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ENSIGN GROUP, INC - Quarter Report: 2012 September (Form 10-Q)

Table of Contents

 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________________
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended September 30, 2012.
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from                      to                     .
Commission file number: 001-33757
__________________________
THE ENSIGN GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)
Delaware
33-0861263
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
27101 Puerta Real, Suite 450
Mission Viejo, CA 92691
(Address of Principal Executive Offices and Zip Code)
(949) 487-9500
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)
_____________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
 
 
(Do not check if a smaller reporting company)
 
Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
As of November 5, 2012, 21,571,671 shares of the registrant’s common stock were outstanding.
 
 
 
 
 


THE ENSIGN GROUP, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012
TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2
 Exhibit 101

2
Table of Contents

Part I. Financial Information

Item 1.        Financial Statements
THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par values)
(Unaudited)
 
September 30,
2012
 
December 31,
2011
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
32,028

 
$
29,584

Accounts receivable—less allowance for doubtful accounts of $13,628 and $12,782 at September 30, 2012 and December 31, 2011, respectively
98,072

 
86,311

Investments—current
4,254

 
—

Prepaid income taxes
3,232

 
5,882

Prepaid expenses and other current assets
7,985

 
7,667

Deferred tax asset—current
10,178

 
11,195

Total current assets
155,749

 
140,639

Property and equipment, net
439,233

 
403,862

Insurance subsidiary deposits and investments
18,149

 
16,752

Escrow deposits
—

 
175

Deferred tax asset
4,787

 
3,514

Restricted and other assets
12,385

 
10,418

Intangible assets, net
4,867

 
2,321

Goodwill
22,180

 
17,177

Other indefinite-lived intangibles
10,598

 
1,481

Total assets
$
667,948

 
$
596,339

Liabilities and equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
23,211

 
$
21,169

Accrued wages and related liabilities
34,868

 
41,958

Accrued self-insurance liabilities—current
15,897

 
12,369

Other accrued liabilities
22,615

 
18,577

Current maturities of long-term debt
7,133

 
6,314

Total current liabilities
103,724

 
100,387

Long-term debt—less current maturities
192,299

 
181,556

Accrued self-insurance liabilities—less current portion
34,928

 
31,904

Fair value of interest rate swap
3,116

 
2,143

Deferred rent and other long-term liabilities
3,306

 
2,864

Total liabilities
337,373

 
318,854

 
 
 
 
Commitments and contingencies (Note 16)

 

Temporary equity - redeemable noncontrolling interest
11,511

 
—

Equity:
 
 
 
Ensign Group, Inc. stockholders' equity:
 
 
 
Common stock; $0.001 par value; 75,000 shares authorized; 22,107 and 21,550 shares issued and outstanding at September 30, 2012, respectively, and 21,575 and 21,179 shares issued and outstanding at December 31, 2011, respectively
22

 
22

Additional paid-in capital
84,881

 
77,257

Retained earnings
238,831

 
204,073

Common stock in treasury, at cost, 344 and 396 shares at September 30, 2012 and December 31, 2011, respectively
(2,347
)
 
(2,559
)
Accumulated other comprehensive loss
(1,901
)
 
(1,308
)
Total Ensign Group, Inc. stockholders' equity
319,486

 
277,485

Non-controlling interest
(422
)
 
—

Total equity
319,064

 
277,485

Total liabilities and equity
$
667,948

 
$
596,339

See accompanying notes to condensed consolidated financial statements.

3
Table of Contents

THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue
$
207,150

 
$
196,346

 
$
613,618

 
$
565,615

Expense:
 
 
 
 
 
 
 
Cost of services (exclusive of facility rent, general and administrative and depreciation and amortization expenses shown separately below)
164,877

 
155,725

 
488,305

 
444,517

Facility rent—cost of services
3,374

 
3,331

 
10,063

 
10,380

General and administrative expense
8,099

 
7,195

 
23,933

 
22,188

Depreciation and amortization
7,179

 
6,179

 
21,145

 
16,784

Total expenses
183,529

 
172,430

 
543,446

 
493,869

Income from operations
23,621

 
23,916

 
70,172

 
71,746

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(3,092
)
 
(5,323
)
 
(9,131
)
 
(10,789
)
Interest income
69

 
68

 
172

 
198

Other expense, net
(3,023
)
 
(5,255
)
 
(8,959
)
 
(10,591
)
Income before provision for income taxes
20,598

 
18,661

 
61,213

 
61,155

Provision for income taxes
7,562

 
7,063

 
23,070

 
23,835

Net income
13,036

 
11,598

 
38,143

 
37,320

Less: net loss attributable to noncontrolling interests
(258
)
 
—

 
(511
)
 
—

Net income attributable to The Ensign Group, Inc.
$
13,294

 
$
11,598

 
$
38,654

 
$
37,320

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.62

 
$
0.55

 
$
1.81

 
$
1.78

Diluted
$
0.60

 
$
0.54

 
$
1.77

 
$
1.73

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
21,488

 
20,995

 
21,369

 
20,920

Diluted
22,010

 
21,570

 
21,899

 
21,571

See accompanying notes to condensed consolidated financial statements.

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THE ENSIGN GROUP, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
13,036

 
$
11,598

 
$
38,143

 
$
37,320

Other comprehensive loss, net of tax:
 
 
 
 
 
 
 
Net unrealized loss on interest rate swap, net of tax of $154 and $380 for the three and nine months ended September 30, 2012, and $816 for both the three and nine months ended September 30, 2011.
(239
)
 
(1,274
)
 
(593
)
 
(1,274
)
Comprehensive income
12,797

 
10,324

 
37,550

 
36,046

Less: net loss attributable to noncontrolling interests
(258
)
 
—

 
(511
)
 
—

Comprehensive income attributable to The Ensign Group, Inc.
$
13,055

 
$
10,324

 
$
38,061

 
$
36,046


See accompanying notes to consolidated financial statements.


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Table of Contents


THE ENSIGN GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended
September 30,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net income
$
38,143

 
$
37,320

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
21,145

 
16,784

Amortization of deferred financing fees and debt discount
620

 
518

Deferred income taxes
124

 
(1,843
)
Provision for doubtful accounts
6,195

 
5,982

Share-based compensation
2,484

 
2,614

Excess tax benefit from share-based compensation
(1,145
)
 
(991
)
Loss on extinguishment of debt
—

 
2,542

Loss on disposition of property and equipment
258

 
121

Change in operating assets and liabilities
 
 
 
Accounts receivable
(17,938
)
 
(17,510
)
Prepaid income taxes
2,650

 
(2,524
)
Prepaid expenses and other current assets
(306
)
 
(1,099
)
Insurance subsidiary deposits and investments
(5,651
)
 
(247
)
Accounts payable
1,143

 
4,216

Accrued wages and related liabilities
(7,090
)
 
1,642

Other accrued liabilities
4,853

 
3,378

Accrued self-insurance
5,796

 
3,041

Deferred rent liability
312

 
(699
)
Net cash provided by operating activities
51,593

 
53,245

Cash flows from investing activities:
 
 
 
Purchase of property and equipment
(26,755
)
 
(29,071
)
Cash payment for business acquisitions
(22,557
)
 
(86,539
)
Cash payment for asset acquisitions
(11,261
)
 
(16,583
)
Escrow deposits
—

 
(9,718
)
Escrow deposits used to fund business acquisitions
175

 
14,422

Cash proceeds from the sale of property and equipment
39

 
653

Restricted and other assets
(1,482
)
 
(34
)
Net cash used in investing activities
(61,841
)
 
(126,870
)
Cash flows from financing activities:
 
 
 
Proceeds from issuance of debt
21,525

 
75,000

Payments on long-term debt
(10,055
)
 
(44,698
)
Repurchase of shares of common stock
(174
)
 
—

Issuance of treasury stock upon exercise of options
386

 
623

Issuance of common stock upon exercise of options
3,996

 
1,282

Dividends paid
(3,873
)
 
(3,468
)
Excess tax benefit from share-based compensation
1,145

 
991

Payments of deferred financing costs
(258
)
 
(2,543
)
Net cash provided by financing activities
12,692

 
27,187

Net increase (decrease) in cash and cash equivalents
2,444

 
(46,438
)
Cash and cash equivalents beginning of period
29,584

 
72,088

Cash and cash equivalents end of period
$
32,028

 
$
25,650

Supplemental disclosures of cash flow information:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
9,220

 
$
10,613

Income taxes
$
19,116

 
$
27,352

Non-cash financing and investing activity:
 
 
 

Acquisition of redeemable noncontrolling interest
$
11,600

 
$
—

Accrued capital expenditures
$
899

 
$
621

See accompanying notes to condensed consolidated financial statements.

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Table of Contents

THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars and shares in thousands, except per share data)
(Unaudited)

1. DESCRIPTION OF BUSINESS

The Company - The Ensign Group, Inc., through its subsidiaries (collectively, Ensign or the Company), provides skilled nursing and rehabilitative care services through the operation of 107 facilities, six home health and four hospice operations as of September 30, 2012, located in Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Oregon, Texas, Utah and Washington. The Company's operations, each of which strives to be the operation of choice in the community it serves, provide a broad spectrum of skilled nursing, assisted living, home health and hospice services, including physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. In the first quarter of 2012, the Company entered into a joint venture to develop and operate urgent care centers and related businesses. These walk-in clinics will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. The Company's facilities have a collective capacity of approximately 12,000 operational skilled nursing, assisted living and independent living beds. As of September 30, 2012, the Company owned 85 of its 107 facilities and operated an additional 22 facilities through long-term lease arrangements, and had options to purchase two of those 22 facilities.
The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenue. All of the Company’s skilled nursing, assisted living and home health and hospice operations are operated by separate, wholly-owned, independent subsidiaries, each of which has its own management, employees and assets. One of the Company’s wholly-owned subsidiaries, referred to as the Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other centralized services to the other operating subsidiaries through contractual relationships with such subsidiaries. The Company also has a wholly-owned captive insurance subsidiary (the Captive) that provides some claims-made coverage to the Company’s operating subsidiaries for general and professional liability, as well as coverage for certain workers’ compensation insurance liabilities.
Like the Company’s facilities, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.
Other Information — The accompanying condensed consolidated financial statements as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 (collectively, the Interim Financial Statements), are unaudited. Certain information and note disclosures normally included in annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company’s audited consolidated statements and notes thereto for the year ended December 31, 2011 which are included in the Company’s annual report on Form 10-K, File No. 001-33757 (the Annual Report) filed with the Securities and Exchange Commission (the SEC). Management believes that the Interim Financial Statements reflect all adjustments which are of a normal and recurring nature necessary to present fairly the Company’s financial position and results of operations in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.


2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The accompanying Interim Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The Company is the sole member or shareholder of various consolidated limited liability companies and corporations; each established to operate various acquired skilled nursing and assisted living facilities, and home health and hospice operations. Additionally, the Company's Interim Financial Statements include accounts of its majority owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. The Company presents noncontrolling interest within the equity section of its condensed consolidated balance sheets. Noncontrolling interest that is redeemable at the option of the minority shareholder is presented outside of permanent equity in the mezzanine section as temporary equity in the Company's consolidated balance sheets. The Company presents the amount of consolidated net income that is attributable to The Ensign Group, Inc. and the noncontrolling interest in its condensed consolidated statements of income.

7
Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Estimates and Assumptions — The preparation of Interim Financial Statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The most significant estimates in the Company’s Interim Financial Statements relate to revenue, allowance for doubtful accounts, intangible assets and goodwill, impairment of long-lived assets, general and professional liability, worker’s compensation, and healthcare claims included in accrued self-insurance liabilities, interest rate swaps, and income taxes. Actual results could differ from those estimates.

Business Segments — The Company has a single reportable segment — long-term care services, which includes the operation of skilled nursing and assisted living facilities, home health, hospice, urgent care and related ancillary services. The Company’s single reportable segment is made up of several individual operating segments grouped together principally based on their geographical locations within the United States. Based on the similar economic and other characteristics of each of the operating segments, management believes the Company meets the criteria for aggregating its operating segments into a single reportable segment.

Fair Value of Financial Instruments — The Company’s financial instruments consist principally of cash and cash equivalents, debt security investments, interest rate swap agreements, accounts receivable, insurance subsidiary deposits, accounts payable and borrowings. The Company believes all of the financial instruments’ recorded values approximate fair values because of their nature or respective short durations. The interest rate swap is carried at fair value on the balance sheet. The Company’s fixed-rate debt instruments do not actively trade in an established market. The fair values of this debt are estimated by discounting the principal and interest payments at rates available to the Company for debt with similar terms and maturities. See further discussion of debt security investments in Note 4, Fair Value Measurements.
Revenue Recognition — The Company recognizes revenue when the following four conditions have been met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is fixed or determinable; and (iv) collection is reasonably assured. The Company's revenue is derived primarily from providing healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis.
Revenue from the Medicare and Medicaid programs accounted for 73.6% and 73.7% of the Company’s revenue for the three and nine months ended September 30, 2012, and 75.0% and 75.3% for the three and nine months ended September 30, 2011, respectively. The Company records revenue from these governmental and managed care programs as services are performed at their expected net realizable amounts under these programs. The Company’s revenue from governmental and managed care programs is subject to audit and retroactive adjustment by governmental and third-party agencies. Consistent with healthcare industry accounting practices, any changes to these governmental revenue estimates are recorded in the period the change or adjustment becomes known based on final settlement. The Company recorded retroactive adjustments that (decreased) increased revenue by $(138) and $174 for the three and nine months ended September 30, 2012 and $40 and $881 for the three and nine months ended September 30, 2011, respectively.
The Company’s service specific revenue recognition policies are as follows:
Skilled Nursing Revenue
The Company’s revenue is derived primarily from providing long-term healthcare services to residents and is recognized on the date services are provided at amounts billable to individual residents. For residents under reimbursement arrangements with third-party payors, including Medicaid, Medicare and private insurers, revenue is recorded based on contractually agreed-upon amounts on a per patient, daily basis. The Company records revenue from private pay patients, at the agreed upon rate, as services are performed.
Home Health and Hospice Revenue Recognition
Episodic Based Revenue —Net service revenue is typically recorded on a 60-day episode payment rate. The Company makes adjustments to revenue on completed episodes to reflect differences between estimated and actual payment amounts, an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company records an estimate for the impact of such payment adjustments based on its historical experience. In addition to revenue recognized on completed episodes, the Company also recognizes a portion of revenue associated with episodes in progress. Episodes in progress are 60-day episodes of care that begin during the reporting period, but were not completed as of the end of the period. The Company estimates this revenue on a monthly basis based upon historical trends. The primary factors underlying

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Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


this estimate are the number of episodes in progress at the end of the reporting period, expected Medicare revenue per episode and the Company's estimate of the average percentage complete based on days completed of the episode of care.
Non-episodic Based Revenue — Revenue is recorded on an accrual basis based upon the date of service at amounts equal to our established or estimated per-visit rates, as applicable.
Hospice Revenue — Revenue is recorded on an accrual basis based upon the date of service at amounts equal to the estimated payment rates. The estimated payment rates are daily rates for each of the levels of care we deliver. The Company makes adjustments to revenue for an inability to obtain appropriate billing documentation or authorizations acceptable to the payor and other reasons unrelated to credit risk. The Company estimates the impact of these adjustments based on its historical experience, which primarily includes historical collection rates on Medicare claims, and records it during the period services are rendered as an estimated revenue adjustment and as a reduction to its outstanding patient accounts receivable. Additionally, as Medicare hospice revenue is subject to an inpatient cap limit and an overall payment cap, the Company monitors its provider numbers and estimates amounts due back to Medicare if a cap has been exceeded. The Company records these adjustments as a reduction to revenue and increases other accrued liabilities.
Accounts Receivable and Allowance for Doubtful Accounts — Accounts receivable consist primarily of amounts due from Medicare and Medicaid programs, other government programs, managed care health plans and private payor sources. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.
In evaluating the collectability of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type and the status of ongoing disputes with third-party payors. On an annual basis, the historical collection percentages are reviewed by payor and by state and are updated to reflect the recent collection experience of the Company. In order to determine the appropriate reserve rate percentages which ultimately establish the allowance, the Company analyzes historical cash collection patterns by payor and by state. The percentages applied to the aged receivable balances are based on the Company’s historical experience and time limits, if any, for managed care, Medicare, Medicaid and other payors. The Company periodically refines its estimates of the allowance for doubtful accounts based on experience with the estimation process and changes in circumstances.
Equity Investment — The Company's majority-owned subsidiary has a non-marketable equity investment which is accounted for under the equity method. The investment is initially recorded at cost and the Company will adjust the carrying amount for its share of the earnings or losses of the investee after the date of investment. The investment is evaluated periodically for impairment. If it is determined that a decline of the investment is other than temporary, then the investment basis would be written down to fair value and the write-down would be included in earnings as a loss.
Property and Equipment — Property and equipment are initially recorded at their historical cost. Repairs and maintenance are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the depreciable assets (ranging from three to 30 years). Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the remaining lease term.
Impairment of Long-Lived Assets — The Company reviews the carrying value of long-lived assets that are held and used in the Company’s operations for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon expected undiscounted future net cash flows from the operations to which the assets relate, utilizing management’s best estimate, appropriate assumptions, and projections at the time. If the carrying value is determined to be unrecoverable from future operating cash flows, the asset is deemed impaired and an impairment loss would be recognized to the extent the carrying value exceeded the estimated fair value of the asset. The Company estimates the fair value of assets based on the estimated future discounted cash flows of the asset. Management has evaluated its long-lived assets and has not identified any asset impairment during the nine months ended September 30, 2012 or 2011.
Intangible Assets and Goodwill — Definite-lived intangible assets consist primarily of favorable leases, lease acquisition costs, patient base, facility trade names and franchise relationships. Favorable leases and lease acquisition costs are amortized over the life of the lease of the facility, typically ranging from ten to 20 years. Patient base is amortized over a period of four to eight months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date. Trade names at facilities are amortized over 30 years and franchise relationships are amortized over 25 years.

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The Company's indefinite-lived intangible assets consist of trade names and home health and hospice Medicare licenses. The Company tests indefinite-lived intangible assets for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the carrying amount of the intangible asset may not be recoverable.
Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill is subject to annual testing for impairment. In addition, goodwill is tested for impairment if events occur or circumstances change that would reduce the fair value of a reporting unit below its carrying amount. The Company defines reporting units as the individual facilities. The Company performs its annual test for impairment during the fourth quarter of each year. The Company did not record any impairment charges to goodwill during the nine months ended September 30, 2012 or 2011.
Self-Insurance — The Company is partially self-insured for general and professional liability up to a base amount per claim (the self-insured retention) with an aggregate, one-time deductible above this limit. Losses beyond these amounts are insured through third-party policies with coverage limits per occurrence, per location and on an aggregate basis for the Company. For claims made after April 1, 2012, the combined self-insured retention was $500 per claim with an aggregate $1,750 deductible limit. For all facilities, except those located in Colorado, the third-party coverage above these limits was $1,000 per occurrence, $3,000 per facility, with a $10,000 blanket aggregate and an additional state-specific aggregate where required by state law. In Colorado, the third-party coverage above these limits was $1,000 per occurrence and $3,000 per facility, which is independent of the $10,000 blanket aggregate applicable to our other 102 facilities.
The self-insured retention and deductible limits for general and professional liability and workers' compensation are self-insured through the Captive, the related assets and liabilities of which are included in the accompanying condensed consolidated balance sheets. The Captive is subject to certain statutory requirements as an insurance provider. These requirements include, but are not limited to, maintaining statutory capital. The Company’s policy is to accrue amounts equal to the actuarially estimated costs to settle open claims of insureds, as well as an estimate of the cost of insured claims that have been incurred but not reported. The Company develops information about the size of the ultimate claims based on historical experience, current industry information and actuarial analysis, and evaluates the estimates for claim loss exposure on a quarterly basis. Accrued general liability and professional malpractice liabilities recorded on an undiscounted basis, net of anticipated insurance recoveries, in the accompanying condensed consolidated balance sheets were $33,730 and $29,196 as of September 30, 2012 and December 31, 2011, respectively. In addition, in accordance with guidance provided by the Financial Accounting Standards Board (FASB) in August 2010, the Company has recorded an asset and equal liability of $3,570 and $2,814 at September 30, 2012 and December 31, 2011, respectively, in order to present the ultimate costs of malpractice claims and the anticipated insurance recoveries on a gross basis.
 The Company’s operating subsidiaries are self-insured for workers’ compensation liability in California. To protect itself against loss exposure in California with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $500 for each claim. In Texas, the operating subsidiaries have elected non-subscriber status for workers’ compensation claims and, effective February 1, 2011, the Company has purchased individual stop-loss coverage that insures individual claims that exceed $750 for each claim. The Company’s operating subsidiaries in other states have third party guaranteed cost coverage. In California and Texas, the Company accrues amounts equal to the estimated costs to settle open claims, as well as an estimate of the cost of claims that have been incurred but not reported. The Company uses actuarial valuations to estimate the liability based on historical experience and industry information. Accrued workers’ compensation liabilities are recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets and were $11,201 and $9,827 as of September 30, 2012 and December 31, 2011, respectively.
The Company provides self-insured medical (including prescription drugs) and dental healthcare benefits to the majority of its employees. The Company is fully liable for all financial and legal aspects of these benefit plans. To protect itself against loss exposure with this policy, the Company has purchased individual stop-loss insurance coverage that insures individual claims that exceed $250 for each covered person with an aggregate individual stop loss deductible of $75. The Company’s accrued liability under these plans recorded on an undiscounted basis in the accompanying condensed consolidated balance sheets was $2,324 and $2,436 at September 30, 2012 and December 31, 2011, respectively.
The Company believes that adequate provision has been made in the Financial Statements for liabilities that may arise out of patient care, workers’ compensation, healthcare benefits and related services provided to date. The amount of the Company’s reserves was determined based on an estimation process that uses information obtained from both company-specific and industry data. This estimation process requires the Company to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and the Company’s assumptions about emerging trends, the Company, with the assistance of an independent actuary, develops information about the size of ultimate claims based on the Company’s historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damage awards with respect to unpaid claims. The self-insured liabilities are based upon estimates, and while management believes that the estimates

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


of loss are reasonable, the ultimate liability may be in excess of or less than the recorded amounts. Due to the inherent volatility of actuarially determined loss estimates, it is reasonably possible that the Company could experience changes in estimated losses that could be material to net income. If the Company’s actual liability exceeds its estimates of loss, its future earnings, cash flows and financial condition would be adversely affected.

Income Taxes —Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at tax rates in effect when such temporary differences are expected to reverse. The Company generally expects to fully utilize its deferred tax assets; however, when necessary, the Company records a valuation allowance to reduce its net deferred tax assets to the amount that is more likely than not to be realized.

For interim reporting purposes, the provision for income taxes is determined based on the estimated annual effective income tax rate applied to pre-tax income, adjusted for certain discrete items occurring during the period. In determining the effective income tax rate for interim financial statements, the Company must consider expected annual income, permanent differences between financial reporting and tax recognition of income or expense and other factors. When the Company takes uncertain income tax positions that do not meet the recognition criteria, it records a liability for underpayment of income taxes and related interest and penalties, if any. In considering the need for and magnitude of a liability for such positions, the Company must consider the potential outcomes from a review of the positions by the taxing authorities.
In determining the need for a valuation allowance, the annual income tax rate for interim periods, or the need for and magnitude of liabilities for uncertain tax positions, the Company makes certain estimates and assumptions. These estimates and assumptions are based on, among other things, knowledge of operations, markets, historical trends and likely future changes and, when appropriate, the opinions of advisors with knowledge and expertise in certain fields. Due to certain risks associated with the Company’s estimates and assumptions, actual results could differ.

Noncontrolling Interest — The noncontrolling interest in a subsidiary is initially recognized at estimated fair value on the acquisition date and is presented within total equity in the Company's condensed consolidated balance sheets. The Company presents the noncontrolling interest and the amount of consolidated net income attributable to The Ensign Group, Inc. in its condensed consolidated statements of income and net income per share is calculated based on net income attributable to The Ensign Group, Inc.'s stockholders. The carrying amount of the noncontrolling interest is adjusted based on an allocation of subsidiary earnings based on ownership interest. Noncontrolling interest that has redemption features outside the Company's control is accounted for as redeemable noncontrolling interest and is recorded as temporary equity. Owners of noncontrolling interest in certain of the Company's subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests at an amount as defined in the applicable agreement. The intent of the parties is to approximate fair value at the time of redemption by using a multiple of earnings that is consistent with generally accepted valuation practices. These contingent redemption rights are embedded in the equity security at issuance, are not free-standing instruments, do not represent a de facto financing and are not under the Company's control.

Stock-Based Compensation — The Company measures and recognizes compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values, ratably over the requisite service period of the award. Net income has been reduced as a result of the recognition of the fair value of all stock options and restricted stock awards issued, the amount of which is contingent upon the number of future grants and other variables.

Derivatives and Hedging Activities — The Company evaluates variable and fixed interest rate risk exposure on a routine basis and to the extent the Company believes that it is appropriate, it will offset most of its variable risk exposure by entering into interest rate swap agreements. It is the Company's policy to only utilize derivative instruments for hedging purposes (i.e. not for speculation). The Company formally designates its interest rate swap agreements as hedges and documents all relationships between hedging instruments and hedged items. The Company formally assesses effectiveness of its hedging relationships, both at the hedge inception and on an ongoing basis, then measures and records ineffectiveness. The Company would discontinue hedge accounting prospectively (i) if it is determined that the derivative is no longer effective in offsetting change in the cash flows of a hedged item, (ii) when the derivative expires or is sold, terminated or exercised, (iii) if it is no longer probable that the forecasted transaction will occur, or (iv) if management determines that designation of the derivative as a hedge instrument is no longer appropriate. The Company’s derivative is recorded on the balance sheet at its fair value.


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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Accumulated Other Comprehensive Loss and Total Comprehensive Income — Accumulated other comprehensive loss refers to revenue, expenses, gains, and losses that are recorded as an element of stockholders’ equity but are excluded from net income. The Company’s other comprehensive loss consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. As of September 30, 2012, accumulated other comprehensive losses were $3,116, recorded net of tax of $1,215, or $1,901, in stockholders' equity. As of December 31, 2011, accumulated other comprehensive losses were $2,143, net of tax of $835, or $1,308.

New Accounting Pronouncements — In July 2012, the FASB amended the guidance on testing indefinite-lived intangible assets, other than goodwill, for impairment. The amendment was issued in response to feedback on the amendments made to the goodwill impairment testing requirements by allowing an entity to perform a qualitative impairment assessment before proceeding to the two-step impairment test. Under the amended guidance, an entity testing an indefinite-lived intangible asset for impairment has the option of performing a qualitative assessment before calculating the fair value of the asset. Although this amendment revises the examples of events and circumstances that an entity should consider in interim periods, it does not revise the requirements to test (1) indefinite-lived intangible assets annually for impairment and (2) between annual tests if there is a change in events or circumstances. This amendment is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012; however, early adoption is permitted. The Company is evaluating whether it will adopt this amendment during its current fiscal year impairment analysis in the fourth quarter. The Company does not believe the adoption of this amendment will have a material effect on its financial statements.

In July 2012, the FASB clarified that an advance fee from a continuing care retirement community resident should be classified as deferred revenue if (1) the contract stipulates that this advance fee must be repaid when a room is reoccupied by a future resident and (2) the refundable amount is "limited to the proceeds from reoccupancy." If the refundable amount is not limited to the proceeds from reoccupancy, the advance fee must be reported as a liability. The above clarification is effective for fiscal periods beginning after December 15, 2012, however early adoption is permitted. The Company does not believe the adoption of this clarification will have a material effect on its financial statements.

Adoption of New Accounting Pronouncements — In December 2011, the FASB indefinitely deferred the provisions that required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which Other Comprehensive Income is presented (for both interim and annual financial statements). During the deferral period, entities will still need to comply with the existing U.S. GAAP requirements for the presentation of reclassification adjustments. The adoption of this amendment did not have a material effect on the Company's financial statements.
In July 2011, the FASB amended its standards on how health care entities present revenue and bad debt expense. Under the new guidance, health care entities are required to present bad debt expense related to patient service revenue as a reduction of patient service revenue (net of contractual allowances and discounts) on the statement of income for entities that do not assess a patient's ability to pay prior to rendering services. Further, it was determined, net presentation of bad debt expense in revenue would only apply to bad debts that are related to patient service revenue, to entities that provide services prior to assessing a patient's ability to pay, or to entities that recognize revenue prior to deciding that collection is reasonably assured. In addition, the final consensus requires health care entities to disclose information about the activity in the allowance for doubtful accounts, such as recoveries and write-offs, by using a mixture of qualitative and quantitative data. It will also require disclosure of the Company's policies for (i) assessing the timing and amount of uncollectible revenue recognized as bad debt expense; and (ii) assessing collectability in the timing and amount of revenue (net of contractual allowances and discounts). The Company adopted the disclosure requirements of this amendment during the first quarter of the current year. The Company determined the requirements for presentation of bad debt expense related to patient service revenue as a reduction of patient service revenue outlined in the amendment is not applicable as the Company assesses each patient's ability to pay prior to rendering services.



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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


3. COMPUTATION OF NET INCOME PER COMMON SHARE

Basic net income per share is computed by dividing net income attributable to Ensign Group, Inc. stockholders by the weighted average number of outstanding common shares for the period. The computation of diluted net income per share is similar to the computation of basic net income per share except that the denominator is increased to include contingently returnable shares and the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued.

A reconciliation of the numerator and denominator used in the calculation of basic net income per common share follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Numerator:
 
 
 
 
 
 
 
Net Income
$
13,036

 
$
11,598

 
$
38,143

 
$
37,320

Less: net loss attributable to the noncontrolling interests (2)
(258
)
 
—

 
(511
)
 
—

Net income attributable to The Ensign Group, Inc.
13,294

 
11,598

 
38,654

 
37,320

Denominator:
 
 
 
 
 
 
 
Weighted average shares outstanding for basic net income per share
21,488

 
20,995

 
21,369

 
20,920

Basic net income per common share
$
0.62

 
$
0.55

 
$
1.81

 
$
1.78


A reconciliation of the numerator and denominator used in the calculation of diluted net income per common share follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Numerator:
 
 
 
 
 
 
 
Net Income
$
13,036

 
$
11,598

 
$
38,143

 
$
37,320

Less: net loss attributable to the noncontrolling interests (2)
(258
)
 
—

 
(511
)
 
—

Net income attributable to The Ensign Group, Inc.
13,294

 
11,598

 
38,654

 
37,320

Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding
21,488

 
20,995

 
21,369

 
20,920

Plus: incremental shares from assumed conversion (1)
522

 
575

 
530

 
651

Adjusted weighted average common shares outstanding
22,010

 
21,570

 
21,899

 
21,571

Diluted net income per common share
$
0.60

 
$
0.54

 
$
1.77

 
$
1.73

(1)
Options outstanding which are anti-dilutive and therefore not factored into the weighted average common shares amount above were 269 and 271 for the three and nine months ended September 30, 2012, respectively, and 49 and 41 for the three and nine months ended September 30, 2011, respectively.
(2)
See further discussion of noncontrolling interest at Note 14, Temporary Equity - Redeemable Noncontrolling Interest.



