues in collecting its accounts receivable (particularly in the workers’ compensation arena). This includes the appeal to SOAH or the District Court for workers’ compensation cases where the insurance carrier failed to reimburse the Company in accordance with the rules of reimbursement mandated by Texas state law.

The Company has recently been successful in its pursuit of collections regarding the stop-loss cases pending before SOAH, receiving positive rulings in over 90% of its claims presented for administrative determination. Further, in a declaratory judgment action before the 353 rd State Judicial District Court of Travis County, Texas, the interpretation of the statute as applied to the stop-loss claims of the Company by SOAH was upheld. It is expected that the ruling of the trial court will be appealed to the State of Texas Third Court of Appeals by the insurance carriers. Claims regarding payment for hospital outpatient services remain pending at the TDWC. It is expected that these claims will be adjudicated at SOAH and ultimately in the Texas District and Appellate Courts.

Bariatric Program for Pasadena, Garland and Baton Rouge Facilities

New bariatric or weight control programs were implemented at the Pasadena and Baton Rouge Facilities in the first quarter of fiscal 2006 and at the Garland Facility in the second quarter of fiscal 2006, to replace the former bariatric programs at those facilities and to reduce costs associated with outside vendor programs. Our programs provide or contract for marketing, pre-authorization and follow up support services to prospective bariatric patients in areas serviced by the Pasadena, Garland or Baton Rouge Facilities. The new bariatric programs have resulted in an increase in bariatric cases at all our facilities. Each of our Baton Rouge and Pasadena facilities was designated as a Bariatric Center of Excellence by the American Society for Bariatric Surgery (ASBS) in August 2006 and June 2007, respectively. The ASBS Center of Excellence designation recognizes surgical programs and surgeons who have demonstrated a track record of favorable short and long-term outcomes in bariatric surgery and have the resources to perform safe bariatric surgeries.

Net Patient Service Revenues

Net patient service revenues increased by $6.9 million, or 19%, compared to the prior year period, to $42.8 million, as net patient service revenue from our Garland Facility increased by $11.3 million, or 74%, partially offsetting a 21% decline of $4.3 million in net patient service revenue at the Pasadena Facility.

Approximately 38%, 57% and 72% of the Company’s net patient service revenue for fiscal years 2007, 2006 and 2005, respectively, were generated at the Company’s Pasadena Facility. The Garland Facility contributed 62%, 43% and 27% in net patient service revenues in fiscal years 2007, 2006 and 2005, respectively.

During fiscal years 2007, 2006 and 2005, approximately 47%, 54% and 60% of the Company’s gross revenues came from surgeries covered by workers’ compensation, and approximately 38%, 31% and 27% came from services covered by commercial and other insurance payers, respectively.

The increase in net patient service revenues is due to several reasons discussed below:


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Increase in bariatric and orthopedic cases at Garland Facility


•

Increase in gross patient service revenues generated by commercial and other insurance payers


•

Increase in average net patient service revenue per case

Increase in bariatric and orthopedic cases at Garland Facility

The Garland Facility had an increase in both bariatric and orthopedic cases due to recruitment of additional physicians. The increase in net patient service revenue is primarily due to an increase in overall number of cases and also due to a 129% increase in number of inpatient cases at our Garland Facility, which typically have a higher average reimbursement per case. This increase has been partially offset by continued decreases in bariatric and orthopedic cases at our Pasadena Facility of 67% and 34%, respectively.

In fiscal year 2007, we added a net of 43 physicians to the staff at the Garland Facility and had a net decrease of two physicians at the Pasadena Facility. Of the net 41 physicians added, 18 specialize in orthopedics and pain management, 6 in neurological surgery and 5 in bariatric surgery. The other additions are hospital-based physicians who do not generally make referrals to our hospitals or directly generate patient revenues.

The utilization rate of our hospitals varies widely among physicians on our medical staffs and among specializations, so an increase in the number of physicians on our medical staffs does not, in itself, result in an increase in patient referrals or revenues. While we attempt to continue to attract and retain additional physicians, the potential loss of physicians who provide significant net patient revenues for the Company may adversely affect our results of operations.

Increase in gross patient service revenue generated by commercial and other insurance payers

We have increased our gross patient service revenues from services covered by commercial and other insurance payers from 31% in 2006 to 38% in 2007, primarily due to maturing of our bariatric program at our Garland Facility. This increase is attributable to an increase in our historical cash collection rate, which in turn increased our net patient service revenues.

Increase in average net patient service revenue per case

Even though the number of cases increased only 2% overall in 2007 compared to 2006, the net patient service revenue increased by 19%. This is primarily due to an increase in the number of inpatient cases at our Garland Facility and a higher cash collection percentage of 45% of gross billed charges in 2007 compared to 41% in 2006.

