Genesis Healthcare, Inc. - Quarter Report: 2010 September (Form 10-Q)

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (do not check if smaller reporting company)

Smaller reporting company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2010.

¨	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: 001-33459

Skilled Healthcare Group, Inc.

(Exact name of registrant as specified in its charter)


Delaware		20-3934755
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

27442 Portola Parkway, Suite 200
Foothill Ranch, California		92610
(Address of principal executive offices)		(Zip Code)

(949) 282-5800

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a 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.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on October 31, 2010.

Class A common stock, $0.001 par value – 20,788,941 shares

Class B common stock, $0.001 par value – 17,000,668 shares

Skilled Healthcare Group, Inc.

Form 10-Q

For the Quarterly Period Ended September 30, 2010

Index


		Page Number
Part I.	Financial Information
Item 1.	Financial Statements		3
	Condensed Consolidated Balance Sheets —September 30, 2010 (unaudited) and December 31, 2009		3
	Condensed Consolidated Statements of Operations — Three and nine months ended September 30, 2010 (unaudited) and September 30, 2009 (unaudited)		4
	Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2010 (unaudited) and September 30, 2009 (unaudited)		5
	Notes to Unaudited Condensed Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		57
Item 4.	Controls and Procedures		58
Part II.	Other Information
Item 1.	Legal Proceedings		60
Item 1A.	Risk Factors		60
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		60
Item 3.	Defaults Upon Senior Securities		60
Item 4.	Reserved		60
Item 5.	Other Information		60
Item 6.	Exhibits		60
Signatures.			61

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

Skilled Healthcare Group, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except per share data)


	September 30, 2010			December 31, 2009
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	3,200		$	3,528
Accounts receivable, less allowance for doubtful accounts of $18,828 and $21,318 at September 30, 2010 and December 31, 2009, respectively		94,771			96,610
Deferred income taxes		19,695			15,003
Prepaid expenses		6,107			8,159
Other current assets		20,747			8,303

Total current assets		144,520			131,603
Property and equipment, less accumulated depreciation of $75,072 and $59,448 at September 30, 2010 and December 31, 2009, respectively		380,662			373,211
Other assets:
Notes receivable		6,675			8,060
Deferred financing costs, net		13,991			13,425
Goodwill		336,404			279,362
Intangible assets, less accumulated amortization of $15,875 and $14,413 at September 30, 2010 and December 31, 2009, respectively		28,293			26,297
Other assets		24,791			24,284

Total other assets		410,154			351,428

Total assets	$	935,336		$	856,242

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	46,526		$	49,355
Employee compensation and benefits		32,691			29,753
Current portion of long-term debt and capital leases		8,295			7,823

Total current liabilities		87,512			86,931
Long-term liabilities:
Insurance liability risks		25,313			27,407
Deferred income taxes		4,313			3,200
Other long-term liabilities		16,933			12,426
Long-term debt and capital leases, less current portion		536,010			450,856

Total liabilities		670,081			580,820
Stockholders’ equity:
Class A common stock, 175,000 shares authorized, $0.001 par value per share; 20,789 and 20,334 issued and outstanding at September 30, 2010 and December 31, 2009, respectively		21			20
Class B common stock, 30,000 shares authorized, $0.001 par value per share; 17,001 and 17,001 issued and outstanding at September 30, 2010 and December 31, 2009, respectively		17			17
Additional paid-in-capital		367,245			365,126
Accumulated deficit		(101,663	)		(89,781	)
Accumulated other comprehensive (loss) income		(365	)		40

Total stockholders’ equity		265,255			275,422

Total liabilities and stockholders’ equity	$	935,336		$	856,242

The accompanying notes are an integral part of these condensed consolidated financial statements.

Skilled Healthcare Group, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Revenue	$	209,199		$	187,447		$	599,489		$	567,675
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)		168,579			151,539			482,291			453,195
Rent cost of revenue		4,796			4,509			14,209			13,568
General and administrative		6,016			6,343			18,479			19,406
Litigation settlement costs		53,505			—			53,505			—
Depreciation and amortization		6,305			6,014			18,241			17,358

		239,201			168,405			586,725			503,527

Other income (expenses):
Interest expense		(10,086	)		(8,417	)		(26,535	)		(24,748	)
Interest income		260			285			684			896
Other income (expense)		9			59			588			(1	)
Equity in earnings of joint venture		746			746			2,221			2,230
Debt retirement costs		—			—			(7,010	)		—

Total other expenses, net		(9,071	)		(7,327	)		(30,052	)		(21,623	)

(Loss) Income from continuing operations before provision for income taxes		(39,073	)		11,715			(17,288	)		42,525
(Benefit) Provision for income taxes		(13,766	)		2,420			(5,406	)		14,000

(Loss) Income from continuing operations		(25,307	)		9,295			(11,882	)		28,525
Loss from discontinued operations, net of tax		—			(243	)		—			(390	)

Net (loss) income	$	(25,307	)	$	9,052		$	(11,882	)	$	28,135

(Loss) earnings per share, basic:
(Loss) earnings per common share from continuing operations	$	(0.68	)	$	0.25		$	(0.32	)	$	0.77
Loss per common share from discontinued operations		—			(0.01	)		—			(0.01	)

(Loss) earnings per share	$	(0.68	)	$	0.24		$	(0.32	)	$	0.76

(Loss) earnings per share, diluted:
(Loss) earnings per common share from continuing operations	$	(0.68	)	$	0.25		$	(0.32	)	$	0.77
Loss per common share from discontinued operations		—			(0.01	)		—			(0.01	)

(Loss) earnings per share	$	(0.68	)	$	0.24		$	(0.32	)	$	0.76

Weighted-average common shares outstanding, basic		36,997			36,927			36,981			36,904

Weighted-average common shares outstanding, diluted		36,997			36,950			36,981			36,943

The accompanying notes are an integral part of these condensed consolidated financial statements.

Skilled Healthcare Group, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)


	Nine Months Ended September 30,
	2010			2009
Cash Flows from Operating Activities
Net (loss) income from continuing operations	$	(11,882	)	$	28,525
Net loss from discontinued operations		—			(390	)

Net (loss) income		(11,882	)		28,135
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		18,241			17,358
Provision for doubtful accounts		7,426			8,332
Non-cash stock-based compensation		2,203			1,738
Disposal of fixed assets		(479	)		61
Amortization of deferred financing costs		3,067			3,289
Tax benefit from reversal of accrual for uncertain tax positions		—			(2,204	)
Write-off of deferred financing costs		6,574			—
Deferred income taxes		(3,387	)		4,324
Amortization of discount and accretion on debt		318			80
Change in the fair value of acquisition-related contingent consideration		125			—
Changes in operating assets and liabilities:
Accounts receivable		(7,862	)		(16,740	)
Payments on notes receivable		3,400			3,412
Other current and non-current assets		(9,637	)		5,788
Accounts payable and accrued liabilities		(3,066	)		(7,102	)
Employee compensation and benefits		2,812			253
Insurance liability risks		(4,700	)		(2,151	)
Other long-term liabilities		985			834

Net cash provided by operating activities		4,138			45,407

Cash Flows from Investing Activities
Additions to property and equipment		(23,161	)		(29,182	)
Acquisition of healthcare facilities and businesses		(45,380	)		(1,650	)

Net cash used in investing activities		(68,541	)		(30,832	)

Cash Flows from Financing Activities
Borrowings under line of credit		155,000			62,500
Repayments under line of credit		(182,000	)		(60,500	)
Repayments of long-term debt and capital leases		(256,018	)		(7,825	)
Proceeds from issuance of long-term debt		357,300			—
Additions to deferred financing costs		(10,207	)		(7,952	)

Net cash provided by (used in) financing activities		64,075			(13,777	)

Cash flows from discontinued operations		—			390

(Decrease) increase in cash and cash equivalents		(328	)		1,188
Cash and cash equivalents at beginning of period		3,528			2,047

Cash and cash equivalents at end of period	$	3,200		$	3,235

The accompanying notes are an integral part of these condensed consolidated financial statements.


	Nine Months Ended September 30,
	2010		2009
Supplemental cash flow information
Cash paid for:
Interest expense, net of capitalized interest	$	23,832	$	26,188
Income taxes, net	$	10,079	$	13,258
Non-cash activities:
Conversion of accounts receivable into notes receivable, net	$	2,403	$	10,257
Liabilities issued as purchase consideration for purchase of business	$	15,030	$	—
Insurance premium financed	$	1,100	$	7,970

The accompanying notes are an integral part of these condensed consolidated financial statements.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Description of Business

Current Business

Skilled Healthcare Group, Inc. (“Skilled”) is a holding company that owns subsidiaries that operate long-term care facilities and provide a wide range of post-acute care services, with a strategic emphasis on sub-acute specialty medical care. Skilled and its consolidated wholly owned companies are collectively referred to as the “Company.” As of September 30, 2010, the Company operated facilities in California, Iowa, Kansas, Missouri, Nevada, New Mexico and Texas, including 79 skilled nursing facilities (“SNFs”), which offer sub-acute care and rehabilitative and specialty healthcare skilled nursing care, and 22 assisted living facilities (“ALFs”), which provide room and board and social services. In addition, the Company provides a variety of ancillary services such as physical, occupational and speech therapy in Company-operated facilities and unaffiliated facilities. Furthermore, as of September 30, 2010, the Company provided hospice care in the Arizona, California, Idaho, Montana, Nevada and New Mexico markets. Additionally, the company operates home health agencies in Nevada, Arizona, Idaho, and Montana. The Company also has an administrative service company that provides a full complement of administrative and consultative services that allows its facility operators, those unrelated facility operator, with whom the Company contracts, and the Company’s ancillary healthcare operators to better focus on delivery of healthcare services. The Company has one such agreement with an unrelated facility operator. The Company is also a member in a joint venture located in Texas that provides institutional pharmacy services, which currently serves eight of the Company’s SNFs and other facilities unaffiliated with the Company.

Recent Developments

On September 7, 2010, the Company reached an agreement to settle the case entitled, VINNIE LAVENDER, by and through her Conservator, WANDA BAKER; WALTER SIMON; JACQUELYN VILCHINSKY vs. SKILLED HEALTHCARE GROUP, INC., et al. (and twenty-two individually-named California nursing facilities receiving administrative services from Skilled Healthcare, LLC) (see Note 8). As part of the settlement, the Company and other defendants entered into separate settlement agreements with the plaintiffs and the Humboldt County District Attorney’s Office, each dated as of September 7, 2010.

Under the terms of the settlement agreements, the Company deposited a total of $50 million into escrow accounts to cover settlement payments to class members, notice and claims administration costs, reasonable attorneys’ fees and costs (in an amount to be determined and approved by the Humboldt County Court) and certain other payments.

The settlement agreements also institute an injunction, pursuant to which the twenty-two defendants that operate California nursing facilities must provide specified nurse staffing levels, comply with specified state and federal laws governing staffing levels and posting requirements, and provide reports and information to a monitor. The injunction will remain in effect for a period of 24 months unless extended for additional three month periods as to those defendants that may be found in violation. Defendants demonstrating compliance for an 18 month period may petition for early termination of the injunction. The Company is required to demonstrate over the term of the injunction that the costs of the injunction are at least $9.6 million. The injunction costs include, among other things, costs attributable to (i) enhanced reporting requirements; (ii) implementing advanced staffing tracking systems; (iii) fees and expenses paid to an auditor and special master; (iv) increased labor and labor related expenses; and (v) lost revenues attributable to admission decisions based on compliance with the terms and conditions of the injunction. To the extent the costs of complying with the injunction are less than $9.6 million, the Company will be required to remit any shortfall to the settlement fund.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Pursuant to the settlement agreements, the plaintiffs and the Humboldt County District Attorney’s Office, as Intervenor on behalf of the People of the State of California, agreed to release the Company and the other defendants from claims related to the causes of action alleged in the Lavender case, as further described in the settlement agreements, which were filed as exhibits to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission (the “SEC”) on September 8, 2010. Neither of the settlement agreements contains an admission or concession of wrongdoing by the Company or any other defendants. See Note 8, Commitments and Contingencies—Litigation, for more information.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 (collectively, the “Interim Financial Statements”), are unaudited. Certain information and footnote disclosures normally included in the Company’s 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 financial statements and notes thereto for the year ended December 31, 2009, which are included in the Company’s 2009 Annual Report on Form 10-K filed with the SEC. Management believes that the Interim Financial Statements reflect all adjustments that are of a normal and recurring nature necessary to fairly present the Company’s financial position and results of operations and cash flows in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.

The accompanying Interim Financial Statements include the accounts of the Company and the Company’s wholly owned companies. All significant intercompany transactions have been eliminated in consolidation.

Estimates and Assumptions

The preparation of the Interim Financial Statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to consolidate subsidiary financial information and 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 revenues and expenses during the reporting period. The most significant estimates in the Interim Financial Statements relate to revenue, allowance for doubtful accounts, the self-insured portion of general and professional liability and workers’ compensation claims and income taxes. Actual results could differ from those estimates.

Information regarding the Company’s significant accounting policies is contained in “Summary of Significant Accounting Policies” in Note 2 in the Company’s 2009 Annual Report on Form 10-K filed with the SEC.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Reclassifications

Certain prior year amounts have been reclassified to conform to current year presentation, including payments on notes receivable in the statement on cash flows and total assets by segment. Payments on notes receivable of $3.4 million for the nine months ended September 30, 2009 were reclassified from investing activity to operating activity in the statement of cash flows and other long term liabilities of $0.3 million for the nine months ended September 30, 2009 were reclassified to tax benefit from reversal of accrual for uncertain tax positions within operating activities in the statement of cash flows. Certain reimbursable room and board costs within the Company’s hospice reporting unit were reclassified from revenue to cost of service in the amount of $0.9 million for the three months ended September 30, 2009 and $3.0 million for the nine months ended September 30, 2009 because they are more appropriately deemed to be pass-through costs.

Revenue and Accounts Receivable

Revenue and accounts receivable are recorded on an accrual basis as services are performed at their estimated net realizable value.

As of September 30, 2010, notes receivable were approximately $11.4 million, of which $4.7 million was reflected as current assets, with the remaining balances reflected as long-term assets. Interest rates on these notes approximate market rates as of the date the notes were delivered.