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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


4. FAIR VALUE MEASUREMENTS

Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted market prices in active markets; Level 2, defined as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3, defined as observable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.

The following table summarizes the financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011:
 
 
September 30, 2012
 
December 31, 2011
 
 
Level 1
 
Level 2
 
Level 3
 
Level 1
 
Level 2
 
Level 3
Cash and cash equivalents
 
$
32,028

 
$
—

 
$
—

 
$
29,584

 
$
—

 
$
—

Fair value of interest rate swap
 
$
—

 
$
3,116

 
$
—

 
$
—

 
$
2,143

 
$
—


Our non-financial assets, which include long-lived assets, including goodwill, intangible assets and property and equipment, are reported at carrying value and are not required to be measured at fair value on a recurring basis. However, on a periodic basis, or whenever events or changes in circumstances indicate that their carrying value may not be recoverable, we assess our long-lived assets for impairment. When impairment has occurred, such long-lived assets are written down to fair value. See Note 2 for further discussion of our significant accounting policies.

Debt Security Investments - Held to Maturity

At September 30, 2012 and December 31, 2011, the Company had approximately $22,403 and $16,466, respectively, in debt security investments which were held to maturity and carried at amortized cost. The carrying value of the debt securities approximates fair value. The Company has the intent and ability to hold these debt securities to maturity. Further, at September 30, 2012, $6,025 is held in AAA-rated debt securities backed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program, $6,376 is held in AA-rated debt securities and $10,002 is held in A-rated debt securities. These debt securities mature from December 2012 to August 2014.

Interest Rate Swap Agreement

In connection with the Senior Credit Facility with a five-bank lending consortium arranged by SunTrust and Wells Fargo (the Facility), in July 2011, the Company entered into an interest rate swap agreement in accordance with Company policy to reduce risk from volatility in the income statement due to changes in the LIBOR interest rate. The swap agreement, with a notional amount of $75,000, amortizing concurrently with the related term loan portion of the Facility, was five years in length and set to mature on July 15, 2016. The interest rate swap has been designated as a cash flow hedge and, as such, changes in fair value are reported in other comprehensive income in accordance with hedge accounting. Under the terms of this swap agreement, the net effect of the hedge was to record swap interest expense at a fixed rate of approximately 4.3%, exclusive of fees. Net interest paid under the swap was $240 and $710 for the three and nine months ended September 30, 2012, and $203 for both periods during the three and nine months ended September 30, 2011. In addition, based on the September 30, 2012 interest rate swap valuation, the Company expects to record swap interest expense of approximately $950 during the year ended December 31, 2012.

The Company assesses hedge effectiveness at inception and on an ongoing basis by performing a regression analysis. The regression analysis compares to the historical monthly changes in fair value of the interest rate swap to the historical monthly changes in the fair value of a hypothetically perfect interest rate swap over the trailing 30 months . The change in fair value of the hypothetical derivative is regarded as a proxy for the present value of the cumulative change in the expected future cash flows on the hedged transaction. The regression analysis serves as the Company's prospective and retrospective assessment of hedge effectiveness. Assuming the hedging relationship qualifies as highly effective, the actual swap will be recorded at fair value on the balance sheet and accumulated other comprehensive income (loss) will be adjusted to reflect the lesser of either the cumulative change in the fair value of the actual swap or the cumulative change in the fair value of the hypothetical derivative.

The interest rate swap agreement is recorded at fair value based upon valuation models which utilize relevant factors such as the contractual terms of the interest rate swap agreements, credit spreads for the contracting parties and interest rate curves. Based on this valuation method, the Company categorized the interest rate swap as Level 2 and recorded accumulated other comprehensive losses as of September 30, 2012 of $3,116, net of tax of $1,215, or $1,901, in stockholders' equity, compared to

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


$2,090, net of tax of $816, or $1,274 as of September 30, 2011. There are no amounts attributable to hedge ineffectiveness that were required to be recognized in earnings.


5. REVENUE AND ACCOUNTS RECEIVABLE

Revenue for the three and nine months ended September 30, 2012 and 2011 is summarized in the following table:
 
Three Months Ended
September 30,
 
2012
 
2011
 
Revenue
 
% of
Revenue
 
Revenue
 
% of
Revenue
Medicaid
$
76,709


37.0
%

$
70,967

 
36.1
%
Medicare
69,526


33.6


71,293

 
36.3

Medicaid — skilled
6,316


3.0


5,024

 
2.6

Total Medicaid and Medicare
152,551


73.6


147,284

 
75.0

Managed care
26,316


12.7


23,621

 
12.0

Private and other payors
28,283


13.7


25,441

 
13.0

Revenue
$
207,150


100.0
%

$
196,346

 
100.0
%

 
Nine Months Ended
September 30,
 
2012
 
2011
 
Revenue
 
% of
Revenue
 
Revenue
 
% of
Revenue
Medicaid
$
223,934


36.5
%

$
204,273

 
36.1
%
Medicare
209,715


34.2


207,897

 
36.8

Medicaid — skilled
18,590


3.0


13,730

 
2.4

Total Medicaid and Medicare
452,239


73.7


425,900

 
75.3

Managed care
77,738


12.7


71,938

 
12.7

Private and other payors
83,641


13.6


67,777

 
12.0

Revenue
$
613,618


100.0
%

$
565,615

 
100.0
%

Accounts receivable as of September 30, 2012 and December 31, 2011 is summarized in the following table:
 
September 30,
2012
 
December 31,
2011

Medicaid
$
33,537

 
$
30,286

Managed care
25,501

 
22,068

Medicare
32,958

 
28,061

Private and other payors
19,704

 
18,678

 
111,700

 
99,093

Less: allowance for doubtful accounts
(13,628
)
 
(12,782
)
Accounts receivable
$
98,072

 
$
86,311



15
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



6. ACQUISITIONS
The Company’s acquisition policy is generally to purchase or lease operations to complement the Company’s existing portfolio. The results of all the Company’s operations are included in the accompanying Interim Financial Statements subsequent to the date of acquisition. Acquisitions are typically paid for in cash and are accounted for using the acquisition method of accounting. Where the Company enters into facility lease agreements, the Company typically does not pay any material amount to the prior facility operator nor does the Company acquire any assets or assume any liabilities, other than rights and obligations under the lease and operations transfer agreement, as part of the transaction. Some leases include options to purchase the facilities. As a result, from time to time, the Company will acquire facilities that the Company has been operating under third-party leases.
During the nine months ended September 30, 2012, the Company acquired four stand-alone skilled nursing facilities, one stand-alone assisted living facility, two home health operations and one hospice operation. The aggregate purchase price of the eight business acquisitions was approximately $20,934, which was paid in cash. The Company also entered into a separate operations transfer agreement with the prior tenant as part of each transaction. The operations acquired during the nine months ended September 30, 2012 are as follows:
•
On February 1, 2012, the Company purchased an assisted living facility in Nevada for approximately $2,111, which was paid in cash. This acquisition added 60 operational assisted living units to the Company's operations.
•
On February 10, 2012, the Company acquired a home health operation in Oregon for approximately $530, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. The Company recognized $530 in other indefinite-lived intangible assets as part of this transaction.
•
On March 1, 2012, the Company acquired a skilled nursing facility in Idaho for approximately $2,780, which was paid in cash. This acquisition added 113 operational skilled nursing beds to the Company's operations.
•
On April 1, 2012, the Company acquired a home health and a hospice operation in Utah and Arizona for approximately $3,000, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. The Company recognized $2,279 in goodwill and $687 in other indefinite-lived intangible assets as part of this transaction.
•
On June 1, 2012, the Company acquired a skilled nursing facility in Texas for $8,002, which was paid in cash. This acquisition added 150 operational skilled nursing beds to the Company's operations.
•
On August 1, 2012, the Company acquired two skilled nursing facilities in Idaho for $4,511, which was paid in cash. One of the skilled nursing facilities acquired also offers assisted living services. These acquisitions added 94 skilled nursing beds and 24 assisted living units to the Company's operations.
The table below presents the allocation of the purchase price for the facilities acquired in business combinations during the nine months ended September 30, 2012 and 2011:
 
September 30,
 
2012
 
2011
Land
$
893

 
$
8,229

Building and improvements
15,303

 
69,883

Equipment, furniture, and fixtures
1,003

 
2,399

Assembled occupancy
239

 
1,010

Goodwill
2,279

 
4,209

Other indefinite-lived intangible assets
1,217

 
809

 
$
20,934

 
$
86,539


In addition, during the nine months ended September 30, 2012, the Company purchased the underlying assets of three of its skilled nursing facilities in California which it previously operated under long-term lease agreements, which contained options to purchase, for $11,386, which was paid in cash. These acquisitions did not impact the Company's operational bed count.

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


In addition, in January 2012, the Company announced the formation of Immediate Clinic (IC), a majority owned subsidiary, to develop and operate urgent care facilities and related businesses. The first IC operated centers opened in the third quarter of 2012.
•
On February 15, 2012, IC purchased an equity investment in an urgent care software service provider for $1,400. See additional details in Note 10, Restricted and Other Assets.
•
On March 1, 2012, DRX Urgent Care LLC (DRX), a newly formed subsidiary of IC, purchased substantially all of the assets and assumed certain liabilities of Doctors Express Franchising LLC, a national urgent care franchise system for $2,000, adjusted for certain items at the time of close and redeemable noncontrolling interest. The noncontrolling interest was fair valued at the acquisition date at $11,600. The Company recognized intangible assets of $7,900 in trade name, $3,000 in franchise relationships and $2,724 in goodwill. See additional details in Note 9, Goodwill and Other Indefinite-Lived Intangible Assets - Net and Note 14, Temporary Equity - Redeemable Noncontrolling Interest.
On October 4, 2012, the Company committed to invest an additional $6,000 to IC in exchange for senior preferred stock, which will result in the Company holding approximately 96% of the outstanding interests in the joint venture on a fully-diluted basis.

The Company’s acquisition strategy has been focused on identifying both opportunistic and strategic acquisitions within its target markets that offer strong opportunities for return on invested capital. The facilities acquired by the Company are frequently underperforming financially and can have regulatory and clinical challenges to overcome. Financial information, especially with underperforming facilities, is often inadequate, inaccurate or unavailable. Consequently, the Company believes that prior operating results are not meaningful, representative of the Company’s current operating results or indicative of the integration potential of its newly acquired facilities. The businesses acquired during the nine months ended September 30, 2012 were not material acquisitions to the Company individually or in the aggregate. Accordingly, pro forma financial information is not presented. These acquisitions have been included in the September 30, 2012 condensed consolidated balance sheet of the Company, and the operating results have been included in the condensed consolidated statement of income of the Company since the dates the Company gained effective control.


7. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
 
September 30,
2012
 
December 31,
2011

Land
$
70,267

 
$
67,179

Buildings and improvements
336,463

 
297,016

Equipment
77,048

 
66,483

Furniture and fixtures
8,750

 
8,731

Leasehold improvements
31,647

 
28,686

Construction in progress
7,627

 
8,213

 
531,802

 
476,308

Less: accumulated depreciation
(92,569
)
 
(72,446
)
Property and equipment, net
$
439,233

 
$
403,862



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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



8. INTANGIBLE ASSETS — Net
 
 
Weighted
 
September 30, 2012
 
December 31, 2011
 
 
Average
Life
 
Gross
Carrying
 
Accumulated
 
 
 
Gross
Carrying
 
Accumulated
 
 
Intangible Assets
 
(Years)
 
Amount
 
Amortization
 
Net
 
Amount
 
Amortization
 
Net
Lease acquisition costs
 
15.5
 
$
684

 
$
(534
)
 
$
150

 
$
846

 
$
(604
)
 
$
242

Favorable lease
 
15.0
 
1,596

 
(399
)
 
1,197

 
1,596

 
(319
)
 
1,277

Assembled occupancy
 
0.5
 
2,205

 
(2,183
)
 
22

 
1,966

 
(1,750
)
 
216

Facility trade name
 
30.0
 
733

 
(165
)
 
568

 
733

 
(147
)
 
586

Franchise relationships
 
25.0
 
3,000

 
(70
)
 
2,930

 
—

 
—

 
—

Total
 
 
 
$
8,218

 
$
(3,351
)
 
$
4,867

 
$
5,141

 
$
(2,820
)
 
$
2,321

Amortization expense was $130 and $569 for the three and nine months ended September 30, 2012 and $339 and $1,045 for the three and nine months ended September 30, 2011, respectively. Of the $569 in amortization expense incurred during the nine months ended September 30, 2012, approximately $433 related to the amortization of patient base intangible assets at recently acquired facilities, which is typically amortized over a period of four to eight months, depending on the classification of the patients and the level of occupancy in a new acquisition on the acquisition date.

Estimated amortization expense for each of the years ending December 31 is as follows:
Year
Amount
2012 (remainder)
$
97

2013
295

2014
295

2015
275

2016
255

2017
255

Thereafter
3,395

 
$
4,867



18
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



9. GOODWILL AND OTHER INDEFINITE-LIVED INTANGIBLE ASSETS

The Company performs its annual goodwill impairment analysis during the fourth quarter of each year for each reporting unit that constitutes a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment. The Company tests for impairment by comparing the net assets of each reporting unit to their respective fair values. The Company determines the estimated fair value of each reporting unit using a discounted cash flow analysis. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.

The following table represents activity in goodwill as of September 30, 2012 and December 31, 2011:
 
Goodwill
January 1, 2012
$
17,177

Additions
5,003

Impairments
—

September 30, 2012
$
22,180



As of September 30, 2012, the Company anticipates that $19,456 in goodwill recognized will be fully deductible for tax purposes. The remaining goodwill balance of $2,724 may be fully deductible for tax purposes dependent on the noncontrolling interest holders exercising their right to require DRX to purchase additional ownership. Refer to additional details in Note 14, Temporary Equity - Redeemable Noncontrolling Interests.
Other indefinite-lived intangible assets consists of the following:
 
September 30,
 
December 31,
 
2012
 
2011
Trade name
$
8,000

 
$
66

Home health and hospice Medicare license
2,598

 
1,415

 
$
10,598

 
$
1,481

During the nine months ended September 30, 2012, the Company recognized $7,900 in trade name intangible assets as part of the DRX acquisition on March 1, 2012. Additionally, the Company recorded $1,183 in home health and hospice Medicare license intangible assets as part of its acquisitions of two home health operations and one hospice operation during the nine months ended September 30, 2012.


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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



10. RESTRICTED AND OTHER ASSETS
Restricted and other assets consist primarily of capital reserves and capitalized debt issuance costs. Capital reserves are maintained as part of the mortgage agreements of the Company and certain of its landlords with the U.S. Department of Housing and Urban Development. These capital reserves are restricted for capital improvements and repairs to the related facilities.
Restricted and other assets consist of the following:
 
September 30,
2012
 
December 31,
2011

Deposits with landlords
$
752

 
$
789

Capital improvement reserves with landlords and lenders
3,704

 
3,585

Debt issuance costs, net
2,959

 
3,230

Long-term insurance losses recoverable asset
3,570

 
2,814

Equity method investment
1,400

 
—

Restricted and other assets
$
12,385

 
$
10,418

Included in other assets, as of September 30, 2012, are anticipated insurance recoveries related to the Company's general and professional liability claims that are recorded on a gross rather than net basis in accordance with an Accounting Standards Update issued by the FASB and a non-marketable equity investment accounted for under the equity method. The investment is recorded at cost and is evaluated periodically for impairment.


11. OTHER ACCRUED LIABILITIES

Other accrued liabilities consist of the following:
 
September 30,
2012
 
December 31,
2011

Quality assurance fee
$
3,732

 
$
3,912

Resident refunds payable
4,453

 
3,346

Deferred revenue
2,170

 
1,856

Cash held in trust for residents
1,586

 
1,648

Resident deposits
1,619

 
1,397

Dividends payable
1,306

 
1,283

Property taxes
3,540

 
2,224

Other
4,209

 
2,911

Other accrued liabilities
$
22,615

 
$
18,577

Quality assurance fee represents amounts payable to California, Utah, Idaho, Washington, Colorado, Iowa, and Nebraska in respect of a mandated fee based on resident days. Resident refunds payable includes amounts due to residents for overpayments and duplicate payments. Deferred revenue occurs when the Company receives payments in advance of services provided. Cash held in trust for residents reflects monies received from, or on behalf of, residents. Maintaining a trust account for residents is a regulatory requirement and, while the trust assets offset the liability, the Company assumes a fiduciary responsibility for these funds. The cash balance related to this liability is included in other current assets in the accompanying condensed consolidated balance sheets.


20
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



12. INCOME TAXES
During the first quarter of 2012, the State of California initiated an examination of the Company's income tax returns for the 2008 and 2009 income tax years. The examination is primarily focused on the Captive and the treatment of related insurance matters. California has not proposed any adjustments. The Company is not currently under examination by any other major income tax jurisdiction. In the third quarter of 2012, the statute of limitations lapsed on the Company's 2008 Federal tax year without any impact on unrecognized tax benefits. The remainder of the Company's 2007 state tax years will lapse during the fourth quarter of 2012. The Company does not believe these lapses will significantly impact unrecognized tax benefits for any uncertain tax positions either. The Company does not believe the California examination or any other event will significantly impact the balance of unrecognized tax benefits in the next twelve months. The net balance of unrecognized tax benefits was not material to the Interim Financial Statements for the three or nine months ended September 30, 2012 or 2011.


13. DEBT

Long-term debt consists of the following:
 
September 30,
2012
 
December 31,
2011

Promissory note with RBS, principal and interest payable monthly and continuing through March 2019, interest at a fixed rate, collateralized by real property, assignment of rents and Company guaranty.
$
21,198

 
$
—

Senior Credit Facility with SunTrust and Wells Fargo, principal and interest payable quarterly, balance due at July 15, 2016, secured by substantially all of the Company’s personal property.
80,313

 
88,125

Ten Project Note with GECC, principal and interest payable monthly; interest is fixed, balance due June 2016, collateralized by deeds of trust on real property, assignment of rents, security agreements and fixture financing statements.
50,363

 
51,185

Promissory note with RBS, principal and interest payable monthly and continuing through January 2018, interest at a fixed rate, collateralized by real property, assignment of rents and Company guaranty.
33,418

 
34,149

Promissory notes, principal, and interest payable monthly and continuing through October 2019, interest at fixed rate, collateralized by deed of trust on real property, assignment of rents and security agreement.
9,272

 
9,471

Mortgage note, principal, and interest payable monthly and continuing through February 2027, interest at fixed rate, collateralized by deed of trust on real property, assignment of rents and security agreement.
5,721

 
5,884

 
200,285

 
188,814

Less current maturities
(7,133
)
 
(6,314
)
Less debt discount
(853
)
 
(944
)
 
$
192,299

 
$
181,556

Promissory Note with RBS Asset Finance, Inc.
On February 17, 2012, two of the Company's real estate holding subsidiaries as Borrowers executed a promissory note in favor of RBS Asset Finance, Inc. (RBS) as Lender for an aggregate of $21,525 (the 2012 RBS Loan). The 2012 RBS Loan was secured by Commercial Deed of Trust, Security Agreement, Assignment of Leases and Rents and Fixture Filings on the properties owned by the Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2012 RBS Loan bears interest at a fixed rate of 4.75%. Amounts borrowed under the 2012 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the RBS Loan is for seven years, with monthly principal and interest payments commencing on April 1, 2012 and the balance due on March 1, 2019.
Among other things, under the RBS Loan the Company must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of September 30, 2012, the Company was in compliance with all loan covenants.

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)




14. TEMPORARY EQUITY- REDEEMABLE NONCONTROLLING INTEREST
Owners of noncontrolling interests in certain of the Company's subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests in DRX at an amount defined in the applicable agreements. The 25% noncontrolling interest is accounted for as redeemable noncontrolling interest as redemption is outside the Company's control. As such, the redeemable noncontrolling interest is reported in the mezzanine section in the Company's condensed consolidated balance sheets as temporary equity. The aggregate estimated maximum amount the Company could be required to pay in future periods is $13,500. As of September 30, 2012, the carrying amount of the redeemable noncontrolling interests is $11,511. The ultimate amount paid could be different as the redemption amount is primarily dependent on the future results of operations of the subject businesses, and the timing of the exercise of these rights.

15. OPTIONS AND AWARDS
Stock-based compensation expense consists of share-based payment awards made to employees and directors, including employee stock options and restricted stock awards, based on estimated fair values. As stock-based compensation expense recognized in the Company’s condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 was based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. The Company estimates forfeitures at the time of grant and, if necessary, revises the estimate in subsequent periods if actual forfeitures differ.
The Company has three option plans, the 2001 Stock Option, Deferred Stock and Restricted Stock Plan (2001 Plan), the 2005 Stock Incentive Plan (2005 Plan) and the 2007 Omnibus Incentive Plan (2007 Plan), all of which have been approved by the stockholders. The total number of shares available under all of the Company’s stock incentive plans was 1,670 as of September 30, 2012.

The Company uses the Black-Scholes option-pricing model to recognize the value of stock-based compensation expense for all share-based payment awards. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. The Company develops estimates based on historical data and market information, which can change significantly over time. The Company granted 175 options and 114 restricted stock awards from the 2007 Plan during the nine months ended September 30, 2012.

The Company used the following assumptions for stock options granted during the three months ended September 30, 2012 and 2011:
Grant Year
 
Options Granted
 
Weighted Average Risk-Free Rate
 
Expected Life
 
Weighted Average Volatility
 
Weighted Average Dividend Yield
2012
 
83

 
0.84
%
 
6.5 years
 
55
%
 
0.93
%
2011
 
9

 
1.42
%
 
6.5 years
 
55
%
 
0.93
%

The Company used the following assumptions for stock options granted during the nine months ended September 30, 2012 and 2011:
Grant Year
 
Options Granted
 
Weighted Average Risk-Free Rate
Expected Life
 
Weighted Average Volatility
 
Weighted Average Dividend Yield
2012
 
175

 
0.84%
-
1.18%
6.5 years
 
55
%
 
0.93
%
2011
 
41

 
1.42%
-
2.53%
6.5 years
 
55
%
 
0.93
%


22
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


For the nine months ended September 30, 2012 and 2011, the following represents the exercise price and fair value displayed at grant date for stock option grants:
Grant Year
 
Granted
 
Weighted Average Exercise Price
 
Weighted Average Fair Value of Options
2012
 
175

 
$
27.04

 
$
12.44

2011
 
41

 
$
26.52

 
$
13.35


The weighted average exercise price equaled the weighted average fair value of common stock on the grant date for all options granted during the periods ended September 30, 2012 and 2011 and therefore, the intrinsic value was $0 at date of grant.

The following table represents the employee stock option activity during the nine months ended September 30, 2012:
 
Number of
Options
Outstanding
 
Weighted
Average
Exercise Price
 
Number of
Options Vested
 
Weighted
Average
Exercise Price
of Options
Vested
January 1, 2012
1,633

 
$
12.97

 
936

 
$
10.65

Granted
175

 
27.04

 
 
 
 
Forfeited
(38
)
 
16.74

 
 
 
 
Exercised
(272
)
 
11.05

 
 
 
 
September 30, 2012
1,498

 
$
14.87

 
838

 
$
11.32


The following summary information reflects stock options outstanding, vested and related details as of September 30, 2012:
 
 
 
 
 
 
 
 
 
 
 
 
Stock Options Vested
 
 
Stock Options Outstanding
 
 
 
 
 
Number Outstanding
 
Black-Scholes Fair Value
 
Remaining Contractual Life (Years)
 
Vested and Exercisable
Year of Grant
 
Exercise Price
 
 
 
 
2003
 
$0.67
-
0.81
 
4

 
*

 
1
 
4

2004
 
1.96
-
2.46
 
13

 
*

 
2
 
13

2005
 
4.99
-
5.75
 
85

 
*

 
3
 
85

2006
 
7.05
-
7.50
 
184

 
1,779

 
4
 
184

2008
 
9.38
-
14.87
 
482

 
2,622

 
6
 
336

2009
 
14.88
-
16.70
 
363

 
2,875

 
7
 
175

2010
 
17.47
-
18.16
 
103

 
918

 
8
 
33

2011
 
21.61
-
29.30
 
91

 
1,126

 
9
 
8

2012
 
24.04
-
28.82
 
173

 
2,280

 
10
 
—

Total
 
 
 
 
 
1,498

 
$
11,600

 
 
 
838

* The Company will not recognize the Black-Scholes fair value for awards granted prior to January 1, 2006 unless such awards are modified.
In addition to the above, during the three and nine months ended September 30, 2012, the Company granted 13 and 114 restricted stock awards, respectively. During the three and nine months ended September 30, 2011, the Company granted 33 and 115 restricted awards, respectively. All awards were granted at an exercise price of $0 and vest over five years.


23
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


A summary of the status of the Company's nonvested restricted stock awards as of September 30, 2012, and changes during the nine-month period ended September 30, 2012 is presented below:
 
Nonvested Restricted Awards
 
Weighted Average Grant Date Fair Value
Nonvested at January 1, 2012
210

 
$
22.32

Granted
114

 
26.55

Vested
(98
)
 
24.74

Forfeited
(9
)
 
22.41

Nonvested at September 30, 2012
217

 
$
22.76


Total share-based compensation expense recognized for the three and nine months ended September 30, 2012 and 2011 was as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Share-based compensation expense related to stock options
$
476

 
$
616

 
$
1,396

 
$
1,834

Share-based compensation expense related to restricted stock awards
292

 
196

 
809

 
448

Share-based compensation expense related to stock awards
$
102

 
$
124

 
$
1,639

 
$
680

Total
$
870

 
$
936

 
$
3,844

 
$
2,962

In future periods, the Company expects to recognize approximately $5,386 and $4,734 in share-based compensation expense for unvested options and unvested restricted stock awards, respectively, that were outstanding as of September 30, 2012. Future share-based compensation expense will be recognized over 3.3 and 3.8 weighted average years for unvested options and restricted stock awards, respectively. There were 661 unvested and outstanding options at September 30, 2012, of which 627 are expected to vest. The weighted average contractual life for options vested at September 30, 2012 was 6.2 years.

The aggregate intrinsic value of options outstanding, vested, expected to vest and exercised as of September 30, 2012 and December 31, 2011 is as follows:
Options
 
September 30,
2012
 
December 31,
2011
Outstanding
 
$
23,587

 
$
18,942

Vested
 
16,158

 
12,960

Expected to vest
 
6,790

 
5,374

Exercised
 
4,925

 
5,651

The intrinsic value is calculated as the difference between the market value of the underlying common stock and the exercise price of the options.


24
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)



16. COMMITMENTS AND CONTINGENCIES
Leases — The Company leases certain facilities and its administrative offices under non-cancelable operating leases, most of which have initial lease terms ranging from five to 20 years. The Company also leases certain of its equipment under non-cancelable operating leases with initial terms ranging from three to five years. Most of these leases contain renewal options, certain of which involve rent increases. Total rent expense, inclusive of straight-line rent adjustments, was $3,489 and $10,407 for the three and nine months ended September 30, 2012 and $3,446 and $10,725 for the three and nine months ended September 30, 2011, respectively.
Six of the Company’s facilities are operated under two separate three-facility master lease arrangements. Under these master leases, a breach at a single facility could subject one or more of the other facilities covered by the same master lease to the same default risk. Failure to comply with Medicare and Medicaid provider requirements is a default under several of the Company’s leases, master lease agreements and debt financing instruments. In addition, other potential defaults related to an individual facility may cause a default of an entire master lease portfolio and could trigger cross-default provisions in the Company’s outstanding debt arrangements and other leases. With an indivisible lease, it is difficult to restructure the composition of the portfolio or economic terms of the lease without the consent of the landlord.
In addition, a number of the Company’s individual facility leases are held by the same or related landlords, and some of these leases include cross-default provisions that could cause a default at one facility to trigger a technical default with respect to others, potentially subjecting certain leases and facilities to the various remedies available to the landlords under separate but cross-defaulted leases. The Company is not aware of any defaults as of September 30, 2012.
Regulatory Matters — Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. Compliance with such laws and regulations can be subject to future governmental review and interpretation, as well as significant regulatory action including fines, penalties, and exclusion from certain governmental programs. The Company believes that it is in compliance in all material respects with all applicable laws and regulations.
A significant portion of the Company’s revenue is derived from Medicaid and Medicare, for which reimbursement rates are subject to regulatory changes and government funding restrictions. Any significant future change to reimbursement rates or regulation on how services are provided could have a material effect on the Company’s operations.
Cost-Containment Measures — Both government and private pay sources have instituted cost-containment measures designed to limit payments made to providers of healthcare services, and there can be no assurance that future measures designed to limit payments made to providers will not adversely affect the Company.
Income Tax Examinations — During the first quarter of 2012, the State of California initiated an examination of the Company's income tax returns for the 2008 and 2009 income tax years. The examination is primarily focused on the Captive and the treatment of related insurance matters. California has not proposed any adjustments. The Company is not currently under examination by any other major income tax jurisdiction. The remainder of the Company's 2007 state tax years will lapse during the fourth quarter. The Company does not believe these lapses will significantly impact unrecognized tax benefits for any uncertain tax positions either. The Company does not believe the California examination or any other event will significantly impact the balance of unrecognized tax benefits in the next twelve months. See Note 12, Income Taxes.
Indemnities — From time to time, the Company enters into certain types of contracts that contingently require the Company to indemnify parties against third-party claims. These contracts primarily include (i) certain real estate leases, under which the Company may be required to indemnify property owners or prior facility operators for post-transfer environmental or other liabilities and other claims arising from the Company’s use of the applicable premises, (ii) operations transfer agreements, in which the Company agrees to indemnify past operators of facilities the Company acquires against certain liabilities arising from the transfer of the operation and/or the operation thereof after the transfer, (iii) certain lending agreements, under which the Company may be required to indemnify the lender against various claims and liabilities, (iv) agreements with certain lenders under which the Company may be required to indemnify such lenders against various claims and liabilities, and (v) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationships. The terms of such obligations vary by contract and, in most instances, a specific or maximum dollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot be reasonably estimated until a specific claim is asserted. Consequently, because no claims have been asserted, no liabilities have been recorded for these obligations on the Company’s balance sheets for any of the periods presented.