Marketing

Our marketing efforts are directed primarily at physicians and other healthcare professionals who are principally responsible for referring patients to our facilities. We market our facilities to physicians by emphasizing the high level of patient satisfaction with our hospitals, the quality and responsiveness of our services and the practice efficiencies provided by our facilities. We believe that providing quality facilities creates a positive environment for patients and physicians. The Company, through its subsidiaries, also has agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective orthopedic and/or bariatric patients in areas serviced by the Pasadena and/or Garland Facilities. These facilities receive orthopedic and bariatric referrals from other sources, and such organizations also refer clients to other area hospitals.

In addition to our arrangements with outside organizations regarding marketing, we implemented new bariatric or weight control programs at the Pasadena Facility in the first quarter, and at the Garland Facility in the second quarter, of fiscal 2006, to replace the former bariatric programs at those facilities and to reduce costs associated with outside vendor programs. Our new programs provide or contract for marketing, pre-authorization and follow up support services to prospective bariatric patients in areas serviced by the Pasadena or Garland Facilities.

Internal Controls

Our outside auditors have advised that there were no identified material weaknesses in our internal controls at August 31, 2007. See Item 9A. Controls and Procedures.

Revenue Recognition

Through the fiscal year ended August 31, 2005, the Company did not participate in managed care contracts. In the quarter ended November 30, 2005, the Company began such participation and currently participates in a small number of managed care contracts. We recognize revenue based upon our estimate of the amount of cash which we will collect for the services delivered. We estimate that we will collect the same percentage of our gross invoices for each facility on a case-by-case basis in each period as we have actually collected during the trailing 12 months. What we term “contractual allowance” is the amount which must be subtracted from gross billed charges to arrive at the net patient service revenue. For the years ended August 31, 2007, 2006 and 2005, our aggregate contractual allowance, as a percentage of gross billed revenues, was 55%, 59% and 58%, respectively.

Accounts Receivable

The focus of our business is relatively complex cases with corresponding large facility reimbursements. Our 2007 gross patient service revenue was generated 47% from service to injured Texas workers (worker’s compensation) and 38% from out-of-network commercial insurance. The principal cases involved were orthopedic spine surgeries and bariatric surgeries for the morbidly obese, respectively. Our accounts receivable are larger and older than those of typical healthcare companies because of our pursuit of additional reimbursements through the MDR process. Historically the Company has not participated in managed care contracts and has not received a substantial amount of reimbursement from Medicare or Medicaid. However, during the first quarter of fiscal 2006, the Company began participation in certain managed care contracts and anticipates entering into additional contracts in the future. So far these contracts have not resulted in any meaningful patient revenues.

Following our approach to revenue recognition, we initially subtract the contractual allowance from the gross receivables. The great bulk of our receivables are due from insurance carriers.

There has been a significant development in the MDR appellate process, as enforced under the 2005 Workers’ Compensation Act, which is described in detail below. On December 7, 2006, in an action before the 201st Judicial District Court of Travis County, Texas, section 413.031 (k) of the Texas Labor Code, as amended and made effective on September 1, 2005, was declared unconstitutional for failing to afford the parties to a medical dispute, brought pursuant to Labor Code section 413.031 and pending before the TDWC, an opportunity for hearing. The Labor Code statute was amended in 2007, and the provisions affording the parties a hearing at SOAH were reinstated. In spite of this recent development, the MDR Division of the TDWC has not issued any Findings and Decisions in the Company’s pending fee disputes.

Because of this extended uncertainty in the MDR process, we do not arbitrarily write off MDR receivables. We evaluate MDR receivables to estimate the amount that should be collected. If that estimate is less than the gross receivables net of contractual allowance and allowance for uncollectible accounts, we then write it down to the estimated collectible amount. At each balance sheet date we also separately classify as long-term receivables all receivables that we expect to collect more than one year from the balance sheet date.

The MDR system is important to an understanding of our financial statements. The following information provides a more detailed description of the MDR process, as well as others of our critical accounting policies and estimates.

Critical Accounting Policies and Estimates

The Consolidated Financial Statements and Notes to Consolidated Financial Statements contain information that is pertinent to the management’s discussion and analysis. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of any contingent assets and liabilities. Management believes these accounting policies involve judgment due to the significant assumptions and estimates necessary in determining the related asset and liability amounts. Management believes it has exercised proper judgment in determining these estimates based on the facts and circumstances available to its management at the time the estimates were made. The significant accounting policies are described in the Company’s financial statements (see Note 1 in Notes to the Consolidated Financial Statements). Of these policies, management believes the following ones may involve a comparatively higher degree of judgment and complexity. We have discussed the development and selection of the critical accounting policies and related disclosures with the Audit Committee of the Board of Directors.