As of September 30, 2010, three Hallmark Rehabilitation business customers had outstanding notes receivable of $10.2 million, or 90% of the total notes receivable balance. These notes receivable as well as the trade receivables from these customers are guaranteed by the assets of the customers as well as personally guaranteed by the principal owners of the customers. As of September 30, 2010, these three customers represented 74.2% of the net accounts receivable for the Company’s rehabilitation therapy services company. For the nine months ended September 30, 2010, these three customers represented approximately 60.5% of the rehabilitation therapy services company external revenue. The remaining notes receivable of $1.2 million, or 10% of the notes receivable balance, are primarily past due accounts converted from accounts receivable to notes receivable.

The notes receivable allowance for uncollectibility as of September 30, 2010 is $0.7 million.

Goodwill and Intangible Assets

Goodwill is accounted for under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations,” and represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for as purchases. In accordance with FASB ASC Topic 350, “Intangibles – Goodwill and Other,” goodwill is subject to periodic testing for impairment. Goodwill of a reporting unit is tested for impairment on an annual basis, or, if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount, between annual testing. The Company has selected October 1 as the date to test goodwill for impairment on an annual basis. As of September 30, 2010, the Company’s carrying value of equity exceeded its market capitalization by approximately $113 million, or 79%, which is a potential indication of impairment. There are a number of changes to the Company’s reimbursement rates that have recently become effective. These include rate changes in several states for which the Company has not yet received rate letters, and Resource Utilization Groups, Version 4 (“RUGs IV”) and MDS 3.0, described in Management’s Discussion and Analysis of Financial Condition and Results of Operations “Sources of Revenue—Medicare”, which have only both been effective since October 1, 2010. The Company is continuing to evaluate the impact of these reimbursement changes. The Company performed a

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

goodwill impairment analysis as of September 30, 2010 and concluded that there was no impairment as of that date. The Company will update its goodwill impairment analysis during the fourth quarter of 2010. The Company did not record any impairment charges for the three and nine months ended September 30, 2010 and 2009.

Interests in joint ventures

Joint ventures are entities over which the Company has significant influence but not control, generally achieved by a shareholding of 50% of the voting rights. The equity method is used to account for investments in joint ventures and investments are initially recognized at cost.

3. Earnings Per Share of Class A Common Stock and Class B Common Stock

The Company computes earnings per share of Class A common stock and Class B common stock in accordance with FASB ASC Topic 260, “Earnings per Share,” using the two-class method. The Company’s Class A common stock and Class B common stock are identical in all respects, except with respect to voting rights and except that each share of Class B common stock is convertible into one share of Class A common stock under certain circumstances. Net income is allocated on a proportionate basis to each class of common stock in the determination of earnings per share.

Basic earnings per share were computed by dividing net income by the weighted-average number of outstanding shares for the period. Dilutive earnings per share is computed by dividing net income plus the effect of assumed conversions (if applicable) by the weighted-average number of outstanding shares after giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and convertible preferred stock, if any.

The following table sets forth the computation of basic and diluted earnings per share of Class A common stock and Class B common stock for the three and nine months ended September 30, 2010 and 2009 (amounts in thousands, except per share data):

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)


	Three Months Ended September 30, 2010									Three Months Ended September 30, 2009									Nine Months Ended September 30, 2010									Nine Months Ended September 30, 2009
	Class A			Class B			Total			Class A			Class B			Total			Class A			Class B			Total			Class A			Class B			Total
(Loss) earnings per share, basic

Numerator:
Allocation of net (loss) income from continuing operations	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	5,015		$	4,280		$	9,295		$	(6,420	)	$	(5,462	)	$	(11,882	)	$	15,374		$	13,151		$	28,525
Allocation of loss from discontinued operations		—			—			—			(131	)		(112	)		(243	)		—			—			—			(210	)		(180	)		(390	)

Allocation of net (loss) income	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	4,884		$	4,168		$	9,052		$	(6,420	)	$	(5,462	)	$	(11,882	)	$	15,164		$	12,971		$	28,135


(Loss) earnings per share, diluted

Numerator:
Allocation of net (loss) income from continuing operations	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	5,018		$	4,277		$	9,295		$	(6,420	)	$	(5,462	)	$	(11,882	)	$	15,386		$	13,139		$	28,525
Allocation of loss from discontinued operations		—			—			—			(131	)		(112	)		(243	)		—			—			—			(210	)		(180	)		(390	)

Allocation of net (loss) income	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	4,887		$	4,165		$	9,052		$	(6,420	)	$	(5,462	)	$	(11,882	)	$	15,176		$	12,959		$	28,135


Denominator for basic and diluted earnings per share:
Weighted average common shares outstanding, basic		19,996			17,001			36,997			19,923			17,004			36,927			19,980			17,001			36,981			19,890			17,014			36,904

Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable		—			—			—			23			—			23			—			—			—			37			2			39

Adjusted weighted-average common shares outstanding, diluted		19,996			17,001			36,997			19,946			17,004			36,950			19,980			17,001			36,981			19,927			17,016			36,943

(Loss) earnings per share, basic:
(Loss) earnings per common share from continuing operations	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	0.25		$	0.25		$	0.25		$	(0.32	)	$	(0.32	)	$	(0.32	)	$	0.77		$	0.77		$	0.77
Loss per common share from discontinued operations		—			—			—			(0.01	)		(0.01	)		(0.01	)		—			—			—			(0.01	)		(0.01	)		(0.01	)

(Loss) earnings per share	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	0.24		$	0.24		$	0.24		$	(0.32	)	$	(0.32	)	$	(0.32	)	$	0.76		$	0.76		$	0.76
(Loss) earnings per share, diluted:
(Loss) earnings per common share from continuing operations	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	0.25		$	0.25		$	0.25		$	(0.32	)	$	(0.32	)	$	(0.32	)	$	0.77		$	0.77		$	0.77
Loss per common share from discontinued operations		—			—			—			(0.01	)		(0.01	)		(0.01	)		—			—			—			(0.01	)		(0.01	)		(0.01	)

(Loss) earnings per share	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	0.24		$	0.24		$	0.24		$	(0.32	)	$	(0.32	)	$	(0.32	)	$	0.76		$	0.76		$	0.76

The following were excluded from the weighted-average diluted shares computation for the three and nine months ended September 30, 2010 and 2009, as their inclusion would have been anti-dilutive (shares in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009
Options to purchase common shares		2,424		613		1,045		507
Non-vested common shares		859		319		5		23

Total excluded		3,283		932		1,050		530

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

4. Business Segments

The Company has two reportable operating segments — Long Term Care (“LTC”), which includes the operation of SNFs and ALFs and is the most significant portion of the Company’s business, and ancillary services, which includes the Company’s rehabilitation therapy, hospice, and home health businesses. The “other” category includes general and administrative items. The Company’s reporting segments are business units that offer different services, and that are managed differently due to the nature of the services provided or the products sold.

At September 30, 2010, LTC services are provided by 79 wholly owned SNF operating companies that offer post-acute, rehabilitative and specialty skilled nursing care, as well as 22 wholly owned ALF operating companies that provide room and board and social services. Ancillary services include rehabilitative services such as physical, occupational and speech therapy provided in the Company’s facilities and in unaffiliated facilities by its wholly owned operating company, Hallmark Rehabilitation GP, LLC. Also included in the ancillary services segment are the Company’s hospice and home health businesses. The Company’s hospice business began providing care to patients in October 2004 and expanded due to (the “Hospice/Home Health Acquisition’). As a result of this acquisition, the Company began providing home health services, which entails direct home nursing and therapy services operations through licensed and Medicare-certified agencies.

The Company evaluates performance and allocates capital resources to each segment based on an operating model that is designed to maximize the quality of care provided and profitability. Accordingly, earnings before net interest, tax, depreciation and amortization (“EBITDA”) is used as the primary measure of each segment’s operating results because it does not include such costs as interest expense, income taxes, depreciation and amortization which may vary from segment to segment depending upon various factors, including the method used to finance the original purchase of a segment or the tax law of the states in which a segment operates. By excluding these items, the Company is better able to evaluate operating performance of the segment by focusing on more controllable measures. General and administrative expenses are not allocated to any segment for purposes of determining segment profit or loss, and are included in the “other” category in the selected segment financial data that follows. The accounting policies of the reporting segments are the same as those described in the accounting policies (see Note 2 above) included in the Company’s 2009 Annual Report on Form 10-K filed with the SEC. Intersegment sales and transfers are recorded at cost plus standard mark-up; intersegment transactions have been eliminated in consolidation.

The following table sets forth selected financial data consolidated by business segment (dollars in thousands):

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)


	Long-term Care Services			Ancillary Services		Other			Elimination			Total
Three Months Ended September 30, 2010
Revenue from external customers	$	172,591		$	36,608	$	—		$	—		$	209,199
Intersegment revenue		324			17,177		—			(17,501	)		—

Total revenue	$	172,915		$	53,785	$	—		$	(17,501	)	$	209,199

Operating income (loss)	$	(31,028	)	$	7,833	$	(6,807	)	$	—		$	(30,002	)
Interest expense, net of interest income													(9,826	)
Other income													9
Equity in earnings of joint venture													746

Loss before provision for income taxes												$	(39,073	)

Depreciation and amortization	$	5,844		$	213	$	248		$	—		$	6,305

Segment capital expenditures	$	4,461		$	819	$	80		$	—		$	5,360

EBITDA(1)	$	(25,175	)	$	8,163	$	(5,930	)	$	—		$	(22,942	)


Three Months Ended September 30, 2009
Revenue from external customers	$	166,224		$	21,223	$	—		$	—		$	187,447
Intersegment revenue		793			16,590		—			(17,383	)		—

Total revenue	$	167,017		$	37,813	$	—		$	(17,383	)	$	187,447

Operating income (loss)	$	22,244		$	3,475	$	(6,677	)	$	—		$	19,042
Interest expense, net of interest income													(8,132	)
Other expense													59
Equity in earnings of joint venture													746

Income before provision for income taxes												$	11,715

Depreciation and amortization	$	5,560		$	149	$	305		$	—		$	6,014

Segment capital expenditures	$	10,064		$	34	$	157		$	—		$	10,255

EBITDA(1)	$	27,803		$	3,551	$	(5,736	)	$	—		$	25,618


	Long-term Care Services			Ancillary Services		Other			Elimination			Total
Nine Months Ended September 30, 2010
Revenue from external customers	$	511,830		$	87,659	$	—		$	—		$	599,489
Intersegment revenue		1,011			50,629		—			(51,640	)		—

Total revenue	$	512,841		$	138,288	$	—		$	(51,640	)	$	599,489

Operating income (loss)	$	12,639		$	19,974	$	(19,849	)	$	—		$	12,764
Interest expense, net of interest income													(25,851	)
Other income													588
Equity in earnings of joint venture													2,221
Debt retirement costs													(7,010	)

Loss before provision for income taxes												$	(17,288	)

Depreciation and amortization	$	16,939		$	518	$	784		$	—		$	18,241

Segment capital expenditures	$	22,124		$	1,245	$	383		$	—		$	23,752

EBITDA(1)	$	30,066		$	20,841	$	(24,103	)	$	—		$	26,804


Nine Months Ended September 30, 2009
Revenue from external customers	$	499,368		$	68,307	$	—		$	—		$	567,675
Intersegment revenue		2,498			50,246		—			(52,744	)		—

Total revenue	$	501,866		$	118,553	$	—		$	(52,744	)	$	567,675

Operating income (loss)	$	69,240		$	15,309	$	(20,401	)	$	—		$	64,148
Interest expense, net of interest income													(23,852	)
Other expense													(1	)
Equity in earnings of joint venture													2,230

Income before provision for income taxes												$	42,525

Depreciation and amortization	$	15,986		$	442	$	931		$	—		$	17,359

Segment capital expenditures	$	28,316		$	207	$	659		$	—		$	29,182

EBITDA(1)	$	85,164		$	15,673	$	(17,492	)	$	—		$	83,345

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

(1)

EBITDA is defined as net income before depreciation, amortization and interest expense (net of interest income) and the provision for income taxes. See reconciliation of net income to EBITDA and a discussion of its uses and limitations in Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations of this quarterly report.

The following table presents the segment assets as of September 30, 2010 compared to December 31, 2009 (dollars in thousands):


	Long-term Care Services		Ancillary Services		Other		Total
September 30, 2010:
Segment total assets	$	706,941	$	157,346	$	71,049	$	935,336
Goodwill and intangibles included in total assets	$	251,392	$	113,305	$	—	$	364,697
December 31, 2009:
Segment total assets	$	715,588	$	91,958	$	48,696	$	856,242
Goodwill and intangibles included in total assets	$	254,536	$	51,123	$	—	$	305,659

5. Income Taxes

For the three months ended September 30, 2010 and 2009, the Company recognized income tax benefit of $13.8 million and income tax expense of $2.4 million, respectively, which was primarily related to the Company’s effective tax rate applied to the Company’s income from continuing operations before provision for income taxes. The effective rate for the three months ended September 30, 2010 was below the Company’s statutory rate primarily as a result of a portion of the litigation settlement costs not being deductible for income tax purposes. The effective rate for the three months ended September 30, 2009 was below the Company’s statutory rate primarily as a result of a reduction of $1.9 million in its accrual for unrecognized tax benefits due to expirations of tax statutes of limitation.

For the nine months ended September 30, 2010 and 2009, the Company recognized income tax benefit of $5.4 million and income tax expense of $14.0 million, respectively, which was primarily related to the Company’s effective tax rate applied to the Company’s income before provision for income taxes. The effective rate for the nine months ended September 30, 2010 was below the Company’s statutory rate primarily as a result of a portion of the litigation settlement costs not being deductible for income tax purposes. The effective rate for the nine months ended September 30, 2009 was below the Company’s statutory rate primarily as a result of a $2.2 million reduction in its accrual for unrecognized tax benefits due to expirations of tax statues of limitations.

For the nine months ended September 30, 2010, total unrecognized tax benefits, including penalties and interest, did not change significantly. As of September 30, 2010, it is reasonably possible that unrecognized tax benefits could decrease by $0.1 million, all of which would affect the Company’s effective tax rate, due to additional statute expirations within the 12-month rolling period ending September 30, 2011.