25
Table of Contents
THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


Litigation — The skilled nursing business involves a significant risk of liability given the age and health of the Company’s patients and residents and the services the Company provides. The Company and others in the industry are subject to an increasing number of claims and lawsuits, including professional liability claims, alleging that services have resulted in personal injury, elder abuse, wrongful death or other related claims. The defense of these lawsuits may result in significant legal costs, regardless of the outcome, and can result in large settlement amounts or damage awards.
In addition to the potential lawsuits and claims described above, the Company is also subject to potential lawsuits under the Federal False Claims Act and comparable state laws alleging submission of fraudulent claims for services to any healthcare program (such as Medicare) or payor. A violation may provide the basis for exclusion from federally-funded healthcare programs. Such exclusions could have a correlative negative impact on the Company’s financial performance. Some states, including California, Arizona and Texas, have enacted similar whistleblower and false claims laws and regulations. In addition, the Deficit Reduction Act of 2005 created incentives for states to enact anti-fraud legislation modeled on the Federal False Claims Act. As such, the Company could face increased scrutiny, potential liability and legal expenses and costs based on claims under state false claims acts in markets in which it does business.
In May 2009, Congress passed the Fraud Enforcement and Recovery Act (FERA) of 2009 which made significant changes to the Federal False Claims Act (FCA), expanding the types of activities subject to prosecution and whistleblower liability. Following changes by FERA, health care providers face significant penalties for the knowing retention of government overpayments, even if no false claim was involved. Health care providers can now be liable for knowingly and improperly avoiding or decreasing an obligation to pay money or property to the government. This includes the retention of any government overpayment. The government can argue, therefore, that a FCA violation can occur without any affirmative fraudulent action or statement, as long as it is knowingly improper. In addition, FERA extended protections against retaliation for whistleblowers, including protections not only for employees, but also contractors and agents. Thus, there is generally no need for an employment relationship in order to qualify for protection against retaliation for whistleblowing.
In July 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The Dodd-Frank Act establishes rigorous standards and supervision to protect the economy and American consumers, investors and businesses. Included under Section 922 of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) will be required to pay a reward to individuals who provide original information to the SEC resulting in monetary sanctions exceeding $1,000 in civil or criminal proceedings. The award will range from 10 to 30 percent of the amount recouped and the amount of the award shall be at the discretion of the SEC. The purpose of this reward program is to “motivate those with inside knowledge to come forward and assist the Government to identify and prosecute persons who have violated securities laws and recover money for victims of financial fraud.”
Other companies in the Company's industry have been the subject of lawsuits alleging negligence, abuses and other causes of action which have, in some cases, resulted in large demand awards and settlements. In addition, there has been an increase in the number of class-action suits filed against the Company and other companies in its industry, which also have the potential to result in large damage awards and settlements. For example, a class action suit was previously filed against the Company in the State of California, alleging, among other things, violations of certain Health and Safety Code provisions and a violation of the Consumer Legal Remedies Act at certain of the Company’s California facilities. In 2007, the Company settled this class action suit, and the settlement was approved by the affected class and the Court.
Healthcare litigation is common and is filed based upon a wide variety of claims and theories, and we are routinely subjected to varying types of claims. One particular type of suit arises from alleged violations of state-established minimum staffing requirements for skilled nursing facilities. Failure to meet these requirements can, among other things, jeopardize a facility's compliance with conditions of participation under certain state and federal healthcare programs; it may also subject the facility to a notice of deficiency, a citation, civil money penalty, or litigation. These "staffing" suits have become more prevalent in the wake of a previous substantial jury award against one of the Company's competitors, and the Company expects the plaintiff's bar to become increasingly aggressive in their pursuit of these staffing and similar claims. The Company is currently defending one such staffing class-action claim filed in Los Angeles Superior Court, and has reached a tentative settlement with class counsel that is awaiting court approval. The total costs associated with the settlement, including attorney's fees, estimated class payout, and related costs and expenses, are projected to be $5,000, of which, $2,596 of this amount was recorded in the quarter ended June 30, 2012, with the balance having been expensed in prior periods. Assuming that the settlement is approved by the court, the settlement will not have a material ongoing adverse effect on the Company’s business, financial condition or results of operations.
Other claims and suits, including class actions, continue to be filed against us and other companies in our industry. If there were a significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, this could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.

26
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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


The Company has been, and continues to be, subject to claims and legal actions that arise in the ordinary course of business, including potential claims related to care and treatment provided at its facilities as well as employment related claims. The Company does not believe that the ultimate resolution of these actions will have a material adverse effect on the Company’s business, cash flows, financial condition or results of operations. A significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, could materially adversely affect the Company’s business, financial condition, results of operations and cash flows.
Medicare Revenue Recoupments — The Company is subject to reviews relating to Medicare services, billings and potential overpayments. The Company had one operation subject to probe review during the nine months ended September 30, 2012. The Company anticipates that these probe reviews will increase in frequency in the future. Further, the Company currently has no facilities on prepayment review; however, others may be placed on prepayment review in the future. If a facility fails prepayment review, the facility could then be subject to undergo targeted review, which is a review that targets perceived claims deficiencies. The Company has no facilities that are currently undergoing targeted review.
Other Matters — In March 2007, the Company learned that the United States Attorney for the Central District of California (DOJ) had commenced an investigation of certain of its facilities and had issued an authorized investigative demand to the Company's bank seeking information pertaining to a total of 18 of its facilities. The DOJ also subsequently served a subpoena on the Company's independent external auditors in 2007, and in 2008 served search warrants and subpoenas on its Service Center and six of its Southern California skilled nursing facilities, seeking specific patient files and other information. Subsequent subpoenas issued to the Company covered additional documentation from the six facilities as well as eight of the other facilities. Based upon the issuance of the subpoenas and execution of the search warrants, the Company concluded that the government had undertaken parallel criminal and civil investigations. The Company pledged full cooperation to, and has been cooperating fully with, the government.

In September 2010 the Company's board of directors appointed a special committee consisting solely of independent directors to advance discussions with the DOJ regarding its investigation. The special committee retained independent counsel, and counsel has retained third party consultants, to facilitate its work. The Company and the special committee have continued cooperating with the DOJ, working to provide information necessary to aid the DOJ's investigation and move the matter toward resolution.

In December 2011, independent counsel for the Company's special committee received confirmation that the DOJ has closed its criminal investigation, although as a matter of course the DOJ reserves the right to reopen such inquiries if new facts come to light.

In January 2012, the DOJ indicated that the government would be seeking certain additional information in furtherance of the remaining civil investigation, and that it would formalize its request for that information in a new subpoena. In January 2012, the Office of the Inspector General of the United States Department of Health & Human Services (HHS) served the new subpoena, seeking specific patient records and documents from 2007 to 2011 from the six Southern California skilled nursing facilities that have been the subject of previous requests. HHS also issued a subpoena to the Company's independent external auditors requesting an update to the information requested in the 2007 subpoena to them, and a subpoena to the Company's independent internal auditors requesting similar information.

The Company has produced records called for in the January 2012 subpoena, and discussions between government representatives and counsel for the special committee are ongoing. The Company continues to cooperate with the government as part of an ongoing effort to move the matter to a resolution. In particular, while the Company seeks to address any questions the government may have after it completes its review of specific patient files requested, counsel for the special committee and counsel for the government are also attempting to develop a process to resolve, in advance of formal litigation, any civil claims the government may believe it has after concluding its investigation. In addition, the Company continues to make improvements to its compliance programs and systems.

The Company cannot predict or provide any assurance as to the possible outcome of the investigations or any possible related proceedings, or as to the possible outcome of any litigation. And although the Company believes there is a reasonable possibility that a loss may be incurred, it cannot estimate the possible loss or range of loss that may result from any such proceedings and, therefore, the Company has not recorded any related accruals. If any litigation were to proceed, and the Company is subjected to, alleged to be liable for, or agrees to a settlement of, claims or obligations under federal Medicare statutes, the federal False Claims Act, or similar state and federal statutes and related regulations, its business, financial condition and results of operations and cash flows could be materially and adversely affected and its stock price could be adversely impacted. Among other things, any settlement or litigation could involve the payment of substantial sums to settle any alleged civil violations, and may also include

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THE ENSIGN GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


the Company's assumption of specific procedural and financial obligations going forward under a corporate integrity agreement and/or other arrangement with the government.
Concentrations
Credit Risk — The Company has significant accounts receivable balances, the collectability of which is dependent on the availability of funds from certain governmental programs, primarily Medicare and Medicaid. These receivables represent the only significant concentration of credit risk for the Company. The Company does not believe there are significant credit risks associated with these governmental programs. The Company believes that an appropriate allowance has been recorded for the possibility of these receivables proving uncollectible, and continually monitors and adjusts these allowances as necessary. The Company’s receivables from Medicare and Medicaid payor programs accounted for approximately 59.5% and 58.9% of its total accounts receivable as of September 30, 2012 and December 31, 2011, respectively. Revenue from reimbursement under the Medicare and Medicaid programs accounted for 73.6% and 73.7% of the Company’s revenue for the three and nine months ended September 30, 2012, and 75.0% and 75.3% for the three and nine months ended September 30, 2011, respectively.
Cash in Excess of FDIC Limits — The Company currently has bank deposits with financial institutions in the U.S. that exceed FDIC insurance limits. FDIC insurance provides protection for bank deposits up to $250. In addition, the Company has uninsured bank deposits with a financial institution outside the U.S. As of November 6, 2012, the Company had approximately $1,001 in uninsured cash deposits. All uninsured bank deposits are held at high quality credit institutions.


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Item 2.        Management's Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K (Annual Report), which discusses our business and related risks in greater detail, as well as subsequent reports we may file from time to time on Forms 10-Q and 8-K, for additional information. The section entitled “Risk Factors” contained in Part II, Item 1A of this Report, and similar discussions in our other SEC filings, also describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.
This Report contains "forward-looking statements," within the meaning of the Private Securities Litigation Reform Act of 1995, which include, but are not limited to the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities and plans and objectives of management. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under the section “Risk Factors” contained in Part II, Item 1A of this Report. These forward-looking statements speak only as of the date of this Report, and are based on our current expectations, estimates and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our” and “us” refer to The Ensign Group, Inc. and its consolidated subsidiaries. All of our skilled nursing, assisted living and home health and hospice operations, the Service Center and the Captive are operated by separate, wholly-owned, independent subsidiaries that have their own management, employees and assets. The use of “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that any of our facilities, the Service Center or the Captive are operated by the same entity. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included in the Annual Report.
Overview
We are a provider of skilled nursing and rehabilitative care services through the operation of 107 facilities, six home health and four hospice operations as of September 30, 2012, located in Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Oregon, Texas, Utah and Washington. Our operations, each of which strives to be the service of choice in the community it serves, provide a broad spectrum of skilled nursing, assisted living, home health and hospice services, including physical, occupational and speech therapies, and other rehabilitative and healthcare services, for both long-term residents and short-stay rehabilitation patients. We recently entered into a joint venture to develop and operate urgent care facilities and related businesses. These walk-in clinics will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. As of September 30, 2012, we owned 85 of our 107 facilities and operated an additional 22 facilities under long-term lease arrangements, and had options to purchase two of those 22 facilities. The following table summarizes our facilities and operational skilled nursing, assisted living and independent living beds by ownership status as of September 30, 2012:
 
Owned
 
Leased (with a Purchase Option)
 
Leased (without a Purchase Option)
 
Total
Number of facilities
85

 
2

 
20

 
107

Percent of total
79.4
%
 
1.9
%
 
18.7
%
 
100.0
%
Operational skilled nursing, assisted living and independent living beds
9,371

 
414

 
2,305

 
12,090

Percent of total
77.5
%
 
3.4
%
 
19.1
%
 
100.0
%

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The Ensign Group, Inc. is a holding company with no direct operating assets, employees or revenues. All of our skilled nursing, assisted living and home health and hospice operations are operated by separate, wholly-owned, independent subsidiaries, which have their own management, employees and assets. In addition, one of our wholly-owned independent subsidiaries, which we call our Service Center, provides centralized accounting, payroll, human resources, information technology, legal, risk management and other services to each operating subsidiary through contractual relationships between such subsidiaries. In addition, we have the Captive that provides some claims-made coverage to our operating subsidiaries for general and professional liability, as well as for certain workers’ compensation insurance liabilities. References herein to the consolidated “Company” and “its” assets and activities, as well as the use of the terms “we,” “us,” “our” and similar verbiage in this quarterly report is not meant to imply that The Ensign Group, Inc. has direct operating assets, employees or revenue, or that any of the facilities, the Service Center or the Captive are operated by the same entity.

Facility Acquisition History
 
December 31,
 
September 30,
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
Cumulative number of facilities
46

 
57

 
61

 
63

 
77

 
82

 
102

 
107

Cumulative number of operational skilled nursing, assisted living and independent living beds
5,585

 
6,667

 
7,105

 
7,324

 
8,948

 
9,539

 
11,702

 
12,090


The following table sets forth the location of our facilities and the number of operational beds located at our facilities as of September 30, 2012:
 
CA
 
AZ
 
TX
 
UT
 
CO
 
WA
 
ID
 
NV
 
NE
 
IA
 
Total
Number of facilities
35

 
13

 
22

 
11

 
5

 
3

 
6

 
3

 
4

 
5

 
107

Operational skilled nursing, assisted living and independent living beds
3,864

 
1,902

 
2,812

 
1,342

 
463

 
274

 
477

 
304

 
296

 
356

 
12,090


On February 1, 2012, we acquired an assisted living facility in Nevada for approximately $2.1 million, which was paid in cash. This acquisition added 60 operational assisted living beds to our operation. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.

On February 10, 2012, we acquired a home health operation in Oregon for approximately $0.5 million, which was paid in cash. The acquisition did not have an impact on the Company's operational bed count. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.
On March 1, 2012, we acquired a skilled nursing facility in Idaho for approximately $2.8 million, which was paid in cash. This acquisition added 113 operational skilled nursing beds to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.
On April 1, 2012, we acquired a home health and hospice operation in Utah and Arizona for approximately $3.0 million, which was paid in cash. The acquisition did not have an impact on our operational bed count. We also entered into a separate operations transfer agreement with the prior owner as part of this transaction.
On June 1, 2012, we acquired a skilled nursing facility in Texas for $8.0 million, which was paid in cash. This addition added 150 operational skilled nursing beds to our operations. We also entered into a separate operations transfer agreement with the prior tenant as part of such transaction.
On August 1, 2012, we acquired two skilled nursing facilities in Idaho for $4.5 million, which was paid in cash. One of the skilled nursing facilities acquired also offers assisted living services. This acquisition added 94 skilled nursing beds and 24 assisted living units to our operations.

In addition, during the nine months ended September 30, 2012, we purchased the underlying assets of three of our skilled nursing facilities in California which we previously operated under long-term lease agreements, which contained options to purchase, for $11.4 million, which was paid in cash. These acquisitions did not impact our operational bed count.
See further discussion of facility acquisitions in Note 6 in Notes to Condensed Consolidated Financial Statements.

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Recent Developments

Board of Directors — Effective June 15, 2012, Mr. Daren J. Shaw was appointed by the board of directors, at the recommendation of the nomination and corporate governance committee, to serve on the audit committee with Mr. John Nackel and Mr. Thomas Maloof (Chair). Mr. Shaw has also been appointed by the board of directors to serve on the nomination and corporate governance committee and the compensation committee. On July 26, 2012, the board of directors appointed Mr. Shaw to serve as the chair of the audit committee effective September 1, 2012.

Joint Venture - Urgent Care

Immediate Clinic (IC) — On January 10, 2012, we announced a joint venture to develop and operate urgent care facilities and related businesses. Immediate Clinic (IC) will offer daily access to healthcare for minor injuries and illnesses, including x-ray and lab services, all from convenient neighborhood locations with no appointments. Design and construction planning for several new locations is currently underway, and IC is also seeking opportunities to acquire existing urgent care operations across the United States. IC opened its first two operations during the third quarter of fiscal 2012. Dr. John Shufeldt resigned as Chief Executive Officer of IC effective September 12, 2012. In addition, on October 4, 2012, we committed to invest an additional $6.0 million to IC in exchange for senior preferred stock which will result in our holding approximately 96% of the outstanding interests in the joint venture on a fully-diluted basis. The proceeds of such investment will be used to continue the development of additional clinics in the Northwest.

On February 15, 2012, IC purchased an equity investment in an urgent care software service provider for $1.4 million. In addition, on March 1, 2012, DRX Urgent Care LLC (DRX), a newly formed subsidiary of IC, purchased substantially all of the assets and assumed certain liabilities of Doctors Express Franchising LLC, a national urgent care franchise system for $2.0 million, adjusted for certain items at the time of close and redeemable noncontrolling interest of $11.6 million. We recognized intangible assets of $7.9 million in trade name, $3.0 million in franchise relationships and $2.7 million in goodwill as part of this transaction.
Key Performance Indicators
We manage our skilled nursing business by monitoring key performance indicators that affect our financial performance. These indicators and their definitions include the following:
•
Routine revenue: Routine revenue is generated by the contracted daily rate charged for all contractually inclusive skilled nursing services. The inclusion of therapy and other ancillary treatments varies by payor source and by contract. Services provided outside of the routine contractual agreement are recorded separately as ancillary revenue, including Medicare Part B therapy services, and are not included in the routine revenue definition.
•
Skilled revenue: The amount of routine revenue generated from patients in our skilled nursing facilities who are receiving higher levels of care under Medicare, managed care, Medicaid, or other skilled reimbursement programs. The other skilled residents that are included in this population represent very high acuity residents who are receiving high levels of nursing and ancillary services which are reimbursed by payors other than Medicare or managed care. Skilled revenue excludes any revenue generated from our assisted living services.
•
Skilled mix: The amount of our skilled revenue as a percentage of our total routine revenue. Skilled mix (in days) represents the number of days our Medicare, managed care, or other skilled patients are receiving services at our skilled nursing facilities divided by the total number of days patients (less days from assisted living services) from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).
•
Quality mix: The amount of routine non-Medicaid revenue as a percentage of our total routine revenue. Quality mix (in days) represents the number of days our non-Medicaid patients are receiving services at our skilled nursing facilities divided by the total number of days patients from all payor sources are receiving services at our skilled nursing facilities for any given period (less days from assisted living services).
•
Average daily rates: The routine revenue by payor source for a period at our skilled nursing facilities divided by actual patient days for that revenue source for that given period.
•
Occupancy percentage (operational beds): The total number of residents occupying a bed in a skilled nursing, assisted living or independent living facility as a percentage of the beds in a facility which are available for occupancy during the measurement period.
•
Number of facilities and operational beds: The total number of skilled nursing, assisted living and independent living facilities that we own or operate and the total number of operational beds associated with these facilities.

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Skilled and Quality Mix. Like most skilled nursing providers, we measure both patient days and revenue by payor. Medicare, managed care and other skilled patients, whom we refer to as high acuity patients, typically require a higher level of skilled nursing and rehabilitative care. Accordingly, Medicare and managed care reimbursement rates are typically higher than from other payors. In most states, Medicaid reimbursement rates are generally the lowest of all payor types. Changes in the payor mix can significantly affect our revenue and profitability.

The following table summarizes our overall skilled mix and quality mix for the periods indicated as a percentage of our total routine revenue (less revenue from assisted living services) and as a percentage of total patient days (less days from assisted living services):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Skilled Mix:
 
 
 
 
 
 
 
Days
25.2
%
 
24.9
%
 
25.8
%
 
25.8
%
Revenue
49.3
%
 
51.3
%
 
50.1
%
 
52.2
%
Quality Mix:
 
 
 
 
 
 
 
Days
38.4
%
 
38.2
%
 
39.0
%
 
38.2
%
Revenue
58.8
%
 
60.5
%
 
59.6
%
 
60.8
%
Occupancy. We define occupancy as the ratio of actual patient days (one patient day equals one resident occupying one bed for one day) during any measurement period to the number of beds in facilities which are available for occupancy during the measurement period. The number of licensed and independent living beds in a skilled nursing, assisted living or independent living facility that are actually operational and available for occupancy may be less than the total official licensed bed capacity. This sometimes occurs due to the permanent dedication of bed space to alternative purposes, such as enhanced therapy treatment space or other desirable uses calculated to improve service offerings and/or operational efficiencies in a facility. In some cases, three- and four-bed wards have been reduced to two-bed rooms for resident comfort, and larger wards have been reduced to conform to changes in Medicare requirements. These beds are seldom expected to be placed back into service. We define occupancy in operational beds as the ratio of actual patient days during any measurement period to the number of available patient days for that period. We believe that reporting occupancy based on operational beds is consistent with industry practices and provides a more useful measure of actual occupancy performance from period to period.
The following table summarizes our overall occupancy statistics for the periods indicated:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Occupancy:
 
 
 
 
 
 
 
Operational beds at end of period
12,090

 
11,461

 
12,090

 
11,461

Available patient days
1,108,622

 
1,032,478

 
3,256,086

 
2,882,973

Actual patient days
872,701

 
812,627

 
2,580,026

 
2,291,107

Occupancy percentage (based on operational beds)
78.7
%
 
78.7
%
 
79.2
%
 
79.5
%

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Revenue Sources
Our total revenue represents revenue derived primarily from providing services to patients and residents of skilled nursing facilities, and to a lesser extent from assisted living facilities and ancillary services. We receive service revenue from Medicaid, Medicare, private payors and other third-party payors, and managed care sources. The sources and amounts of our revenue are determined by a number of factors, including bed capacity and occupancy rates of our healthcare facilities, the mix of patients at our facilities and the rates of reimbursement among payors. Payment for ancillary services varies based upon the service provided and the type of payor. The following table sets forth our total revenue by payor source and as a percentage of total revenue for the periods indicated:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2012
 
2011
 
2012
 
2011
 
 
$
 
%
 
$
 
%
 
$
 
%
 
$
 
%
 
 
(Dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicaid
 
$
76,709

 
37.0
%
 
$
70,967

 
36.1
%
 
$
223,934

 
36.5
%
 
$
204,273

 
36.1
%
Medicare
 
69,526

 
33.6

 
71,293

 
36.3

 
209,715

 
34.2

 
207,897

 
36.8

Medicaid-skilled
 
6,316

 
3.0

 
5,024

 
2.6

 
18,590

 
3.0

 
13,730

 
2.4

Total
 
152,551

 
73.6

 
147,284

 
75.0

 
452,239

 
73.7

 
425,900

 
75.3

Managed Care
 
26,316

 
12.7

 
23,621

 
12.0

 
77,738

 
12.7

 
71,938

 
12.7

Private and Other(1)
 
28,283

 
13.7

 
25,441

 
13.0

 
83,641

 
13.6

 
67,777

 
12.0

Total revenue
 
$
207,150

 
100.0
%
 
$
196,346

 
100.0
%
 
$
613,618

 
100.0
%
 
$
565,615

 
100.0
%
______________________
(1)
Includes revenue from assisted living facilities, home health and hospice and franchise operations.
Critical Accounting Policies Update
There have been no significant changes during the nine-month period ended September 30, 2012 to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our Annual Report on Form 10-K filed with the SEC, except for the following:

Noncontrolling Interest

The noncontrolling interest in a subsidiary is initially recognized at estimated fair value on the acquisition date and is presented within total equity in our condensed consolidated balance sheets. We present the noncontrolling interest and the amount of consolidated net income attributable to The Ensign Group, Inc. in our condensed consolidated statements of income and net income per share is calculated based on net income attributable to The Ensign Group, Inc.'s stockholders. The carrying amount of the noncontrolling interest is adjusted based on an allocation of subsidiary earnings based on ownership interest. Noncontrolling interest that has redemption features outside our control is accounted for as redeemable noncontrolling interest and is recorded as temporary equity. Owners of noncontrolling interest in certain of our subsidiaries have the right in certain circumstances to require it to purchase additional ownership interests at an amount as defined in the applicable agreement. The intent of the parties is to approximate fair value at the time of redemption by using a multiple of earnings that is consistent with generally accepted valuation practices. These contingent redemption rights are embedded in the equity security at issuance, are not free-standing instruments, do not represent a de facto financing and are not under our control.
Equity Investment
Our majority-owned subsidiary has a non-marketable equity investment which is accounted for under the equity method. The investment is initially recorded at cost and we will adjust the carrying amount for its share of the earnings or losses of the investee after the date of investment. The investment is evaluated periodically for impairment. If it is determined that a decline of the investment is other than temporary, then the investment basis would be written down to fair value and the write-down would be included in earnings as a loss.


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Industry Trends
The skilled nursing industry has evolved to meet the growing demand for post-acute and custodial healthcare services generated by an aging population, increasing life expectancies and the trend toward shifting of patient care to lower cost settings. The skilled nursing industry has evolved in recent years, which we believe has led to a number of favorable improvements in the industry, as described below:
•
Shift of Patient Care to Lower Cost Alternatives. The growth of the senior population in the United States continues to increase healthcare costs, often faster than the available funding from government-sponsored healthcare programs. In response, federal and state governments have adopted cost-containment measures that encourage the treatment of patients in more cost-effective settings such as skilled nursing facilities, for which the staffing requirements and associated costs are often significantly lower than acute care hospitals, inpatient rehabilitation facilities and other post-acute care settings. As a result, skilled nursing facilities are generally serving a larger population of higher-acuity patients than in the past.
•
Significant Acquisition and Consolidation Opportunities. The skilled nursing industry is large and highly fragmented, characterized predominantly by numerous local and regional providers. We believe this fragmentation provides significant acquisition and consolidation opportunities for us.
•
Improving Supply and Demand Balance. The number of skilled nursing facilities has declined modestly over the past several years. We expect that the supply and demand balance in the skilled nursing industry will continue to improve due to the shift of patient care to lower cost settings, an aging population and increasing life expectancies.
•
Increased Demand Driven by Aging Populations and Increased Life Expectancy. As life expectancy continues to increase in the United States and seniors account for a higher percentage of the total U.S. population, we believe the overall demand for skilled nursing services will increase. At present, the primary market demographic for skilled nursing services is primarily individuals age 75 and older. According to the 2010 U.S. Census, there were over 40 million people in the United States in 2010 that are over 65 years old. The 2010 U.S. Census estimates this group is one of the fastest growing segments of the United States population and is expected to more than double between 2000 and 2030.

We believe the skilled nursing industry has been and will continue to be impacted by several other trends. The use of long-term care insurance is increasing among seniors as a means of planning for the costs of skilled nursing services. In addition, as a result of increased mobility in society, reduction of average family size, and the increased number of two-wage earner couples, more seniors are looking for alternatives outside the family for their care.
Effects of Changing Prices — Medicare reimbursement rates and procedures are subject to change from time to time, which could materially impact our revenue. Medicare reimburses our skilled nursing facilities under a prospective payment system (PPS) for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group (RUG) category that is based upon each patient’s acuity level. As of October 1, 2010, the RUG categories were expanded from 53 to 66 with the introduction of minimum data set (MDS) 3.0. Should future changes in skilled nursing facility payments reduce rates or increase the standards for reaching certain reimbursement levels, our Medicare revenues could be reduced, with a corresponding adverse impact on our financial condition or results of operations.

Centers for Medicare and Medicaid Services (CMS) Rulings — On July 27, 2012, the CMS announced a final rule updating Medicare skilled nursing facility PPS payments in fiscal year 2013. The update, a 1.8% or $670 million increase, reflects a 2.5% market basket increase, reduced by a 0.7% multi-factor productivity (MFP) adjustment mandated by the Patient Protection and Affordable Care Act (PPACA). This increase will be offset by the 2% sequestration reduction, discussed below, which will become effective January 1, 2013.

On July 6, 2012, CMS announced its proposed rule for the Home Health Prospective Payment System (PPS) increasing payments to home health service organizations by $20.0 million. The proposed home health rule provides a net increase of 0.1% in Medicare payments, made up of a 2.5% market basket increase, offset by mandatory cuts under the Patient Protection and Affordable Care Act. If finalized, the proposed rule will be effective beginning January 1, 2013.

In July 2012, CMS issued its final rule for hospice services for its 2013 fiscal year. The rule includes a market basket increase of 2.6% less 0.3% reduction in the market basket as a result of the PPACA and a 0.7% reduction due to productivity adjustment.
Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels, our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition or results of operations.


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Medicare Part B Therapy Cap — Some of our rehabilitation therapy revenue is paid by the Medicare Part B program under a fee schedule. Congress has established annual caps that limit the amounts that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to any Medicare beneficiary under Medicare Part B. The Deficit Reduction Act of 2005 (DRA) added Sec. 1833(g)(5) of the Social Security Act and directed the Centers for Medicare and Medicaid Services to develop a process that allows exceptions for Medicare beneficiaries to therapy caps when continued therapy is deemed medically necessary.

The therapy cap exception was reauthorized in a number of subsequent laws, most recently in the Middle Class Tax Relief and Job Creation Act of 2012 which extends the exceptions process through December 31, 2012. The statutory Medicare Part B outpatient therapy cap for occupational therapy and the combined cap for physical therapy and speech-language pathology services are $1,880, respectively, for 2012. These amounts represent annual per beneficiary therapy caps determined for each calendar year. Similar to the therapy cap, Congress established a threshold of $3,700 for physical therapy and speech-language pathology services combined and a separate threshold of $3,700 for occupational therapy services. All therapy services rendered above this limit are subject to medical review and certain providers will be required to submit a request for an exception. Beginning October 1, 2012 some therapy providers are required to submit requests for exceptions. Prior to October 1, 2012 there was no requirement for an exception request when the threshold was exceeded.

The application of annual caps, or the discontinuation of exceptions to the annual caps, could have an adverse effect on our rehabilitation therapy revenue. Additionally, the exceptions to these caps may not be extended beyond December 31, 2012, which could also have an adverse effect on our revenue after that date.
Medicare Coverage Settlement Agreement — A proposed federal class action settlement was filed in federal district court on October 16, 2012 that would end the Medicare coverage standard for skilled nursing, home health and outpatient therapy services that a beneficiary's condition must be expected to improve. The proposed settlement would require the Centers for Medicare and Medicaid Services to issue guidance stating that skilled nursing, home health and outpatient therapy services can be covered under Medicare so long as the beneficiary's clinical condition required skilled care in order to maintain the beneficiary's current condition or to prevent or slow further deterioration. Implementation of the provisions of this settlement agreement could impact reimbursement for our services favorably.
Federal Regulations — On August 2, 2011, the President signed into law the Budget Control Act of 2011 (Budget Control Act), which raised the debt ceiling and put into effect a series of actions for deficit reduction. The Budget Control Act creates a Congressional Joint Select Committee on Deficit Reduction (the Committee) that was tasked with proposing additional deficit reduction of at least $1.5 trillion over ten years. As the Committee was unable to achieve its targeted savings, this regulation triggered automatic reductions in discretionary and mandatory spending starting in 2013, including reductions of not more than 2% to payments to Medicare providers. The Budget Control Act also requires Congress to vote on an amendment to the Constitution that would require a balanced budget.

State Regulations — On March 24, 2011, the governor of California signed Assembly Bill 97 (AB 97), the budget trailer bill on health, into law.  AB 97 outlines significant cuts to  state  health and human services programs.  Specifically, the law reduces provider payments by 10% for physicians, pharmacies, clinics, medical transportation, certain hospitals, home health, and nursing facilities.  AB X1 19 Long Term Care  was subsequently approved by the governor on June 28, 2011.  AB X1 19 limits  the 10% payment reduction to skilled-nursing providers to 14 months for the services provided on June 1, 2011 through July 31, 2012, with a promise to repay by December 31, 2012.  Federal approval was obtained on October 27, 2011.  There can be no assurance that the reduction in provider payments will not lead to material adverse consequences in the future.

Federal Health Care Reform — On March 23, 2010, President Obama signed PPACA into law, which contained several sweeping changes to America’s health insurance system. Among other reforms contained in PPACA, many Medicare providers received reductions in their market basket updates. Unlike for some other Medicare providers, PPACA makes no reduction to the market basket update for skilled nursing facilities in fiscal years 2010 or 2011. However, under PPACA, the skilled nursing facility market basket update will be subject to a full productivity adjustment beginning in fiscal year 2012. In addition, PPACA enacted several reforms with respect to skilled nursing facilities and hospice organizations, including payment measures to realize significant savings of federal and state funds by deterring and prosecuting fraud and abuse in both the Medicare and Medicaid programs. While many of the provisions of PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are:

•
Enhanced CMPs and Escrow Provisions — PPACA included expanded civil monetary penalty (CMP) provisions applicable to all Medicare and Medicaid providers. PPACA provided for the imposition of CMPs of up to $50,000 and, in some cases, treble damages, for actions relating to alleged false statements to the federal government.