Revenue Recognition

Background

The Company’s revenue recognition policy is significant because net patient service revenue is a primary component of its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to recognize in connection with the Company’s services is subject to significant judgments and estimates, which are discussed below.

Revenue Recognition Policy

Through the fiscal year ended August 31, 2005, the Company did not participate in managed care contracts. In the quarter ended November 30, 2005, the Company began such participation and currently participates in a small number of managed care contracts. The Company records revenue pursuant to the following policy. The Company has established billing rates for its medical services which it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Company’s estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues are based on historical cash collections as discussed below and may not represent amounts ultimately expected to be collected. At such time as the Company can determine that ultimate collections have exceeded or have been less than the revenue recorded on a group of accounts, additional revenue or reduction in revenue is recorded as a change in estimate during the current period. The Company does adjust current period revenue for actual differences in estimated revenue recorded in prior periods and actual cash collections. As the Company is able to identify specific closed blocks of business, the Company compares the actual cash collections on gross billed charges to the estimated collections that were recorded in revenue. The Company records additional revenue or a reduction in revenue in the current period equal to the difference in the estimate recorded and the actual cash collected.

In the last three fiscal years, the Company has recorded additional revenue on two specific blocks of business during the fiscal year ended August 31, 2006 as follows:

1. The Company collected $4,928,992 on a block of business generated at our Garland Facility (which was acquired in August 2003) between September 2003 and December 2004. Gross billings on this block of receivables were $8,482,598. The contractual allowance booked on this block of receivables was $5,986,285, or approximately 70.5%, generating net revenue of $2,496,313. Since the Company actually collected $4,928,992 on this block of receivables, additional revenue in the amount of $2,400,000 was recorded in the second quarter of fiscal year 2006.

2. The Company collected $3,572,519 on a block of business generated at our Garland Facility between January 2005 and February 2006. Gross billings on this block of receivables were $6,604,840. The contractual allowance booked on this block of receivables was $4,531,716, or approximately 68.6%, generating net revenue of $2,073,123. Since the Company actually collected $3,572,519 on this block of receivables, additional revenues in the amounts of $1,000,000 and $500,000 were recorded in the first and second quarters of fiscal year 2006, respectively.

Contractual Allowance

The Company computes its contractual allowance based on the ratio of the Company’s historical cash collections during the trailing twelve months to gross billed revenue on a case-by-case basis by operating facility. This ratio of cash collections to billed services is then applied to the gross billed services by operating facility.

Comparison of the Fiscal Years Ended August 31, 2007 and August 31, 2006

Net patient service revenue increased by $6,856,507, or 19%, from $35,989,314 to $42,845,821, and total surgical cases increased by 2% from 2,588 cases in fiscal year 2006 to 2,642 cases in fiscal year 2007.

The Garland Facility had an increase in both bariatric and orthopedic cases due to recruitment of additional physicians. The increase in net patient service revenue is primarily due to a 21% increase in the inpatient cases, which typically have a higher average reimbursement per case.

According to the Company’s revenue recognition policy, during the fiscal year ended August 31, 2006, the Company had recorded additional revenue on two specific blocks of business as follows:

1. The Company collected $4,928,992 on a block of business generated at our Garland Facility (which was acquired in August 2003) between September 2003 and December 2004. Gross billings on this block of receivables were $8,482,598. The contractual allowance booked on this block of receivables was $5,986,285, or approximately 70.5%, generating net revenue of $2,496,313. Since the Company actually collected $4,928,992 on this block of receivables, additional revenue in the amount of $2,400,000 was recorded in the second quarter of fiscal year 2006.

2. The Company collected $3,572,519 on a block of business generated at our Garland Facility between January 2005 and February 2006. Gross billings on this block of receivables were $6,604,840. The contractual allowance booked on this block of receivables was $4,531,716, or approximately 68.6%, generating net revenue of $2,073,123. Since the Company actually collected $3,572,519 on this block of receivables, additional revenues in the amounts of $1,000,000 and $500,000 were recorded in the first and second quarters of fiscal year 2006, respectively.

Excluding the above-mentioned additional revenue on two specific blocks of business, net patient service revenue per case increased $3,818, or 31%, from $12,399 in 2006 to $16,217 in 2007, and the number of cases increased by 2%.

The Company computes its contractual allowance based on the ratio of the Company’s historical cash collections during the trailing twelve months to gross billed revenue on a case-by-case basis by operating facility. In compliance with this revenue recognition policy, due to a higher percentage of gross patient service revenues from commercial and other insurance payers from 31% in 2006 to 38% in 2007, the Company’s contractual allowance as a percentage of gross patient revenue has decreased from 59% in 2006 to 55% in 2007.