The Company is subject to taxation in the United States and in various state jurisdictions. The Company’s tax years 2007 and forward are subject to examination by the United States Internal Revenue Service and from 2005 forward by the Company’s material state jurisdictions. The Internal Revenue Service has started an examination of the Company’s 2007 and 2008 tax years.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

6. Other Current Assets and Other Assets

Other current assets consist of the following as of September 30, 2010 and December 31, 2009 (dollars in thousands):


	September 30, 2010		December 31, 2009
Current portion of notes receivable, net	$	4,023	$	3,762
Supplies inventory		2,864		2,788
Income tax refund receivable		172		1,597
Prepaid income taxes		13,579		—
Other current assets		109		156

	$	20,747	$	8,303

Other assets consist of the following at September 30, 2010 and December 31, 2009 (dollars in thousands):


	September 30, 2010		December 31, 2009
Equity investment in joint ventures	$	5,743	$	5,041
Restricted cash		14,330		14,610
Deposits and other assets		4,718		4,633

	$	24,791	$	24,284

7. Other Long-Term Liabilities

Other long-term liabilities consist of the following at September 30, 2010 and December 31, 2009 (dollars in thousands):


	September 30, 2010		December 31, 2009
Deferred rent	$	7,147	$	6,855
Other long-term tax liability		78		85
Asbestos abatement liability		3,849		5,486
Other noncurrent liabilities		5,859		—

	$	16,933	$	12,426

8. Commitments and Contingencies

Litigation

Lavender, et al. vs. Skilled Healthcare Group, Inc., et al. (and twenty-two individually-named California nursing facilities receiving administrative services from Skilled Healthcare, LLC)

On May 4, 2006, three plaintiffs filed a complaint against the Company in the Superior Court of California, Humboldt County, entitled VINNIE LAVENDER, by and through her Conservator, WANDA BAKER; WALTER SIMON; JACQUELYN VILCHINSKY vs. SKILLED HEALTHCARE GROUP, INC., et al. (and twenty-two individually-named California nursing facilities receiving administrative services from Skilled Healthcare, LLC) (the “Humboldt County Action”). The complaint alleged, among other things, that certain California-based facilities operated by the Company’s wholly owned operating companies failed to provide an adequate number of qualified personnel to care for their residents and misrepresented the quality of care provided in their facilities.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In response to the complaint, the Company filed a demurrer. On November 28, 2006, the Humboldt Court denied the demurrer. On January 31, 2008, the Humboldt Court denied the Company’s motion for a protective order as to the names and addresses of residents within the facility and on April 7, 2008, the Humboldt Court granted Plaintiffs’ motion to compel electronic discovery by the Company. On May 27, 2008, Plaintiffs’ motion for class certification was heard, and the Humboldt Court entered its order granting plaintiffs’ motion for class certification on June 19, 2008. The Company subsequently petitioned the California Court of Appeal, First Appellate District, for a writ and reversal of the order granting class certification. The Court of Appeal denied the Company’s writ on November 6, 2008 and the Company accordingly filed a petition for review with the California Supreme Court. On January 21, 2009, the California Supreme Court denied the Company’s petition for review.

Trial in this matter commenced November 30, 2009. On July 6, 2010, the jury returned a verdict in the liability, statutory damages and restitution damages phase of the trial, awarding $677 million in compensatory damages against the twenty-two defendant facilities, with Skilled and Skilled Healthcare LLC also liable as agents. On August 6, 2010, the Company filed a motion for mistrial or new trial based upon juror misconduct. On August 13, 2010, the Company filed motions for judgment notwithstanding the verdict and for new trial on all grounds other than juror misconduct. On August 26, 2010, the Humboldt Court entered an order for permanent injunction against the Company and all other defendants. On August 27, 2010, the Humboldt Court denied the motion for mistrial or new trial based on juror misconduct. Also on August 27, 2010, the Company filed a notice of appeal of the Humboldt Court’s August 26, 2010 order for permanent injunction. Because no final judgment had been entered, the Company did not file a notice of appeal of the Humboldt Court’s denial of the motion for mistrial or new trial based on juror misconduct.

On September 7, 2010, the Company reached agreement to settle the Humboldt County Action. As part of the settlement, the Company and other defendants entered into separate settlement agreements with the plaintiffs and the Humboldt County District Attorney’s Office, each dated as of September 7, 2010.

Under the terms of the settlement agreements, the Company deposited a total of $50.0 million into escrow accounts to cover settlement payments to class members, notice and claims administration costs, reasonable attorneys’ fees and costs (in an amount to be determined and approved by the Humboldt County Court in the fourth quarter of 2010) and certain other payments.

The settlement agreements also instituted an injunction, pursuant to which the twenty-two defendants that operate California nursing facilities must provide specified nurse staffing levels, comply with specified state and federal laws governing staffing levels and posting requirements, and provide reports and information to a monitor. The injunction will remain in effect for a period of twenty-four months unless extended for additional three-month periods as to those defendants that may be found in violation. Defendants demonstrating compliance for an eighteen-month period may petition for early termination of the injunction. The Company is required to demonstrate over the term of the injunction that the costs of the injunction are at least $9.6 million. The injunction costs include, among other things, costs attributable to (i) enhanced reporting requirements; (ii) implementing advanced staffing tracking systems; (iii) fees and expenses paid to an auditor and special master; (iv) increased labor and labor related expenses; and (v) lost revenues attributable to admission decisions based on compliance with the terms and conditions of the injunction. To the extent the costs of complying with the injunction are less than $9.6 million, the Company will be required to remit any shortfall to the settlement fund.

Pursuant to the settlement agreements, the plaintiffs and the Humboldt County District Attorney’s Office, as Intervenor on behalf of the People of the State of California, have agreed to release the Company and the other defendants from claims related to the causes of action alleged in the Lavender case, as further described in the settlement agreements, which were filed as exhibits to the Company’s Current Report on Form 8-K filed with the

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

SEC on September 8, 2010. Neither of the settlement agreements contains an admission or concession of wrongdoing by the Company or any other defendants. The settlement is subject to final approval by the Humboldt Court for which a hearing is scheduled for November 30, 2010. Under the terms of the settlement agreements, the Company’s appeal of the Humboldt Court’s order for permanent injunction has been stayed pending the Humboldt Court’s final approval of the settlement. The effective date for the settlement and the injunction pursuant to the settlement would be after the appeal period expires, which is 60 days following the Humboldt Court’s final approval. The Company continues to pursue its claim for insurance coverage.

Shepardson v. Skilled Healthcare Group, Inc.

On July 24, 2009, a purported class action complaint captioned Shepardson v. Skilled Healthcare Group, Inc., et al. was filed in the U.S. District Court for the Central District of California against the Company, its Chairman and Chief Executive Officer, its current Chief Financial Officer, its former Chief Financial Officer, and investment banks that underwrote the Company’s initial public offering, on behalf of two classes of purchasers of its securities. On November 10, 2009, the District Court appointed lead plaintiffs and co-lead counsel, re-captioned the action “In re Skilled Healthcare Group Inc. Securities Litigation,” and ordered that lead plaintiffs file an amended class action complaint.

An amended class action complaint was filed on January 12, 2010 on behalf of purchasers of the Company’s Class A common stock pursuant or traceable to the Company’s initial public offering and purchasers between May 14, 2007 and June 9, 2009, inclusive, against the Company, its Chairman and Chief Executive Officer, its President, its current Chief Financial Officer, its former Chief Financial Officer, its largest stockholder and related entities, and a director affiliated with that stockholder. The amended class action complaint sought an unspecified amount of damages (including rescissory damages), and asserted claims under the federal securities laws relating to the Company’s June 9, 2009 announcement that it would restate its financial statements for the period from January 1, 2006 to March 31, 2009, and that the restatement was likely to require cumulative charges against after-tax earnings in the aggregate amount of between $8.0 million and $9.0 million over the affected periods. The complaint also alleged that the Company’s registration statement and prospectus, financial statements, and public statements about its results of operations contained material false and misleading statements. Defendants moved to dismiss the amended class action complaint on March 15, 2010. In September 2010, the parties reached a settlement in the amount of $3.0 million. The Company contributed the portion of its $1.0 million insurance retention that it had not incurred in legal fees ($0.5 million), and its insurance carriers contributed the balance of the $3.0 million.

BMFEA Matter

On April 15, 2009, two of Skilled Healthcare Group’s wholly owned companies, Eureka Healthcare and Rehabilitation Center, LLC, which operates Eureka Healthcare and Rehabilitation Center (the “Facility”), and Skilled Healthcare, LLC, the Administrative Services provider for the Facility, were served with a search warrant that relates to an investigation of the Facility by the California Attorney General’s Bureau of Medi-Cal Fraud & Elder Abuse (“BMFEA”). The search warrant related to, among other things, records, property and information regarding certain enumerated patients of the Facility and covered the period from January 1, 2007 through the date of the search. The Facility represents less than 1% of the Company’s revenue and less than 0.3% of its Adjusted EBITDA based on full year 2009 and 2008. Nevertheless, although the Company is unable to assess the potential exposure, any fines or penalties that may result from the BMFEA’s investigation could be significant. The Company is committed to working cooperatively with the BMFEA on this matter.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Insurance

The Company maintains insurance for workers’ compensation, general and professional liability, employee benefits liability, property, casualty, directors’ and officers’ liability, inland marine, crime, boiler and machinery, automobile, employment practices liability and earthquake and flood. The Company believes that its insurance programs are adequate and where there has been a direct transfer of risk to the insurance carrier, the Company does not recognize a liability in the condensed consolidated financial statements.

Workers’ Compensation. The Company has maintained workers’ compensation insurance as statutorily required. Most of its commercial workers’ compensation insurance purchased is loss sensitive in nature, except as noted below. As a result, the Company is responsible for adverse loss development. Additionally, the Company self-insures the first unaggregated $1.0 million per workers’ compensation claim for all California, New Mexico and Nevada businesses. The Company has elected not to carry workers’ compensation insurance in Texas and it may be liable for negligence claims that are asserted against it by its Texas-based employees. The Company has purchased guaranteed cost policies for Kansas, Missouri, Iowa, and its recently acquired Nevada, Arizona, Idaho, and Montana based hospice and home health operations. There are no deductibles associated with these programs. The Company recognizes a liability in its consolidated financial statements for its estimated self-insured workers’ compensation risks. Historically, estimated liabilities have been sufficient to cover actual claims.

General and Professional Liability. The Company’s skilled nursing and assisted living services subject it to certain liability risks. Malpractice claims may be asserted against the Company if its services are alleged to have resulted in patient injury or other adverse effects, the risk of which may be greater for higher-acuity patients, such as those receiving specialty and sub-acute services, than for traditional LTC patients. The Company has from time to time been subject to malpractice claims and other litigation in the ordinary course of business.

Effective September 1, 2008, California-based skilled nursing facility companies purchased individual general and professional liability insurance policies with a per occurrence and annual aggregate coverage limit of $1.0 million and $3.0 million, respectively, and an unaggregated $0.1 million per claim self-insured retention. These policies are renewable for up to three years.

Until December 31, 2009, the Company’s Kansas and Des Moines, Iowa businesses were insured on an occurrence basis with a per occurrence and annual aggregate coverage limit of $1.0 million and $3.0 million, respectively. There are no applicable self-insurance retentions or deductibles under these contracts. Until December 31, 2009, the Company’s Missouri businesses were underwritten on a claims-made basis with no applicable self-insured retentions or deductibles and have a per occurrence and annual aggregate coverage limit of $1.0 million and $3.0 million, respectively.

Effective September 1, 2008, the Company also had an excess liability policy with a $14.0 million per loss limit and an $18.0 million annual aggregate limit for losses arising from claims in excess of $1.1 million for the California skilled nursing facilities and in excess of $1.0 million for all other businesses. The policy is renewable for up to three years. The Company retains an unaggregated self-insured retention of $1.0 million per claim for all Texas, New Mexico and Nevada businesses, its California businesses other than skilled nursing facility companies, and its Davenport, Iowa facility. Effective January 1, 2010 all of the facilities located in Kansas, Missouri and Iowa were added to this excess policy with the same unaggregated self-insured retention of $1.0 million per claim for all of these facilities. Effective May 1, 2010 all of the acquired hospice and home health businesses located in Arizona, Idaho, Montana and Nevada were added to this excess policy which provides $14.0 million in excess coverage in addition to the $1.0 million per claim/$3.0 million annual aggregate claims made coverage purchased for these businesses at the time of their acquisition.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Employee Medical Insurance. Medical preferred provider option programs are offered as a component of the Company’s employee benefits. The Company retains a self-insured amount up to a contractual stop loss amount of $0.3 million per claim on its preferred provider organization plan and all other employee medical plans are guaranteed cost plans for the Company.

A summary of the liabilities related to insurance risks are as follows (dollars in thousands):


	As of September 30, 2010											As of December 31, 2009
	General and Professional			Employee Medical			Workers’ Compensation			Total		General and Professional			Employee Medical			Workers’ Compensation			Total
Current	$	4,228	⁽¹⁾	$	1,859	⁽²⁾	$	4,249	⁽²⁾	$	10,336	$	6,960	⁽¹⁾	$	1,784	⁽²⁾	$	4,198	⁽²⁾	$	12,942
Non-current		13,739			—			11,574			25,313		16,660			—			10,747			27,407

	$	17,967		$	1,859		$	15,823		$	35,649	$	23,620		$	1,784		$	14,945		$	40,349

(1)	Included in accounts payable and accrued liabilities.

(2)	Included in employee compensation and benefits.

Financial Guarantees

Substantially all of the Company’s wholly owned companies guarantee the 11.0% senior subordinated notes maturing on January 15, 2014, the Company’s first lien senior secured term loan and the Company’s revolving credit facility. These guarantees are full and unconditional and joint and several. Other companies of the Company that are not guarantors are considered minor.