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•
Nursing Home Transparency Requirements — In addition to expanded CMP provisions, PPACA imposed substantial new transparency requirements for Medicare-participating nursing facilities. Existing law required Medicare providers to disclose to CMS: (1) any person or entity that owns directly or indirectly an ownership interest of five percent or more in a provider; (2) officers and directors (if a corporation) and partners (if a partnership); and (3) holders of a mortgage, deed of trust, note or other obligation secured by the entity or the property of the entity. PPACA expanded the information required to be disclosed to include: (4) the facility’s organizational structure; (5) additional information on officers, directors, trustees, and “managing employees” of the facility (including their names, titles, and start dates of services); and (6) information on any “additional disclosable party” of the facility. CMS has not yet promulgated regulations to implement these provisions.

•
Face-to-Face Encounter Requirements — PPACA imposed new patient face-to-face encounter requirements on home health agencies and hospices to establish a patient's ongoing eligibility for Medicare home health services or hospice services, as applicable. Effective for patients with home health starts of care on or after January 1, 2011 and for hospice patients with a third or later benefit period on or after January 1, 2011, a certifying physician or other designated health care professional must conduct and properly document the face-to-face encounters with the Medicare beneficiary within a specified timeframe, and failure of the face-to-face encounter to occur and be properly documented during the applicable timeframe could render the patient's care ineligible for reimbursement under Medicare.

•
Suspension of Payments During Pending Fraud Investigations — PPACA also provided the federal government with expanded authority to suspend payment if a provider is investigated for allegations or issues of fraud. Section 6402 of the PPACA provides that Medicare and Medicaid payments may be suspended pending a “credible investigation of fraud,” unless the Secretary of Health and Human Services determined that good cause exists not to suspend payments. “Credible investigation of fraud” is undefined, although the Secretary must consult with the Office of the Inspector General (OIG) in determining whether a credible investigation of fraud exists. This suspension authority created a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercised its authority to suspend Medicaid payments pending a fraud investigation. To the extent the Secretary applied this suspension of payments provision to one or more of our facilities for allegations of fraud, such a suspension could adversely affect our revenue, cash flow, financial condition and results of operations. OIG promulgated regulations making these provisions effective as of March 25, 2011.

•
Overpayment Reporting and Repayment; Expanded False Claims Act Liability — PPACA also enacted several important changes that expand potential liability under the federal False Claims Act. PPACA provided that overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within the later of sixty days of identification of the overpayment, or the date the corresponding cost report (if applicable) is due. Any overpayment retained after the deadline is considered an “obligation” for purposes of the federal False Claims Act.

•
Skilled Nursing Facility Value-Based Purchasing Program — PPACA required the U.S. Department of Health and Human Services (HHS) to develop a plan to implement a value-based purchasing program for Medicare payments to skilled nursing facilities. HHS delivered a report to Congress outlining its plans for implementing this value-based purchasing program. The value-based purchasing program would provide payment incentives for Medicare-participating skilled nursing facilities to improve the quality of care provided to Medicare beneficiaries. Among the most relevant factors in HHS' plans to implement value-based purchasing for skilled nursing facilities is the current Nursing Home Value-Based Purchasing Demonstration Project, which will conclude in December 2012. HHS indicates it will complete an evaluation of the demonstration program in the autumn of 2013, and any permanent value-based purchasing program for skilled nursing facilities will be implemented after that evaluation.

•
Voluntary Pilot Program — Bundled Payments — To support the policies of making all providers responsible during an episode of care and rewarding value over volume, HHS will establish, test and evaluate alternative payment methodologies for Medicare services through a five-year, national, voluntary pilot program starting in 2013. This program will provide incentives for providers to coordinate patient care across the continuum and to be jointly accountable for an entire episode of care centered around a hospitalization. HHS will develop qualifying provider payment methods that may include bundled payments and bids from entities for episodes of care that begins three days prior to hospitalization and spans 30 days following discharge. The bundled payment will cover the costs of acute care inpatient services; physicians’ services delivered in and outside of an acute care hospital; outpatient hospital services including emergency department services; post-acute care services, including home health services, skilled nursing services, inpatient rehabilitation services; and inpatient hospital services. The payment methodology will include payment for services, such as care coordination, medication reconciliation, discharge planning and transitional care services, and other patient-centered activities. Payments for items and services cannot result in spending more than would otherwise be expended for such

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entities if the pilot program were not implemented. As with Medicare’s shared savings program discussed above, payment arrangements among providers on the backside of the bundled payment must take into account significant hurdles under the Anti-kickback Law, the Stark Law and the Civil Monetary Penalties Law. This pilot program may expand in 2016 if expansion would reduce Medicare spending without also reducing quality of care.

•
Accountable Care Organizations — PPACA authorized CMS to enter into contracts with Accountable Care Organizations (ACOs). ACOs are entities of providers and suppliers organized to deliver services to Medicare beneficiaries and eligible to receive a share of any cost savings the entity can achieve by delivering services to those beneficiaries at a cost below a set baseline and with sufficient quality of care. CMS recently finalized regulations to implement the ACO initiative. The widespread adoption of ACO payment methodologies in the Medicare program, and in other programs and payors, could impact our operations and reimbursement for our services.

On June 28, 2012 the United States Supreme Court ruled that the enactment of PPACA did not violate the Constitution of the United States. This ruling permits the implementation of most of the provisions of PPACA to proceed. The provisions of PPACA discussed above are only examples of federal health reform provisions that we believe may have a material impact on the long-term care industry and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that these and other provisions of PPACA may be interpreted, clarified, or applied to our facilities or operations in a way that could have a material adverse impact on the results of operations.

Historically, adjustments to reimbursement under Medicare have had a significant effect on our revenue. For a discussion of historic adjustments and recent changes to the Medicare program and related reimbursement rates see Risk Factors - Risks Related to Our Business and Industry - “Our revenue could be impacted by federal and state changes to reimbursement and other aspects of Medicaid and Medicare,” “Our future revenue, financial condition and results of operations could be impacted by continued cost containment pressures on Medicaid spending,” “We may not be fully reimbursed for all services for which each facility bills through consolidated billing, which could adversely affect our revenue, financial condition and results of operations” and “Reforms to the U.S. healthcare system will impose new requirements upon us and may lower our reimbursements." The federal government and state governments continue to focus on efforts to curb spending on healthcare programs such as Medicare and Medicaid. We are not able to predict the outcome of the legislative process. We also cannot predict the extent to which proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals and existing new legislation will have on us. Efforts to impose reduced allowances, greater discounts and more stringent cost controls by government and other payors are expected to continue and could adversely affect our business, financial condition and results of operations.

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Table of Contents

Results of Operations

The following table sets forth details of our revenue, expenses and earnings as a percentage of total revenue for the periods indicated:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Expenses:
 
 
 
 
 
 
 
Cost of services (exclusive of facility rent, general and administrative expense and depreciation and amortization shown separately below)
79.6

 
79.3

 
79.6

 
78.6

Facility rent—cost of services
1.6

 
1.7

 
1.6

 
1.8

General and administrative expense
3.9

 
3.7

 
3.9

 
3.9

Depreciation and amortization
3.5

 
3.1

 
3.4

 
3.0

Total expenses
88.6

 
87.8

 
88.5

 
87.3

Income from operations
11.4

 
12.2

 
11.5

 
12.7

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(1.5
)
 
(2.7
)
 
(1.5
)
 
(1.9
)
Interest income
—

 
—

 
—

 
—

Other expense, net
(1.5
)
 
(2.7
)
 
(1.5
)
 
(1.9
)
Income before provision for income taxes
9.9

 
9.5

 
10.0

 
10.8

Provision for income taxes
3.6

 
3.6

 
3.8

 
4.2

Net income
6.3

 
5.9

 
6.2

 
6.6

Less: net (loss) attributable to the noncontrolling interests
(0.1
)
 
—

 
(0.1
)
 
—

Net income attributable to Ensign
6.4
 %
 
5.9
 %
 
6.3
 %
 
6.6
 %

The table below reconciles net income to EBITDA and EBITDAR for the periods presented:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
 
(Dollars in thousands)
Consolidated Statements of Income Data:
 
 
 
 
 
 
 
Net income
$
13,036

 
$
11,598

 
$
38,143

 
$
37,320

Net loss attributable to noncontrolling interests
258

 
—

 
511

 
—

Interest expense, net
3,023

 
5,255

 
8,959

 
10,591

Provision for income taxes
7,562

 
7,063

 
23,070

 
23,835

Depreciation and amortization
7,179

 
6,179

 
21,145

 
16,784

EBITDA(1)
$
31,058

 
$
30,095

 
$
91,828

 
$
88,530

Facility rent—cost of services
3,374

 
3,331

 
10,063

 
10,380

EBITDAR(1)
$
34,432

 
$
33,426

 
$
101,891

 
$
98,910

_______________________
(1)
EBITDA and EBITDAR are supplemental non-GAAP financial measures. Regulation G, Conditions for Use of Non-GAAP Financial Measures, and other provisions of the Securities Exchange Act of 1934, as amended, define and prescribe the conditions for use of certain non-GAAP financial information. We calculate EBITDA as net income, adjusted for net losses attributable to noncontrolling interest, before (a) interest expense, net, (b) provision for income taxes, and (c) depreciation and amortization. We calculate EBITDAR by adjusting EBITDA to exclude facility rent—cost of services. These non-GAAP financial measures are used in addition to and in conjunction with results presented in accordance with GAAP. These non-GAAP financial measures should not be relied upon to the exclusion of GAAP financial measures.

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These non-GAAP financial measures reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP results and the accompanying reconciliations to corresponding GAAP financial measures, provide a more complete understanding of factors and trends affecting our business.
We believe EBITDA and EBITDAR are useful to investors and other external users of our financial statements in evaluating our operating performance because:
•
they are widely used by investors and analysts in our industry as a supplemental measure to evaluate the overall operating performance of companies in our industry without regard to items such as interest expense, net and depreciation and amortization, which can vary substantially from company to company depending on the book value of assets, capital structure and the method by which assets were acquired; and
•
they help investors evaluate and compare the results of our operations from period to period by removing the impact of our capital structure and asset base from our operating results.
We use EBITDA and EBITDAR:
•
as measurements of our operating performance to assist us in comparing our operating performance on a consistent basis;
•
to allocate resources to enhance the financial performance of our business;
•
to evaluate the effectiveness of our operational strategies; and
•
to compare our operating performance to that of our competitors.
We typically use EBITDA and EBITDAR to compare the operating performance of each skilled nursing and assisted living facility. EBITDA and EBITDAR are useful in this regard because they do not include such costs as net interest expense, income taxes, depreciation and amortization expense, and, with respect to EBITDAR, facility rent — cost of services, which may vary from period-to-period depending upon various factors, including the method used to finance facilities, the amount of debt that we have incurred, whether a facility is owned or leased, the date of acquisition of a facility or business, and the tax law of the state in which a business unit operates. As a result, we believe that the use of EBITDA and EBITDAR provide a meaningful and consistent comparison of our business between periods by eliminating certain items required by GAAP.
We also establish compensation programs and bonuses for our facility level employees that are partially based upon the achievement of EBITDAR targets.
Despite the importance of these measures in analyzing our underlying business, designing incentive compensation and for our goal setting, EBITDA and EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP. Therefore, our EBITDA and EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported in accordance with GAAP. Some of these limitations are:
•
they do not reflect our current or future cash requirements for capital expenditures or contractual commitments;
•
they do not reflect changes in, or cash requirements for, our working capital needs;
•
they do not reflect the net interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;
•
they do not reflect any income tax payments we may be required to make;
•
although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and EBITDAR do not reflect any cash requirements for such replacements; and
•
other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.
We compensate for these limitations by using them only to supplement net income on a basis prepared in accordance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business.
Management strongly encourages investors to review our condensed consolidated financial statements in their entirety and to not rely on any single financial measure. Because these non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. For information about our financial results as reported in accordance with GAAP, see our condensed consolidated financial statements and related notes included elsewhere in this document.

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Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011
 
Three Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Total Facility Results:
 
 
 
 
 
 
 
Revenue
$
207,150

 
$
196,346

 
$
10,804

 
5.5
 %
Number of facilities at period end
107

 
99

 
8

 
8.1
 %
Actual patient days
872,701

 
812,627

 
60,074

 
7.4
 %
Occupancy percentage — Operational beds
78.7
%
 
78.7
%
 
 
 
—
 %
Skilled mix by nursing days
25.2
%
 
24.9
%
 
 
 
0.3
 %
Skilled mix by nursing revenue
49.3
%
 
51.3
%
 
 
 
(2.0
)%
 
Three Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Same Facility Results(1):
 
 
 
 
 
 
 
Revenue
$
139,664

 
$
144,357

 
$
(4,693
)
 
(3.3
)%
Number of facilities at period end
62

 
62

 
—

 
—
 %
Actual patient days
537,256

 
536,500

 
756

 
0.1
 %
Occupancy percentage — Operational beds
82.2
%
 
81.8
%
 
 
 
0.4
 %
Skilled mix by nursing days
28.7
%
 
28.7
%
 
 
 
—
 %
Skilled mix by nursing revenue
53.3
%
 
55.7
%
 
 
 
(2.4
)%
 
Three Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Transitioning Facility Results(2):
 
 
 
 
 
 
 
Revenue
$
37,163

 
$
35,147

 
$
2,016

 
5.7
%
Number of facilities at period end
20

 
20

 
—

 
—
%
Actual patient days
168,062

 
159,750

 
8,312

 
5.2
%
Occupancy percentage — Operational beds
75.7
%
 
71.9
%
 
 
 
3.8
%
Skilled mix by nursing days
18.8
%
 
16.8
%
 
 
 
2.0
%
Skilled mix by nursing revenue
40.0
%
 
38.6
%
 
 
 
1.4
%
 
Three Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Recently Acquired Facility Results(3):
 
 
 
 
 
 
 
Revenue
$
30,323

 
$
16,842

 
$
13,481

 
NM
Number of facilities at period end
25

 
17

 
8

 
NM
Actual patient days
167,383

 
116,377

 
51,006

 
NM
Occupancy percentage — Operational beds
71.9
%
 
75.2
%
 
 
 
NM
Skilled mix by nursing days
16.8
%
 
11.0
%
 
 
 
NM
Skilled mix by nursing revenue
37.0
%
 
29.1
%
 
 
 
NM
_______________________
(1)
Same Facility results represent all facilities purchased prior to January 1, 2009.
(2)
Transitioning Facility results represents all facilities purchased from January 1, 2009 to December 31, 2010.
(3)
Recently Acquired Facility (or “Acquisitions”) results represent all facilities purchased on or subsequent to January 1, 2011.


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Table of Contents

Revenue. Revenue increased $10.8 million, or 5.5%, to $207.1 million for the three months ended September 30, 2012 compared to $196.3 million for the three months ended September 30, 2011. Of the $10.8 million increase, Medicare and managed care revenue increased $0.9 million, or 1.0%, Medicaid revenue increased $5.7 million, or 8.1%, private and other revenue increased $2.8 million, or 11.2% and other skilled revenue increased $1.3 million, or 25.7%. Revenue generated by Recently Acquired Facilities increased by approximately $13.5 million. Since January 1, 2011, the Company has acquired 25 facilities, five home health and two hospice operations in ten states.

Revenue generated by Same Facilities decreased $4.7 million, or 3.3%, for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. Medicare revenue per patient day decreased 12.3% during the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. This decrease was primarily due to the impact of the CMS imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented on October 1, 2011. This rate reduction was partially offset by an increase in other skilled and managed care days of 9.9% and 2.1%, respectively, as well as an increase in occupancy of 0.4% to 82.2%.

Revenue at Transitioning Facilities increased by $2.0 million, or 5.7% for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. This increase was achieved despite a decrease in Medicare revenue per patient day of 9.8% at Transitioning Facilities for the three months ended September 30, 2012. The increase was primarily due to an increase in skilled mix by nursing days of 2.0%, to 18.8%, which was the result of an increase in Medicare patient days at Transitioning Facilities of 7.0%, as well as an increase in occupancy of 3.8% to 75.7%.

The following table reflects the change in the skilled nursing average daily revenue rates by payor source, excluding services that are not covered by the daily rate:
 
Three Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
%
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
Change
Skilled Nursing Average Daily Revenue Rates:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
$
564.05

 
$
643.35

 
$
483.99

 
$
536.50

 
$
464.93

 
$
472.68

 
$
539.13

 
$
616.78

 
(12.6
)%
Managed care
380.35

 
369.63

 
399.24

 
415.53

 
398.82

 
490.71

 
383.29

 
375.05

 
2.2
 %
Other skilled
565.92

 
538.68

 
582.27

 
550.61

 
—

 
—

 
568.60

 
539.85

 
5.3
 %
Total skilled revenue
494.56

 
535.11

 
467.43

 
509.47

 
454.10

 
474.63

 
487.11

 
529.46

 
(8.0
)%
Medicaid
171.03

 
168.44

 
161.56

 
160.86

 
150.51

 
137.38

 
166.74

 
164.60

 
1.3
 %
Private and other payors
195.48

 
188.75

 
166.36

 
177.01

 
167.14

 
152.27

 
180.75

 
177.24

 
2.0
 %
Total skilled nursing revenue
$
266.15

 
$
275.75

 
$
219.68

 
$
221.55

 
$
206.73

 
$
180.37

 
$
249.38

 
$
257.06

 
(3.0
)%

Medicare daily rates decreased by 12.6%, due to the impact of the CMS imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented in October 2011. The third quarter 2011 results include the impact of the implementation of RUGS IV on both revenue reimbursement and related cost structure changes included in MDS 3.0 and concurrent therapy. The average Medicaid rate increased 1.3% for the three months ended September 30, 2012 relative to the same period in the prior year, primarily due to increases in rates in several states and increased acuity in case mix states where rates were cut, partially offset by decreases in rates in Arizona due to changes in base reimbursement rates.
Historically, we have generally experienced lower occupancy rates, lower skilled mix and quality mix at Recently Acquired Facilities and therefore, we anticipate generally lower overall occupancy during years of growth. In the future, if we acquire additional facilities into our overall portfolio, we expect this trend to continue. Accordingly, we anticipate our overall occupancy will vary from quarter to quarter based upon the maturity of the facilities within our portfolio.

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Table of Contents

Payor Sources as a Percentage of Skilled Nursing Services. We use both our skilled mix and quality mix as measures of the quality of reimbursements we receive at our skilled nursing facilities over various periods. The following tables set forth our percentage of skilled nursing patient revenue and days by payor source:
 
Three Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Percentage of Skilled Nursing Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
33.6
%
 
37.9
%
 
26.9
%
 
29.6
%
 
31.7
%
 
25.8
%
 
32.3
%
 
35.9
%
Managed care
15.5

 
14.3

 
9.5

 
7.2

 
5.3

 
3.3

 
13.4

 
12.5

Other skilled
4.2

 
3.5

 
3.6

 
1.8

 
—

 
—

 
3.6

 
2.9

Skilled mix
53.3

 
55.7

 
40.0

 
38.6

 
37.0

 
29.1

 
49.3

 
51.3

Private and other payors
7.0

 
7.0

 
10.7

 
10.7

 
24.8

 
32.6

 
9.5

 
9.2

Quality mix
60.3

 
62.7

 
50.7

 
49.3

 
61.8

 
61.7

 
58.8

 
60.5

Medicaid
39.7

 
37.3

 
49.3

 
50.7

 
38.2

 
38.3

 
41.2

 
39.5

Total skilled nursing
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%

 
Three Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Percentage of Skilled Nursing Days:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
15.9
%
 
16.3
%
 
12.2
%
 
12.2
%
 
14.1
%
 
9.8
%
 
14.9
%
 
14.9
%
Managed care
10.9

 
10.7

 
5.2

 
3.9

 
2.7

 
1.2

 
8.7

 
8.6

Other skilled
1.9

 
1.7

 
1.4

 
0.7

 
—

 
—

 
1.6

 
1.4

Skilled mix
28.7

 
28.7

 
18.8

 
16.8

 
16.8

 
11.0

 
25.2

 
24.9

Private and other payors
9.5

 
10.2

 
14.2

 
13.3

 
30.8

 
38.7

 
13.2

 
13.3

Quality mix
38.2

 
38.9

 
33.0

 
30.1

 
47.6

 
49.7

 
38.4

 
38.2

Medicaid
61.8

 
61.1

 
67.0

 
69.9

 
52.4

 
50.3

 
61.6

 
61.8

Total skilled nursing
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%

Cost of Services (exclusive of facility rent and depreciation and amortization shown separately). Cost of services increased $9.2 million, or 5.9%, to $164.9 million for the three months ended September 30, 2012 compared to $155.7 million for the three months ended September 30, 2011. Of the $9.2 million increase, Same Facilities decreased $3.0 million, or 2.6%, and Recently Acquired Facilities increased $10.8 million. Cost of services increased as a percent of total revenue to 79.6% for the three months ended September 30, 2012 as compared to 79.3% for the three months ended September 30, 2011.
Facility Rent — Cost of Services. Facility rent — cost of services increased $0.1 million, or 1.3%, to $3.4 million for the three months ended September 30, 2012 compared to $3.3 million for the three months ended September 30, 2011. Facility rent-cost of services decreased as a percent of total revenue to 1.6% for the three months ended September 30, 2012 as compared to 1.7% for the three months ended September 30, 2011. Facility rent increased due to rent expense for a facility on which the Company has begun construction activities, but has not commenced operations of a skilled nursing facility as of September 30, 2012. This increase was partially offset by decreases in rent due to our purchase of the underlying assets of seven of our skilled nursing facilities in California, Utah and Idaho which we previously operated under long-term lease agreements.
General and Administrative Expense. General and administrative expense increased $0.9 million, or 12.6%, to $8.1 million for the three months ended September 30, 2012 compared to $7.2 million for the three months ended September 30, 2011. General and administrative expenses increased as a percent of total revenue to 3.9% for the three months ended September 30, 2012 as compared to 3.7% for the three months ended September 30, 2011. The $1.3 million increase was primarily due to increases in wages and benefits due to our growth and increased legal costs incurred in connection with the ongoing investigation into the billing and reimbursement process of some of our subsidiaries being conducted by the Department of Justice (DOJ).

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Depreciation and Amortization. Depreciation and amortization expense increased $1.0 million, or 16.2%, to $7.2 million for the three months ended September 30, 2012 compared to $6.2 million for the three months ended September 30, 2011. Depreciation and amortization expense increased as a percent of total revenue to 3.5% for the three months ended September 30, 2012 as compared to 3.1% for the three months ended September 30, 2011. This increase was primarily related to the additional depreciation of $0.4 million at Recently Acquired Facilities, as well as increases of $0.4 million and $0.3 million at Same and Transitioning Facilities, respectively, due to recent renovations and the purchase of the underlying assets of seven of our skilled nursing facilities which we previously operated under a long-term lease agreement. Of the $0.4 million increase at Recently Acquired Facilities, $0.1 million represented amortization expense of patient base intangible assets which are amortized over four to eight months.
Other Income (Expense). Other expense, net decreased $2.3 million, or 42.5%, to $3.0 million for the three months ended September 30, 2012 compared to $5.3 million for the three months ended September 30, 2011. The decrease in other expense, net was primarily the result of a one-time exit fee and related extinguishment fees of $2.5 million upon prepaying the Fourth Amended and Restated Loan Agreement with GECC (Six Project Note) and exiting our former revolving credit facility during the three months ended September 30, 2011. This decrease was partially offset by increased interest expense due to the additional $21.5 million in long-term debt added with the promissory notes with RBS Asset Finance, Inc. (2012 RBS Loan) in February 2012.
Provision for Income Taxes. Provision for income taxes increased $0.5 million, or 7.1%, to $7.6 million for the three months ended September 30, 2012 compared to $7.1 million for the three months ended September 30, 2011. This increase resulted from the increase in income before income taxes of $1.9 million, or 10.4%. Our effective tax rate was 36.7% for the three months ended September 30, 2012 as compared to 37.9% for the three months ended September 30, 2011.


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Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011
 
Nine Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Total Facility Results:
 
 
 
 
 
 
 
Revenue
$
613,618

 
$
565,615

 
$
48,003

 
8.5
 %
Number of facilities at period end
107

 
99

 
8

 
8.1
 %
Actual patient days
2,580,026

 
2,291,107

 
288,919

 
12.6
 %
Occupancy percentage — Operational beds
79.2
%
 
79.5
%
 
 
 
(0.3
)%
Skilled mix by nursing days
25.8
%
 
25.8
%
 
 
 
—
 %
Skilled mix by nursing revenue
50.1
%
 
52.2
%
 
 
 
(2.1
)%
 
Nine Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Same Facility Results(1):
 
 
 
 
 
 
 
Revenue
$
421,993

 
$
430,621

 
$
(8,628
)
 
(2.0
)%
Number of facilities at period end
62

 
62

 
—

 
—
 %
Actual patient days
1,614,554

 
1,601,360

 
13,194

 
0.8
 %
Occupancy percentage — Operational beds
82.9
%
 
82.3
%
 
 
 
0.6
 %
Skilled mix by nursing days
29.6
%
 
29.2
%
 
 
 
0.4
 %
Skilled mix by nursing revenue
54.3
%
 
56.2
%
 
 
 
(1.9
)%
 
Nine Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Transitioning Facility Results(2):
 
 
 
 
 
 
 
Revenue
$
108,611

 
$
104,442

 
$
4,169

 
4.0
%
Number of facilities at period end
20

 
20

 
—

 
—
%
Actual patient days
493,258

 
481,277

 
11,981

 
2.5
%
Occupancy percentage — Operational beds
74.6
%
 
73.0
%
 
 
 
1.6
%
Skilled mix by nursing days
17.8
%
 
16.2
%
 
 
 
1.6
%
Skilled mix by nursing revenue
38.3
%
 
37.7
%
 
 
 
0.6
%
 
Nine Months Ended
September 30,
 
 
 
 
 
2012
 
2011
 
 
 
 
 
(Dollars in thousands)
 
Change
 
% Change
Recently Acquired Facility Results(3):
 
 
 
 
 
 
 
Revenue
$
83,014

 
$
30,552

 
$
52,462

 
NM
Number of facilities at period end
25

 
17

 
8

 
NM
Actual patient days
472,152

 
208,453

 
263,699

 
NM
Occupancy percentage — Operational beds
72.9
%
 
75.1
%
 
 
 
NM
Skilled mix by nursing days
17.4
%
 
13.2
%
 
 
 
NM
Skilled mix by nursing revenue
38.6
%
 
32.9
%
 
 
 
NM
_______________________
(1)
Same Facility results represent all facilities purchased prior to January 1, 2009.
(2)
Transitioning Facility results represents all facilities purchased from January 1, 2009 to December 31, 2010.
(3)
Recently Acquired Facility (or “Acquisitions”) results represent all facilities purchased on or subsequent to January 1, 2011.


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Table of Contents

Revenue. Revenue increased $48.0 million, or 8.5%, to $613.6 million for the nine months ended September 30, 2012 compared to $565.6 million for the nine months ended September 30, 2011. Of the $48.0 million increase, Medicare and managed care revenue increased ­$7.6 million, or 2.7%, Medicaid revenue increased $19.7 million, or 9.6%, private and other revenue increased $15.9 million, or 23.4% and other skilled revenue increased $4.9 million, or 35.4%. Revenue generated by Recently Acquired Facilities increased by approximately $52.5 million. Since January 1, 2011, the Company has acquired 25 facilities and five home health and two hospice operations in ten states.

Revenue generated by Same Facilities decreased $8.6 million, or 2.0%, for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. Medicare revenue per patient day decreased 12.3% during the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. This decrease was primarily due to the impact of the CMS imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented on October 1, 2011. This rate reduction was partially offset by an increase in skilled mix by nursing days of 0.4%, to 29.6%, which was the result of an increase in Medicare patient days at Same Facilities of 2.0% as well as an increase in occupancy of 0.6% to 82.9%.

Revenue at Transitioning Facilities increased by $4.2 million, or 4.0%, for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. This increase was achieved despite a decrease in Medicare revenue per patient day of 9.4% at Transitioning Facilities for the nine months ended September 30, 2012. This increase was primarily due to an increase in skilled mix by nursing days of 1.6%, to 17.8%, which was the result of increases in managed care and Medicare patient days of 29.7% and 5.2%, respectively, as well as an increase in occupancy of 1.6% to 74.6%.

The following table reflects the change in the skilled nursing average daily revenue rates by payor source, excluding services that are not covered by the daily rate:
 
Nine Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
%
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
Change
Skilled Nursing Average Daily Revenue Rates:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
$
561.39

 
$
640.30

 
$
484.52

 
$
535.07

 
$
471.11

 
$
468.00

 
$
539.61

 
$
617.12

 
(12.6
)%
Managed care
371.90

 
368.52

 
405.64

 
424.72

 
405.85

 
489.89

 
376.64

 
373.99

 
0.7
 %
Other skilled
571.69

 
530.87

 
579.57

 
520.02

 
—

 
—

 
572.78

 
530.02

 
8.1
 %
Total skilled revenue
491.37

 
530.69

 
469.82

 
508.88

 
460.53

 
470.05

 
485.99

 
526.38

 
(7.7
)%
Medicaid
170.11

 
167.54

 
162.71

 
160.42

 
147.24

 
138.87

 
166.22

 
164.76

 
0.9
 %
Private and other payors
197.05

 
187.29

 
170.78

 
173.71

 
165.15

 
156.45

 
182.19

 
179.69

 
1.4
 %
Total skilled nursing revenue
$
267.72

 
$
275.62

 
$
218.53

 
$
218.57

 
$
207.64

 
$
189.26

 
$
250.98

 
$
259.85

 
(3.4
)%

Medicare daily rates decreased by 12.6%, due to the impact of the CMS imposed 11.1% reduction in Medicare skilled nursing PPS payments and therapy changes, which were implemented in October 2011. The year to date 2011 results include the impact of the implementation of RUGS IV on both revenue reimbursement and related cost structure changes included in MDS 3.0 and concurrent therapy. The average Medicaid rate increased 0.9% for the nine months ended September 30, 2012 relative to the same period in the prior year, primarily due to increases in rates in several states and increased acuity in case mix states where rates were cut, partially offset by decreases in rates in Arizona due to changes in base reimbursement rates.
Historically, we have generally experienced lower occupancy rates, lower skilled mix and quality mix at Recently Acquired Facilities and therefore, we anticipate generally lower overall occupancy during years of growth. In the future, if we acquire additional facilities into our overall portfolio, we expect this trend to continue. Accordingly, we anticipate our overall occupancy will vary from quarter to quarter based upon the maturity of the facilities within our portfolio.