Total costs and expenses decreased by $786,497, or 2%, from $39,956,339 in fiscal 2006 to $39,169,842 in fiscal 2007. The following describes the various changes in costs and expenses:


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Compensation and benefits increased by $1,020,072, or 9%. During fiscal year 2007, the Company incurred a $124,425 non-cash pre-tax compensation expense related to employees’ incentive stock options granted. Excluding this non-cash compensation expense, the increase in compensation and benefits in the current fiscal year is 8% compared to the prior fiscal year, primarily due to an increase in number of cases.


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Medical services and supplies expenses increased $1,765,021, or 24%, while the number of surgery cases increased 2%. The increase was due to a 21% increase in the number of inpatient procedures, which typically require more medical services and supplies


•

Other operating expenses decreased by $3,377,652, or 18%. In August 2006, the Company settled in principle the class action lawsuit alleging federal securities law causes of action against the Company for $1.5 million. Setting aside this $1.5 million settlement, the other operating expenses decreased by 11%. The Company made continued efforts to reduce other operating expenses.

Other income decreased by $830,510 from $667,402 in 2006 to $163,108 other expense, net, in 2007. The decrease in other income is primarily due to a Medicare refund of approximately $604,000 for an overpayment settlement received in 2006.

The income tax benefit for the fiscal year ended August 31, 2007 is due to the change in the Company’s deferred tax valuation allowance.

The income from discontinued operations represents the income at our Baton Rouge Facility partially offset by losses at the West Houston Facility. The combined net patient service revenues at these facilities increased $3,046,335, or 33%, from $9,342,985 in 2006 to $12,389,320 in 2007, whereas the total surgical cases increased 1% from 1,406 cases in fiscal year 2006 to 1,419 cases in fiscal year 2007. The net patient revenue per case increased $2,086, or 31%, from $6,645 in 2006 to $8,731 in fiscal 2007. Although the number of cases at our facilities increased 1%, the 31% increase in net patient service revenue per case was due to an increase of 47% in inpatient cases, primarily bariatric surgeries, at our Baton Rouge Facility. Total costs and expenses of the discontinued operations decreased by $1,047,161, or 8%, from $12,992,208 in fiscal 2006 to $11,945,047 in fiscal 2007. In 2006, the assets related to discontinued operations had a depreciation expense of $1,584,384, which was $-0- in 2007 in accordance with FASB 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Excluding this 2006 depreciation expense, the costs and expenses increased by $537,223 in 2007 compared to 2006, primarily due to an increase in net patient service revenues. The West Houston Facility was sold in the second quarter of fiscal year 2007.

The extraordinary gain in 2007 of $29,844, net of income taxes, relates to gains on the purchase of minority interests from certain minority interest holders at an amount less than the net book value of the minority interest liability on the date of purchase.

Comparison of the Fiscal Years Ended August 31, 2006 and August 31, 2005

Net patient service revenue decreased by $5,628,837, or 14%, from $41,618,151 to $35,989,314, and total surgical cases decreased by 1% from 2,623 cases in fiscal year 2005 to 2,588 cases in fiscal year 2006.

1. The Company collected $4,928,992 on a block of business generated at our Garland Facility (which was acquired in August 2003) between September 2003 and December 2004. Gross billings on this block of receivables were $8,482,598. The contractual allowance booked on this block of receivables was $5,986,285, or approximately 70.5%, generating net revenue of $2,496,313. Since the Company actually collected $4,928,992 on this block of receivables, additional revenue in the amount of $2,400,000 was recorded in the second quarter of fiscal year 2006.

2. The Company collected $3,572,519 on a block of business generated at our Garland Facility between January 2005 and February 2006. Gross billings on this block of receivables were $6,604,840. The contractual allowance booked on this block of receivables was $4,531,716, or approximately 68.6%, generating net revenue of $2,073,123. Since the Company actually collected $3,572,519 on this block of receivables, additional revenues in the amounts of $1,000,000 and $500,000 were recorded in the first and second quarters of fiscal year 2006, respectively.

The net patient revenue per case decreased $1,960, or 12%, from $15,867 in 2005 to $13,907 in fiscal 2006. Although the number of cases at our facilities decreased 1%, the 12% decline in net patient service revenue per case was the result of the increased number of outpatient cases that typically have a lower average reimbursement per procedure. In addition, decreases in net patient service revenue per case were attributable to a change in the surgical mix of cases, and reimbursement by workers’ compensation insurance payers below the TDWC fee guideline.