9. Stockholders’ Equity

Accumulated Other Comprehensive Income

Accumulated other comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that, under U.S. GAAP, are recorded as an element of stockholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. For the three and nine months ended September 30, 2010, there was $0.4 million of other comprehensive income net of tax compared to the $0.5 million and $1.2 million for the three and nine months ended September 30, 2009.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

2007 Stock Incentive Plan

The fair value of the stock option grants for the nine months ended September 30, 2010 and 2009 under FASB ASC Topic 718, “Compensation – Stock Compensation,” was estimated on the date of the grants using the Black-Scholes option pricing model with the following assumptions:


	Nine Months Ended September 30,
	2010			2009
Risk-free interest rate		2.57	%		2.62	%
Expected Life		6.25 years			6.25 years
Dividend yield		0	%		0	%
Volatility		44.18	%		54.34	%
Weighted-average fair value	$	2.81		$	5.49

There were no new stock options granted in the three months ended September 30, 2010 and 2009, respectively. There were 531,339 and 328,253 new stock options granted in the nine months ended September 30, 2010 and 2009, respectively.

There were no options exercised during the three and nine months ended September 30, 2010. As of September 30, 2010, there was $2.0 million of unrecognized compensation cost related to outstanding stock options, net of forecasted forfeitures. This amount is expected to be recognized over a weighted-average period of 3.0 years. To the extent the forfeiture rate is different than the Company has anticipated, stock-based compensation related to these awards will be different from the Company’s expectations.

The following table summarizes stock option activity during the nine months ended September 30, 2010 under the 2007 Stock Incentive Plan:


	Number of Shares			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value (in thousands)
Outstanding at January 1, 2010		576,549		$	12.07
Granted		531,339		$	6.06
Exercised		—		$	—
Forfeited or cancelled		(95,000	)	$	10.55

Outstanding at September 30, 2010		1,012,888		$	9.06		8.53	$	—

Fully vested and expected to vest at September 30, 2010 (assuming a 5% forfeiture rate)		954,512		$	9.20		8.49	$	—

Exercisable at September 30, 2010		240,138		$	13.56		7.10	$	—

Aggregate intrinsic value represents the value of the Company’s closing stock price on the last trading day of the fiscal period in excess of the exercise price, multiplied by the number of options outstanding or exercisable.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Compensation related to stock option grants and stock awards included in general and administrative expenses was $0.6 million and $0.3 million for the three months ended September 30, 2010 and 2009, and $1.4 million and $1.0 million for the nine months ended September 30, 2010, and 2009, respectively. The amount of compensation included in cost of services was $0.4 million and $0.2 million for the three months ended September 30, 2010, and 2009, and $0.7 million for the nine months ended September 30, 2010, and 2009, respectively.

10. 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 prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions. The following table summarizes the valuation of the Company’s interest rate hedge transactions as of September 30, 2010 by the FASB ASC Topic 820, “Fair Value Measurement and Disclosures,” fair value hierarchy (dollars in thousands):


	Level 1		Level 2			Level 3		Total
Interest rate cap	$	—	$	31		$	—	$	31
Interest rate swap	$	—	$	(522	)	$	—	$	(522	)
Contingent consideration – acquisition	$	—	$	—		$	5,097	$	5,097

The Company entered into an interest rate cap agreement and an interest rate swap agreement on June 30, 2010 as required by the refinancing described in Note 11, Debt. The interest rate cap agreement is for a notional amount of $70.0 million with a cap rate on 1 month LIBOR of 2.0% from July 2010 to December 2011. The interest rate swap agreement is for a notional amount of $70.0 million with an interest rate of 2.3% from January 2012 to June 2013. The Company paid $0.1 million for the interest rate cap and the interest rate swap had no value at inception. Both the interest rate cap and swap are categorized as Level 2 measurements, as their values can be determined by using data available in public markets.

On May 1, 2010, the Company acquired substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada (“the Hospice/Home Health Acquisition”), described in Note 13 Acquisition. As part of the purchase agreement, the purchase consideration included cash, promissory notes, contingent consideration, and deferred cash payments. The contingent consideration arrangement requires the Company to pay contingent payments should the acquired operations achieve certain financial targets based on EBITDA, as defined in the acquisition agreement, which was filed as an exhibit to the Company’s Report on Form 10Q filed with the SEC on May 4, 2010. The purchase price included in the initial closing price adjusted by the amount up to $7.0 million over period of 5 years. We estimated the fair value of the contingent consideration using a probability-weighted discounted cash flow model. This fair value measurement is based on significant input not observable in the market and thus represents a Level 3 measurement. The contingent consideration was recorded at the date of acquisition in the amount of $4.9 million. As of June 30, 2010 the contingent consideration had a fair value of $5.0 million. This is included in the Company’s other non-current liabilities on the balance sheet, see Note 7 Other Long-term Liabilities.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The change in fair value of interest rate hedge transactions designated as hedging instruments against the variability of cash flows associated with floating-rate, long-term debt obligations is reported in accumulated other comprehensive income.

11. Debt

The Company’s long-term debt is summarized as follows (dollars in thousands):


	As of September 30, 2010			As of December 31, 2009
Revolving Credit Facility, interest rate comprised of LIBOR( subject to a 1.50% floor) plus 3.75% or 5.25% at September 30, 2010, and LIBOR plus 2.75%, or 2.99% at December 31, 2009; collateralized by substantially all assets of the Company; September 30, 2010 amount due 2015, December 31, 2009 amount due 2012	$	45,000		$	61,000
Revolving Credit Facility, interest rate based on prime plus 1.75%, or 5.00% at December 31, 2009) collateralized by substantially all assets of the Company, due 2012		—			11,000
Term Loan, interest rate based on LIBOR (subject to a 1.50% floor) plus 3.75%, or 5.25% at September 30, 2010, and LIBOR plus 2.00%, or 2.28% at December 31, 2009; collateralized by substantially all assets of the Company; September 30, 2010 amount due 2016, December 31, 2009 amount due 2012		355,722			100,000
Term Loan, interest rate swapped at 2.58% through December 31, 2010 as of December 31, 2009; collateralized by substantially all assets of the Company; amount due 2012		—			145,000
Term Loan, interest rate based on LIBOR plus 2.00%, or 2.25% at December 31, 2009; collateralized by substantially all assets of the Company; amount due 2012		—			3,300
2014 Senior Subordinated Notes, interest rate 11.0%, with an original issue discount of $358 and $438 at September 30, 2010 and December 31, 2009, respectively, interest payable semiannually, principal due 2014		129,642			129,562
Notes payable, interest rate fixed at 6.5%, payable in monthly installments, collateralized by a first priority deed of trust, due December 2018		1,444			1,544
Insurance premium financing		367			5,071
Hospice/Home Health Acquisition note, interest rate fixed at 6.00%, payable in annual installments		9,941			—
Present value of capital lease obligations at effective interest rates, collateralized by property and equipment		2,189			2,202

Total long-term debt and capital leases		544,305			458,679
Less amounts due within one year		(8,295	)		(7,823	)

Long-term debt and capital leases, net of current portion	$	536,010		$	450,856

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

On April 9, 2010, the Company entered into an up to $360.0 million senior secured term loan and a $100.0 million revolving credit facility (the “Restated Credit Agreement”) that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. As of September 30, 2010, there was $45.0 million outstanding on the revolving credit facility.

The term loan requires principal payments of 0.25% of the original principal amount issued on the last business day of each of March, June, September and December, commencing on June 30, 2010, with the balance due April 9, 2016. Amounts borrowed under the term loan may be prepaid at any time without penalty except for LIBOR breakage costs. Commitments under the revolving loan terminate on April 9, 2015. However, if any of the 2014 Senior Subordinated Notes remain outstanding on October 14, 2013, then the maturity date of the term loan and revolving loan will be October 14, 2013. Amounts borrowed pursuant to the Restated Credit Agreement are secured by substantially all of the Company’s assets.

Under the Restated Credit Agreement, the Company must maintain compliance with specified financial covenants measured on a quarterly basis. The Restated Credit Agreement also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the Restated Credit Agreement, subject to certain exceptions and minimum thresholds, the Company is required to apply all of the proceeds from any issuance of debt, as much as half of the proceeds from any issuance of equity, half of the Company’s annual Consolidated Excess Cash Flow, as defined in the Restated Credit Agreement, and amounts received in connection with any sale of the Company’s assets to repay the outstanding amounts under the Restated Credit Agreement.

Loans outstanding under the Restated Credit Agreement bear interest, at the Company’s election, either at the prime rate plus an initial margin of 2.75% or the London Interbank Offered Rate (“LIBOR”) plus an initial margin of 3.75%. Under the terms of the Restated Credit Agreement there is a LIBOR floor of 1.50%. The Company has a 0.5% commitment fee on the unused portion of the revolving line of credit. The Company has the right to increase its borrowings under the term loan and/or the revolving loan up to an aggregate amount of $150 million provided that the Company is in compliance with the Restated Credit Agreement, that the additional debt would not cause any covenant violation of the Restated Credit Agreement, and that existing or new lenders within the Restated Credit Agreement or new lenders agree to increase their commitments. To reduce the risk related to interest rate fluctuations, the Restated Credit Agreement requires the Company to enter into an interest rate swap, cap or similar agreement to effectively fix or cap the interest rate on 40% of its funded long-term debt. The Company entered into two interest rate hedge transactions, as described in Note 10 – “Fair Value Measurements”, in order to comply with this requirement.

In addition, the Company expensed deferred financing fees in the amount of $6.6 million. In conjunction with the closing of the refinancing, the Company terminated its then existing swap agreements as they were incompatible with the new financing due to the existence of the LIBOR floor. The termination of the swap agreements cost $0.4 million, which was recorded as debt retirement costs.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company issued $10.0 million of notes as part of the purchase consideration for the Hospice/Home Health Acquisition. The note bears interest at 6.00% with $2.0 million of principal due annually beginning November 1, 2010. The $10.0 million of notes are payable to the selling entities, of which the Company’s President and Chief Operating Officer of Home and Hospice Care Investments, LLC and the Company’s Regional Vice President of Hospice/Home Health are significant shareholders.

12. Discontinued Operations

In accordance with FASB ASC Topic 205, “Presentation of Financial Statements,” and FASB ASC Topic 360, “Property, Plant and Equipment,” the results of operations of disposed assets and the losses related to the abandonment have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as the operations and cash flows have been eliminated from the Company’s ongoing operations.

During 2009, the Company noted that its hospice business based in Ventura, CA, was not meeting expectations. The Company closed the operations on September 30, 2009 and recorded a net loss of $0.4 million, which includes the write-off of the $0.2 million intangible asset associated with the hospice business based in Ventura, California. Patients for the hospice business based in Ventura, California, were transferred to other local hospice businesses.

The Company continues to operate its hospice businesses in Anaheim, California, Arizona, Idaho, Montana, Nevada, and New Mexico.

A summary of the discontinued operations for the periods presented is as follows (in thousands):


	Three Months Ended September 30,					Nine Months Ended September 30,
	2010		2009			2010		2009
Net operating revenues	$	—	$	174		$	—	$	635
Loss from discontinued operations before income tax		—		(396	)		—		(637	)
Tax benefit		—		153			—		247

Loss from discontinued operations	$	—	$	(243	)	$	—	$	(390	)

13. Acquisitions

Effective May 1, 2010, the Company acquired substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada, referred to herein as the Hospice/Home Health Acquisition. The total consideration payable by the Company in connection with acquisition transactions is approximately $63.0 million, consisting of approximately $45.3 million in cash, with the remainder in the form of deferred and contingent payments payable over a three to five year period. The cash portion of the purchase price was funded by a $30.0 million delayed draw on the Company’s refinanced term loan with the remainder of the cash consideration funded from the Company’s revolving credit facility. For the nine months ended September 30, 2010, the Hospice/Home Health Acquisition contributed revenue of $23.3 million and EBITDA of $3.6 million. The goodwill of $57.0 million arising from the acquisition represents the commercial opportunity for the Company to expand the existing Hospice operations as well as a complement to the Company’s existing core operations and is expected to be deductible for income tax purposes over the next 15 years. All of the goodwill is included in the Company’s Ancillary Services segment.

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The assets of Hospice/Home Health Acquisition were recorded at estimated fair value as of the date of acquisition under the purchase method of accounting. The following table summarizes the allocation of the purchase price to the fair value of assets acquired at the date of acquisition (dollars in thousands):


Depreciable fixed assets, Net	$	591
Licenses		5,140
Goodwill		57,042

Total assets acquired	$	62,773

The purchase consideration is equal to the sum of the cash paid and the fair value of the deferred payments, the promissory notes, and the contingent consideration. As part of the purchase price, annual aggregate deferred cash payments of $1.0 million are to be made over a 3-year period starting May 1, 2011. The promissory notes bear interest at 6.00% with $2.0 million of principal payments due annually beginning November 1, 2010. The contingent consideration arrangement requires the Company to pay contingent payments should the acquired operations achieve certain financial targets based on EBITDA, as defined in the acquisition agreement. The purchase price included in the initial closing price adjusted by the amount up to $7.0 million over period of 5 years. The notes payable, the deferred payments and the contingent consideration are payable to the selling entities, of which the Company’s President and Chief Operating Officer of Home and Hospice Care Investments, LLC and the Company’s Regional Vice President of Hospice/Home Health are significant shareholders. We estimated the fair value of the contingent consideration using a probability-weighted discounted cash flow model. This fair value measurement is based on significant input not observable in the market and thus represents a Level 3 measurement as defined in Note 10, Fair Value Measurements. The following table summarizes the allocation of the total purchase consideration at the date of acquisition (dollars in thousands):


Cash	$	45,380
Deferred cash payments		2,537
Promissory note		9,926
Contingent Consideration		4,930

Total purchase consideration	$	62,773

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not indicate future performance. Our forward-looking statements, which reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2009 and our subsequent reports on Form 10-Q and Form 8-K filed with the Securities and Exchange Commission (the “SEC”). As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our,” and “us” refer to Skilled Healthcare Group, Inc. and its wholly owned companies. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes included in this report.