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Table of Contents

Payor Sources as a Percentage of Skilled Nursing Services. We use both our skilled mix and quality mix as measures of the quality of reimbursements we receive at our skilled nursing facilities over various periods. The following tables set forth our percentage of skilled nursing patient revenue and days by payor source:
 
Nine Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Percentage of Skilled Nursing Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
34.8
%
 
38.1
%
 
26.6
%
 
29.1
%
 
33.1
%
 
29.7
%
 
33.3
%
 
36.3
%
Managed care
15.3

 
14.8

 
8.7

 
7.3

 
5.5

 
3.2

 
13.2

 
13.1

Other skilled
4.2

 
3.3

 
3.0

 
1.3

 
—

 
—

 
3.6

 
2.8

Skilled mix
54.3

 
56.2

 
38.3

 
37.7

 
38.6

 
32.9

 
50.1

 
52.2

Private and other payors
7.0

 
7.1

 
10.6

 
10.6

 
26.0

 
30.7

 
9.5

 
8.6

Quality mix
61.3

 
63.3

 
48.9

 
48.3

 
64.6

 
63.6

 
59.6

 
60.8

Medicaid
38.7

 
36.7

 
51.1

 
51.7

 
35.4

 
36.4

 
40.4

 
39.2

Total skilled nursing
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%

 
Nine Months Ended
September 30,
 
Same Facility
 
Transitioning
 
Acquisitions
 
Total
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Percentage of Skilled Nursing Days:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Medicare
16.6
%
 
16.4
%
 
12.0
%
 
11.9
%
 
14.6
%
 
12.0
%
 
15.5
%
 
15.3
%
Managed care
11.0

 
11.1

 
4.7

 
3.8

 
2.8

 
1.2

 
8.8

 
9.1

Other skilled
2.0

 
1.7

 
1.1

 
0.5

 
—

 
—

 
1.5

 
1.4

Skilled mix
29.6

 
29.2

 
17.8

 
16.2

 
17.4

 
13.2

 
25.8

 
25.8

Private and other payors
9.6

 
10.4

 
13.6

 
13.4

 
32.7

 
37.2

 
13.2

 
12.4

Quality mix
39.2

 
39.6

 
31.4

 
29.6

 
50.1

 
50.4

 
39.0

 
38.2

Medicaid
60.8

 
60.4

 
68.6

 
70.4

 
49.9

 
49.6

 
61.0

 
61.8

Total skilled nursing
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%

Cost of Services (exclusive of facility rent and depreciation and amortization shown separately). Cost of services increased $43.8 million, or 9.9%, to $488.3 million for the nine months ended September 30, 2012 compared to $444.5 million for the nine months ended September 30, 2011. Of the $43.8 million increase, Same Facilities decreased $0.7 million, or 0.2% and Recently Acquired Facilities increased $41.2 million. Cost of services increased as a percent of total revenue to 79.6% for the nine months ended September 30, 2012 as compared to 78.6% for the nine months ended September 30, 2011.
Facility Rent — Cost of Services. Facility rent — cost of services decreased $0.3 million, or 3.1%, to $10.1 million for the nine months ended September 30, 2012 compared to $10.4 million for the nine months ended September 30, 2011. Facility rent-cost of services decreased as a percent of total revenue to 1.6% for the nine months ended September 30, 2012 as compared to 1.8% for the nine months ended September 30, 2011. The decrease in facility rent is due to our purchase of the underlying assets of eight of our skilled nursing facilities in California, Utah and Idaho which we previously operated under long-term lease agreements, partially offset by normal annual increases in rent at leased facilities and additional rent recognized for a facility which the Company has begun construction activities, but has not commenced operations of a skilled nursing facility as of September 30, 2012.
General and Administrative Expense. General and administrative expense increased $1.7 million, or 7.9%, to $23.9 million for the nine months ended September 30, 2012 compared to $22.2 million for the nine months ended September 30, 2011. General and administrative expenses remained consistent as a percent of total revenue at 3.9% for the nine months ended September 30, 2012 and 2011. The $2.1 million increase was primarily due to increases in wages and benefits due to our growth and increased

46
Table of Contents

legal costs incurred in connection with the ongoing investigation into the billing and reimbursement process of some of our subsidiaries being conducted by the Department of Justice (DOJ).
Depreciation and Amortization. Depreciation and amortization expense increased $4.3 million, or 26.0%, to $21.1 million for the nine months ended September 30, 2012 compared to $16.8 million for the nine months ended September 30, 2011. Depreciation and amortization expense increased as a percent of total revenue to 3.4% for the nine months ended September 30, 2012 as compared to 3.0% for the nine months ended September 30, 2011. This increase was primarily related to the additional depreciation of $1.7 million at Recently Acquired Facilities, as well as increases of $1.7 million and $0.9 million at Same and Transitioning Facilities, respectively, due to recent renovations and the purchase of the underlying assets of eight of our skilled nursing facilities which we previously operated under a long-term lease agreements. Of the $1.7 million increase at Recently Acquired Facilities, $0.4 million represented amortization expense of patient base intangible assets which are amortized over four to eight months.
Other Income (Expense). Other expense, net decreased $1.6 million, or 15.4%, to $9.0 million for the nine months ended September 30, 2012 compared to $10.6 million for the nine months ended September 30, 2011. The decrease in other expense, net was primarily the result of a one-time exit fee and related extinguishment fees of $2.5 million upon prepaying the Six Project Note and exiting our former revolving credit facility during the nine months ended September 30, 2011. This decrease was partially offset by increased interest expense due to the additional $21.5 million in long-term debt added with the promissory notes with RBS Asset Finance, Inc. (2012 RBS Loan) in February 2012.
Provision for Income Taxes. Provision for income taxes decreased $0.7 million, or 3.2%, to $23.1 million for the nine months ended September 30, 2012 compared to $23.8 million for the nine months ended September 30, 2011. This decrease resulted from the decrease in our effective tax rate of 1.3% to 37.7% for the nine months ended September 30, 2012 as compared to 39.0% for the nine months ended September 30, 2011.


Liquidity and Capital Resources
Our primary sources of liquidity have historically been derived from our cash flow from operations, proceeds from our IPO, long-term debt secured by our real property and our revolving credit facilities.
Since 2004, we have financed the majority of our facility acquisitions primarily through refinancing of existing facilities, and cash generated from operations or proceeds from our IPO. Cash paid for business acquisitions was $22.6 million and $86.5 million for the nine months ended September 30, 2012 and 2011, respectively. Cash paid for asset acquisitions was $11.3 million and $16.6 million for the nine months ended September 30, 2012 and 2011, respectively. Where we enter into a facility lease agreement, we typically do not pay any material amount to the prior facility operator, nor do we acquire any assets or assume any liabilities, other than our rights and obligations under the new lease and operations transfer agreement, as part of the transaction. Total capital expenditures for property and equipment were $26.8 million and $29.1 million for the nine months ended September 30, 2012 and 2011, respectively. We currently have a combined $33.0 million budgeted for renovation projects for 2012.

We believe our current cash balances, our cash flow from operations and the $75.0 million revolving credit facility portion of our senior credit facility with a five-bank lending consortium arranged by SunTrust and Wells Fargo (the Facility) will be sufficient to cover our operating needs for at least the next 12 months. We may in the future seek to raise additional capital to fund growth, capital renovations, operations and other business activities, but such additional capital may not be available on acceptable terms, on a timely basis, or at all.

Our cash and cash equivalents as of September 30, 2012 consisted of bank term deposits, money market funds and U.S. Treasury bill related investments. In addition, as of September 30, 2012, we held debt security investments of approximately $22.4 million, of which $6.0 million are AAA-rated and backed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program upon maturity. The remaining $16.4 million debt security investments are split between AA- and A-rated securities. Our market risk exposure is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Due to the low risk profile of our investment portfolio, an immediate 10% change in interest rates would not have a material effect on the fair market value of our portfolio. Accordingly, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.

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Table of Contents


The following table presents selected data from our condensed consolidated statement of cash flows for the periods presented:
 
Nine Months Ended
September 30,
 
2012
 
2011
 
(In thousands)
Net cash provided by operating activities
$
51,593

 
$
53,245

Net cash used in investing activities
(61,841
)
 
(126,870
)
Net cash provided by financing activities
12,692

 
27,187

Net increase (decrease) in cash and cash equivalents
2,444

 
(46,438
)
Cash and cash equivalents at beginning of period
29,584

 
72,088

Cash and cash equivalents at end of period
$
32,028

 
$
25,650

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011
Net cash provided by operations for the nine months ended September 30, 2012 was $51.6 million compared to $53.2 million for the nine months ended September 30, 2011, a decrease of $1.6 million. This decrease was primarily due to the timing of our payments of wages and third-party vendor invoices and increases in investments at the end of the nine months ended September 30, 2012 as compared to the end of the nine months ended September 30, 2011. These decreases were partially offset by our improved operating results, which contributed $67.8 million in 2012 after adding back depreciation and amortization, deferred income taxes, provision for doubtful accounts, share-based compensation, excess tax benefits from share-based compensation and loss on disposition of property and equipment (non-cash charges), as compared to $63.0 million for 2011, an increase of $4.8 million.
Net cash used in investing activities for the nine months ended September 30, 2012 was $61.8 million compared to $126.9 million for the nine months ended September 30, 2011, a decrease of $65.1 million. The decrease was primarily the result of $60.9 million in cash paid for business acquisitions, asset acquisitions and purchased property and equipment in the nine months ended September 30, 2012 compared to $127.5 million in the nine months ended September 30, 2011.
Net cash provided by financing activities for the nine months ended September 30, 2012 was $12.7 million as compared to $27.2 million for the nine months ended September 30, 2011, a decrease of $14.5 million. This decrease was primarily due to the receipt of $75.0 million in proceeds from the term loan portion of the Facility during the nine months ended September 30, 2011 as compared to $21.5 million in proceeds received from the 2012 RBS Loan during the nine months ended September 30, 2012, a decrease of $53.5 million. The reduction in long-term debt proceeds received was partially offset by a decrease in long-term debt repayments from $44.7 million for the nine months ended September 30, 2011 to $10.1 million for the nine months ended September 30, 2012, a difference of $34.6 million. The decrease is due to the use of long-term debt proceeds to repay existing debt in the prior year.

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Table of Contents

Principal Debt Obligations and Capital Expenditures

Total long-term debt obligations, net of debt discount, outstanding as of September 30, 2012 and the years ended December 31, 2011, 2010 and 2009 were as follows:
 
December 31,
 
September 30,
 
2009
 
2010
 
2011
 
2012
 
(in thousands)
Senior Credit Facility
$
—

 
$
—

 
$
88,125

 
$
80,313

Ten Project Note
53,200

 
52,229

 
51,185

 
50,363

Six Project Loan
39,970

 
39,495

 
—

 
—

Mortgage Loan and Promissory Notes
15,064

 
49,744

 
48,560

 
68,756

Bond payable
1,232

 
1,038

 
—

 
—

Total
$
109,466

 
$
142,506

 
$
187,870

 
$
199,432


The following table represents the Company’s cumulative facility growth from 2008 to the present:
 
December 31,
 
September 30,
 
2008
 
2009
 
2010
 
2011
 
2012
Cumulative number of facilities
63

 
77

 
82

 
102

 
107


Promissory Notes with RBS Asset Finance, Inc.

On February 22, 2012, two of our real estate holding subsidiaries as Borrowers executed a promissory note in favor of RBS Asset Finance, Inc. (RBS) as Lender for an aggregate of $21.5 million (the 2012 RBS Loan). The 2012 RBS Loan was secured by Commercial Deed of Trust, Security Agreement, Assignment of Leases and Rents and Fixture Filings on the two properties owned by the two Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2012 RBS Loan bears interest at a fixed rate of 4.75%. Amounts borrowed under the 2012 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the RBS Loan is for seven years, with monthly principal and interest payments commencing on March 1, 2012 and the balance due on March 1, 2019.

Among other things, under the 2012 RBS Loan, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of September 30, 2012, we were in compliance with all loan covenants. As of September 30, 2012, our subsidiaries had $21.2 million outstanding on the 2012 RBS Loan.

On December 31, 2010, four of our real estate holding subsidiaries as Borrowers executed a promissory note in favor of RBS as Lender for an aggregate of $35.0 million (2010 RBS Loan). The 2010 RBS Loan was secured by Commercial Deeds of Trust, Security Agreements, Assignment of Leases and Rents and Fixture Fillings on the four properties owned by the four Borrowers, and other related instruments and agreements, including without limitation a promissory note and a Company guaranty. The 2010 RBS Loan bears interest at a fixed rate of 6.04%. Amounts borrowed under the 2010 RBS Loan may be prepaid starting after the second anniversary of the note subject to certain prepayment fees. The term of the 2010 RBS Loan is for seven years, with monthly principal and interest payments commencing on February 1, 2011 and the balance due on January 1, 2018.

Among other things, under the 2010 RBS Loan, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum debt service coverage ratio, an average occupancy rate and a minimum project yield. The Loan Documents also include certain additional affirmative and negative covenants, including limitations on the disposition of the Borrowers and the collateral and minimum average cash balance requirements. As of September 30, 2012, we were in compliance with all loan covenants. As of September 30, 2012, our subsidiaries had $33.4 million outstanding on the RBS Loan.

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Senior Credit Facility with Five-Bank Lending Consortium Arranged by SunTrust and Wells Fargo

On July 15, 2011, we entered into the Facility in an aggregate principal amount of up to $150.0 million comprised of a $75.0 million revolving credit facility and a $75.0 million term loan advanced in one drawing on July 15, 2011. Borrowings under the term loan portion of the Facility will amortize in equal quarterly installments that commenced on September 30, 2011, in an aggregate annual amount equal to 5.0% per annum of the original principal amount, with the remaining principal balance due and payable in full on July 15, 2016. Borrowings under the revolving credit facility portion of the Facility shall be due and payable in full on July 15, 2016. Interest rates per annum applicable to the Facility will be, at our option, (i) LIBOR plus an initial margin of 2.5% or (ii) the Base Rate (as defined by the Facility) plus an initial margin of 1.5%. Under the terms of the Facility, the applicable margin adjusts based on our leverage ratio as set forth in further detail in the Facility agreement. In addition, we have a commitment fee on the unused portion of the revolving credit facility that ranges from 0.3% to 0.5% based on our leverage ratio for the applicable four-quarter period. Amounts borrowed pursuant to the Facility are guaranteed by certain of our wholly-owned subsidiaries and secured by substantially all of our personal property. To reduce the risk related to interest rate fluctuations, we, on behalf of the subsidiaries, entered into an interest rate swap agreement to effectively fix the interest rate on the term loan portion of the Facility. See further details of the interest rate swap at Note 4 in Notes to Consolidated Financial Statements, Fair Value Measurements.

Among other things, under the Facility, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a maximum net leverage ratio, minimum interest coverage ratio and minimum asset coverage ratio. The loan documents also include certain additional reporting, affirmative and negative covenants including limitations on the incurrence of additional indebtedness, liens, investments in other businesses, dividends declared in excess of 20% of consolidated net income, stock repurchases and capital expenditures. As of September 30, 2012, we were in compliance with all loan covenants.
  
Proceeds of the term loan portion of the Facility and any initial borrowings under the revolver portion of the Facility were used to refinance the Fourth Amended and Restated Loan Agreement with General Electric Capital Corporation (GECC) (or Six Project Note) and revolving credit facility with GECC (or the Revolver), and shall continue to be used to fund facility acquisitions and other general working capital requirements. As of September 30, 2012, our subsidiaries had $80.3 million outstanding on the Facility.
Term Loan with General Electric Capital Corporation

On December 29, 2006, a number of our independent real estate holding subsidiaries jointly entered into the Third Amended and Restated Loan Agreement, with GECC, which consists of an approximately $55.7 million multiple-advance term loan, further referred to as the Ten Project Note. The Ten Project Note matures in June 2016, and is currently secured by the real and personal property comprising the ten facilities owned by these subsidiaries. The Ten Project Note was funded in advances, with each advance bearing interest at a separate rate. The interest rates range from 6.95% to 7.50% per annum.
Under the Ten Project Note, we are subject to standard reporting requirements and other typical covenants for a loan of this type. Effective October 1, 2006 and continuing each calendar quarter thereafter, we are subject to restrictive financial covenants, including average occupancy, Debt Service (as defined in the agreement) and Project Yield (as defined in the agreement). As of September 30, 2012, we were in compliance with all loan covenants. As of September 30, 2012, our subsidiaries had $50.4 million outstanding on the Ten Project Note.
Promissory Notes with Johnson Land Enterprises, Inc.
On October 1, 2009, four of our subsidiaries entered into four separate promissory notes with Johnson Land Enterprises, LLC, for an aggregate of $10.0 million, as a part of our acquisition of three skilled nursing facilities in Utah. The unpaid balance of principal and accrued interest from these notes is due on September 30, 2019. The notes bear interest at a rate of 6.0% per annum. As of September 30, 2012, our subsidiaries had $9.3 million outstanding on the Promissory Notes.
Mortgage Loan with Continental Wingate Associates, Inc.
Ensign Southland LLC, a subsidiary of The Ensign Group, Inc., entered into a mortgage loan on January 30, 2001 with Continental Wingate Associates, Inc. The mortgage loan is insured with the U.S. Department of Housing and Development, or HUD, which subjects our Southland facility to HUD oversight and periodic inspections. As of September 30, 2012, the balance outstanding on this mortgage loan was approximately $5.7 million. The unpaid balance of principal and accrued interest from this mortgage loan is due on February 1, 2027. The mortgage loan bears interest at the rate of 7.5% per annum.
This mortgage loan is secured by the real property comprising the Southland Care Center facility and the rents, issues and profits thereof, as well as all personal property used in the operation of the facility.

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Common Stock Repurchase Program

The board of directors authorized the repurchase of up to $10.0 million of our common stock during the twelve month period ending November 2, 2012.  Under this program, we are authorized to repurchase our issued and outstanding common shares from time to time in open-market and privately negotiated transactions and block trades in accordance with federal securities laws, including Rule 10b-18 promulgated under the Securities Exchange Act of 1934 as amended.

The number of shares repurchased will depend entirely upon the levels of cash available, the attractiveness of alternate investment and business opportunities either at hand or on the horizon, Management's perception of value relative to market price and other legal, regulatory and contractual requirements. The repurchase program does not obligate us to repurchase any particular dollar amount or number of shares of common stock.  To date, 7,340 shares have been repurchased for a total of $0.2 million.
Contractual Obligations, Commitments and Contingencies
We lease certain facilities and our Service Center office under operating leases, most of which have initial lease terms ranging from five to 20 years. Most of these leases contain options to renew or extend the lease term, some of which involve rent increases. We also lease a majority of our equipment under operating leases with initial terms ranging from three to five years. Total rent expense, inclusive of straight-line rent adjustments, was $3.5 million and $10.4 million for the three and nine months ended September 30, 2012 and $3.4 million and $10.7 million for the three and nine months ended September 30, 2011, respectively.
In March 2007, we learned that the United States Attorney for the Central District of California (DOJ) had commenced an investigation of certain of our facilities and had issued an authorized investigative demand to our bank seeking information pertaining to a total of 18 of our facilities. The DOJ also subsequently served a subpoena on our independent external auditors in 2007, and in 2008 served search warrants and subpoenas on our Service Center and six of our Southern California skilled nursing facilities, seeking specific patient files and other information. Subsequent subpoenas issued to us covered additional documentation from the six facilities as well as eight of the other facilities. Based upon the issuance of the subpoenas and execution of the search warrants, we concluded that the government had undertaken parallel criminal and civil investigations. We pledged full cooperation to, and have been cooperating fully with, the government.
In September 2010 our board of directors appointed a special committee consisting solely of independent directors to advance discussions with the DOJ regarding its investigation. The special committee retained independent counsel, and counsel has retained third party consultants, to facilitate its work. The Company and the special committee have continued cooperating with the DOJ, working to provide information necessary to aid the DOJ's investigation and move the matter toward resolution.
  
In December 2011, independent counsel for our special committee received confirmation that the DOJ has closed its criminal investigation, although as a matter of course the DOJ reserves the right to reopen such inquiries if new facts come to light.

In January 2012, the DOJ indicated that the government would be seeking certain additional information in furtherance of the remaining civil investigation, and that it would formalize its request for that information in a new subpoena. In January 2012, the Office of the Inspector General of the United States Department of Health & Human Services (HHS) served the new subpoena, seeking specific patient records and documents from 2007 to 2011 from the six Southern California skilled nursing facilities that have been the subject of previous requests. HHS also issued a subpoena to our independent external auditors requesting an update to the information requested in the 2007 subpoena to them, and a subpoena to our independent internal auditors requesting similar information.

We produced records called for in the January 2012 subpoena, and discussions between government representatives and counsel for the special committee are ongoing. We continue to cooperate with the government as part of an ongoing effort to move the matter to a resolution. In particular, while we seek to address any questions the government may have after it completes its review of specific patient files requested, counsel for the special committee and counsel for the government are also attempting to develop a process to resolve, in advance of formal litigation, any civil claims the government may believe it has after concluding its investigation. In addition, we continue to make improvements to our compliance programs and systems.
Inflation

We have historically derived a substantial portion of our revenue from the Medicare program. We also derive revenue from state Medicaid and similar reimbursement programs. Payments under these programs generally provide for reimbursement levels that are adjusted for inflation annually based upon the state’s fiscal year for the Medicaid programs and in each October for the Medicare program. These adjustments may not continue in the future, and even if received, such adjustments may not reflect the actual increase in our costs for providing healthcare services.

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Labor and supply expenses make up a substantial portion of our cost of services. Those expenses can be subject to increase in periods of rising inflation and when labor shortages occur in the marketplace. To date, we have generally been able to implement cost control measures or obtain increases in reimbursement sufficient to offset increases in these expenses. We may not be successful in offsetting future cost increases.

New Accounting Pronouncements

In July 2012, the FASB amended the guidance on testing indefinite-lived intangible assets, other than goodwill, for impairment. The amendment was issued in response to feedback on the amendments made to the goodwill impairment testing requirements by allowing an entity to perform a qualitative impairment assessment before proceeding to the two-step impairment test. Under the amended guidance, an entity testing an indefinite-lived intangible asset for impairment has the option of performing a qualitative assessment before calculating the fair value of the asset. Although this amendment revises the examples of events and circumstances that an entity should consider in interim periods, it does not revise the requirements to test (1) indefinite-lived intangible assets annually for impairment and (2) between annual tests if there is a change in events or circumstances. This amendment is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012; however, early adoption is permitted. We are evaluating whether we will adopt this amendment during our current fiscal year impairment analysis in the fourth quarter. We do not believe the adoption of this amendment will have a material effect on our financial statements.

In July 2012, the FASB clarified that an advance fee from a continuing care retirement community resident should be classified as deferred revenue if (1) the contract stipulates that this advance fee must be repaid when a room is reoccupied by a future resident and (2) the refundable amount is "limited to the proceeds from reoccupancy." If the refundable amount is not limited to the proceeds from reoccupancy, the advance fee must be reported as a liability. The above clarification is effective for fiscal periods beginning after December 15, 2012, however early adoption is permitted. We do not believe the adoption of this clarification will have a material effect on our financial statements.
Adoption of New Accounting Pronouncements
In December 2011, the Financial Accounting Standards Board (FASB) indefinitely deferred the provisions that required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which Other Comprehensive Income is presented (for both interim and annual financial statements). During the deferral period, entities will still need to comply with the existing U.S. GAAP requirements for the presentation of reclassification adjustments. The adoption of this amendment did not have a material effect on our financial statements.
In July 2011, the FASB amended its standards on how health care entities present revenue and bad debt expense. Under the new guidance, health care entities are required to present bad debt expense related to patient service revenue as a reduction of patient service revenue (net of contractual allowances and discounts) on the statement of income for entities that do not assess a patient's ability to pay prior to rendering services. Further, it was determined, net presentation of bad debt expense in revenue would only apply to bad debts that are related to patient service revenue, to entities that provide services prior to assessing a patient's ability to pay, or to entities that recognize revenue prior to deciding that collection is reasonably assured. In addition, the final consensus requires health care entities to disclose information about the activity in the allowance for doubtful accounts, such as recoveries and write-offs, by using a mixture of qualitative and quantitative data. It will also require disclosure of the Company's policies for (i) assessing the timing and amount of uncollectible revenue recognized as bad debt expense; and (ii) assessing collectability in the timing and amount of revenue (net of contractual allowances and discounts). We adopted the disclosure requirements of this amendment during the first quarter of the current year. We determined the requirements for presentation of bad debt expense related to patient service revenue as a reduction of patient service revenue outlined in the amendment is not applicable as we assess each patient's ability to pay prior to rendering services.


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Item 3.        Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk. We are exposed to interest rate changes in connection with the revolving credit facility portion of the Facility, which is available but historically has not regularly been used to maintain liquidity and fund capital expenditures and operations. Our interest rate risk management objective is to balance the impact of interest rate changes on earnings and cash flows and maintain a lower interest rate. To achieve this objective, we have historically borrowed primarily at fixed rates, although the revolving credit facility portion of the Facility is available and could be used for short-term borrowing purposes. As of September 30, 2012, we had outstanding borrowings under the revolving credit facility portion of the Facility of $10.0 million.

The Facility agreement exposes us to variability in interest payments due to changes in LIBOR interest rates. We entered into an interest rate swap agreement to reduce risk from volatility in the income statement on the term loan portion of the Facility. The swap agreement, with a notional amount of $75.0 million, amortizing concurrently with the related term loan portion of the Facility, is five years in length and set to mature on July 15, 2016. Under the terms of this agreement, the net effect of the hedge was to record swap interest expense at a fixed rate of approximately 4.3%.

Our cash and cash equivalents as of September 30, 2012 consisted of bank term deposits, money market funds and U.S. Treasury bill related investments. In addition, as of September 30, 2012, we held debt security investments of approximately $22.4 million, of which $6.0 million are AAA-rated and backed by the FDIC under the Temporary Liquidity Guarantee Program upon maturity. The remaining $16.4 million debt security investments are split between AA- and A-rated securities. Our market risk exposure is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Due to the low risk profile of our investment portfolio, an immediate 10% change in interest rates would not have a material effect on the fair market value of our portfolio. Accordingly, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.

The above only incorporates those exposures that exist as of September 30, 2012, and does not consider those exposures or positions which could arise after that date. If we diversify our investment portfolio into securities and other investment alternatives, we may face increased risk and exposures as a result of interest risk and the securities markets in general.


Item 4.        Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)), as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.
There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the three months ended September 30, 2012, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II. Other Information


Item 1.        Legal Proceedings
Certain legal proceedings in which we are involved are discussed in Part I, Item 3, of our Annual Report on Form 10-K for the year ended December 31, 2011. In addition, for more information regarding our legal proceedings, please see Note 16 included in Part 1, Item 1 of this Form 10-Q.
We are party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of business, including claims that our services have resulted in injury or death to the residents of our facilities and claims related to employment, staffing requirements and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations and financial condition. In most states in which we have operations, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions. As such, we do not carry insurance coverage for punitive damages. There can be no assurance that we will not be liable for punitive damages awarded in litigation or that such an award if rendered would not have a material and adverse impact on our earnings or prospects.
We operate in an industry that is extremely regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, our industry is frequently subject to the regulatory practices, which could subject us to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.


Item 1A.    Risk Factors
Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and trading price of our common stock. Please refer also to our Annual Report on Form 10-K (File No. 001-33757) for additional information concerning these and other uncertainties that could negatively impact the Company.
Risks Related to Our Business and Industry
Our revenue could be impacted by federal and state changes to reimbursement and other aspects of Medicaid and Medicare.

We derived 40.0% and 39.5% of our revenue from the Medicaid program for the three and nine months ended September 30, 2012 and 38.7% and 38.5% during the three and nine months ended September 30, 2011, respectively. We derived 33.6% and 34.2% of our revenue from the Medicare program for the three and nine months ended September 30, 2012 and 36.3% and 36.8% for the three and nine months ended September 30, 2011, respectively. If reimbursement rates under these programs are reduced or fail to increase as quickly as our costs, or if there are changes in the way these programs pay for services, our business and results of operations would be adversely affected. The services for which we are currently reimbursed by Medicaid and Medicare may not continue to be reimbursed at adequate levels or at all. Further limits on the scope of services being reimbursed, delays or reductions in reimbursement or changes in other aspects of reimbursement could impact our revenue. For example, in the past, the enactment of the Deficit Reduction Act of 2005 (DRA), the Medicaid Voluntary Contribution and Provider-Specific Tax Amendments of 1991 and the Balanced Budget Act of 1997 (BBA) caused changes in government reimbursement systems, which, in some cases, made obtaining reimbursements more difficult and costly and lowered or restricted reimbursement rates for some of our residents.

The Medicaid and Medicare programs are subject to statutory and regulatory changes affecting base rates or basis of payment, retroactive rate adjustments, annual caps that limit the amount that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to Medicare beneficiaries, administrative or executive orders and government funding restrictions, all of which may materially adversely affect the rates and frequency at which these programs reimburse us for our services. For example, the Medicaid Integrity Contractor (MIC) program is increasing the scrutiny placed on Medicaid payments,

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and could result in recoupments of alleged overpayments in an effort to rein in Medicaid spending. In April 2012 President Obama released a budget proposal that would cut $302.8 billion from the Medicare and Medicaid programs over the next decade. Included within this budget are proposals that would impact long-term care facilities. The President's budget proposal would reduce skilled nursing facility payments by up to 3% beginning in 2016 for facilities with high rates of preventable hospital readmissions. The budget proposal would also adjust payment rate updates for post-acute care providers. In addition, the budget proposal would create a home health care co-payment of $100 for each 60-day episode of care. Implementation of these and other measures to reduce or delay reimbursement could result in substantial reductions in our revenue and profitability. Payors may disallow our requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable because either adequate or additional documentation was not provided or because certain services were not covered or considered reasonably necessary. Additionally, revenue from these payors can be retroactively adjusted after a new examination during the claims settlement process or as a result of post-payment audits. New legislation and regulatory proposals could impose further limitations on government payments to healthcare providers.