The Company computes its contractual allowance based on the ratio of the Company’s historical cash collections during the trailing twelve months to gross billed revenue on a case-by-case basis by operating facility. In compliance with this revenue recognition policy, due to slower collections on the receivables associated with the workers’ compensation dispute resolution process, the Company’s contractual allowance as a percentage of gross patient revenue increased from 58% in 2005 to 59% in 2006.

Total costs and expenses decreased by $4,642,037, or 10%, from $44,598,376 in fiscal 2005 to $39,956,339 in fiscal 2006. The following discusses the various changes in costs and expenses:


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Compensation and benefits decreased by $3,096,347, or 22%. During fiscal year 2005, the Company incurred a $431,821 non-cash pre-tax compensation expense related to former employees’ incentive stock options previously granted. In fiscal year 2005, the Company also incurred a $138,015 non-cash pre-tax compensation expense related to acceleration of vesting of all outstanding stock options and extending the exercise date of a stock option. Excluding these non-cash compensation expenses, the decline in compensation and benefits in the current fiscal year is 19% compared to the prior fiscal year. The Company made a concerted effort to reduce employee costs and expenses to match the decline in revenue.

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Medical services and supplies expenses decreased $1,112,099, or 13%, while the number of surgery cases decreased 1%. The decrease in medical services and supplies expense was due to an overall increase in outpatient cases, which typically require less medical supplies, from 64% to 78% of total number of cases from 2005 to 2006.


•

Other operating expenses decreased by $323,731, or 2%. In August 2006, the Company settled in principle the class action lawsuit alleging federal securities law causes of action against the Company for $1.5 million. Setting aside this $1.5 million settlement, the other operating expenses decreased by 9%. The Company made efforts to reduce other operating expenses to match the decline in revenue. The Company also spent approximately an additional $599,000, or 12%, in advertising and marketing costs from $5,012,000 in fiscal year 2005 to $5,611,000 in fiscal year 2006.

Other income increased by $619,621 from $47,781 in 2005 to $667,402 in 2006. The increase in other income is primarily due to a Medicare refund of approximately $604,000 for an overpayment settlement.

The income tax benefit of the net operating loss does not have the expected relationship to net loss due to the establishment of a deferred tax valuation allowance.

The loss on discontinued operations represents the losses at our Baton Rouge and West Houston Facilities. The combined net patient service revenues at these facilities decreased $4,313,725, or 32%, from $13,656,710 in 2005 to $9,342,985 in 2006, whereas the total surgical cases increased 18% from 1,196 cases in fiscal year 2005 to 1,406 cases in fiscal year 2006. The net patient revenue per case decreased $4,773, or 42%, from $11,418 in 2005 to $6,645 in fiscal 2006. Although the number of cases at our facilities increased 18%, the 32% decline in net patient service revenue per case was primarily due to a change in the surgical mix of cases. Total costs and expenses of the discontinued operations decreased by $4,123,680, or 24%, from $17,115,888 in fiscal 2005 to $12,992,208 in fiscal 2006. In 2005, the bankruptcy filing of the Baton Rouge Facility caused increased legal fees and other operating expenses of approximately $1,453,000. Setting aside these one-time expenses, the decrease in operating expenses was 17%. The Company made efforts to reduce costs and expenses to match the decline in revenue. Costs and expenses did not reduce proportionately to the decrease in revenues due to fixed overhead and operating expenses, as well as time required to implement cost cutting measures.

The extraordinary gain in fiscal year 2006 of $431,199, net of income taxes, relates to gains on the purchase of minority interests from certain minority interest holders at an amount less than the net book value of the minority interest liability on the date of purchase.

Liquidity and Capital Resources

The Company maintained sufficient liquidity to meet its business needs in fiscal 2007. As of August 31, 2007, its principal source of liquidity was $5,436,787 in cash and current portion of net accounts receivable of $10,526,365.

Cash flows from operating activities

Total cash flow provided by operating activities was $5,894,414 (including $312,540 provided by discontinued activities) during fiscal year 2007, primarily due to a net income of $4,155,480, depreciation and amortization of $2,334,012 and an increase in accounts payable and accrued liabilities of $1,333,136, partially offset by an increase in accounts receivable of $2,415,113 due to an increase in net patient service revenues and slower collection on MDR accounts.

In 2006, the Company made the decision to sell the assets related to its Baton Rouge and West Houston Facilities and its land in The Woodlands, Texas. During the fiscal year ended August 31, 2007, the Company sold its West Houston Facility. In May 2007, the Company signed an earnest money contract for sale of the land in The Woodlands, Texas, and the sale was subsequently completed in September 2007. The net proceeds and gain on sale of land in The Woodlands, Texas were $1.8 million and $28,000, respectively. The Company entered into the Sale Agreement for the sale of assets related to its Baton Rouge Facility on November 8, 2007, and the sale is expected to be completed in the second quarter of fiscal year 2008, subject to the satisfaction of certain closing conditions. The expected sales proceeds and gain on sale of the assets related to the Baton Rouge Facility are $20 million and $6 million, respectively. None of these assets is encumbered by secured lien or debt, so all proceeds from the sale of any of those assets, net of selling expenses, would be available to the Company to pursue its business plans.