Business Overview

We are a holding company that owns subsidiaries that operate skilled nursing facilities, assisted living facilities, hospices, home health providers and a rehabilitation therapy business. We have an administrative service company that provides a full complement of administrative and consultative services that allows our facility operators and third-party facility operators with whom we contract to better focus on delivery of healthcare services. We have one such service agreement with an unrelated facility operator. These subsidiaries focus on providing high-quality care to our patients and have a strong commitment to treating patients who require a high level of skilled nursing care and extensive rehabilitation therapy, whom we refer to as high-acuity patients. As of September 30, 2010, we owned or leased 79 skilled nursing facilities and 22 assisted living facilities, together comprising 11,076 licensed beds. Our facilities, approximately 74.3% of which we own, are located in California, Texas, Iowa, Kansas, Missouri, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. For the nine months ended September 30, 2010, we generated approximately 82.2% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, hospice care and home health services.

Recent Developments

As discussed in Note 8, “Commitments and Contingencies—Litigation,” on September 7, 2010, we reached an agreement to settle the case entitled, VINNIE LAVENDER, by and through her Conservator, WANDA BAKER; WALTER SIMON; JACQUELYN VILCHINSKY vs. SKILLED HEALTHCARE GROUP, INC., et al. (and twenty-two individually-named California nursing facilities receiving administrative services from Skilled Healthcare, LLC) (the “Humboldt County Action”). As part of the settlement, we and other defendants entered into separate settlement agreements with the plaintiffs and the Humboldt County District Attorney’s Office, each dated as of September 7, 2010.

Under the terms of the settlement agreements, we deposited a total of $50 million into escrow accounts to cover settlement payments to class members, notice and claims administration costs, certain service payments to named plaintiffs, reasonable attorneys’ fees and costs (in an amount to be determined and approved by the Humboldt County Court) and certain other payments.

The settlement agreements also instituted an injunction, pursuant to which the twenty-two defendants that operate California nursing facilities must provide specified nurse staffing levels, comply with specified state and federal laws governing staffing levels and posting requirements, and provide reports and information to a monitor. The injunction will remain in effect for a period of twenty-four months unless extended for additional three-month periods as to those defendants that may be found in violation. Defendants demonstrating compliance for an eighteen-month period may petition for termination of the injunction. The Company is required to demonstrate over the term of the injunction that the costs of the injunction are at least $9.6 million. The injunction costs include, among other things, costs attributable to (i) enhanced reporting requirements; (ii) implementing advanced staffing tracking systems; (iii) fees and expenses paid to an auditor and special master; (iv) increased labor and labor related expenses; and (v) lost revenues attributable to admission decisions based on compliance with the terms and conditions of the injunction. To the extent the costs of complying with the injunction are less than $9.6 million, the Company will be required to remit any shortfall to the settlement fund.

Revenue

Revenue by Service Offering

We operate our business in two reportable segments: long-term care services and ancillary services. Long-term care services includes the operation of skilled nursing and assisted living facilities as well as an administrative service company that provides a full complement of administrative and consultative services that allows its facility operators, those unrelated facility operator, with whom we contract, and our ancillary healthcare operators to better focus on delivery of healthcare services. Long-term care services is the most significant portion of our business. Ancillary services include our integrated and third-party rehabilitation therapy, hospice and home health businesses.

In our long-term care services segment, we derive the majority of our revenue by providing skilled nursing care and integrated rehabilitation therapy services to residents in our network of skilled nursing facilities. The remainder of our long-term care segment revenue is generated by our assisted living facilities. In our ancillary services segment, we derive revenue by providing related healthcare services, including our rehabilitation therapy services provided to third-party facilities, hospice care and home health care.

The following table shows the revenue and percentage of our total revenue generated by each of these segments for the periods presented (dollars in thousands):


	Three Months Ended September 30,
	2010					2009
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars			Percentage
Long-term care services:
Skilled nursing facilities	$	166,041		79.4	%	$	160,173		85.4	%	$	5,868			3.7	%
Assisted living facilities		6,550		3.1			6,051		3.2			499			8.2

Total long-term care services		172,591		82.5			166,224		88.6			6,367			3.8
Ancillary services:
Rehabilitation therapy services		19,160		9.2			19,095		10.3			65			0.3
Hospice		13,858		6.6			2,128		1.1			11,730			551.2
Home Health		3,590		1.7			—		—			3,590			100.0

Total ancillary services		36,608		17.5			21,223		11.4			15,385			72.5

Total	$	209,199		100.0	%	$	187,447		100.0	%	$	21,752			11.6	%


	Nine Months Ended September 30,
	2010					2009
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars			Percentage
Long-term care services:
Skilled nursing facilities	$	492,959		82.2	%	$	481,242		84.8	%	$	11,717			2.4	%
Assisted living facilities		18,871		3.1			18,126		3.2			745			4.1

Total long-term care services		511,830		85.3			499,368		88.0			12,462			2.5
Ancillary services:
Rehabilitation therapy services		54,624		9.1			57,154		10.0			(2,530	)		(4.4	)
Hospice		26,786		4.6			11,153		2.0			15,633			140.2
Home Health		6,249		1.0			—		0.0			6,249			100.0

Total ancillary services		87,659		14.7			68,307		12.0			19,352			28.3

Total	$	599,489		100.0	%	$	567,675		100.0	%	$	31,814			5.6	%

Sources of Revenue

The following table sets forth revenue consolidated by state and revenue by state as a percentage of total revenue for the periods presented (dollars in thousands):


	Three Months Ended September 30,
	2010					2009
	Revenue Dollars		Percentage of Revenue			Revenue Dollars		Percentage of Revenue
California	$	84,935		40.6	%	$	83,041		44.3	%
Texas		47,924		22.9			48,119		25.7
New Mexico		21,816		10.4			18,914		10.1
Kansas		15,837		7.6			14,573		7.8
Missouri		14,101		6.7			13,931		7.4
Nevada		13,884		6.6			7,835		4.2
Other		10,702		5.2			1,034		0.5

Total	$	209,199		100.0	%	$	187,447		100.0	%


	Nine Months Ended September 30,
	2010					2009
	Revenue Dollars		Percentage of Revenue			Revenue Dollars		Percentage of Revenue
California	$	250,944		41.9	%	$	253,033		44.6	%
Texas		142,114		23.7			143,887		25.3
New Mexico		64,101		10.7			60,766		10.7
Kansas		45,712		7.6			42,757		7.5
Missouri		28,168		4.7			41,648		7.3
Nevada		33,307		5.6			23,363		4.1
Other		35,143		5.8			2,221		0.5

Total	$	599,489		100.0	%	$	567,675		100.0	%

Long-Term Care Services Segment

Skilled Nursing Facilities. Within our skilled nursing facilities, we generate our revenue from Medicare, Medicaid, managed care providers, insurers, private pay and other sources. We believe that our skilled mix, which we define as the number of Medicare and non-Medicaid managed care patient days at our skilled nursing facilities divided by the total number of patient days at our skilled nursing facilities for any given period, is an important indicator of our success in attracting high-acuity patients because it represents the percentage of our patients who are reimbursed by Medicare and managed care payors, for whom we receive higher reimbursement rates. Medicare and managed care payors typically do not provide reimbursement for custodial care, which is a basic level of healthcare. Several of our skilled nursing facilities include our Express Recovery™ program. This program uses a dedicated unit within a skilled nursing facility to deliver a comprehensive rehabilitation and recovery regimen in accommodations uniquely designed to serve high-acuity patients.

The following table sets forth our Medicare, managed care, private pay/other and Medicaid patient days as a percentage of total patient days and the level of skilled mix for our skilled nursing facilities:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Medicare		15.5	%		15.8	%		15.9	%		16.5	%
Managed care		7.0			6.6			6.9			7.0

Skilled mix		22.6			22.4			22.8			23.5
Private pay and other		16.2			18.0			16.5			18.0
Medicaid		61.2			59.6			60.7			58.5

Total		100.0	%		100.0	%		100.0	%		100.0	%

Our skilled mix remained consistent in the three months ended September 30, 2010 compared to the three months ended September 30, 2009. The decrease in skilled mix for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009 was primarily due to new and re-admissions staying flat coupled by a decrease in overall average length of stay. We attribute the shortened length of stays to the challenging economic environment which affects those patients wishing to avoid co-pays and in their early discharge as compared to historical trends. While admissions remain flat, we continue to face competitive pressures, primarily due to the continued development of new facilities and fill up of recently completed facilities in Texas near our existing facilities.

Assisted Living Facilities. Within our assisted living facilities, which are mostly in Kansas, we generate our revenue primarily from private pay sources, with a small portion earned from Medicaid or other state specific programs.

Ancillary Service Segment

Rehabilitation Therapy. As of September 30, 2010, we provided rehabilitation therapy services to a total of 169 healthcare facilities, including 69 of our facilities, as compared to 175 facilities, including 67 of our facilities, as of September 30, 2009. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net decrease of 6 facilities serviced was comprised of 19 new facilities serviced, net of 25 cancellations. Of the 25 cancellations, 24 facilities were operated by two customers, one of whom was canceled for non-payment. While margins for these two customers were lower than our other rehabilitation therapy customers on average, there has been a negative impact to rehabilitation therapy revenue in 2010 as a result of these cancellations as we have not fully replaced the revenue represented by these contracts. Rehabilitation therapy revenue derived from servicing our own facilities is included in our revenue from skilled nursing facilities. Our rehabilitation therapy business receives payment for services from the third-party skilled nursing facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered.

Hospice. We provide hospice care in California and New Mexico and as of May 1, 2010, we provided hospice care in Arizona, Nevada, Idaho, and Montana due to the acquisition of substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada (the “Hospice/Home Health Acquisition”). We derive substantially all of the revenue from our hospice business from Medicare and managed care reimbursement for hospice services. Our objective is to increase the number of patients that each of our hospice programs serves, thus improving our site-level margins and leveraging our overhead.

Federal legislation imposes a Medicare payment cap on hospice service programs, as described in this Item 2 under “Regulatory and Other Governmental Actions Affecting Revenue” below. We are managing the Medicare cap and its impact on our hospice business by actively managing our average length-of-stay on a market-by-market basis. A key component of this strategy is to analyze each hospice program’s mix of patients and referral sources to achieve an optimal balance of the types of patients and referral sources that we serve at each of our programs. We believe this strategy will increase our net patient service revenue by reducing the possibility of experiencing a Medicare cap contractual adjustment. Developing new relationships and thereby adjusting patient mix takes time to implement and will continue to be an ongoing process.

Home Health. As of May 1, 2010, we provided home health care in Arizona, Nevada, Idaho and Montana. We derive substantially all of the revenue from our home health business from Medicare. Net service revenue is recorded under the Medicare payment program (“PPS”) based on a 60-day episode payment rate that is subject to downward adjustment based on certain variables including, but not limited to: (a) an outlier payment if our patient’s care was unusually costly; (b) a low utilization adjustment (“LUPA”) if the number of visits was fewer than five; (c) a partial payment if our patient transferred to another provider or we received a patient from another provider before completing the episode; (d) a payment adjustment based upon the level of therapy services required (thresholds set at 6, 14 and 20 visits); (e) the number of episodes of care provided to a patient, regardless of whether the same home health provider provided care for the entire series of episodes; (f) changes in the base episode payments established by the Medicare Program; (g) adjustments to the base episode payments for case mix and geographic wages; and (h) recoveries of overpayments.

Regulatory and Other Governmental Actions Affecting Revenue

The following table summarizes the amount of revenue that we received from each of the payor classes in the periods presented (dollars in thousands):


	Three Months Ended September 30,
	2010					2009
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage
Medicare	$	78,586		37.6	%	$	64,000		34.1	%
Medicaid		65,876		31.5			61,217		32.7

Subtotal Medicare and Medicaid		144,462		69.1			125,217		66.8
Managed Care		18,893		9.0			17,245		9.2
Private pay and other		45,844		21.9			44,985		24.0

Total	$	209,199		100.0	%	$	187,447		100.0	%


	Nine Months Ended September 30,
	2010					2009
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage
Medicare	$	218,665		36.5	%	$	201,719		35.5	%
Medicaid		191,911		32.0			177,614		31.3

Subtotal Medicare and Medicaid		410,576		68.5			379,333		66.8
Managed Care		55,146		9.2			53,491		9.4
Private pay and other		133,767		22.3			134,851		23.8

Total	$	599,489		100.0	%	$	567,675		100.0	%

We derive a substantial portion of our revenue from government Medicare and Medicaid programs. In addition, our rehabilitation therapy services, for which we receive payment from private payors, is significantly dependent on Medicare and Medicaid funding, as those private payors are often reimbursed by these programs.

Medicare. Medicare is a federal health insurance program for people age 65 or older, people under age 65 with certain disabilities, and people of all ages with End-Stage Renal Disease. Part A of the Medicare program includes hospital insurance that helps to cover hospital inpatient care and skilled nursing facility inpatient care under certain circumstances (e.g., up to 100 days of inpatient skilled nursing coverage following a 3-day qualifying hospital stay, and no custodial or long-term care). It also helps cover hospice care and some home health care. Skilled nursing facilities are paid on the basis of a prospective payment system, or PPS. The PPS payment rates are adjusted for case mix and geographic variation in wages and cover all costs of furnishing covered skilled nursing facilities services (routine, ancillary, and capital-related costs). The amount to be paid is determined by classifying each patient into a resource utilization group, or RUG, category, which is based upon each patient’s acuity level. Payment rates have historically increased each federal fiscal year according to a skilled nursing facilities market basket index.

On July 22, 2010, CMS published a notice containing its fiscal year 2011 per diem payment rates for skilled nursing facilities, effective for services provided beginning October 1, 2010 through September 30, 2011. Under the notice, CMS revised and rebased the skilled nursing facility market basket, resulting in a 1.7% market basket increase factor for fiscal year 2011. The fiscal year 2011 market basket adjustment will increase aggregate payments to skilled nursing facilities nationwide by approximately $542.0 million. Skilled nursing facility payment rates are calculated using a market basket index that reflects changes in the value of goods and services relevant to nursing home care. CMS also make a forecast error adjustment if the difference between the projected and actual market basket index exceeds 0.5%. To calculate the fiscal year 2011 payment rate, CMS looked at the most recent available data from fiscal year 2009, when the forecasted market basket index was 3.4% and the actual increase was 2.8%. As a result the fiscal year 2011 market basket increase factor of 2.3% was decreased by 0.6%, for the net positive updated of 1.7%. In addition, the July 22, 2010 notice describes a provision of the Patient Protection and Affordable Care Act of 2010 (“PPACA”) that changes the implementation schedule in fiscal year 2011 for the Resource Utilization Groups, Version 4 (“RUGs IV”) case-mix classification system. CMS will delay implementing the provision “until system modifications are completed,” according to a CMS press release. Comments in response to the notice were due by September 20, 2010.