In addition, on October 1, 2010, the next generation of the Minimum Data Set (MDS) 3.0 was implemented, creating significant changes in the methodology for calculating the RUGS category under Medicare Part A, most notably eliminating Section T. Because therapy does not necessarily begin upon admission, MDS 2.0 and the RUGS-III system included a provision to capture therapy services that are scheduled to occur but have not yet been provided in order to calculate a RUG level that better reflects the level of care the recipient would actually receive. This is eliminated with MDS 3.0, which creates a new category of assessment called the Medicare Short Stay Assessment. This assessment provides for calculation of a rehabilitation RUG for residents discharged on or before day eight who received less than five days of therapy.
On July 27, 2012, the Centers for Medicare and Medicaid Services (CMS) announced a final rule updating Medicare skilled nursing facility PPS payments in fiscal year 2013. The update, a 1.8% or $670 million increase, reflects a 2.5% market basket increase, reduced by a 0.7% multi-factor productivity (MFP) adjustment mandated by the Patient Protection and Affordable Care Act (PPACA). This increase will be offset by the 2% sequestration reduction, discussed below, which will become effective January 1, 2013.
On July 6, 2012, CMS announced its proposed rule for the Home Health Prospective Payment System (PPS) increasing payments to home health service organizations by $20.0 million. The proposed home health rule provides a net increase of 0.1% in Medicare payments, made up of a 2.5% market basket increase, offset by mandatory cuts under the Patient Protection and Affordable Care Act. If finalized, the proposed rule will be effective beginning January 1, 2013.
On February 22, 2012, the President signed into law H.R. 3630, which among other things extended a payroll tax rate reduction and delayed a cut in physician and Part B services.  In establishing the funding for the law, payments to nursing facilities for residents' unpaid Medicare A co-insurance was reduced. The Deficit Reduction Act of 2005 had previously limited reimbursement of bad debt to 70% on privately responsibility co-insurance. However, under H.R. 3630, this reimbursement will be reduced to 65%.
Further, prior to the introduction of H.R. 3630, we were reimbursed for 100% of bad debt related to dual-eligible Medicare residents' co-insurance.  H.R. 3630 will phase down the dual-eligible reimbursement over three years.  Effective October 1, 2012, Medicare dual-eligible co-insurance reimbursement will decrease from 100% to 88%, with further reductions to 77% and 65% as of October 1, 2013 and 2014, respectively.  Any reductions in Medicare or Medicaid reimbursement could materially adversely affect our profitability.
On August 2, 2011, the President signed into law the Budget Control Act of 2011 (Budget Control Act), which raised the debt ceiling and put into effect a series of actions for deficit reduction. The Budget Control Act creates a Congressional Joint Select Committee on Deficit Reduction (the Committee) that was tasked with proposing additional deficit reduction of at least $1.5 trillion over ten years. As the Committee was unable to achieve its targeted savings, this regulation triggered automatic reductions in discretionary and mandatory spending starting in 2013, including reductions of not more than 2% to payments to Medicare providers. The Budget Control Act also requires Congress to vote on an amendment to the Constitution that would require a balanced budget.
Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels, our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition or results of operations.


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Our future revenue, financial condition and results of operations could be impacted by continued cost containment pressures on Medicaid spending.

Medicaid, which is largely administered by the states, is a significant payor for our skilled nursing services. Rapidly increasing Medicaid spending, combined with slow state revenue growth, has led many states to institute measures aimed at controlling spending growth. For example, in February 2009, the California legislature approved a new budget to help relieve a $42 billion budget deficit. The budget package was signed after months of negotiation, during which time California's governor declared a fiscal state of emergency in California. The new budget implements spending cuts in several areas, including Medi-Cal spending. Some of the spending cuts are triggered only if an inadequate amount of federal funding is received from the American Recovery and Reinvestment Act of 2009. Further, California initially had extended its cost-based Medi-Cal long-term care reimbursement system enacted through Assembly Bill 1629 (A.B.1629) through the 2009-2010 and 2010-2011 rate years with a growth rate of up to five percent for both years. However, due to California's severe budget crisis, in July 2009, the State passed a budget-balancing proposal that eliminated this five percent growth cap by amending the current statute to provide that, for the 2009-2010 and 2010-2011 rate years, the weighted average Medi-Cal reimbursement rate paid to long-term care facilities shall not exceed the weighted average Medi-Cal reimbursement rate for the 2008-2009 rate year. In addition, the budget proposal increased the amounts that California nursing facilities will pay to Medi-Cal in quality assurance fees for the 2009-2010 and 2010-2011 rate years by including Medicare revenue in the calculation of the quality assurance fee that nursing facilities pay under A.B. 1629. Although overall reimbursement from Medi-Cal remained stable, individual facility rates varied.

California's Governor signed the budget trailer into law in October 2010. Despite its enactment, these changes in reimbursement to long-term care facilities will be implemented retroactively to the beginning of the calendar quarter in which California submitted its request for federal approval of CMS. Most recently, on January 10, 2011, the California Governor proposed a budget for 2011-2012 which proposes to reduce Medi-Cal provider payments by 10%, including payments to long-term care facilities. Because state legislatures control the amount of state funding for Medicaid programs, cuts or delays in approval of such funding by legislatures could reduce the amount of, or cause a delay in, payment from Medicaid to skilled nursing facilities. Since a significant portion of our revenue is generated from our skilled nursing operations in California, these budget reductions, if approved, could adversely affect our net patient service revenue and profitability. We expect continuing cost containment pressures on Medicaid outlays for skilled nursing facilities, and any such decline could adversely affect our financial condition and results of operations.

On March 24, 2011, the governor of California signed Assembly Bill 97 (AB 97), the budget trailer bill on health, into law.  AB 97 outlines significant cuts to  state  health and human services programs.  Specifically, the law reduces provider payments by 10% for physicians, pharmacies, clinics, medical transportation, certain hospitals, home health, and nursing facilities.  AB X1 19 Long Term Care  was subsequently approved by the governor on June 28, 2011.  AB X1 19 limits  the 10% payment reduction to skilled-nursing providers to 14 months for the services provided on June 1, 2011 through July 31, 2012 with a promise to repay by December 31, 2012.  Federal approval was obtained on October 27, 2011. There can be no assurance that the reduction in provider payments will not lead to material adverse consequences in the future.

To generate funds to pay for the increasing costs of the Medicaid program, many states utilize financial arrangements such as provider taxes. Under provider tax arrangements, states collect taxes or fees from healthcare providers and then return the revenue to these providers as Medicaid expenditures. Congress, however, has placed restrictions on states' use of provider tax and donation programs as a source of state matching funds. Under the Medicaid Voluntary Contribution and Provider-Specific Tax Amendments of 1991, the federal medical assistance percentage available to a state was reduced by the total amount of healthcare related taxes that the state imposed, unless certain requirements are met. The federal medical assistance percentage is not reduced if the state taxes are broad-based and not applied specifically to Medicaid reimbursed services. In addition, the healthcare providers receiving Medicaid reimbursement must be at risk for the amount of tax assessed and must not be guaranteed to receive reimbursement through the applicable state Medicaid program for the tax assessed. Lower Medicaid reimbursement rates would adversely affect our revenue, financial condition and results of operations.

We may not be fully reimbursed for all services for which each facility bills through consolidated billing, which could adversely affect our revenue, financial condition and results of operations.

Skilled nursing facilities are required to perform consolidated billing for certain items and services furnished to patients and residents. The consolidated billing requirement essentially confers on the skilled nursing facility itself the Medicare billing responsibility for the entire package of care that its residents receive in these situations. The BBA also affected skilled nursing facility payments by requiring that post-hospitalization skilled nursing services be “bundled” into the hospital's Diagnostic Related Group (DRG) payment in certain circumstances. Where this rule applies, the hospital and the skilled nursing facility must, in effect, divide the payment which otherwise would have been paid to the hospital alone for the patient's treatment, and no additional funds are paid by Medicare for skilled nursing care of the patient. At present, this provision applies to a limited number of DRGs,

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but already is apparently having a negative effect on skilled nursing facility utilization and payments, either because hospitals are finding it difficult to place patients in skilled nursing facilities which will not be paid as before or because hospitals are reluctant to discharge the patients to skilled nursing facilities and lose part of their payment. This bundling requirement could be extended to more DRGs in the future, which would accentuate the negative impact on skilled nursing facility utilization and payments. We may not be fully reimbursed for all services for which each facility bills through consolidated billing, which could adversely affect our revenue, financial condition and results of operations.

Reforms to the U.S. healthcare system will impose new requirements upon us and may lower our reimbursements.

The Patient Protection and Affordable Care Act (PPACA) and the Health Care and Education Reconciliation Act of 2010 (the Reconciliation Act) were recently enacted as new laws. These new laws include sweeping changes to how health care is paid for and furnished in the United States.

PPACA, as modified by the Reconciliation Act, is projected to expand access to Medicaid for approximately 16 million additional people. It also reduces the projected growth of Medicare by $500 billion over ten years by tying payments to providers more closely to quality outcomes. It also imposes new obligations on skilled nursing facilities, requiring them to disclose information regarding ownership, expenditures and certain other information. This information will be disclosed on a website for comparison by members of the public.

To address potential fraud and abuse in federal health care programs, including Medicare and Medicaid, PPACA includes provider screening and enhanced oversight periods for new providers and suppliers, as well as enhanced penalties for submitting false claims. It also provides funding for enhanced anti-fraud activities. The new law imposes enrollment moratoria in elevated risk areas by requiring providers and suppliers to establish compliance programs. PPACA also provides the federal government with expanded authority to suspend payment if a provider is investigated for allegations or issues of fraud. Section 6402 of the PPACA provides that Medicare and Medicaid payments may be suspended pending a “credible investigation of fraud,” unless the Secretary of Health and Human Services determines that good cause exists not to suspend payments. To the extent the Secretary applies this suspension of payments provision to one of our facilities for allegations of fraud, such a suspension could adversely affect our results of operations.

Under PPACA, the U.S. Department of Health and Human Services (HHS) will establish, test and evaluate alternative payment methodologies for Medicare services through a five-year, national, voluntary pilot program starting in 2013. This program will provide incentives for providers to coordinate patient care across the continuum and to be jointly accountable for an entire episode of care centered around a hospitalization. HHS will develop qualifying provider payment methods that may include bundled payments and bids from entities for episodes of care that begins three days prior to hospitalization and spans 30 days following discharge. The bundled payment will cover the costs of acute care inpatient services; physicians’ services delivered in and outside of an acute care hospital; outpatient hospital services including emergency department services; post-acute care services, including home health services, skilled nursing services; inpatient rehabilitation services; and inpatient hospital services. The payment methodology will include payment for services, such as care coordination, medication reconciliation, discharge planning and transitional care services, and other patient-centered activities. Payments for items and services cannot result in spending more than would otherwise be expended for such entities if the pilot program were not implemented. As with Medicare’s shared savings program discussed above, payment arrangements among providers on the backside of the bundled payment must take into account significant hurdles under the Anti-kickback Law, the Stark Law and the Civil Monetary Penalties Law. This pilot program may expand in 2016 if expansion would reduce Medicare spending without also reducing quality of care.

PPACA attempts to improve the health care delivery system through incentives to enhance quality, improve beneficiary outcomes and increase value of care. One of these key delivery system reforms is the encouragement of Accountable Care Organizations (ACOs). ACOs will facilitate coordination and cooperation among providers to improve the quality of care for Medicare beneficiaries and reduce unnecessary costs. Participating ACOs that meet specified quality performance standards will be eligible to receive a share of any savings if the actual per capita expenditures of their assigned Medicare beneficiaries are a sufficient percentage below their specified benchmark amount. Quality performance standards will include measures in such categories as clinical processes and outcomes of care, patient experience and utilization of services.

In addition, PPACA required HHS to develop a plan to implement a value-based purchasing program for Medicare payments to skilled nursing facilities. HHS delivered a report to Congress outlining its plans for implementing this value-based purchasing program. The value-based purchasing program would provide payment incentives for Medicare-participating skilled nursing facilities to improve the quality of care provided to Medicare beneficiaries. Among the most relevant factors in HHS' plans to implement value-based purchasing for skilled nursing facilities is the current Nursing Home Value-Based Purchasing Demonstration Project, which will conclude in December 2012. HHS indicates it will complete an evaluation of the demonstration

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program in the autumn of 2013, and any permanent value-based purchasing program for skilled nursing facilities will be implemented after that evaluation.

We cannot predict what effect these changes will have on our business, including the demand for our services or the amount
of reimbursement available for those services. However, it is possible these new laws may lower reimbursement and adversely affect our business.

On June 28, 2012 the United States Supreme Court ruled that the enactment of PPACA did not violate the Constitution of the United States. This ruling permits the implementation of most of the provisions of PPACA to proceed. The provisions of PPACA discussed above are only examples of federal health reform provisions that we believe may have a material impact on the long-term care industry and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that these and other provisions of PPACA may be interpreted, clarified, or applied to our facilities or operations in a way that could have a material adverse impact on the results of operations.
 
Increased competition for, or a shortage of, nurses and other skilled personnel could increase our staffing and labor costs and subject us to monetary fines.

Our success depends upon our ability to retain and attract nurses, Certified Nurse Assistants (CNAs) and therapists. Our success also depends upon our ability to retain and attract skilled management personnel who are responsible for the day-to-day operations of each of our facilities. Each facility has a facility leader responsible for the overall day-to-day operations of the facility, including quality of care, social services and financial performance. Depending upon the size of the facility, each facility leader is supported by facility staff that is directly responsible for day-to-day care of the patients and marketing and community outreach programs. Other key positions supporting each facility may include individuals responsible for physical, occupational and speech therapy, food service and maintenance. We compete with various healthcare service providers, including other skilled nursing providers, in retaining and attracting qualified and skilled personnel.

We operate one or more skilled nursing facilities in the states of Arizona, California, Colorado, Idaho, Iowa, Nebraska, Nevada, Texas, Utah and Washington. With the exception of Utah, which follows federal regulations, each of these states has established minimum staffing requirements for facilities operating in that state. Failure to comply with these requirements can, among other things, jeopardize a facility's compliance with the conditions of participation under relevant state and federal healthcare programs. In addition, if a facility is determined to be out of compliance with these requirements, it may be subject to a notice of deficiency, a citation, or a significant fine or litigation risk. For example, we are aware of one company in our industry that is subject to a substantial judgment as a result of not complying with minimum staffing laws. Deficiencies may also result in the suspension of patient admissions and/or the termination of Medicaid participation, or the suspension, revocation or nonrenewal of the skilled nursing facility's license. If the federal or state governments were to issue regulations which materially change the way compliance with the minimum staffing standard is calculated or enforced, our labor costs could increase and the current shortage of healthcare workers could impact us more significantly.

Increased competition for or a shortage of nurses or other trained personnel, or general inflationary pressures may require that we enhance our pay and benefits packages to compete effectively for such personnel. We may not be able to offset such added costs by increasing the rates we charge to our patients. Turnover rates and the magnitude of the shortage of nurses or other trained personnel vary substantially from facility to facility. An increase in costs associated with, or a shortage of, skilled nurses, could negatively impact our business. In addition, if we fail to attract and retain qualified and skilled personnel, our ability to conduct our business operations effectively would be harmed.

We are subject to various government reviews, audits and investigations that could adversely affect our business, including an obligation to refund amounts previously paid to us, potential criminal charges, the imposition of fines, and/or the loss of our right to participate in Medicare and Medicaid programs.

As a result of our participation in the Medicaid and Medicare programs, we are subject to various governmental reviews, audits and investigations to verify our compliance with these programs and applicable laws and regulations. We are also subject to audits under various government programs, including Recovery Audit Contractors (RAC), Zone Program Integrity Contractors (ZPIC), Program Safeguard Contractors (PSC) and Medicaid Integrity Contributors (MIC) programs, in which third party firms engaged by CMS conduct extensive reviews of claims data and medical and other records to identify potential improper payments under the Medicare programs. Private pay sources also reserve the right to conduct audits. We believe that billing and reimbursement errors and disagreements are common in our industry. We are regularly engaged in reviews, audits and appeals of our claims for reimbursement due to the subjectivities inherent in the process related to patient diagnosis and care, record keeping, claims processing and other aspects of the patient service and reimbursement processes, and the errors and disagreements those subjectivities can produce. An adverse review, audit or investigation could result in:

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an obligation to refund amounts previously paid to us pursuant to the Medicare or Medicaid programs or from private payors, in amounts that could be material to our business;

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state or federal agencies imposing fines, penalties and other sanctions on us;

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loss of our right to participate in the Medicare or Medicaid programs or one or more private payor networks;

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an increase in private litigation against us; and

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damage to our reputation in various markets.

In 2004, one of our Medicare fiscal intermediaries began to conduct selected reviews of claims previously submitted by and paid to some of our facilities. While we have always been subject to post-payment audits and reviews, more intensive “probe reviews” appear to be a permanent procedure with our fiscal intermediary. Although some of these probe reviews identified patient miscoding, documentation deficiencies and other errors in our recordkeeping and Medicare billing, these errors resulted in no Medicare revenue recoupment, net of appeal recoveries, to the federal government and related resident copayments. As of September 30, 2012, we had one facility under probe review.

If the government or court were to conclude that such errors and deficiencies constituted criminal violations, or were to conclude that such errors and deficiencies resulted in the submission of false claims to federal healthcare programs, or if it were to discover other problems in addition to the ones identified by the probe reviews that rose to actionable levels, we and certain of our officers might face potential criminal charges and/or civil claims, administrative sanctions and penalties for amounts that could be material to our business, results of operations and financial condition. In addition, we and/or some of our key personnel could be temporarily or permanently excluded from future participation in state and federal healthcare reimbursement programs such as Medicaid and Medicare. In any event, it is likely that a governmental investigation alone, regardless of its outcome, would divert material time, resources and attention from our management team and our staff, and could have a materially detrimental impact on our results of operations during and after any such investigation or proceedings.

In some cases, probe reviews can also result in a facility being temporarily placed on prepayment review of reimbursement claims, requiring additional documentation and adding steps and time to the reimbursement process for the affected facility. Failure to meet claim filing and documentation requirements during the prepayment review could subject a facility to an even more intensive “targeted review,” where a corrective action plan addressing perceived deficiencies must be prepared by the facility and approved by the fiscal intermediary. During a targeted review, additional claims are reviewed pre-payment to ensure that the prescribed corrective actions are being followed. Failure to make corrections or to otherwise meet the claim documentation and submission requirements could eventually result in Medicare decertification. None of our operations are currently on prepayment review, although some may be placed on prepayment review in the future. We have no operations that are currently undergoing targeted review.

Public and government calls for increased survey and enforcement efforts toward long-term care facilities could result in increased scrutiny by state and federal survey agencies. In addition, potential sanctions and remedies based upon alleged regulatory deficiencies could negatively affect our financial condition and results of operations.

CMS has undertaken several initiatives to increase or intensify Medicaid and Medicare survey and enforcement activities, including federal oversight of state actions. CMS is taking steps to focus more survey and enforcement efforts on facilities with findings of substandard care or repeat violations of Medicaid and Medicare standards, and to identify multi-facility providers with patterns of noncompliance. In addition, the Department of Health and Human Services has adopted a rule that requires CMS to charge user fees to healthcare facilities cited during regular certification, recertification or substantiated complaint surveys for deficiencies, which require a revisit to assure that corrections have been made. CMS is also increasing its oversight of state survey agencies and requiring state agencies to use enforcement sanctions and remedies more promptly when substandard care or repeat violations are identified, to investigate complaints more promptly, and to survey facilities more consistently.

The intensified and evolving enforcement environment impacts providers like us because of the increase in the scope or number of inspections or surveys by governmental authorities and the severity of consequent citations for alleged failure to comply with regulatory requirements. We also divert personnel resources to respond to federal and state investigations and other enforcement actions. The diversion of these resources, including our management team, clinical and compliance staff, and others take away from the time and energy that these individuals could otherwise spend on routine operations. As noted, from time to time in the ordinary course of business, we receive deficiency reports from state and federal regulatory bodies resulting from such inspections or surveys. The focus of these deficiency reports tends to vary from year to year. Although most inspection deficiencies

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are resolved through an agreed-upon plan of corrective action, the reviewing agency typically has the authority to take further action against a licensed or certified facility, which could result in the imposition of fines, imposition of a provisional or conditional license, suspension or revocation of a license, suspension or denial of payment for new admissions, loss of certification as a provider under state or federal healthcare programs, or imposition of other sanctions, including criminal penalties. In the past, we have experienced inspection deficiencies that have resulted in the imposition of a provisional license and could experience these results in the future. We currently have no facilities operating under provisional licenses which were the result of inspection deficiencies.

Furthermore, in some states, citations in one facility impact other facilities in the state. Revocation of a license at a given facility could therefore impair our ability to obtain new licenses or to renew existing licenses at other facilities, which may also trigger defaults or cross-defaults under our leases and our credit arrangements, or adversely affect our ability to operate or obtain financing in the future. If state or federal regulators were to determine, formally or otherwise, that one facility's regulatory history ought to impact another of our existing or prospective facilities, this could also increase costs, result in increased scrutiny by state and federal survey agencies, and even impact our expansion plans. Therefore, our failure to comply with applicable legal and regulatory requirements in any single facility could negatively impact our financial condition and results of operations as a whole.

When a facility is found to be deficient under state licensing and Medicaid and Medicare standards, sanctions may be threatened or imposed such as denial of payment for new Medicaid and Medicare admissions, civil monetary penalties, focused state and federal oversight and even loss of eligibility for Medicaid and Medicare participation or state licensure. Sanctions such as denial of payment for new admissions often are scheduled to go into effect before surveyors return to verify compliance. Generally, if the surveyors confirm that the facility is in compliance upon their return, the sanctions never take effect. However, if they determine that the facility is not in compliance, the denial of payment goes into effect retroactive to the date given in the original notice. This possibility sometimes leaves affected operators, including us, with the difficult task of deciding whether to continue accepting patients after the potential denial of payment date, thus risking the retroactive denial of revenue associated with those patients' care if the operators are later found to be out of compliance, or simply refusing admissions from the potential denial of payment date until the facility is actually found to be in compliance. In the past, some of our facilities have been in denial of payment status due to findings of continued regulatory deficiencies, resulting in an actual loss of the revenue associated with the Medicare and Medicaid patients admitted after the denial of payment date. Additional sanctions could ensue and, if imposed, these sanctions, entailing various remedies up to and including decertification, would further negatively affect our financial condition and results of operations. From time to time, we have opted to voluntarily stop accepting new patients pending completion of a new state survey, in order to avoid possible denial of payment for new admissions during the deficiency cure period, or simply to avoid straining staff and other resources while retraining staff, upgrading operating systems or making other operational improvements.
 
Facilities with otherwise acceptable regulatory histories generally are given an opportunity to correct deficiencies and continue their participation in the Medicare and Medicaid programs by a certain date, usually within nine months, although where denial of payment remedies are asserted, such interim remedies go into effect much sooner. Facilities with deficiencies that immediately jeopardize patient health and safety and those that are classified as poor performing facilities, however, are not generally given an opportunity to correct their deficiencies prior to the imposition of remedies and other enforcement actions. Moreover, facilities with poor regulatory histories continue to be classified by CMS as poor performing facilities notwithstanding any intervening change in ownership, unless the new owner obtains a new Medicare provider agreement instead of assuming the facility's existing agreement. However, new owners (including us, historically) nearly always assume the existing Medicare provider agreement due to the difficulty and time delays generally associated with obtaining new Medicare certifications, especially in previously-certified locations with sub-par operating histories. Accordingly, facilities that have poor regulatory histories before we acquire them and that develop new deficiencies after we acquire them are more likely to have sanctions imposed upon them by CMS or state regulators. In addition, CMS has increased its focus on facilities with a history of serious quality of care problems through the special focus facility initiative. A facility's administrators and owners are notified when it is identified as a special focus facility. This information is also provided to the general public. The special focus facility designation is based in part on the facility's compliance history typically dating before our acquisition of the facility. Local state survey agencies recommend to CMS that facilities be placed on special focus status. A special focus facility receives heightened scrutiny and more frequent regulatory surveys. Failure to improve the quality of care can result in fines and termination from participation in Medicare and Medicaid. A facility “graduates” from the program once it demonstrates significant improvements in quality of care that are continued over time.

We have received notices of potential sanctions and remedies based upon alleged regulatory deficiencies from time to time, and such sanctions have been imposed on some of our facilities. We have had several facilities placed on special focus facility status, due largely or entirely to their respective regulatory histories prior to our acquisition of the operations, and have successfully graduated four facilities from the program to date. CMS currently has not included any of our facilities on its special focus facilities listing, however, facilities may be identified for such status in the future.

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Annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary may reduce our future revenue and profitability or cause us to incur losses.

Some of our rehabilitation therapy revenue is paid by the Medicare Part B program under a fee schedule. Congress has established annual caps that limit the amounts that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to any Medicare beneficiary under Medicare Part B. The BBA requires a combined cap for physical therapy and speech-language pathology and a separate cap for occupational therapy.

The DRA directs CMS to create a process to allow exceptions to therapy caps for certain medically necessary services provided on or after January 1, 2006 for patients with certain conditions or multiple complexities whose therapy services are reimbursed under Medicare Part B. A significant portion of the residents in our skilled nursing facilities and patients served by our rehabilitation therapy programs whose therapy is reimbursed under Medicare Part B have qualified for the exceptions to these reimbursement caps. DRA added Sec. 1833(g)(5) of the Social Security Act and directed them to develop a process that allows exceptions for Medicare beneficiaries to therapy caps when continued therapy is deemed medically necessary.

The therapy cap exception was reauthorized in a number of subsequent laws, most recently in the Middle Class Tax Relief and Job Creation Act of 2012 which extends the exceptions process through December 31, 2012. The statutory Medicare Part B outpatient therapy cap for occupational therapy and the combined cap for physical therapy and speech-language pathology services are $1,880, respectively, for 2012. These amounts represent annual per beneficiary therapy caps determined for each calendar year. Similar to the therapy cap, Congress established a threshold of $3,700 for physical therapy and speech-language pathology services combined and a separate threshold of $3,700 for occupational therapy services. All therapy services rendered above this limit are subject to medical review and certain providers will be required to submit a request for an exception. Beginning October 1, 2012 some therapy providers are required to submit requests for exceptions. Prior to October 1, 2012 there was no requirement for an exception request when the threshold was exceeded.

The application of annual caps, or the discontinuation of exceptions to the annual caps, could have an adverse effect on our rehabilitation therapy revenue. Additionally, the exceptions to these caps may not be extended beyond December 31, 2012, which could also have an adverse effect on our revenue after that date.

Our hospice operations are subject to annual Medicare caps calculated by Medicare. If such caps were to be exceeded by any of our hospice providers, our business and consolidated financial condition, results of operations and cash flows could be materially adversely affected.

With respect to our hospice operations, overall payments made by Medicare to each provider number are subject to an inpatient cap amount and an overall payment cap, which are calculated and published by the Medicare fiscal intermediary on an annual basis covering the period from November 1 through October 31. If payments received by any one of our hospice provider numbers exceeds either of these caps, we may be required to reimburse Medicare for payments received in excess of the caps, which could have a material adverse effect on our business and consolidated financial condition, results of operations and cash flows.

We are subject to extensive and complex federal and state government laws and regulations which could change at any time and increase our cost of doing business and subject us to enforcement actions.

We, along with other companies in the healthcare industry, are required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things:

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facility and professional licensure, certificates of need, permits and other government approvals;
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adequacy and quality of healthcare services;
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qualifications of healthcare and support personnel;
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quality of medical equipment;
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confidentiality, maintenance and security issues associated with medical records and claims processing;
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relationships with physicians and other referral sources and recipients;
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constraints on protective contractual provisions with patients and third-party payors;
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operating policies and procedures;

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certification of additional facilities by the Medicare program; and
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payment for services.

The laws and regulations governing our operations, along with the terms of participation in various government programs, regulate how we do business, the services we offer, and our interactions with patients and other healthcare providers. These laws and regulations are subject to frequent change. We believe that such regulations may increase in the future and we cannot predict the ultimate content, timing or impact on us of any healthcare reform legislation. Changes in existing laws or regulations, or the enactment of new laws or regulations, could negatively impact our business. If we fail to comply with these applicable laws and regulations, we could suffer civil or criminal penalties and other detrimental consequences, including denial of reimbursement, imposition of fines, temporary suspension of admission of new patients, suspension or decertification from the Medicaid and Medicare programs, restrictions on our ability to acquire new facilities or expand or operate existing facilities, the loss of our licenses to operate and the loss of our ability to participate in federal and state reimbursement programs.

We are subject to federal and state laws, such as the Federal False Claims Act, state false claims acts, the illegal remuneration provisions of the Social Security Act, the federal anti-kickback laws, state anti-kickback laws, and the federal “Stark” laws, that govern financial and other arrangements among healthcare providers, their owners, vendors and referral sources, and that are intended to prevent healthcare fraud and abuse. Among other things, these laws prohibit kickbacks, bribes and rebates, as well as other direct and indirect payments or fee-splitting arrangements that are designed to induce the referral of patients to a particular provider for medical products or services payable by any federal healthcare program, and prohibit presenting a false or misleading claim for payment under a federal or state program. They also prohibit some physician self-referrals. Possible sanctions for violation of any of these restrictions or prohibitions include loss of eligibility to participate in federal and state reimbursement programs and civil and criminal penalties. Changes in these laws could increase our cost of doing business. If we fail to comply, even inadvertently, with any of these requirements, we could be required to alter our operations, refund payments to the government, enter into corporate integrity, deferred prosecution or similar agreements with state or federal government agencies, and become subject to significant civil and criminal penalties.

In May 2009, Congress passed the Fraud Enforcement and Recovery Act (FERA) of 2009 which made significant changes to the federal False Claims Act (FCA), expanding the types of activities subject to prosecution and whistleblower liability. Following changes by FERA, health care providers face significant penalties for known retention of government overpayments, even if no false claim was involved. Health care providers can now be liable for knowingly and improperly avoiding or decreasing an obligation to pay money or property to the government. This includes the retention of any government overpayment. The government can argue, therefore, that a FCA violation can occur without any affirmative fraudulent action or statement, as long as it is knowingly improper. In addition, FERA extended protections against retaliation for whistleblowers, including protections not only for employees, but also contractors and agents. Thus, there is no need for an employment relationship in order to qualify for protection against retaliation for whistleblowing.

We are also required to comply with state and federal laws governing the transmission, privacy and security of health information. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) requires us to comply with certain standards for the use of individually identifiable health information within our company, and the disclosure and electronic transmission of such information to third parties, such as payors, business associates and patients. These include standards for common electronic healthcare transactions and information, such as claim submission, plan eligibility determination, payment information submission and the use of electronic signatures; unique identifiers for providers, employers and health plans; and the security and privacy of individually identifiable health information. In addition, some states have enacted comparable or, in some cases, more stringent privacy and security laws. If we fail to comply with these state and federal laws, we could be subject to criminal penalties and civil sanctions and be forced to modify our policies and procedures.

Our failure to obtain or renew required regulatory approvals or licenses or to comply with applicable regulatory requirements, the suspension or revocation of our licenses or our disqualification from participation in federal and state reimbursement programs, or the imposition of other harsh enforcement sanctions could increase our cost of doing business and expose us to potential sanctions. Furthermore, if we were to lose licenses or certifications for any of our facilities as a result of regulatory action or otherwise, we could be deemed to be in default under some of our agreements, including agreements governing outstanding indebtedness and lease obligations.


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Increased civil and criminal enforcement efforts of government agencies against skilled nursing facilities could harm our business, and could preclude us from participating in federal healthcare programs.

Both federal and state government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare companies and, in particular, skilled nursing facilities. The focus of these investigations includes, among other things:

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cost reporting and billing practices;

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quality of care;

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financial relationships with referral sources; and

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medical necessity of services provided.

If any of our facilities is decertified or loses its licenses, our revenue, financial condition or results of operations would be adversely affected. In addition, the report of such issues at any of our facilities could harm our reputation for quality care and lead to a reduction in our patient referrals and ultimately a reduction in occupancy at these facilities. Also, responding to enforcement efforts would divert material time, resources and attention from our management team and our staff, and could have a materially detrimental impact on our results of operations during and after any such investigation or proceedings, regardless of whether we prevail on the underlying claim.