Cash flows from investing activities

Total cash flow used in investing activities was $4,659,967 (including $41,360 provided by discontinued activities) during fiscal year 2007, primarily due to restricted cash of $4,049,149 sent to the DeAn Joint Venture for capital improvement projects. See also discussion above under “Cash flows from operating activities” for sale of the land in The Woodlands, Texas in September 2007, and also sale of assets related to the Baton Rouge Facility, which is expected to be completed in the second quarter of fiscal year 2008, subject to the satisfaction of certain closing conditions.

Cash flows from financing activities

Total cash flow provided by financing activities was $774,226 (including $130,299 used in discontinued activities) during fiscal year 2007. During fiscal year 2007, the Company borrowed $734,601 under its Credit Agreement. The Company also received $503,945 from the exercise of employees’ stock options. In fiscal 2007, the class action lawsuit settlement was approved by the Court, and in accordance with the terms of the settlement, the Company paid $100,000 and signed a note payable for $1.4 million to be paid in 36 equal monthly installments. The note bears interest of 6% per annum and is secured by a deed of trust on the Garland Facility. The Company has paid $216,231 of the $1.4 million note payable.

The Company had working capital of $7,705,373 as of August 31, 2007, and maintained a liquid position by a current ratio of approximately 1.43 to 1.

The Company and certain of its subsidiaries on May 27, 2005 entered into a Credit and Security Agreement (the “Credit Agreement”) with Merrill Lynch Capital for a new five-year revolving credit facility for up to $10 million, subject to a borrowing base based on eligible accounts receivable and further subject to a $2 million reserve until satisfaction of certain conditions. As of August 31, 2007, the Company had drawn $7.1 million of approximately $8.0 million available to it under the Credit Agreement based on its borrowing base at that date. The Company’s obligations are secured by a first priority security interest in all existing and future accounts receivable and accounts receivable-related items, other assets and deposit accounts of certain subsidiaries, a pledge of 75% of equity interest in the operating entities of the Garland and Pasadena Facilities and a negative pledge for the equity interests in the Company and other subsidiaries. The real estate holding subsidiaries of Dynacq are not borrowers under the Credit Agreement, and their real estate and equipment assets are not pledged to secure the obligations under such facility.

The Credit Agreement, among other things, requires that the Company maintain certain performance financial covenants, restricts its ability to incur certain additional indebtedness, and contains various customary provisions, including affirmative and negative covenants, representations and warranties and events of default. Please refer to the Form 8-K filed on June 1, 2005 for further information.

As of October 30, 2007, the Company had an approximately $2.3 million cash balance. As of October 31, 2007, the Company had paid down the full amount drawn of approximately $7.1 million and had approximately $8.0 million available under the Credit Agreement based on its borrowing base on that date. The availability of borrowings under our Credit Agreement is subject to various conditions as described above.

We believe we will be able to meet our ongoing liquidity and cash needs for fiscal year 2008 through the combination of available cash, cash flow from operations, proceeds from sales of assets, and borrowings under our Credit Agreement. All net proceeds from the sale of assets held for sale, including the Baton Rouge Facility, would be available to meet our ongoing liquidity and cash needs.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Executive Summary

Update on Assets Held for Sale

In 2006, the Company made the decision to sell the assets related to its Baton Rouge and West Houston facilities and its land in The Woodlands, Texas. The Company sold the West Houston facility in the quarter ended February 28, 2007, the land in The Woodlands, Texas in the quarter ended November 30, 2007 and the Baton Rouge facility in the quarter ended February 29, 2008. The net proceeds and gain on sale of land in The Woodlands, Texas were $1.8 million and $28,000, respectively. The net proceeds and gain on sale of the Baton Rouge facility were $16.5 million and $2.8 million (net of income tax of $1.7 million), respectively.

Update on MDRs

The Company, in conjunction with most of the Texas hospital medical providers, continues its efforts to resolve the pending claims regarding payment for the treatment of injured workers under the Texas workers’ compensation laws. The Company exhausts all of its available avenues in collecting its accounts receivable (particularly in the workers’ compensation arena). This includes the appeal to SOAH or the District Court for workers’ compensation cases where the insurance carrier failed to reimburse the Company in accordance with the rules of reimbursement mandated by Texas state law.