On July 22, 2010, CMS published a notice increasing Medicare payments to hospices in fiscal year 2011 by 1.8%, or approximately $220.0 million. CMS said the notice reflects a 2.6% increase in the market basket, offset by a 0.8% decrease in payments to hospices due to a revised phase out of the wage index budget neutrality adjustment factor, starting with a 10% reduction in fiscal year 2010 and a 15% reduction each year from fiscal year 2011 through fiscal year 2016. The fiscal year 2011 hospice payment rates are effective for care and services furnished on or after October 1, 2010 through September 30, 2011. Comments in response to the notice were due by September 20, 2010.

The Deficit Reduction Act of 2005 (“DRA”) required CMS to implement an exceptions process for therapy expenses incurred in 2006. Under this process, a Medicare enrollee (or person acting on behalf of the enrollee) could request an exception from the therapy caps, and the individual could obtain an exception if the provision of services was determined to be medically necessary (CMS established an automatic process to facilitate exceptions). Congress has since extended this exception process several times; most recently, H.R. 4961, the Temporary Extension Act of 2010, extended the outpatient therapy cap exception process through March 31,

2010. The PPACA further extends the outpatient therapy exception process through December 31, 2010. Following the revised expiration date for the therapy cap exception process, it is uncertain whether any further extension of the therapy cap exceptions will be included in any other federal legislation. If subsequent federal legislation fails to extend the therapy cap exceptions, the imposition of therapy caps could lead to reduced revenue to our facilities that bill for the affected therapy services and our rehabilitation company could experience reduced revenue from its third party contracts. Such reductions in revenue could adversely impact our results of operations.

Beginning January 1, 2006, the Medicare Modernization Act of December 2003, or MMA, implemented a major expansion of the Medicare program through the introduction of a prescription drug benefit under Medicare Part D. Medicare beneficiaries who elect Part D coverage and are dual eligible beneficiaries, those eligible for both Medicare and Medicaid benefits, are enrolled automatically in Part D and have their outpatient prescription drug costs covered by this Medicare benefit, subject to certain limitations. Most of the skilled nursing facility residents we serve whose drug costs are currently covered by state Medicaid programs are dual eligible beneficiaries. Accordingly, Medicaid is no longer a significant payor for the prescription pharmacy services provided to these residents.

Historically, adjustments to reimbursement levels 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 “Business — Sources of Reimbursement” in Part 1, Item 1 in our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission and “Risk Factors — Reductions in Medicare reimbursement rates, including annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary, or changes in the rules governing the Medicare program could have a material adverse effect on our revenue, financial condition and results of operations” in Part 1, Item 1A of our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Medicare Hospice Cap. Various provisions were included in Section 1814 of the Social Security Act, the legislation creating the Medicare hospice benefit, to manage the cost to the Medicare program for hospice. These measures include the patient’s waiver of curative care requirement, the six-month terminal prognosis requirement and the Medicare payment caps. The Medicare hospice benefit includes two fixed annual caps on payment, both of which are assessed on a hospice-specific basis. One cap is an absolute dollar amount; the other limits the number of days of inpatient care. The caps are calculated from November 1 through October 31 of each year. The Medicare revenue paid to a hospice program from November 1 to October 31 of the following year may not exceed an annual aggregate cap amount. This annual aggregate cap amount is calculated by multiplying the number of first time Medicare hospice beneficiaries during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year. If a hospice exceeds its aggregate cap, then the hospice must repay the excess back to Medicare. The Medicare cap amount is reduced proportionately for patients who transferred in and out of our hospice services. The Medicare cap amount is adjusted annually for inflation, but is not adjusted for geographic differences in wage levels, although hospice per diem payment rates are wage indexed. Our hospice program exceeded the Medicare cap limit in 2009 by $2.1 million.

On July 23, 2010, CMS published a proposed rule containing a number of changes that would reduce Medicare payments to home health agencies under the home health PPS by 4.75% in calendar year 2011, representing an approximate $900.0 million cut in

Medicare payments to home health agencies from payments received by home health agencies in calendar year 2010. The proposed net reduction includes the combined effects of a market basket updated ($270.0 million increase), a wage index update ($20.0 million increase), purported reductions to the home health PPS rates to account for increases in aggregate case-mix unrelated to underlying changes in patients’ health status ($700.0 million decrease), and application of a 1% reduction to the home health market basket update, as mandated by the PPACA. Based on updated data analysis of case-mix changes, instead of the planned 2.71% reduction for calendar year 2011, CMS said it proposes to reduce home health PPS rates by 3.79% in calendar year 2011 and a further 3.79% in calendar year 2012. The July 23, 2010 proposed rule also contains provisions implementing further reductions in rates under the PPACA changes to the home health agency outlier policy. As noted above, home health agencies receive outlier payments for 60-day home health episodes of care that carry unusually high costs. Prior to the enactment of the PPACA, total outlier payments could not exceed 5% of total projected or estimate home health payments in a given year. However, due to uncontrolled growth in outlier payments in a few discrete areas of the country, the PPACA implemented a change to the existing home health outlier policy through a 5% reduction to home health PPS rates, with total outlier payments not to exceed 2.5% of the total payments estimated for a given year. Home health agencies are also permanently subject to a 10% agency-level cap on outlier payments. Comments on the proposed rule were due by September 14, 2010.

Medicaid. Medicaid is a state-administered medical assistance program for the indigent, operated by the individual states with the financial participation of the federal government. Each state has relatively broad discretion in establishing its Medicaid reimbursement formulas and coverage of service, which must be approved by the federal government in accordance with federal guidelines. All states in which we operate cover long-term care services for individuals who are Medicaid eligible and qualify for institutional care. Providers must accept the Medicaid reimbursement level as payment in full for services rendered. Medicaid programs generally make payments directly to providers, except in cases where the state has implemented a Medicaid managed care program, under which providers receive Medicaid payments from managed care organizations (MCOs) that have subcontracted with the Medicaid program. All states in which we currently do business have all, or a portion of, their Medicaid population enrolled in a Medicaid MCO.

With the passage of the DRA, specifically section 6034, Congress created the Medicaid Integrity Program, or MIP, through section 1936 of the Social Security Act, or the SSA. Section 1936 of the SSA requires the Secretary of Health and Human Services, or HHS, to enter into contracts with eligible entities to perform four activities: (1) the review of Medicaid provider actions to detect fraud or potential fraud; (2) the auditing of Medicaid provider claims; (3) the identification of overpayments; and (4) the education of providers and others on payment integrity and quality of care issues. The contractors that perform these activities are known as Medicaid Integrity Contractors, or MICs.

Specifically, three types of MICs will perform the following activities: (1) Review of Provider MICs, which analyze Medicaid claims data to identify aberrant claims and potential billing vulnerabilities, and which also provide leads to Audit of Provider and Identification of Overpayment MICs, or Audit MICs, of providers to be audited; (2) Audit MICs, which conduct post-payment audits of all types of Medicaid providers, and, where appropriate, identify overpayments to these providers; and (3) Education MICs, which develop training materials to conduct provider education and training on payment integrity and quality of care issues, and which highlight the value of education in preventing fraud and abuse in the Medicaid program.

Provider MIC audits began in Florida and South Carolina at the end of fiscal year 2008; audits in other jurisdictions began in fiscal year 2009. As of December 2009, MICs began actively conducting audits in over 30 states, including California, Texas, and New Mexico. Statements from CMS regarding the preliminary results of the first 500 MIC audits indicate that nearly 30% of the audits conducted have been of long-term care facilities. Unlike the Medicare Recovery Audit Contractor, or RAC, program, the MIC audits are not subject to a uniform set of federal standards, but rather are governed according to state regulations and procedures relating to Medicaid provider audits and appeals. As such, a great degree of uncertainty surrounds whether and to what extent the results of audits conducted by this new set of audit contractors will result in recoupments of alleged overpayments to our facilities. To the extent the MICs apply different or more stringent standards than other past analogous audit programs, the MIC audits could result in recoupments of alleged overpayments and could have an adverse impact on our results of operations.

In addition, Section 6411 of the PPACA expanded the RAC program, which formerly included only Medicare Part A and Part B claims, to also include Medicare Part C and Part D claims, as well as Medicaid claims. The expansion of the RAC program will take place by December 31, 2010. It is uncertain at this time how the recently-expanded RAC program will interact with the MIC program. To the extent that RAC and MIC jurisdiction overlaps regarding Medicaid claims and results in duplicative attempts to recoup alleged overpayments, such results could have an adverse impact on our results of operations.

Rapidly increasing Medicaid spending, combined with slow state revenue growth, has led many states to institute measures aimed at controlling spending growth. For example, 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 2009, on July 24, 2009, the California Legislature passed a budget balancing proposal that eliminated this five percent growth cap by amending the then-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. Despite the California Legislature’s decision in 2009 to hold the growth cap flat for the 2010-2011 rate year and California’s continuing budget crisis in 2010, on October 19, 2010, the California Legislature passed a budget trailer bill that extended A.B. 1629 through the 2011-2012 rate year and ameliorated the 2009 growth cap reductions. The Legislature amended current statute to provide that, for the 2010-2011 rate year, the weighted average Medi-Cal reimbursement rate paid to long-term care facilities shall not exceed 3.93% if the increase in the federal medical assistance percentage (FMAP) pursuant to the federal American Recovery and Reinvestment Act of 2009 (ARRA) (Public Law 111-5) is extended for the entire 2010-2011 rate year, or 3.14%, if the increase in the FMAP pursuant to ARRA is not extended for that period of time, plus the projected cost of complying with new state or federal mandates. In addition, the budget trailer bill provided that for the 2011-2012 rate year, the weighted average Medi-Cal reimbursement rate paid to long-term care facilities shall not exceed 2.4%, plus the projected cost of complying with new state or federal mandates. Moreover, the budget trailer bill extended a change to the A.B. 1629 long-term care reimbursement system that was implemented in July of 2009 as a result of California’s 2009 budget crisis; namely, the amounts that California nursing facilities will pay to Medi-Cal in quality assurance fees for the for the 2009-2010 to 2011-2012, inclusive, rate years will include will include Medicare revenue in the calculation of the quality assurance fee that nursing facilities pay under A.B. 1629. California’s Governor signed the budget trailer bill into law on October 21, 2010. However, 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 to CMS; i.e., retroactive to August 1, 2010. Given that Medicaid outlays are a significant component of state budgets, we expect continuing cost containment pressures on Medicaid outlays for skilled nursing facilities in the states in which we operate. In addition, the DRA of 2005 limited the circumstances under which an individual may become financially eligible for Medicaid and nursing home services paid for by Medicaid.

Federal Health Care Reform. In addition to the provisions described above affecting Medicare and Medicaid participating providers, the PPACA enacted several reforms with respect to skilled nursing facilities and hospices, 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 the PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of the PPACA are effective immediately or within six to twelve months of the PPACA’s enactment date.

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Enhanced CMPs and Escrow Provisions. Effective March 23, 2010, the PPACA includes expanded civil monetary penalty (“CMP”) provisions applicable to all Medicare and Medicaid providers. Sections 6402 and 6408 of the PPACA provide 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. Section 6111 of the PPACA also includes CMP provisions specific to skilled nursing facilities that in limited circumstances provide for up to a fifty percent (50%) reduction in CMPs where a facility self-reports and promptly corrects an alleged deficiency within ten (10) calendar days. In addition, the new CMP provisions specific to skilled nursing facilities provide that the Secretary of Health and Human Services may provide for the collection and placement of the CMP amount into an escrow account on the earlier of the date informal dispute resolution is completed or ninety (90) days after the imposition of the CMP. If an appeal is successful, the facility would receive a refund of the collected amounts with interest. This CMP escrow provision is a departure from prior policy, which only required remittance of CMP amounts following the final disposition of a CMP dispute. On July 12, 2010, CMS published a proposed rule implementing the PPACA’s enhanced CMP and escrow provisions. Comments on the proposed rule were due by August 11, 2010; it is anticipated that the final rule implementing these provisions will be issued to take effect by July 1, 2011. To the extent our facilities are assessed large CMPs that are collected and placed into an escrow account pending lengthy appeals, such actions could adversely affect the results of operations.

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Nursing Home Transparency Requirements. In addition to expanded CMP provisions, the PPACA imposes substantial new transparency requirements for Medicare-participating nursing facilities. Existing law requires Medicare providers to disclose to CMS: (1) any person or entity that owns directly or indirectly an ownership interest of five percent (5%) 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. Section 6101 of the PPACA expands 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. “Managing employee” is defined broadly as an individual (including a general manager, business manager, administrator, director, or consultant) who directly or indirectly manages, advises, or supervises any element of the practices, finances, or operations of the facility. “Additional disclosable party” of the facility is defined as any person or entity that (1) exercises operational, financial, or managerial control over the facility, or provides policies or procedures for the operations of the facility, or provides financial or cash management services to the facility; (2) leases or subleases real property to the facility, or owns

a whole or partial interest equal to or exceeding five percent (5%) of the total cash value of such real property; or (3) provides management or administrative services, management or clinical consulting services, or accounting or financial services to the facility. Beginning March 23, 2010, facilities must have this information available for submission to the Secretary of Health & Human Services, the OIG, the state in which the facility is located, and the state long-term care ombudsman upon request. Thus, the new transparency provisions could result in the potential for greater government scrutiny and oversight of the ownership and investment structure for skilled nursing facilities, as well as more extensive disclosure of entities and individuals that comprise part of skilled nursing facilities’ ownership structure.

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Suspension of Payments During Pending Fraud Investigations. The 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, beginning March 23, 2010, 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. “Credible investigation of fraud” is undefined, although the Secretary must consult with the Office of the Inspector General in determining whether a credible investigation of fraud exists. This suspension authority creates a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercises its authority to suspend Medicaid payments pending a fraud investigation. 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 the results of operations.