Federal law provides that practitioners, providers and related persons may not participate in most federal healthcare programs, including the Medicaid and Medicare programs, if the individual or entity has been convicted of a criminal offense related to the delivery of a product or service under these programs or if the individual or entity has been convicted under state or federal law of a criminal offense relating to neglect or abuse of patients in connection with the delivery of a healthcare product or service. Other individuals or entities may be, but are not required to be, excluded from such programs under certain circumstances, including, but not limited to, the following:

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medical necessity of services provided;

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conviction related to fraud;

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conviction relating to obstruction of an investigation;

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conviction relating to a controlled substance;

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licensure revocation or suspension;

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exclusion or suspension from state or other federal healthcare programs;

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filing claims for excessive charges or unnecessary services or failure to furnish medically necessary services;

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ownership or control of an entity by an individual who has been excluded from the Medicaid or Medicare programs, against whom a civil monetary penalty related to the Medicaid or Medicare programs has been assessed or who has been convicted of a criminal offense under federal healthcare programs; and

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the transfer of ownership or control interest in an entity to an immediate family or household member in anticipation of, or following, a conviction, assessment or exclusion from the Medicare or Medicaid programs.

The OIG, among other priorities, is responsible for identifying and eliminating fraud, abuse and waste in certain federal healthcare programs. The OIG has implemented a nationwide program of audits, inspections and investigations and from time to time issues “fraud alerts” to segments of the healthcare industry on particular practices that are vulnerable to abuse. The fraud alerts inform healthcare providers of potentially abusive practices or transactions that are subject to criminal activity and reportable to the OIG. An increasing level of resources has been devoted to the investigation of allegations of fraud and abuse in the Medicaid and Medicare programs, and federal and state regulatory authorities are taking an increasingly strict view of the requirements imposed on healthcare providers by the Social Security Act and Medicaid and Medicare programs. Although we have created a corporate compliance program that we believe is consistent with the OIG guidelines, the OIG may modify its guidelines or interpret

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its guidelines in a manner inconsistent with our interpretation or the OIG may ultimately determine that our corporate compliance program is insufficient.

In some circumstances, if one facility is convicted of abusive or fraudulent behavior, then other facilities under common control or ownership may be decertified from participating in Medicaid or Medicare programs. Federal regulations prohibit any corporation or facility from participating in federal contracts if it or its principals have been barred, suspended or declared ineligible from participating in federal contracts. In addition, some state regulations provide that all facilities under common control or ownership licensed within a state may be de-licensed if one or more of the facilities are de-licensed. If any of our facilities were decertified or excluded from participating in Medicaid or Medicare programs, our revenue would be adversely affected.

The Office of the Inspector General or other organizations may choose to more closely scrutinize the billing practices of for-profit skilled nursing facilities, which could result in an increase in regulatory monitoring and oversight, decreased reimbursement rates, or otherwise adversely affect our business, financial condition and results of operations.

In December 2010, the OIG released a report entitled “Questionable Billing by Skilled Nursing Facilities.” The report examined the billing practices of skilled nursing facilities based on Medicare Part A claims from 2006 to 2008 and found, among other things, that for-profit skilled nursing facilities were more likely to bill for higher paying therapy RUGs, particularly in the ultra high therapy categories, than government and not-for-profit operators. It also found that for-profit skilled nursing facilities showed a higher incidence of patients using RUGs with higher activities of daily living (ADL) scores, and had a “long” average length of stay among Part A beneficiaries, compared to their government and not-for-profit counterparts. The OIG recommended that CMS vigilantly monitor overall payments to skilled nursing facilities, adjust RUG rates annually, change the method for determining how much therapy is needed to ensure appropriate payments and conduct additional reviews for skilled nursing operators that exceed certain thresholds for higher paying therapy RUGs. CMS concurred with and agreed to take action on three of the four recommendations, declining only to change the methodology for assessing a patient's therapy needs. The OIG issued a separate memorandum to CMS listing 384 specific facilities that the OIG had identified as being in the top one percent for use of ultra high therapy, RUGs with high ADL scores, or “long” average lengths of stay, and CMS agreed to forward the list to the appropriate fiscal intermediaries or other contractors for follow up. Although we believe our therapy assessment and billing practices are consistent with applicable law and CMS requirements, we cannot predict the extent to which the OIGs recommendations to CMS will be implemented and, what effect, if any, such proposals would have on us. Two of our facilities have been listed on the report. Our business model, like those of some other for-profit operators, is based in part on seeking out higher-acuity patients whom we believe are generally more profitable, and over time our overall patient mix has consistently shifted to higher-acuity and higher-RUGs patients in most facilities we operate. We also use specialized care-delivery software that assists our caregivers in more accurately capturing and recording ADL services in order to, among other things, increase reimbursement to levels appropriate for the care actually delivered. These efforts may place us under greater scrutiny with the OIG, CMS, our fiscal intermediaries, recovery audit contractors and others, as well as other government agencies, unions, advocacy groups and others who seek to pursue their own mandates and agendas. Efforts by officials and others to make or advocate for any increase in regulatory monitoring and oversight, adversely change RUG rates, revise methodologies for assessing and treating patients, or conduct more frequent or intense reviews of our treatment and billing practices, could reduce our reimbursement, increase our costs of doing business and otherwise adversely affect our business, financial condition and results of operations.

State efforts to regulate or deregulate the healthcare services industry or the construction or expansion of healthcare facilities could impair our ability to expand our operations, or could result in increased competition.

Some states require healthcare providers, including skilled nursing facilities, to obtain prior approval, known as a certificate of need, for:

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the purchase, construction or expansion of healthcare facilities;

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capital expenditures exceeding a prescribed amount; or

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changes in services or bed capacity.

In addition, other states that do not require certificates of need have effectively barred the expansion of existing facilities and the development of new ones by placing partial or complete moratoria on the number of new Medicaid beds they will certify in certain areas or in the entire state. Other states have established such stringent development standards and approval procedures for constructing new healthcare facilities that the construction of new facilities, or the expansion or renovation of existing facilities, may become cost-prohibitive or extremely time-consuming. Our ability to acquire or construct new facilities or expand or provide new services at existing facilities would be adversely affected if we are unable to obtain the necessary approvals, if there are changes in the standards applicable to those approvals, or if we experience delays and increased expenses associated with obtaining

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those approvals. We may not be able to obtain licensure, certificate of need approval, Medicaid certification, or other necessary approvals for future expansion projects. Conversely, the elimination or reduction of state regulations that limit the construction, expansion or renovation of new or existing facilities could result in increased competition to us or result in overbuilding of facilities in some of our markets. If overbuilding in the skilled nursing industry in the markets in which we operate were to occur, it could reduce the occupancy rates of existing facilities and, in some cases, might reduce the private rates that we charge for our services.

Changes in federal and state employment-related laws and regulations could increase our cost of doing business.

Our operations are subject to a variety of federal and state employment-related laws and regulations, including, but not limited to, the U.S. Fair Labor Standards Act which governs such matters as minimum wages, overtime and other working conditions, the Americans with Disabilities Act (ADA) and similar state laws that provide civil rights protections to individuals with disabilities in the context of employment, public accommodations and other areas, the National Labor Relations Act, regulations of the Equal Employment Opportunity Commission (EEOC), regulations of the Office of Civil Rights, regulations of state Attorneys General, family leave mandates and a variety of similar laws enacted by the federal and state governments that govern these and other employment law matters. Because labor represents such a large portion of our operating costs, changes in federal and state employment-related laws and regulations could increase our cost of doing business.

The compliance costs associated with these laws and evolving regulations could be substantial. For example, all of our facilities are required to comply with the ADA. The ADA has separate compliance requirements for “public accommodations” and “commercial properties,” but generally requires that buildings be made accessible to people with disabilities. Compliance with ADA requirements could require removal of access barriers and non-compliance could result in imposition of government fines or an award of damages to private litigants. Further legislation may impose additional burdens or restrictions with respect to access by disabled persons. In addition, federal proposals to introduce a system of mandated health insurance and flexible work time and other similar initiatives could, if implemented, adversely affect our operations. We also may be subject to employee-related claims such as wrongful discharge, discrimination or violation of equal employment law. While we are insured for these types of claims, we could experience damages that are not covered by our insurance policies or that exceed our insurance limits, and we may be required to pay such damages directly, which would negatively impact our cash flow from operations.

Compliance with federal and state fair housing, fire, safety and other regulations may require us to make unanticipated expenditures, which could be costly to us.

We must comply with the federal Fair Housing Act and similar state laws, which prohibit us from discriminating against individuals if it would cause such individuals to face barriers in gaining residency in any of our facilities. Additionally, the Fair Housing Act and other similar state laws require that we advertise our services in such a way that we promote diversity and not limit it. We may be required, among other things, to change our marketing techniques to comply with these requirements.

In addition, we are required to operate our facilities in compliance with applicable fire and safety regulations, building codes and other land use regulations and food licensing or certification requirements as they may be adopted by governmental agencies and bodies from time to time. Like other healthcare facilities, our skilled nursing facilities are subject to periodic surveys or inspections by governmental authorities to assess and assure compliance with regulatory requirements. Surveys occur on a regular (often annual or biannual) schedule, and special surveys may result from a specific complaint filed by a patient, a family member or one of our competitors. We may be required to make substantial capital expenditures to comply with these requirements.

We depend largely upon reimbursement from third-party payors, and our revenue, financial condition and results of operations could be negatively impacted by any changes in the acuity mix of patients in our facilities as well as payor mix and payment methodologies.

Our revenue is affected by the percentage of our patients who require a high level of skilled nursing and rehabilitative care, whom we refer to as high acuity patients, and by our mix of payment sources. Changes in the acuity level of patients we attract, as well as our payor mix among Medicaid, Medicare, private payors and managed care companies, significantly affect our profitability because we generally receive higher reimbursement rates for high acuity patients and because the payors reimburse us at different rates. For the nine months ended September 30, 2012, 73.7% of our revenue was provided by government payors that reimburse us at predetermined rates. If our labor or other operating costs increase, we will be unable to recover such increased costs from government payors. Accordingly, if we fail to maintain our proportion of high acuity patients or if there is any significant increase in the percentage of our patients for whom we receive Medicaid reimbursement, our results of operations may be adversely affected.


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Initiatives undertaken by major insurers and managed care companies to contain healthcare costs may adversely affect our business. Among other initiatives, these payors attempt to control healthcare costs by contracting with healthcare providers to obtain services on a discounted basis. We believe that this trend will continue and may limit reimbursements for healthcare services. If insurers or managed care companies from whom we receive substantial payments were to reduce the amounts they pay for services, we may lose patients if we choose not to renew our contracts with these insurers at lower rates.

Compliance with state and federal employment, immigration, licensing and other laws could increase our cost of doing business.

We have hired personnel, including skilled nurses and therapists, from outside the United States. If immigration laws are changed, or if new and more restrictive government regulations proposed by the Department of Homeland Security are enacted, our access to qualified and skilled personnel may be limited.

We operate in at least one state that requires us to verify employment eligibility using procedures and standards that exceed those required under federal Form I-9 and the statutes and regulations related thereto. Proposed federal regulations would extend similar requirements to all of the states in which our facilities operate. To the extent that such proposed regulations or similar measures become effective, and we are required by state or federal authorities to verify work authorization or legal residence for current and prospective employees beyond existing Form I-9 requirements and other statutes and regulations currently in effect, it may make it more difficult for us to recruit, hire and/or retain qualified employees, may increase our risk of non-compliance with state and federal employment, immigration, licensing and other laws and regulations and could increase our cost of doing business.

We are subject to litigation that could result in significant legal costs and large settlement amounts or damage awards.

The skilled nursing business involves a significant risk of liability given the age and health of our patients and residents and the services we provide. We and others in our industry are subject to a large and increasing number of claims and lawsuits, including professional liability claims, alleging that our services have resulted in personal injury, elder abuse, wrongful death or other related claims. The defense of these lawsuits has in the past, and may in the future, result in significant legal costs, regardless of the outcome, and can result in large settlement amounts or damage awards. Plaintiffs tend to sue every healthcare provider who may have been involved in the patient's care and, accordingly, we respond to multiple lawsuits and claims every year.

In addition, plaintiffs' attorneys have become increasingly more aggressive in their pursuit of claims against healthcare providers, including skilled nursing providers and other long-term care companies, and have employed a wide variety of advertising and publicity strategies. Among other things, these strategies include establishing their own Internet websites, paying for premium advertising space on other websites, paying Internet search engines to optimize their plaintiff solicitation advertising so that it appears in advantageous positions on Internet search results, including results from searches for our company and facilities, using newspaper, magazine and television ads targeted at customers of the healthcare industry generally, as well as at customers of specific providers, including us. From time to time, law firms claiming to specialize in long-term care litigation have named us, our facilities and other specific healthcare providers and facilities in their advertising and solicitation materials. These advertising and solicitation activities could result in more claims and litigation, which could increase our liability exposure and legal expenses, divert the time and attention of our personnel from day-to-day business operations, and materially and adversely affect our financial condition and results of operations. Furthermore, to the extent the frequency and/or severity of losses from such claims and suits increases, our liability insurance premiums could increase and/or available insurance coverage levels could decline, which could materially and adversely affect our financial condition and results of operations.

Other companies in our industry have been the subject of lawsuits alleging negligence, abuses and other causes of action which have, in some cases, resulted in large damage awards and settlements. In addition, there has been an increase in the number of class-action suits filed against us and other companies in our industry, which also have the potential to result in large damage awards and settlements. A class action suit was previously filed against us in the State of California alleging, among other things, violations of certain Health and Safety Code provisions and a violation of the Consumer Legal Remedies Act at certain of our California facilities. In 2007, we settled this class action suit, and the settlement was approved by both the class and the Court.

Healthcare litigation is common and is filed based upon a wide variety of claims and theories, and we are routinely subjected to varying types of claims. One particular type of suit arises from alleged violations of state-established minimum staffing requirements for skilled nursing facilities. Failure to meet these requirements can, among other things, jeopardize a facility's compliance with conditions of participation under certain state and federal healthcare programs; it may also subject the facility to a notice of deficiency, a citation, civil money penalties, or litigation. These "staffing" suits have become more prevalent in the wake of a previous substantial jury award against one of our competitors, and we expect the plaintiff's bar to become increasingly aggressive in their pursuit of these staffing and similar claims. We are currently defending one such staffing class-action claim filed in Los Angeles Superior Court, and have reached a tentative settlement with class counsel that is awaiting court approval.

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The total costs associated with the settlement, including attorney's fees, estimated class payout, and related costs and expense, are projected to be $5.0 million, of which $2.6 million of this amount was recorded in the quarter ended June 30, 2012, with the balance having been expensed in prior periods. Assuming that the settlement is approved by the court, the settlement will not have a material ongoing material adverse effect on our business, financial condition, or results of operations.

Other claims and suits, including class actions, continue to be filed against us and other companies in our industry. If there were a significant increase in the number of these claims or an increase in amounts owing should plaintiffs be successful in their prosecution of these claims, this could have a material adverse effect to our business, financial condition, results of operations and cash flows. In addition, we contract with a variety of landlords, lenders, vendors, suppliers, consultants and other individuals and businesses. These contracts typically contain covenants and default provisions. If the other party to one or more of our contracts were to allege that we have violated the contract terms, we could be subject to civil liabilities which could have a material adverse effect on our financial condition and results of operations.

Were litigation to be instituted against one or more of our subsidiaries, a successful plaintiff might attempt to hold us or another subsidiary liable for the alleged wrongdoing of the subsidiary principally targeted by the litigation. If a court in such litigation decided to disregard the corporate form, the resulting judgment could increase our liability and adversely affect our financial condition and results of operations.

On February 26, 2009, Congress reintroduced the Fairness in Nursing Home Arbitration Act of 2009. After failing to be enacted into law in the 110th Congress in 2008, the Fairness in Nursing Home Arbitration Act of 2009 was introduced in the 111th Congress and referred to the House and Senate judiciary committees in March 2009. The 111th Congress did not pass the bill and therefore has been cleared from the present agenda. This bill may be reintroduced in the 112th Congress. If enacted, this bill would require, among other things, that agreements to arbitrate nursing home disputes be made after the dispute has arisen rather than before prospective residents move in, to prevent nursing home operators and prospective residents from mutually entering into a pre-admission pre-dispute arbitration agreement. We use arbitration agreements, which have generally been favored by the courts, to streamline the dispute resolution process and reduce our exposure to legal fees and excessive jury awards. If we are not able to secure pre-admission arbitration agreements, our litigation exposure and costs of defense in patient liability actions could increase, our liability insurance premiums could increase, and our business may be adversely affected.

The U.S. Department of Justice is conducting an investigation into the billing and reimbursement processes of some of our operating subsidiaries, which could adversely affect our operations and financial condition.

In March 2007, we learned that the United States Attorney for the Central District of California (DOJ) had commenced an investigation of certain of our facilities and had issued an authorized investigative demand to our bank seeking information pertaining to a total of 18 of our facilities. The DOJ also subsequently served a subpoena on our independent external auditors in 2007, and in 2008 served search warrants and subpoenas on our Service Center and six of our Southern California skilled nursing facilities, seeking specific patient files and other information. Subsequent subpoenas issued to us covered additional documentation from the six facilities as well as eight of the other facilities. Based upon the issuance of the subpoenas and execution of the search warrants, we concluded that the government had undertaken parallel criminal and civil investigations. We pledged full cooperation to, and have been cooperating fully with, the government.
In September 2010 our board of directors appointed a special committee consisting solely of independent directors to advance discussions with the DOJ regarding its investigation. The special committee retained independent counsel, and counsel has retained third party consultants, to facilitate its work. The Company and the special committee have continued cooperating with the DOJ, working to provide information necessary to aid the DOJ's investigation and move the matter toward resolution.
  
In December 2011, independent counsel for our special committee received confirmation that the DOJ has closed its criminal investigation, although as a matter of course the DOJ reserves the right to reopen such inquiries if new facts come to light.

In January 2012, the DOJ indicated that the government would be seeking certain additional information in furtherance of the remaining civil investigation, and that it would formalize its request for that information in a new subpoena. In January 2012, the Office of the Inspector General of the United States Department of Health & Human Services (HHS) served the new subpoena, seeking specific patient records and documents from 2007 to 2011 from the six Southern California skilled nursing facilities that have been the subject of previous requests. HHS also issued a subpoena to our independent external auditors requesting an update to the information requested in the 2007 subpoena to them, and a subpoena to our independent internal auditors requesting similar information.


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We produced records called for in the January 2012 subpoena, and discussions between government representatives and counsel for the special committee are ongoing. We continue to cooperate with the government as part of an ongoing effort to move the matter to a resolution. In particular, while we seek to address any questions the government may have after it completes its review of specific patient files requested, counsel for the special committee and counsel for the government are also attempting to develop a process to resolve, in advance of formal litigation, any civil claims the government may believe it has after concluding its investigation. In addition, we continue to make improvements to our compliance programs and systems.

We cannot predict or provide any assurance as to the possible outcome of the investigations or any possible related proceedings, or as to the possible outcome of any litigation. And although we believe there is a reasonable possibility that a loss may be incurred, we cannot estimate the possible loss or range of loss that may result from any such proceedings and, therefore, we have not recorded any related accruals. If any litigation were to proceed, and we are subjected to, alleged to be liable for, or agree to a settlement of, claims or obligations under federal Medicare statutes, the federal False Claims Act, or similar state and federal statutes and related regulations, our business, financial condition and results of operations and cash flows could be materially and adversely affected and our stock price could be adversely impacted. Among other things, any settlement or litigation could involve the payment of substantial sums to settle any alleged civil violations, and may also include our assumption of specific procedural and financial obligations going forward under a corporate integrity agreement and/or other arrangement with the government.

We conduct regular internal investigations into the care delivery, recordkeeping and billing processes of our operating subsidiaries. These reviews sometimes detect instances of noncompliance which we attempt to correct, which can decrease our revenue.

From time to time our systems and controls highlight potential compliance issues, which we investigate as they arise. We have initiated internal inquiries into possible recordkeeping and related irregularities at our skilled nursing facilities, which were detected by our internal compliance team in the course of its ongoing reviews.

Through these internal inquiries, we have identified potential deficiencies in the assessment of and recordkeeping for small subsets of patients. We have also identified and, at the conclusion of such investigations, assisted in implementing, targeted improvements in the assessment and recordkeeping practices to make them consistent with the existing standards and policies applicable to our skilled nursing facilities in these areas. We continue to monitor the measures implemented for effectiveness, and perform follow-up reviews to ensure compliance. Consistent with healthcare industry accounting practices, we record any charge for refunded payments against revenue in the period in which the claim adjustment becomes known.

If additional reviews result in identification and quantification of additional amounts to be refunded, we would accrue additional liabilities for claim costs and interest, and repay any amounts due in normal course. If future investigations ultimately result in findings of significant billing and reimbursement noncompliance which could require us to record significant additional provisions or remit payments, our business, financial condition and results of operations could be materially and adversely affected and our stock price could decline.

We may be unable to complete future facility or business acquisitions at attractive prices or at all, which may adversely affect our revenue; we may also elect to dispose of underperforming or non-strategic operations, which would also decrease our revenue.

To date, our revenue growth has been significantly driven by our acquisition of new facilities and businesses. Subject to general market conditions and the availability of essential resources and leadership within our company, we continue to seek both single-and multi-facility acquisition and business acquisition opportunities that are consistent with our geographic, financial and operating objectives.

We face competition for the acquisition of facilities and businesses and expect this competition to increase. Based upon factors such as our ability to identify suitable acquisition candidates, the purchase price of the facilities, prevailing market conditions, the availability of leadership to manage new facilities and our own willingness to take on new operations, the rate at which we have historically acquired facilities has fluctuated significantly. In the future, we anticipate the rate at which we may acquire facilities will continue to fluctuate, which may affect our revenue.

We have also historically acquired a few facilities, either because they were included in larger, indivisible groups of facilities or under other circumstances, which were or have proven to be non-strategic or less desirable, and we may consider disposing of such facilities or exchanging them for facilities which are more desirable. To the extent we dispose of such a facility without simultaneously acquiring a facility in exchange, our revenues might decrease.

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We may not be able to successfully integrate acquired facilities and businesses into our operations, and we may not achieve the benefits we expect from any of our facility acquisitions.

We may not be able to successfully or efficiently integrate new acquisitions with our existing operations, culture and systems. The process of integrating acquired facilities into our existing operations may result in unforeseen operating difficulties, divert management's attention from existing operations, or require an unexpected commitment of staff and financial resources, and may ultimately be unsuccessful. Existing facilities available for acquisition frequently serve or target different markets than those that we currently serve. We also may determine that renovations of acquired facilities and changes in staff and operating management personnel are necessary to successfully integrate those facilities into our existing operations. We may not be able to recover the costs incurred to reposition or renovate newly acquired facilities. The financial benefits we expect to realize from many of our acquisitions are largely dependent upon our ability to improve clinical performance, overcome regulatory deficiencies, rehabilitate or improve the reputation of the facilities in the community, increase and maintain occupancy, control costs, and in some cases change the patient acuity mix. If we are unable to accomplish any of these objectives at facilities we acquire, we will not realize the anticipated benefits and we may experience lower than anticipated profits, or even losses.

During the nine months ended September 30, 2012, we acquired five facilities and three business with a total of 441 operational beds. During the year ended December 31, 2011, we acquired twenty facilities and three businesses with a total of 2,161 operational beds. This growth has placed and will continue to place significant demands on our current management resources. Our ability to manage our growth effectively and to successfully integrate new acquisitions into our existing business will require us to continue to expand our operational, financial and management information systems and to continue to retain, attract, train, motivate and manage key employees, including facility-level leaders and our local directors of nursing. We may not be successful in attracting qualified individuals necessary for future acquisitions to be successful, and our management team may expend significant time and energy working to attract qualified personnel to manage facilities we may acquire in the future. Also, the newly acquired facilities may require us to spend significant time improving services that have historically been substandard, and if we are unable to improve such facilities quickly enough, we may be subject to litigation and/or loss of licensure or certification. If we are not able to successfully overcome these and other integration challenges, we may not achieve the benefits we expect from any of our facility acquisitions, and our business may suffer.

In undertaking acquisitions, we may be adversely impacted by costs, liabilities and regulatory issues that may adversely affect our operations.

In undertaking acquisitions, we also may be adversely impacted by unforeseen liabilities attributable to the prior providers who operated those facilities, against whom we may have little or no recourse. Many facilities we have historically acquired were underperforming financially and had clinical and regulatory issues prior to and at the time of acquisition. Even where we have improved operations and patient care at facilities that we have acquired, we still may face post-acquisition regulatory issues related to pre-acquisition events. These may include, without limitation, payment recoupment related to our predecessors' prior noncompliance, the imposition of fines, penalties, operational restrictions or special regulatory status. Further, we may incur post-acquisition compliance risk due to the difficulty or impossibility of immediately or quickly bringing non-compliant facilities into full compliance. Diligence materials pertaining to acquisition targets, especially the underperforming facilities that often represent the greatest opportunity for return, are often inadequate, inaccurate or impossible to obtain, sometimes requiring us to make acquisition decisions with incomplete information. Despite our due diligence procedures, facilities that we have acquired or may acquire in the future may generate unexpectedly low returns, may cause us to incur substantial losses, may require unexpected levels of management time, expenditures or other resources, or may otherwise not meet a risk profile that our investors find acceptable. For example, in July of 2006 we acquired a facility that had a history of intermittent noncompliance. Although the facility had already been surveyed once by the local state survey agency after being acquired by us, and that survey would have met the heightened requirements of the special focus facility program, based upon the facility's compliance history prior to our acquisition, in January 2008, state officials nevertheless recommended to CMS that the facility be placed on special focus facility status. In addition, in October of 2006, we acquired a facility which had a history of intermittent non-compliance. This facility was surveyed by the local state survey agency during the third quarter of 2008 and passed the heightened survey requirements of the special focus facility program. Both facilities have successfully graduated from the Centers for Medicare and Medicaid Services' Special Focus program. We currently have no facilities on special focus facility status.

In addition, we might encounter unanticipated difficulties and expenditures relating to any of the acquired facilities, including contingent liabilities. For example, when we acquire a facility, we generally assume the facility's existing Medicare provider number for purposes of billing Medicare for services. If CMS later determined that the prior owner of the facility had received overpayments from Medicare for the period of time during which it operated the facility, or had incurred fines in connection with the operation of the facility, CMS could hold us liable for repayment of the overpayments or fines. If the prior operator is defunct or otherwise unable to reimburse us, we may be unable to recover these funds. We may be unable to improve every facility that

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we acquire. In addition, operation of these facilities may divert management time and attention from other operations and priorities, negatively impact cash flows, result in adverse or unanticipated accounting charges, or otherwise damage other areas of our company if they are not timely and adequately improved.

We also incur regulatory risk in acquiring certain facilities due to the licensing, certification and other regulatory requirements affecting our right to operate the acquired facilities. For example, in order to acquire facilities on a predictable schedule, or to acquire declining operations quickly to prevent further pre-acquisition declines, we frequently acquire such facilities prior to receiving license approval or provider certification. We operate such facilities as the interim manager for the outgoing licensee, assuming financial responsibility, among other obligations for the facility. To the extent that we may be unable or delayed in obtaining a license, we may need to operate the facility under a management agreement from the prior operator. Any inability in obtaining consent from the prior operator of a target acquisition to utilizing its license in this manner could impact our ability to acquire additional facilities. If we were subsequently denied licensure or certification for any reason, we might not realize the expected benefits of the acquisition and would likely incur unanticipated costs and other challenges which could cause our business to suffer.

Termination of our patient admission agreements and the resulting vacancies in our facilities could cause revenue at our facilities to decline.

Most state regulations governing skilled nursing and assisted living facilities require written patient admission agreements with each patient. Several of these regulations also require that each patient have the right to terminate the patient agreement for any reason and without prior notice. Consistent with these regulations, all of our skilled nursing patient agreements allow patients to terminate their agreements without notice, and all of our assisted living resident agreements allow residents to terminate their agreements upon thirty days' notice. Patients and residents terminate their agreements from time to time for a variety of reasons, causing some fluctuations in our overall occupancy as patients and residents are admitted and discharged in normal course. If an unusual number of patients or residents elected to terminate their agreements within a short time, occupancy levels at our facilities could decline. As a result, beds may be unoccupied for a period of time, which would have a negative impact on our revenue, financial condition and results of operations.

We face significant competition from other healthcare providers and may not be successful in attracting patients and residents to our facilities.

The skilled nursing, assisted living, home health and hospice fields are highly competitive, and we expect that these fields may become increasingly competitive in the future. Our skilled nursing facilities compete primarily on a local and regional basis with many long-term care providers, from national and regional multi-facility providers that have substantially greater financial resources to small providers who operate a single nursing facility. We also compete with other skilled nursing and assisted living facilities, and with inpatient rehabilitation facilities, long-term acute care hospitals, home healthcare and other similar services and care alternatives. Increased competition could limit our ability to attract and retain patients, attract and retain skilled personnel, maintain or increase private pay and managed care rates or expand our business.

We may not be successful in attracting patients to our operations, particularly Medicare, managed care, and private pay patients who generally come to us at higher reimbursement rates. Some of our competitors have greater financial and other resources than us, may have greater brand recognition and may be more established in their respective communities than we are. Competing companies may also offer newer facilities or different programs or services than we do and may thereby attract current or potential patients. Other competitors may have lower expenses or other competitive advantages, and, therefore, present significant price competition for managed care and private pay patients. In addition, some of our competitors operate on a not-for-profit basis or as charitable organizations and have the ability to finance capital expenditures on a tax-exempt basis or through the receipt of charitable contributions, neither of which are available to us.

If we do not achieve and maintain competitive quality of care ratings from CMS and private organizations engaged in similar monitoring activities, or if the frequency of CMS surveys and enforcement sanctions increases, our business may be negatively affected.

CMS, as well as certain private organizations engaged in similar monitoring activities, provides comparative data available to the public on its web site, rating every skilled nursing facility operating in each state based upon quality-of-care indicators. These quality-of-care indicators include such measures as percentages of patients with infections, bedsores and unplanned weight loss. In addition, CMS has undertaken an initiative to increase Medicaid and Medicare survey and enforcement activities, to focus more survey and enforcement efforts on facilities with findings of substandard care or repeat violations of Medicaid and Medicare standards, and to require state agencies to use enforcement sanctions and remedies more promptly when substandard care or repeat violations are identified. We have found a correlation between negative Medicaid and Medicare surveys and the incidence of

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professional liability litigation. From time to time, we experience a higher than normal number of negative survey findings in some of our facilities.

In December 2008, CMS introduced the Five-Star Quality Rating System to help consumers, their families and caregivers compare nursing homes more easily. The Five-Star Quality Rating System gives each nursing home a rating of between one and five stars in various categories. In cases of acquisitions, the previous operator's clinical ratings are included in our overall Five-Star Quality Rating. The prior operator's results will impact our rating until we have sufficient clinical measurements subsequent to the acquisition date. If we are unable to achieve quality of care ratings that are comparable or superior to those of our competitors, our ability to attract and retain patients could be adversely affected.

If we are unable to obtain insurance, or if insurance becomes more costly for us to obtain, our business may be adversely affected.