The Company continues to be successful in its pursuit of collections regarding the stop-loss cases pending before SOAH. As of February 29, 2008, approximately 160 of the Company’s pending cases in which the application of the stop-loss methodology was at issue have been decided in the Company’s favor; however nearly all of SOAH’s decisions in these cases have been appealed by the insurance carriers to the District Court. Approximately 150 cases are set for hearing between February and May 2008.

As expected, the declaratory judgment recently issued by the District Court upholding the interpretation of the statute as applied to the stop-loss claims of the Company by SOAH has been appealed by several insurance carriers to the Texas Third Court of Appeals, where it is currently pending. Notably, the agency responsible for drafting and enforcing this fee guideline did not appeal that judgment.

New Fee Guideline for Texas Workers’ Compensation cases

Starting March 1, 2008, Texas Workers’ Compensation 2008 Acute Care Hospital Outpatient and Inpatient Facility Fee Guidelines became effective. The reimbursement amounts are determined by applying the most recently adopted and effective Medicare reimbursement formula and factors as published annually in the Federal Register. However, if the maximum allowable reimbursement for the procedure performed cannot be calculated using these fee guidelines, then reimbursement shall be determined on a fair and reasonable basis.

Based on this new Fee Guideline, the reimbursement due the Company for workers’ compensation cases will be lower than we previously experienced. Although we have not yet completed our evaluation of the negative impact this will have for cases starting March 1, 2008, we anticipate discontinuing our focus on Texas workers’ compensation cases because of these lower reimbursement rates. Our patient service revenues may decrease as a result of both the decreased number of procedures and the lower reimbursement rates for workers’ compensation procedures still being performed.

Listing of Company’s Common Stock on Nasdaq Global Market

Effective with the open of business on February 29, 2008, the Company’s common stock was listed on the Nasdaq Global Market instead of the Nasdaq Capital Market. The trading symbol for the Company’s common stock continues to be DYII.

Repurchase of Common Stock

Of the 500,000 shares authorized to repurchase in January 2002, the Company purchased 10,000 shares in December 2007 at an average cost of $3.80 per share.

On February 29, 2008 the Company’s Board of Directors authorized a program of repurchasing up to 2 million of its outstanding securities from time to time in open market transactions at prevailing prices on NASDAQ. Subsequent to the fiscal quarter ended February 29, 2008, the Company has repurchased 76,954 shares at an average cost of $4.70 per share.

Net Patient Service Revenues

Net patient service revenues for the quarter ended February 29, 2008 increased $11,798,702, or 127%, from the second fiscal quarter of 2007. The increase is primarily due to additional revenues of $3,835,000 recognized in the quarter ended February 29, 2008 on closed MDR accounts receivable and also due to an increase in the number of inpatient cases. The amount of additional revenues from MDR settlements reached in the first six months of the current fiscal year may not be indicative of the amounts that may be obtained from settlements reached for the remainder of the fiscal year ending August 31, 2008 or even after that. We are unable to estimate with any certainty the progress of the settlements for the remaining cases.

Overall, the number of cases increased 194, or 32%, from 608 cases for the fiscal quarter ended February 28, 2007 to 802 cases during the fiscal quarter ended February 29, 2008. However, the number of inpatient cases increased 224, or 172%, from 130 inpatient cases in 2007 to 354 cases in 2008.

Costs and Expenses

Costs and expenses increased $3,758,109, or 40%, in the second fiscal quarter of the current year, compared to that of the prior year, primarily due to an increase in compensation and in medical services and supplies. Compensation increased due to increase in revenues and also due to payout of cash incentive bonuses during the current quarter. Medical services and supplies increases were due to an increase in the number of inpatient cases.

Accounts Receivable

Our accounts receivable are larger and older than those of typical healthcare companies because of our pursuit of additional reimbursements through the MDR process. Please see Accounts Receivable in our Notes to Consolidated Financial Statements, as well as Accounts Receivable in our Form 10-K for the fiscal year ended August 31, 2007 for a more complete discussion. The delays caused by the unexpected and extended reimbursement process have increased our collection costs, including legal fees and expenses associated with collection and reimbursement activities.

Update on Critical Accounting Policies and Estimates

There have been no changes to the critical accounting policies used in our reporting of results of operations and financial position for the quarter ended February 29, 2008. For a discussion of our critical accounting policies see Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K for the fiscal year ended August 31, 2007.

Three Months Ended February 29, 2008 Compared to the Three Months Ended February 28, 2007

Net patient service revenue increased by $11,798,702, or 127%, from $9,281,163 to $21,079,865, and total surgical cases increased by 32% from 608 cases to 802 cases for the quarters ended February 29, 2008 and February 28, 2007, respectively.