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Overpayment Reporting and Repayment; Expanded False Claims Act Liability. The PPACA also enacted several important changes that expand potential liability under the federal False Claims Act. Effective March 23, 2010, Section 6402 of the PPACA provides 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 (60) 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. This new provision substantially tightens the repayment and reporting requirements generally associated with operations of health care providers to avoid FCA exposure. To the extent we incur additional operational costs to comply with the new overpayment reporting and repayment provision, such costs may adversely affect the results of operations.

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Expanded Basis for Mandatory Medicaid Exclusions. Beginning January 1, 2011, Section 6501 of the PPACA substantially expands the reach of mandatory exclusions for Medicaid to include individuals or entities that own, control, or manage an entity that is affiliated with a suspended, excluded, or terminated individual or entity. To the extent this expanded exclusion provision is applied in a manner that results in the exclusion from Medicaid of more of our facilities than would otherwise occur under pre-PPACA law, such additional exclusion could have a material adverse impact on the results of operations.

The provisions of the PPACA discussed above are examples of recently-enacted federal health reform provisions that we believe may have a material impact on the long-term care industry generally and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of the PPACA. It is possible that other provisions of the 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.

Managed Care. Our managed care patients consist of individuals who are insured by a third-party entity, typically called a senior Health Maintenance Organization, or senior HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a senior HMO plan.

Private Pay and Other. Private pay and other sources consist primarily of individuals or parties who directly pay for their services or are beneficiaries of the Department of Veterans Affairs or hospice beneficiaries.

Critical Accounting Policies and Estimates Update

Disclosure of our critical accounting policies are more fully disclosed in our discussion and analysis of financial condition and results of operations in our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission and as included below.

Results of Operations

The following table summarizes some of our key performance indicators, along with other statistics, for each of the periods indicated:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Occupancy statistics (skilled nursing facilities):
Available beds in service at end of period		9,378			9,094			9,378			9,094
Available patient days		855,522			839,244			2,528,567			2,478,427
Actual patient days		709,792			698,489			2,108,941			2,080,944
Occupancy percentage		83.0	%		83.2	%		83.4	%		84.0	%
Average daily number of patients		7,715			7,592			7,725			7,623

Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)
LTC only Medicare (Part A)	$	498		$	504		$	497		$	500
Medicare blended rate (Part A & B)		566			564			560			558
Managed care		374			372			377			369
Medicaid		151			147			149			145
Private and other		168			159			169			161
Weighted-average for all	$	234		$	230		$	234		$	232

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,
	2010			2009			2010			2009
Revenue		100.0	%		100.0	%		100.0	%		100.0	%
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)		80.6			80.8			80.5			79.8
Rent cost of revenue		2.3			2.4			2.4			2.4
General and administrative		2.9			3.4			3.1			3.4
Litigation settlement costs		25.6			—			8.9			—
Depreciation and amortization		3.0			3.2			3.0			3.1

		114.4			89.8			97.9			88.7

Other income (expenses):
Interest expense		(4.8	)		(4.5	)		(4.4	)		(4.4	)
Interest income		0.1			0.1			0.1			0.1
Other income (expense)		—			—			0.1			—
Equity in earnings of joint venture		0.4			0.4			0.4			0.4
Debt retirement costs		—			—			(1.2	)		—

Total other expenses, net		(4.3	)		(4.0	)		(5.0	)		(3.9	)

(Loss) Income from continuing operations before provision for income taxes		(18.7	)		6.2			(2.9	)		7.4
(Benefit) Provision for income taxes		(6.6	)		1.3			(0.9	)		2.5

(Loss) Income from continuing operations		(12.1	)		4.9			(2.0	)		4.9
Loss from discontinued operations, net of tax		—			(0.1	)		—			(0.1	)

Net (loss) income		(12.1	)%		4.8	%		(2.0	)%		4.8	%

EBITDA		(11.0	)%		13.7	%		4.5	%		14.7	%
Adjusted EBITDA		14.6	%		13.8	%		14.6	%		14.8	%

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Reconciliation from net income to EBITDA and Adjusted EBITDA (in thousands):
Net (loss) income	$	(25,307	)	$	9,052		$	(11,882	)	$	28,135
Interest expense, net of interest income		9,826			8,132			25,851			23,852
(Benefit) Provision for income taxes		(13,766	)		2,420			(5,406	)		14,000
Depreciation and amortization expense		6,305			6,014			18,241			17,358

EBITDA		(22,942	)		25,618			26,804			83,345
Disposal of asset		—			1			(479	)		60
Discontinued operations		—			243			—			390
Debt retirement costs		—			—			7,010			—
Litigation settlement costs		53,505			—			53,505			—
Acquisition costs		—			—			400			—

Adjusted EBITDA	$	30,563		$	25,862		$	87,240		$	83,795

(1)

We define EBITDA as net income before depreciation, amortization and interest expense (net of interest income) and the provision for (benefit from) income taxes. EBITDA margin is EBITDA as a percentage of revenue. Adjusted EBITDA is EBITDA adjusted for non-core business items, which for this report includes the following (each to the extent applicable in the appropriate period):

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discontinued operations, net of tax;

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gains or losses on sale of assets;

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provision for the impairment of long-lived assets, including goodwill;

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the write-off of deferred financing costs of extinguished debt;

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acquisition costs; and

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certain litigation expenses.

We believe that the presentation of EBITDA and Adjusted EBITDA provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.

Specifically, we believe that a report of EBITDA and Adjusted EBITDA provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods. EBITDA and Adjusted EBITDA are two of the primary indicators management uses for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of U.S. generally accepted accounting principles, or US GAAP, expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA and Adjusted EBITDA to benchmark the performance of our business against expected results and analyze year-over-year trends (each as described below) and to compare our operating performance to that of our competitors.

Management uses both EBITDA and Adjusted EBITDA to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a facility-by-facility level. We typically use Adjusted EBITDA for these purposes at the administrative level (because the adjustments to EBITDA are not generally allocable to any individual business unit) and we typically use EBITDA to compare the operating performance of each skilled nursing and assisted living facility, as well as to assess the performance of our operating segments: long-term care services, which include the operation of our skilled nursing and assisted living facilities; and ancillary services, which include our rehabilitation therapy and hospice businesses. EBITDA and Adjusted EBITDA are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes, depreciation and amortization expense and special charges, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a facility is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. These types of charges are dependent on factors unrelated to our underlying business. As a result, we believe that the use of EBITDA and Adjusted EBITDA provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.

We also make capital allocations to each of our facilities based on expected EBITDA returns and establish compensation programs and bonuses for our facility-level employees that are based upon the achievement of pre-established EBITDA and Adjusted EBITDA targets.

Finally, we use Adjusted EBITDA to determine compliance with our debt covenants and assess our ability to borrow additional funds and to finance or expand operations. The credit agreement governing our first lien term loan uses a measure substantially similar to Adjusted EBITDA as the basis for determining compliance with our financial covenants, specifically our minimum interest coverage ratio and our maximum total leverage ratio, and for determining the interest rate of our first lien term loan. The indenture governing our 11.0% senior subordinated notes also uses a substantially similar measurement for determining the amount of additional debt we may incur. For example, both our credit facility and the indenture governing our 11.0% senior subordinated notes include adjustments for gains or losses on sale of assets, and the write-off of deferred financing costs of extinguished debt. Our credit facility also includes an adjustment for expenses we incurred in connection with the defense and settlement of the Humboldt County Action. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our credit facility. In addition, if we cannot satisfy certain financial covenants under the indenture for our 11.0% senior subordinated notes, we cannot engage in certain specified activities, such as incurring additional indebtedness or making certain payments.

Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA and Adjusted EBITDA are non-GAAP financial measures that have no standardized meaning defined by GAAP. Therefore, our EBITDA and Adjusted EBITDA 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 under GAAP. Some of these limitations are:

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they do not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments;

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they do not reflect changes in, or cash requirements for, our working capital needs;

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they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;

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they do not reflect any income tax payments we may be required to make;

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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 Adjusted EBITDA do not reflect any cash requirements for such replacements;

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they are not adjusted for all non-cash income or expense items that are reflected in our consolidated statements of cash flows;

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they do not reflect the impact on earnings of charges resulting from certain matters we consider not to be indicative of our ongoing operations such as certain litigation settlement costs; and

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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 EBITDA and Adjusted EBITDA only to supplement net income on a basis prepared in conformance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business. We strongly encourage investors to consider net income determined under GAAP as compared to EBITDA and Adjusted EBITDA, and to perform their own analysis, as appropriate.

Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009

Revenue. Revenue increased $21.8 million, or 11.6%, to $209.2 million in the three months ended September 30, 2010 from $187.4 million in the three months ended September 30, 2009.

The following table shows revenue dollars and revenue percentage for long-term care services:


	Three Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars		Percentage
	(dollars in millions)
Long-term care services:
Skilled nursing facilities	$	166.0		79.4	%	$	160.2		85.4	%	$	5.8		3.7	%
Assisted living facilities		6.6		3.1			6.1		3.2			0.5		8.2

Total long-term care services	$	172.6		82.5	%	$	166.3		88.6	%	$	6.3		3.8	%

Skilled nursing facility revenue increased $2.1 million due to the addition of the December 2009 acquisition of a facility in Davenport, Iowa and our newly developed facility in Fort Worth, Texas. Additionally, for skilled nursing facilities operated for all of the three months ended September 30, 2009 and 2010, revenue increased $3.7 million due to a higher weighted average per patient day rate from Medicare, Medicaid and managed care pay sources. Our skilled mix remained relatively consistent at 22.6% in the three months ended September 30, 2010 from 22.4% in the three months ended September 30, 2009. While admissions remain flat, we continue to face competitive pressures, primarily due to the continued development of new facilities and fill up of recently completed developments in Texas near our existing facilities. Our average daily Medicare rate decreased 0.5% to $567 in the three months ended September 30, 2010 from $564 in the three months ended September 30, 2009. Our average daily Medicaid rate increased 3.4% to $151 in the three months ended September 30, 2010 from $146 per day in the three months ended September 30, 2009, primarily due to increased Medicaid rates in Texas, Nevada and Missouri. We have experienced net reductions in Medicaid rates in California and Kansas. Revenue at our assisted living facilities increased to $6.6 million in the three months ended September 30, 2010 from $6.1 million in the three months ended September 30, 2009, primarily due to our newly developed facility in Tonganoxie, Kansas, which opened in April 2009 and was not fully occupied in the three months ended September 30, 2009.

The following table shows revenue dollars and revenue percentage for ancillary services:


	Three Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars		Percentage
	(dollars in millions)
Ancillary services:
Rehabilitation therapy services for non-affiliated entities	$	19.2		9.2	%	$	19.1		10.3	%	$	0.1		0.01	%
Hospice		13.9		6.6			2.0		1.1			11.9		551.2
Home Health		3.6		1.7			—		—			3.6		100.0

Total ancillary services	$	36.6		17.5	%	$	21.1		11.4	%	$	15.5		72.5	%

Rehabilitation therapy services revenue increased slightly to $19.2 million for the three months ended September 30, 2010 and 2009. Hospice revenue for the three months ended September 30, 2010 increased primarily due to the Hospice/Home Health Acquisition.

Cost of Services Expenses. Cost of services expenses increased $17.1 million, or 11.3%, to $168.6 million, or 80.6% of revenue, in the three months ended September 30, 2010, from $151.5 million, or 80.8% of revenue, in the three months ended September 30, 2009.

The following table shows cost of service dollars (prior to intersegment eliminations) and cost of services as a percentage of revenue for long-term care services:


	Three Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Cost of Service Dollars (prior to intersegment eliminations)		Revenue Percentage			Cost of Service Dollars (prior to intersegment eliminations)		Revenue Percentage

											Dollars		Percentage
	(dollars in millions)
Long-term care services:
Skilled nursing facilities	$	130.4		78.6	%	$	124.9		78.0	%	$	5.5		4.4	%
Assisted living facilities		4.6		69.7			4.2		68.9			0.4		9.5
Regional operations support		5.5		n/a			5.5		n/a			—		—

Total long-term care services	$	140.5		81.4	%	$	134.6		80.9	%	$	5.9		4.4	%

Cost of services expenses at our skilled nursing facilities increased $2.1 million due to the opening of the Fort Worth Center of Rehabilitation and acquisition of St. Mary Healthcare, and $3.4 million from operating costs increasing at facilities acquired or developed prior to July 1, 2009 by $4 per patient day, or 2.2%, to $183 per patient day in the three months ended September 30, 2010 from $179 per patient day in the three months ended September 30, 2009. The $3.4 million increase in operating costs resulted from a $1.4 million increase in labor costs, which represented an increase of $2, or 1.5%, on a per patient day basis. Additionally, the increase in operating costs resulted from a $1.0 million increase in taxes and licenses and a $1.0 million increase in expenses related to rehab/ancillaries. Cost of services expenses at our assisted living facilities increased $0.4 million in the three months ended September 30, 2010 compared to the three months ended September 30, 2009.

The following table shows cost of service dollars (prior to intersegment eliminations), revenue (prior to intersegment eliminations) and cost of services as a percentage of revenue (prior to intersegment eliminations) for ancillary services:


	Three Months Ended September 30,
	2010							2009							Increase/(Decrease)
	Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Profitability (prior to intersegment eliminations) percentage			Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Profitability (prior to intersegment eliminations) percentage

															Dollars		Percentage
	(dollars in millions)
Ancillary services:
Rehabilitation therapy services for non-affiliated entities	$	36.4	$	31.3		86.0	%	$	35.7	$	30.0		84.0	%	$	1.3		4.3	%
Hospice		13.9		10.8		77.7			2.0		4.1		205.0			6.7		163.4
Home Health		3.6		3.3		91.7			—		—		—			3.3		100.0

Total ancillary services	$	53.9	$	45.4		84.2	%	$	37.7	$	34.1		90.5	%	$	11.3		33.1	%

Rehabilitation therapy costs as a percentage of revenue increased to 86.0% from 84.0% in the three months ended September 30, 2010, as compared to the same period in 2009, as the result of increased bad debt expense, costs associated with the roll out of our new Enterprise Resource Planning (“ERP”) system for our therapy line of business and a slight increase in overhead. Cost of services expense in our hospice business was challenged by labor inefficiencies in our California operations in the three months ended September 30, 2009, which have since been mostly remediated. The increase in hospice cost of services was primarily due to the previously mentioned Hospice/Home Health Acquisition. Hospice and home health costs of services included $0.4 million of acquisition related costs in the three months ended September 30, 2010 which will not recur. In the next twelve months, we expect our cost of services expense to increase primarily due to complying with the terms of the injunction related to the Humboldt County Action described in Note 8, Commitments and Contingencies—Litigation.