It may become more difficult and costly for us to obtain coverage for resident care liabilities and other risks, including property and casualty insurance. For example, the following circumstances may adversely affect our ability to obtain insurance at favorable rates:

•
we experience higher-than-expected professional liability, property and casualty, or other types of claims or losses;

•
we receive survey deficiencies or citations of higher-than-normal scope or severity;

•
we acquire especially troubled operations or facilities that present unattractive risks to current or prospective insurers;

•
insurers tighten underwriting standards applicable to us or our industry; or

•
insurers or reinsurers are unable or unwilling to insure us or the industry at historical premiums and coverage levels.

If any of these potential circumstances were to occur, our insurance carriers may require us to significantly increase our self-insured retention levels or pay substantially higher premiums for the same or reduced coverage for insurance, including workers compensation, property and casualty, automobile, employment practices liability, directors and officers liability, employee healthcare and general and professional liability coverages.
 
In some states, the law prohibits or limits insurance coverage for the risk of punitive damages arising from professional liability and general liability claims or litigation. Coverage for punitive damages is also excluded under some insurance policies. As a result, we may be liable for punitive damage awards in these states that either are not covered or are in excess of our insurance policy limits. Claims against us, regardless of their merit or eventual outcome, also could inhibit our ability to attract patients or expand our business, and could require our management to devote time to matters unrelated to the day-to-day operation of our business.

With few exceptions, workers' compensation and employee health insurance costs have also increased markedly in recent years. To partially offset these increases, we have increased the amounts of our self-insured retention (SIR) and deductibles in connection with general and professional liability claims. We also have implemented a self-insurance program for workers compensation in California, and elected non-subscriber status for workers' compensation in Texas. If we are unable to obtain insurance, or if insurance becomes more costly for us to obtain, or if the coverage levels we can economically obtain decline, our business may be adversely affected.

Our self-insurance programs may expose us to significant and unexpected costs and losses.

We have maintained general and professional liability insurance since 2002 and workers' compensation insurance since 2005 through a wholly-owned subsidiary insurance company, Standardbearer Insurance Company, Ltd. (Standardbearer), to insure our SIR and deductibles as part of a continually evolving overall risk management strategy. We establish the insurance loss reserves based on an estimation process that uses information obtained from both company-specific and industry data. The estimation process requires us to continuously monitor and evaluate the life cycle of the claims. Using data obtained from this monitoring and our assumptions about emerging trends, we, along with an independent actuary, develop information about the size of ultimate claims based on our historical experience and other available industry information. The most significant assumptions used in the estimation process include determining the trend in costs, the expected cost of claims incurred but not reported and the expected costs to settle or pay damages with respect to unpaid claims. It is possible, however, that the actual liabilities may exceed our estimates of loss. We may also experience an unexpectedly large number of successful claims or claims that result in costs or liability significantly in excess of our projections. For these and other reasons, our self-insurance reserves could prove to be

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inadequate, resulting in liabilities in excess of our available insurance and self-insurance. If a successful claim is made against us and it is not covered by our insurance or exceeds the insurance policy limits, our business may be negatively and materially impacted.

Further, because our SIR under our general and professional liability and workers compensation programs applies on a per claim basis, there is no limit to the maximum number of claims or the total amount for which we could incur liability in any policy period.

In May 2006, we began self-insuring our employee health benefits. With respect to our health benefits self-insurance, our reserves and premiums are computed based on a mix of company specific and general industry data that is not specific to our own company. Even with a combination of limited company-specific loss data and general industry data, our loss reserves are based on actuarial estimates that may not correlate to actual loss experience in the future. Therefore, our reserves may prove to be insufficient and we may be exposed to significant and unexpected losses.

The geographic concentration of our facilities could leave us vulnerable to an economic downturn, regulatory changes or acts of nature in those areas.

Our facilities located in California, Texas and Arizona account for the majority of our total revenue. As a result of this concentration, the conditions of local economies, changes in governmental rules, regulations and reimbursement rates or criteria, changes in demographics, state funding, acts of nature and other factors that may result in a decrease in demand and/or reimbursement for skilled nursing services in these states could have a disproportionately adverse effect on our revenue, costs and results of operations. Moreover, since approximately 30% of our facilities are located in California, we are particularly susceptible to revenue loss, cost increase or damage caused by natural disasters such as fires, earthquakes or mudslides.

In addition, our facilities in Texas, Nebraska and Iowa are more susceptible to revenue loss, cost increases or damage caused by natural disasters including hurricanes, tornadoes and flooding. These acts of nature may cause disruption to us, our employees and our facilities, which could have an adverse impact on our patients and our business. In order to provide care for our patients, we are dependent on consistent and reliable delivery of food, pharmaceuticals, utilities and other goods to our facilities, and the availability of employees to provide services at our facilities. If the delivery of goods or the ability of employees to reach our facilities were interrupted in any material respect due to a natural disaster or other reasons, it would have a significant impact on our facilities and our business. Furthermore, the impact, or impending threat, of a natural disaster may require that we evacuate one or more facilities, which would be costly and would involve risks, including potentially fatal risks, for the patients. The impact of disasters and similar events is inherently uncertain. Such events could harm our patients and employees, severely damage or destroy one or more of our facilities, harm our business, reputation and financial performance, or otherwise cause our business to suffer in ways that we currently cannot predict.

The actions of a national labor union that has pursued a negative publicity campaign criticizing our business in the past may adversely affect our revenue and our profitability.

We continue to maintain our right to inform our employees about our views of the potential impact of unionization upon the workplace generally and upon individual employees. With one exception, to our knowledge the staffs at our facilities that have been approached to unionize have uniformly rejected union organizing efforts. If employees decide to unionize, our cost of doing business could increase, and we could experience contract delays, difficulty in adapting to a changing regulatory and economic environment, cultural conflicts between unionized and non-unionized employees, strikes and work stoppages, and we may conclude that affected facilities or operations would be uneconomical to continue operating.

The unwillingness on the part of both our management and staff to accede to union demands for “neutrality” and other concessions has resulted in a negative labor campaign by at least one labor union, the Service Employees International Union. From 2002 to 2007, this union, and individuals and organizations allied with or sympathetic to this union actively prosecuted a negative retaliatory publicity action, also known as a “corporate campaign,” against us and filed, promoted or participated in multiple legal actions against us. The union's campaign asserted, among other allegations, poor treatment of patients, inferior medical services provided by our employees, poor treatment of our employees, and health code violations by us. In addition, the union has publicly mischaracterized actions taken by the DHS against us and our facilities. In numerous cases, the union's allegations created the false impression that violations and other events that occurred at facilities prior to our acquisition of those facilities were caused by us. Since a large component of our business involves acquiring underperforming and distressed facilities, and improving the quality of operations at these facilities, we may have been associated with the past poor performance of these facilities. To the extent this union or another elects to directly or indirectly prosecute a corporate campaign against us or any of our facilities, our business could be negatively affected.


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The Service Employees International Union has issued in the past, and may again issue in the future, public statements alleging that we or other for-profit skilled nursing operators have engaged in unfair, questionable or illegal practices in various areas, including staffing, patient care, patient evaluation and treatment, billing and other areas and activities related to the industry and our operations. We continue to anticipate similar criticisms, charges and other negative publicity from such sources on a regular basis, particularly in the current political environment and following the recent December 2010 OIG report entitled “Questionable Billing by Skilled Nursing Facilities," described above in "The Office of the Inspector General or other organizations may choose to more closely scrutinize the billing practices of for-profit skilled nursing facilities, which could result in an increase in regulatory monitoring and oversight, decreased reimbursement rates, or otherwise adversely affect our business, financial condition and results of operations." Two of our facilities have been listed on the report. Such reports provide unions and their allies with additional opportunities to make negative statements about, and to encourage regulators to seek investigatory and enforcement actions against, the industry in general and non-union operators like us specifically. Although we believe that our operations and business practices substantially conform to applicable laws and regulations, we cannot predict the extent to which we might be subject to adverse publicity or calls for increased regulatory scrutiny from union and union ally sources, or what effect, if any, such negative publicity would have on us, but to the extent they are successful, our revenue may be reduced, our costs may be increased and our profitability and business could be adversely affected.

This union has also attempted to pressure hospitals, doctors, insurers and other healthcare providers and professionals to cease doing business with or referring patients to us. If this union or another union is successful in convincing our patients, their families or our referral sources to reduce or cease doing business with us, our revenue may be reduced and our profitability could be adversely affected. Additionally, if we are unable to attract and retain qualified staff due to negative public relations efforts by this or other union organizations, our quality of service and our revenue and profits could decline. Our strategy for responding to union allegations involves clear public disclosure of the union's identity, activities and agenda, and rebuttals to its negative campaign.

Our ability to respond to unions, however, may be limited by some state laws, which purport to make it illegal for any recipient of state funds to promote or deter union organizing. For example, such a state law passed by the California Legislature was successfully challenged on the grounds that it was preempted by the National Labor Relations Act, only to have the challenge overturned by the Ninth Circuit in 2006 before being ultimately upheld by the United States Supreme Court in 2008. In addition, proposed legislation making it more difficult for employees and their supervisors to educate co-workers and oppose unionization, such as the proposed Employee Free Choice Act which would allow organizing on a single “card check” and without a secret ballot and similar changes to federal law, regulation and labor practice being advocated by unions and considered by Congress and the National Labor Relations Board, could make it more difficult to maintain union-free workplaces in our facilities. If proponents of these and similar laws are successful in facilitating unionization procedures or hindering employer responses thereto, our ability to oppose unionization efforts could be hindered, and our business could be negatively affected.

A number of our facilities are operated under master lease arrangements or leases that contain cross-default provisions, and in some cases the breach of a single facility lease could subject multiple facilities to the same risk.

We currently occupy approximately 6% of our facilities under agreements that are structured as master leases. Under a master lease, we may lease a large number of geographically dispersed properties through an indivisible lease. With an indivisible lease, it is difficult to restructure the composition of the portfolio or economic terms of the lease without the consent of the landlord. Failure to comply with Medicare or Medicaid provider requirements is a default under several of our master lease and debt financing instruments. In addition, other potential defaults related to an individual facility may cause a default of an entire master lease portfolio and could trigger cross-default provisions in our outstanding debt arrangements and other leases, which would have a negative impact on our capital structure and our ability to generate future revenue, and could interfere with our ability to pursue our growth strategy.

In addition, we occupy approximately 7% of our facilities under individual facility leases that are held by the same or related landlords, the largest of which covers five of our facilities. These leases typically contain cross-default provisions that could cause a default at one facility to trigger a technical default with respect to one or more other locations, potentially subjecting us to the various remedies available to the landlords under each of the related leases.


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Failure to generate sufficient cash flow to cover required payments or meet operating covenants under our long-term debt, mortgages and long-term operating leases could result in defaults under such agreements and cross-defaults under other debt, mortgage or operating lease arrangements, which could harm our operations and cause us to lose facilities or experience foreclosures.

At September 30, 2012, we had $200.3 million of outstanding indebtedness under the Facility, Ten Project Note, promissory notes, bonds and mortgage notes, plus $128.1 million of operating lease obligations. We intend to continue financing our facilities through mortgage financing, long-term operating leases and other types of financing, including borrowings under our lines of credit and future credit facilities we may obtain.

We may not generate sufficient cash flow from operations to cover required interest, principal and lease payments. In addition, our outstanding credit facilities and mortgage loans contain restrictive covenants and require us to maintain or satisfy specified coverage tests on a consolidated basis and on a facility or facilities basis. These restrictions and operating covenants include, among other things, requirements with respect to occupancy, debt service coverage, project yield, net leverage ratios, minimum interest coverage ratios and minimum asset coverage ratios. These restrictions may interfere with our ability to obtain additional advances under existing credit facilities or to obtain new financing or to engage in other business activities, which may inhibit our ability to grow our business and increase revenue.

From time to time the financial performance of one or more of our mortgaged facilities may not comply with the required operating covenants under the terms of the mortgage. Any non-payment, noncompliance or other default under our financing arrangements could, subject to cure provisions, cause the lender to foreclose upon the facility or facilities securing such indebtedness or, in the case of a lease, cause the lessor to terminate the lease, each with a consequent loss of revenue and asset value to us or a loss of property. Furthermore, in many cases, indebtedness is secured by both a mortgage on one or more facilities, and a guaranty by us. In the event of a default under one of these scenarios, the lender could avoid judicial procedures required to foreclose on real property by declaring all amounts outstanding under the guaranty immediately due and payable, and requiring us to fulfill our obligations to make such payments. If any of these scenarios were to occur, our financial condition would be adversely affected. For tax purposes, a foreclosure on any of our properties would be treated as a sale of the property for a price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure, but would not receive any cash proceeds, which would negatively impact our earnings and cash position. Further, because our mortgages and operating leases generally contain cross-default and cross-collateralization provisions, a default by us related to one facility could affect a significant number of other facilities and their corresponding financing arrangements and operating leases.

Because our term loans, promissory notes, bonds, mortgages and lease obligations are fixed expenses and secured by specific assets, and because our revolving loan obligations are secured by virtually all of our assets, if reimbursement rates, patient acuity mix or occupancy levels decline, or if for any reason we are unable to meet our loan or lease obligations, we may not be able to cover our costs and some or all of our assets may become at risk. Our ability to make payments of principal and interest on our indebtedness and to make lease payments on our operating leases depends upon our future performance, which will be subject to general economic conditions, industry cycles and financial, business and other factors affecting our operations, many of which are beyond our control. If we are unable to generate sufficient cash flow from operations in the future to service our debt or to make lease payments on our operating leases, we may be required, among other things, to seek additional financing in the debt or equity markets, refinance or restructure all or a portion of our indebtedness, sell selected assets, reduce or delay planned capital expenditures or delay or abandon desirable acquisitions. Such measures might not be sufficient to enable us to service our debt or to make lease payments on our operating leases. The failure to make required payments on our debt or operating leases or the delay or abandonment of our planned growth strategy could result in an adverse effect on our future ability to generate revenue and sustain profitability. In addition, any such financing, refinancing or sale of assets might not be available on terms that are economically favorable to us, or at all.

If we decide to expand our presence in the assisted living, home health, hospice or urgent care industries, we would become subject to risks in a market in which we have limited experience.

The majority of our facilities have historically been skilled nursing facilities. If we decide to expand our presence in the assisted living, home health, hospice and urgent care industries or other relevant healthcare service, our existing overall business model would change and we would become subject to risks in a market in which we have limited experience. Although assisted living operations generally have lower costs and higher margins than skilled nursing, they typically generate lower overall revenue than skilled nursing operations. In addition, assisted living and urgent care revenue is derived primarily from private payors as opposed to government reimbursement. In most states, skilled nursing, assisted living, home health, hospice and urgent care are regulated by different agencies, and we have less experience with the agencies that regulate assisted living, home health, hospice and urgent care. In general, we believe that assisted living is a more competitive industry than skilled nursing. If we decided to

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expand our presence in the assisted living, home health, hospice and urgent care industries, we might have to adjust part of our existing business model, which could have an adverse effect on our business.

If our referral sources fail to view us as an attractive skilled nursing provider, or if our referral sources otherwise refer fewer patients, our patient base may decrease.

We rely significantly on appropriate referrals from physicians, hospitals and other healthcare providers in the communities in which we deliver our services to attract appropriate residents and patients to our facilities. Our referral sources are not obligated to refer business to us and may refer business to other healthcare providers. We believe many of our referral sources refer business to us as a result of the quality of our patient care and our efforts to establish and build a relationship with our referral sources. If we lose, or fail to maintain, existing relationships with our referral resources, fail to develop new relationships, or if we are perceived by our referral sources as not providing high quality patient care, our occupancy rate and the quality of our patient mix could suffer. In addition, if any of our referral sources have a reduction in patients whom they can refer due to a decrease in their business, our occupancy rate and the quality of our patient mix could suffer.

We may need additional capital to fund our operations and finance our growth, and we may not be able to obtain it on terms acceptable to us, or at all, which may limit our ability to grow.

Our ability to maintain and enhance our facilities and equipment in a suitable condition to meet regulatory standards, operate efficiently and remain competitive in our markets requires us to commit substantial resources to continued investment in our facilities and equipment. We are sometimes more aggressive than our competitors in capital spending to address issues that arise in connection with aging and obsolete facilities and equipment. In addition, continued expansion of our business through the acquisition of existing facilities, expansion of our existing facilities and construction of new facilities may require additional capital, particularly if we were to accelerate our acquisition and expansion plans. Financing may not be available to us or may be available to us only on terms that are not favorable. In addition, some of our outstanding indebtedness and long-term leases restrict, among other things, our ability to incur additional debt. If we are unable to raise additional funds or obtain additional funds on terms acceptable to us, we may have to delay or abandon some or all of our growth strategies. Further, if additional funds are raised through the issuance of additional equity securities, the percentage ownership of our stockholders would be diluted. Any newly issued equity securities may have rights, preferences or privileges senior to those of our common stock.

The condition of the financial markets, including volatility and deterioration in the capital and credit markets, could limit the availability of debt and equity financing sources to fund the capital and liquidity requirements of our business, as well as, negatively impact or impair the value of our current portfolio of cash, cash equivalents and investments, including U.S. Treasury securities and U.S.-backed investments.

Financial markets experienced significant disruptions from 2008 through 2010. These disruptions impacted liquidity in the debt markets, making financing terms for borrowers less attractive and, in certain cases, significantly reducing the availability of certain types of debt financing. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to borrowers.

Further, our cash, cash equivalents and investments are held in a variety of interest-bearing instruments, including U.S. treasury securities. As a result of the uncertain domestic and global political, credit and financial market conditions, investments in these types of financial instruments pose risks arising from liquidity and credit concerns. Given that future deterioration in the U.S. and global credit and financial markets is a possibility, no assurance can be made that losses or significant deterioration in the fair value of our cash, cash equivalents, or investments will not occur. Uncertainty surrounding the trading market for U.S. government securities or impairment of the U.S. government's ability to satisfy its obligations under such treasury securities could impact the liquidity or valuation of our current portfolio of cash, cash equivalents, and investments, a substantial portion of which were invested in U.S. treasury securities. Further, unless and until the current U.S. and global political, credit and financial market crisis has been sufficiently resolved, it may be difficult for us to liquidate our investments prior to their maturity without incurring a loss, which would have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Though we anticipate that the cash amounts generated internally, together with amounts available under the revolving credit facility portion of the Facility, will be sufficient to implement our business plan for the foreseeable future, we may need additional capital if a substantial acquisition or other growth opportunity becomes available or if unexpected events occur or opportunities arise. We cannot assure you that additional capital will be available or available on terms favorable to us. If capital is not available, we may not be able to fund internal or external business expansion or respond to competitive pressures or other market conditions.


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Delays in reimbursement may cause liquidity problems.

If we experience problems with our information systems or if issues arise with Medicare, Medicaid or other payors, we may encounter delays in our payment cycle. From time to time, we have experienced such delays as a result of government payors instituting planned reimbursement delays for budget balancing purposes or as a result of prepayment reviews. For example, in January 2009, the State of California announced expected cash shortages in February which impacted payments to Medi-Cal providers from late March through April. Medi-Cal had also delayed the release of the reimbursement rates which were announced in January 2010. These rate increases were put in place on a retrospective basis, effective August 1, 2009.

Further, on March 24, 2011, the governor of California signed Assembly Bill 97 (AB 97), the budget trailer bill on health, into law.  AB 97 outlines significant cuts to  state  health and human services programs.  Specifically, the law reduces provider payments by 10% for physicians, pharmacy, clinics, medical transportation, certain hospitals, home health, and nursing facilities.  AB X1 19 Long Term Care  was subsequently approved by the governor on June 28, 2011.  AB X1 19 limits  the 10% payment reduction to skilled-nursing providers to 14 months for the services provided on June 1, 2011 through July 31, 2012, with a promise to repay by December 31, 2012.  Federal approval was obtained on October 27, 2011. However, the application as to how the cash deferral will be applied is still being finalized. The effective date is to be June 1, 2011, or on such other date or dates as may be applicable.  The impact of this new law on us cannot be predicted with certainty as the application of the law has not been finalized.  There can be no assurance that the reduction in provider payments will not lead to material adverse consequences in the future.

Compliance with the regulations of the Department of Housing and Urban Development may require us to make unanticipated expenditures which could increase our costs.

Two of our facilities are currently subject to regulatory agreements with the Department of Housing and Urban Development (HUD) that give the Commissioner of HUD broad authority to require us to be replaced as the operator of those facilities in the event that the Commissioner determines there are operational deficiencies at such facilities under HUD regulations. In 2006, one of our HUD-insured mortgaged facilities did not pass its HUD inspection. Following an unsuccessful appeal of the decision, we requested a re-inspection. The re-inspection occurred in the fourth quarter of 2009 and the facility passed its HUD re-inspection. Compliance with HUD's requirements can often be difficult because these requirements are not always consistent with the requirements of other federal and state agencies. Appealing a failed inspection can be costly and time-consuming and, if we do not successfully remediate the failed inspection, we could be precluded from obtaining HUD financing in the future or we may encounter limitations or prohibitions on our operation of HUD-insured facilities.

Failure to comply with existing environmental laws could result in increased expenditures, litigation and potential loss to our business and in our asset value.

Our operations are subject to regulations under various federal, state and local environmental laws, primarily those relating to the handling, storage, transportation, treatment and disposal of medical waste; the identification and warning of the presence of asbestos-containing materials in buildings, as well as the encapsulation or removal of such materials; and the presence of other substances in the indoor environment.

Our facilities generate infectious or other hazardous medical waste due to the illness or physical condition of the patients. Each of our facilities has an agreement with a waste management company for the proper disposal of all infectious medical waste, but the use of a waste management company does not immunize us from alleged violations of such laws for operations for which we are responsible even if carried out by a third party, nor does it immunize us from third-party claims for the cost to cleanup disposal sites at which such wastes have been disposed.

Some of the facilities we lease, own or may acquire may have asbestos-containing materials. Federal regulations require building owners and those exercising control over a building's management to identify and warn their employees and other employers operating in the building of potential hazards posed by workplace exposure to installed asbestos-containing materials and potential asbestos-containing materials in their buildings. Significant fines can be assessed for violation of these regulations. Building owners and those exercising control over a building's management may be subject to an increased risk of personal injury lawsuits. Federal, state and local laws and regulations also govern the removal, encapsulation, disturbance, handling and disposal of asbestos-containing materials and potential asbestos-containing materials when such materials are in poor condition or in the event of construction, remodeling, renovation or demolition of a building. Such laws may impose liability for improper handling or a release into the environment of asbestos containing materials and potential asbestos-containing materials and may provide for fines to, and for third parties to seek recovery from, owners or operators of real properties for personal injury or improper work exposure associated with asbestos-containing materials and potential asbestos-containing materials. The presence of asbestos-containing materials, or the failure to properly dispose of or remediate such materials, also may adversely affect our ability to attract and retain patients and staff, to borrow when using such property as collateral or to make improvements to such property.

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The presence of mold, lead-based paint, underground storage tanks, contaminants in drinking water, radon and/or other substances at any of the facilities we lease, own or may acquire may lead to the incurrence of costs for remediation, mitigation or the implementation of an operations and maintenance plan and may result in third party litigation for personal injury or property damage. Furthermore, in some circumstances, areas affected by mold may be unusable for periods of time for repairs, and even after successful remediation, the known prior presence of extensive mold could adversely affect the ability of a facility to retain or attract patients and staff and could adversely affect a facility's market value and ultimately could lead to the temporary or permanent closure of the facility.

If we fail to comply with applicable environmental laws, we would face increased expenditures in terms of fines and remediation of the underlying problems, potential litigation relating to exposure to such materials, and a potential decrease in value to our business and in the value of our underlying assets.

In addition, because environmental laws vary from state to state, expansion of our operations to states where we do not currently operate may subject us to additional restrictions in the manner in which we operate our facilities.

If we fail to safeguard the monies held in our patient trust funds, we will be required to reimburse such monies, and we may be subject to citations, fines and penalties.

Each of our facilities is required by federal law to maintain a patient trust fund to safeguard certain assets of their residents and patients. If any money held in a patient trust fund is misappropriated, we are required to reimburse the patient trust fund for the amount of money that was misappropriated. In 2005 we became aware of two separate and unrelated instances of employees misappropriating an aggregate of approximately $0.4 million in patient trust funds, some of which was recovered from the employees and some of which we were required to reimburse from our funds. If any monies held in our patient trust funds are misappropriated in the future and are unrecoverable, we will be required to reimburse such monies, and we may be subject to citations, fines and penalties pursuant to federal and state laws.

We are a holding company with no operations and rely upon our multiple independent operating subsidiaries to provide us with the funds necessary to meet our financial obligations. Liabilities of any one or more of our subsidiaries could be imposed upon us or our other subsidiaries.

We are a holding company with no direct operating assets, employees or revenues. Each of our facilities is operated through a separate, wholly-owned, independent subsidiary, which has its own management, employees and assets. Our principal assets are the equity interests we directly or indirectly hold in our multiple operating and real estate holding subsidiaries. As a result, we are dependent upon distributions from our subsidiaries to generate the funds necessary to meet our financial obligations and pay dividends. Our subsidiaries are legally distinct from us and have no obligation to make funds available to us. The ability of our subsidiaries to make distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization, which may limit the amount of funds available for distribution to investors or shareholders, agreements of those subsidiaries, the terms of our financing arrangements and the terms of any future financing arrangements of our subsidiaries.

Risks Related to Ownership of our Common Stock

We may not be able to pay or maintain dividends and the failure to do so would adversely affect our stock price.

Our ability to pay and maintain cash dividends is based on many factors, including our ability to make and finance acquisitions, our ability to negotiate favorable lease and other contractual terms, anticipated operating cost levels, the level of demand for our beds, the rates we charge and actual results that may vary substantially from estimates. Some of the factors are beyond our control and a change in any such factor could affect our ability to pay or maintain dividends. In addition, the revolving credit facility portion of the Facility restricts our ability to pay dividends to stockholders if we receive notice that we are in default under this agreement. The failure to pay or maintain dividends could adversely affect our stock price.


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If the ownership of our common stock continues to be highly concentrated, it may prevent you and other stockholders from influencing significant corporate decisions and may result in conflicts of interest that could cause our stock price to decline.

Our current executive officers, directors and their affiliates, if they act together, will have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transactions. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors' perception that conflicts of interest may exist or arise.

The market price and trading volume of our common stock may be volatile, which could result in rapid and substantial losses for our stockholders.

The market price of our common stock may be highly volatile and could be subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. On some occasions in the past, when the market price of a stock has been volatile, holders of that stock have instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending or settling the lawsuit. Such a lawsuit could also divert the time and attention of our management from our business.

Future offerings of debt or equity securities by us may adversely affect the market price of our common stock.

In the future, we may attempt to increase our capital resources by offering debt or additional equity securities, including commercial paper, medium-term notes, senior or subordinated notes, series of preferred shares or shares of our common stock. Upon liquidation, holders of our debt securities and preferred shares, and lenders with respect to other borrowings, would receive a distribution of our available assets prior to any distribution to the holders of our common stock. Additional equity offerings may dilute the economic and voting rights of our existing stockholders or reduce the market price of our common stock, or both. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, holders of our common stock bear the risk of our future offerings reducing the market price of our common stock and diluting their shareholdings in us. We also intend to continue to actively pursue acquisitions of facilities and may issue shares of stock in connection with these acquisitions.

Any shares issued in connection with our acquisitions, the exercise of outstanding stock options or otherwise would dilute the holdings of the investors who purchase our shares.

Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could result in a restatement of our financial statements, cause investors to lose confidence in our financial statements and our company and have a material adverse effect on our business and stock price.

We produce our consolidated financial statements in accordance with the requirements of GAAP. Effective internal controls are necessary for us to provide reliable financial reports to help mitigate the risk of fraud and to operate successfully as a publicly traded company. As a public company, we are required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, which requires annual management assessments of the effectiveness of our internal controls over financial reporting.

Testing and maintaining internal controls can divert our management's attention from other matters that are important to our business. We may not be able to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 or our independent registered public accounting firm may not be able or willing to issue an unqualified report if we conclude that our internal controls over financial reporting are not effective. If either we are unable to conclude that we have effective internal controls over financial reporting or our independent registered public accounting firm is unable to provide us with an unqualified report as required by Section 404, investors could lose confidence in our reported financial information and our company, which could result in a decline in the market price of our common stock, and cause us to fail to meet our reporting obligations in the future, which in turn could impact our ability to raise additional financing if needed in the future.


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Our amended and restated certificate of incorporation, amended and restated bylaws and Delaware law contain provisions that could discourage transactions resulting in a change in control, which may negatively affect the market price of our common stock.

In addition to the effect that the concentration of ownership by our significant stockholders may have, our amended and restated certificate of incorporation and our amended and restated bylaws contain provisions that may enable our management to resist a change in control. These provisions may discourage, delay or prevent a change in the ownership of our company or a change in our management, even if doing so might be beneficial to our stockholders. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock. Such provisions set forth in our amended and restated certificate of incorporation or amended and restated bylaws include:

•
our board of directors are authorized, without prior stockholder approval, to create and issue preferred stock, commonly referred to as “blank check” preferred stock, with rights senior to those of common stock;

•
advance notice requirements for stockholders to nominate individuals to serve on our board of directors or to submit proposals that can be acted upon at stockholder meetings;

•
our board of directors are classified so not all members of our board are elected at one time, which may make it more difficult for a person who acquires control of a majority of our outstanding voting stock to replace our directors;

•
stockholder action by written consent is limited;

•
special meetings of the stockholders are permitted to be called only by the chairman of our board of directors, our chief executive officer or by a majority of our board of directors;

•
stockholders are not permitted to cumulate their votes for the election of directors;

•
newly created directorships resulting from an increase in the authorized number of directors or vacancies on our board of directors are filled only by majority vote of the remaining directors;

•
our board of directors is expressly authorized to make, alter or repeal our bylaws; and

•
stockholders are permitted to amend our bylaws only upon receiving the affirmative vote of at least a majority of our outstanding common stock.

These and other provisions in our amended and restated certificate of incorporation, amended and restated bylaws and Delaware law could discourage acquisition proposals and make it more difficult or expensive for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including delaying or impeding a merger, tender offer or proxy contest involving us. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.


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Item 2.        Unregistered Sales of Equity Securities and Use of Proceeds
None.

Item 3.        Defaults Upon Senior Securities
None.

Item 4.        Mine Safety Disclosures

None.

Item 5.        Other Information
None.


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Item 6.        Exhibits
EXHIBIT INDEX
Exhibit
 
Description
 

 
 
31.1

 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 

 
 
31.2

 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 

 
 
32.1

 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 

 
 
32.2

 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101

 
Interactive data file (furnished electronically herewith pursuant to Rule 406T of Regulation S-T)


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
THE ENSIGN GROUP, INC.
 
 
 
November 7, 2012
BY: 
/s/ SUZANNE D. SNAPPER  
 
 
Suzanne D. Snapper 
 
 
Chief Financial Officer and
Duly Authorized Officer 


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EXHIBIT INDEX
Exhibit
 
Description
 

 
 
31.1

 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 

 
 
31.2

 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 

 
 
32.1

 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 

 
 
32.2

 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101

 
Interactive data file (furnished electronically herewith pursuant to Rule 406T of Regulation S-T)



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