The Garland and Pasadena facilities had an increase in inpatient cases due to recruitment of additional physicians. The increase is primarily due to additional revenues of $3,835,000 recognized in the quarter ended February 29, 2008 on closed MDR accounts receivable and also due to an increase in the number of inpatient cases. Overall, the number of cases increased 194, or 32%, from 608 cases for the fiscal quarter ended February 28, 2007 to 802 cases during the fiscal quarter ended February 29, 2008. However, the number of inpatient cases increased 224, or 172%, from 130 inpatient cases in 2007 to 354 cases in 2008. Inpatient cases typically have a higher average reimbursement per case.

According to the Company’s revenue recognition policy, the Company recorded additional revenue of $3,835,000 and $4,517,000 during the three and six months ended February 29, 2008 related to amounts collected on MDR accounts receivable. The Company settled various MDR claims for our Pasadena and Garland facilities and collected a total of $15,091,000 for dates of service ranging from 2001 to 2005. This amount represents payments received initially at the time of filing of the claim, additional monies received upon filing the MDR claim and the settlement amount. On these closed MDR accounts receivable, the Company had recognized approximately $10,574,000 as net revenue during the relevant fiscal years when the service was performed. Gross billings on this block of receivables were $20,251,000. Since the Company actually collected $4,517,000 more on this block of receivables, additional revenue of $682,000 and $3,835,000 was recorded in the first and second quarter of the current fiscal year. The amount of additional revenues from MDR settlements reached in the first six months of the current fiscal year may not be indicative of the amounts that may be obtained from settlements reached for the remainder of the fiscal year ending August 31, 2008 or even after that. We are unable to estimate with any certainty the progress of the settlements for the remaining cases.

Starting March 1, 2008, Texas Workers’ Compensation 2008 Acute Care Hospital Outpatient and Inpatient Facility Fee Guidelines became effective. Based on this new Fee Guideline, the reimbursement due the Company for workers’ compensation cases will be lower than we previously experienced. Although we have not yet completed our evaluation of the negative impact this will have for cases starting March 1, 2008, we anticipate discontinuing our focus on Texas workers’ compensation cases because of these lower reimbursement rates. Our patient service revenues may decrease as a result of both the decreased number of procedures and the lower reimbursement rates for workers’ compensation procedures still being performed.

Excluding the above-mentioned additional revenues, net patient service revenue per case increased $6,237 or 41%, from $15,265 in 2007 to $21,502 in 2008, as well as the number of cases increased by 32%.

The Company computes its contractual allowance based on the ratio of the Company’s historical cash collections during the trailing twelve months to gross billed revenue on a case-by-case basis by operating facility. In compliance with this revenue recognition policy, the Company’s contractual allowance as a percentage of gross patient revenue decreased from 56% in 2007 to 49% (excluding the additional revenue of $3,835,000) in 2008.

Total costs and expenses increased by $3,758,109, or 40%, from $9,347,835 in 2007 to $13,105,944 in 2008. The following discusses the various changes in costs and expenses:


•

Compensation and benefits increased by $1,708,723, or 59%. During the quarter ended February 29, 2008, the Company incurred a $124,425 non-cash pre-tax compensation expense related to employees’ incentive stock options granted in fiscal year 2007. Excluding this non-cash compensation expense, the increase in compensation and benefits in the current fiscal quarter is 55% compared to the prior fiscal year, primarily due to an increase in number of cases, and also due to annual cash incentive bonus paid to employees.


•

Medical services and supplies expenses increased by $1,693,683, or 86%, while the number of surgery cases increased 32%. The increase was primarily due to a 172% increase in the number of inpatient procedures, which typically require more medical services and supplies.


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Other operating expenses increased by $367,720, or 9%. Even though the net patient service revenue increased by 127%, the marginal increase in other operating expenses was due to the continued efforts made by the Company to reduce costs and expenses.

The income from discontinued operations represents the income at our Baton Rouge facility and, for the quarter ended February 28, 2007, the West Houston facility. The sale of the Baton Rouge facility was completed in December 2007. The net patient service revenues at these facilities decreased $1,831,843, or 89%, from $2,051,277 in 2007 to $219,434 in 2008, and the total surgical cases decreased 86% from 333 cases in 2007 to 46 cases in 2008. The decrease is due to the Baton Rouge facility being in operation for only 14 days in the current fiscal quarter before it was sold. Total costs and expenses of the discontinued operations decreased by $2,203,506, or 74%, from $2,993,002 in 2007 to $789,496 in 2008.

The gain on sale of discontinued operations during the quarter ended February 29, 2008 was $4,448,184. Provision for income taxes on this gain was $1,687,000.

The extraordinary gain, net of income taxes, relates to gains on the purchase of minority interests from certain minority interest holders at an amount less than the net book value of the minority interest liability on the date of purchase.


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