Rent cost of revenue. Rent cost of revenue increased by $0.3 million, or 6.7%, to $4.8 million, or 2.3% of revenue, in the three months ended September 30, 2010 from $4.5 million, or 2.4% of revenue, in the three months ended September 30, 2009 primarily due to rent costs of facilities relating to the Hospice/Home Health Acquisition as well as rental rate increases at certain of our skilled nursing facilities.

General and Administrative Services Expenses. Our general and administrative services expenses decreased $0.3 million, or 4.7%, to $6.0 million, or 2.9% of revenue, in the three months ended September 30, 2010 from $6.3 million, or 3.2% of revenue, in the three months ended September 30, 2009.

Litigation Settlement Expense. Litigation settlement expense was $53.5 million for the quarter ended September 30, 2010 with no comparable amount for the quarter ended September 30, 2009. The $53.5 million was comprised of a $50.0 million cash settlement related to the Humboldt County Action described in Note 8, Commitments and Contingencies—Litigation, to our unaudited condensed consolidated financial statements and $3.0 million of related legal expenses, and $0.5 million in securities class action costs related to the Shepardson v. Skilled Healthcare Group, Inc. litigation described in Note 8, Commitments and Contingencies—Litigation.

Depreciation and Amortization. Depreciation and amortization increased by $0.3 million, or 5.0%, to $6.3 million in the three months ended September 30, 2010 from $6.0 million in the three months ended September 30, 2009. This increase primarily resulted from increased depreciation and amortization related to the opening of our new Fort Worth skilled nursing facility as well as new assets placed in service subsequent to July 1, 2010.

Interest Expense. Interest expense increased by $1.6 million, or 19.8 %, to $10.1 million in the three months ended September 30, 2010 from $8.4 million in the three months ended September 30, 2009. The increase in our interest expense was primarily due to a increase in the average interest rate on our debt from 5.8% in the three months ended September 30, 2009 to 6.7% in the three months ended September 30, 2010 which resulted in additional interest expense of $1.1 million. The increase in our cost of borrowing was due to the refinancing of our credit facility in April 2010. Average debt outstanding increased by $47.6 million, from $470.4 million in the three months ended September 30, 2009 to $518.0 million in the three months ended September 30, 2010 which resulted in additional interest expense of $0.8 million. The increase in average debt outstanding was primarily due to the Hospice/Home Health Acquisition. The remainder of the variance in interest expense was due to a $0.3 million decrease in deferred financing fee amortization. The all in rate for the three months ended September 30, 2010 was 7.7%, as compared to 7.1% for the three months ended September 30, 2009.

Interest Income. Our interest income remained consistent at $0.3 million for the three months ended September 30, 2010 and 2009.

Equity in Earnings of Joint Venture. Equity earnings of our joint venture remained consistent at $0.7 million for the three months ended September 30, 2010 and 2009.

Provision for Income Taxes. We had a tax benefit of $13.8 million, or 35.2% of our pre-tax loss, for the three months ended September 30, 2010, as compared to a tax expense of $2.4 million, or 20.7% of pre-tax earnings for the three months ended September 30, 2009. The tax benefit for the three months ended September 30, 2010 is due to the pre-tax loss incurred as a result of our litigation settlement costs.

EBITDA. EBITDA decreased by $48.5 million to a loss of $22.9 million in the three months ended September 30, 2010 from $25.6 million in the three months ended September 30, 2009. The $48.5 million decrease was primarily related to the $53.5 million increase in litigation settlement expense, a $0.3 decrease in general and administrative expenses, a $17.1 million increase in cost of services, offset by a $21.8 million increase in revenue, all discussed above.

Loss from Continuing Operations. Income from continuing operations decreased by $50.8 million to a loss of $39.1 million in the three months ended September 30, 2010 from income of $11.7 million in the three months ended September 30, 2009. The $50.8 million decrease was related primarily to the $53.5 million litigation settlement expense, all discussed above.

Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Revenue. Revenue increased $31.8 million, or 5.6%, to $599.5 million in the nine months ended September 30, 2010, from $567.6 million in the nine months ended September 30, 2009.

The following table shows revenue dollars and revenue percentage for long-term care services:


	Nine Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars		Percentage
	(dollars in millions)
Long-term care services:
Skilled nursing facilities	$	493.0		82.2	%	$	481.2		84.8	%	$	11.8		2.4	%
Assisted living facilities		18.9		3.1			18.1		3.2			0.8		4.1

Total long-term care services	$	511.9		85.3	%	$	499.3		88.0	%	$	12.6		2.5	%

The increase of $10.2 million in skilled nursing facilities revenue resulted primarily from the addition of acquired and developed facilities since the beginning of 2009, which includes the opening of the Dallas Center of Rehabilitation, Fort Worth Center of Rehabilitation, and the acquisition of two facilities in Iowa. Additionally, for skilled nursing facilities operated for all of 2009 and the nine months ended September 30, 2010, revenue increased $4.6 million due to a higher weighted average per patient day rate from Medicare, Medicaid and managed care pay sources, offset by a $3.7 million decrease due to a decline in occupancy rates. Our revenue related to the administration of third party facilities decreased $0.8 million. Per patient day rates were negatively impacted by the decrease in our skilled mix in the nine months ended September 30, 2010 as compared to September 30, 2009. We believe our skilled mix declined to 22.8% in the nine months ended September 30, 2010 from 23.5% in the nine months ended September 30, 2009 primarily due to new and re-admissions staying flat coupled by a decrease in overall average length of stay in most payor classes. We attribute the shortened length of stays to various components including the demand and government support in discharging patients home sooner coupled with a challenging economic environment which affects those patients wishing to avoid co-pays, which results in their early discharge as compared to historical trends. While admissions remain flat, we continue to face competitive pressures, primarily due to the development of new facilities in Texas near our existing facilities. Our average daily Part A Medicare rate decreased 0.6% to $497 in the nine months ended September 30, 2010 from $500 in the nine months ended September 30, 2009 due to a 1.1% Medicare rate reduction effective October 1, 2009. Our average daily Medicaid rate increased 3.5% to $150 in the nine months ended September 30, 2010 from $145 per day in the nine months ended September 30, 2009, primarily due to increased Medicaid rates in Texas, Nevada and Missouri. We have experienced net reductions in Medicaid rates in California and Kansas. Revenue at our assisted living facilities increased to $0.8 million in the nine months ended September 30, 2010 from $18.1 million in the nine months ended September 30, 2009, primarily due to our newly developed facility in Tonganoxie, Kansas, which opened in April 2009 and was not fully occupied in the nine months ended September 30, 2009.

The following table shows revenue dollars and revenue percentage for ancillary services:


	Nine Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Revenue Dollars		Revenue Percentage			Revenue Dollars		Revenue Percentage			Dollars			Percentage
	(dollars in millions)
Ancillary services:
Rehabilitation therapy services
for non-affiliated entities	$	54.6		9.1	%	$	57.2		10.0	%	$	(2.6	)		(4.4	)%
Hospice		26.8		4.6			11.2		2.0			15.6			140.2
Home Health		6.2		1.0			—		—			6.2			100.0

Total ancillary services	$	87.6		14.7	%	$	68.4		12.0	%	$	19.2			28.3	%

The decrease in rehabilitation therapy services revenue resulted primarily from a decrease in therapy services under existing third-party facility contracts due to the decrease in facilities serviced. For a detailed discussion of the decrease in facilities serviced, see “Sources of Revenue – Ancillary Service Segment” under Part I, Item 2 of this report. Therapy services revenue was also negatively impacted in the nine months ended September 30, 2010 by the delay in extending the outpatient therapy cap exception. Hospice and home health revenue increased in the nine months ended September 30, 2010 as compared to the nine months ended September 30, 2009, as a result of the Hospice/Home Health Acquisition.

Cost of Services Expenses. Our cost of services expenses increased $29.1 million, or 6.4%, to $482.3 million, or 80.5% of revenue, in the nine months ended September 30, 2010, from $453.2 million, or 79.8% of revenue, in the nine months ended September 30, 2009.

The following table shows cost of service dollars (prior to intersegment eliminations) and cost of services as a percentage of revenue for long-term care services:


	Nine Months Ended September 30,
	2010					2009					Increase/(Decrease)
	Cost of Service Dollars (prior to intersegment eliminations)		Revenue Percentage			Cost of Service Dollars (prior to intersegment eliminations)		Revenue Percentage			Dollars		Percentage
	(dollars in millions)
Long-term care services:
Skilled nursing facilities	$	386.3		78.4	%	$	374.0		77.7	%	$	12.3		3.3	%
Assisted living facilities		13.4		70.9		$	12.8		70.7			0.6		4.7
Regional operations support		16.7		n/a		$	16.2		n/a			0.5		3.1

Total long-term care services	$	416.4		81.3	%	$	403.0		80.7	%	$	13.4		3.3	%

Cost of services expenses at our skilled nursing facilities increased $8.4 million due to the addition of acquired and developed facilities since the beginning of 2009, which includes the opening of the Dallas Center of Rehabilitation, Fort Worth Center of Rehabilitation, and the acquisition of two facilities in Iowa, and $4.0 million resulted from operating costs increasing at facilities acquired or developed prior to January 1, 2009 by $3 per patient day, or 1.7%, to $182 per patient day in the nine months ended September 30, 2010 from $179 per patient day in the nine months ended September 30, 2009. The $4.0 million increase in operating

costs resulted from a $3.0 million increase in labor costs, or 2.2%, on a per patient day basis, as the fixed labor costs increased as a percent of total labor costs due to the decline in census and also due to slight labor rate increases. Additionally, the increase in operating costs resulted from a $2.0 million increase in taxes and licenses, a $0.9 million increase in rehab/ancillaries expense, a $0.4 million increase in other operating expenses, offset by a $2.3 million decrease in bad debt expense. Cost of services expenses at our assisted living facilities increased $0.6 million in the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. In the next twelve months, we expect our cost of services expense to increase primarily due to complying with the terms of the injunction related to the Humboldt County Action described in Note 8, Commitments and Contingencies—Litigation.


	Nine Months Ended September 30,
	2010							2009							Increase/(Decrease)
	Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Profitability (prior to intersegment eliminations) percentage			Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Profitability (prior to intersegment eliminations) percentage			Dollars			Percentage
	(dollars in millions)
Ancillary services:
Rehabilitation therapy services for non-affiliated entities	$	105.2	$	89.3		84.9	%	$	107.4	$	90.4		84.2	%	$	(1.1	)		(1.2	)%
Hospice		26.8		22.2		82.8			11.2		12.2		108.9			10.0			82.0
Home Health		6.2		5.5		88.7			—		—		—			5.5			100.0

Total ancillary services	$	138.2	$	117.0		84.7	%	$	118.6	$	102.6		86.5	%	$	14.4			14.0	%

Rehabilitation therapy costs as a percentage of revenue increased primarily because fixed costs increased as a percentage of total costs due to a decrease in third party facility contracts, as described under “Sources of Revenue—Ancillary Service Segment—Rehabilitation Therapy.” The increase in hospice cost of services was the result of the Hospice/Home Health Acquisition. Cost of services expense in our hospice business was challenged by labor inefficiencies in our California operations in 2009, which have since been remediated. Hospice and home health costs of services included $0.4 million of acquisition related costs in the nine months ended September 30, 2010 which will not recur.

Rent Cost of Revenue. Rent cost of revenue increased by $0.6 million, or 4.4%, to $14.2 million, or 2.4% of revenue, the nine months ended September 30, 2010, from $13.6 million, or 2.4% of revenue, for the nine months ended September 30, 2009, primarily due to rent costs of facilities relating to the Hospice/Home Health Acquisition as well as the rental rate increases at certain of our skilled facilities.

General and Administrative Services Expenses. Our general and administrative services expenses decreased $0.9 million, or 4.6%, to $18.5 million, or 3.1% of revenue, in the nine months ended September 30, 2010 from $19.4 million, or 3.4% of revenue, in the nine months ended September 30, 2009. The nine months ended September 30, 2009 included non-recurring legal and accounting costs of $0.9 million related to the 2009 restatement.

Litigation Settlement Expense. Litigation settlement expense was $53.5 million for the nine months ended September 30, 2010 with no comparable amount for the nine months ended September 30, 2009. The $53.5 million was comprised of a $50.0 million cash settlement related to the Humboldt County Action described in Note 8, Commitments and Contingencies—Litigation, $3.0 million of related legal expenses, and $0.5 million in securities class action costs related to the Shepardson v. Skilled Healthcare Group, Inc. described in Note 8, Commitments and Contingencies—Litigation.

Depreciation and Amortization. Depreciation and amortization increased by $0.8 million, or 4.6%, to $18.2 million, or 3.0% of revenue, in the nine months ended September 30, 2010, from $17.4 million, or 3.0% of revenue, in the nine months ended September 30, 2009. This increase primarily resulted from increased depreciation and amortization related to the opening of our developed skilled nursing facilities in Dallas and Fort Worth as well as other new assets placed in service during 2009 and 2010.

Interest Expense. Interest expense increased by $1.8 million, or 7.3%, to $26.5 million in the nine months ended September 30, 2010, from $24.7 million in the nine months ended September 30, 2009. The increase in our interest expense was primarily due to an increase in the average interest rate on our debt from 5.9% for the nine months ended September 30, 2009, to 6.2% for the nine months ended September 30, 2010, which resulted in additional interest expense of $1.2 million. The increase in our cost of borrowing was due to the refinancing of our credit facility in April 2010. Average debt outstanding increased by $13.6 million, from $479.0 million for the nine months ended September 30, 2009 to $492.6 million for the nine months ended September 30, 2010 which resulted in additional interest expense of $0.6. The increase in average debt outstanding was primarily due to the Hospice/Home Health Acquisition. The all in rate for the nine months ended September 30, 2010 was 7.2%, as compared to 6.8% in the nine months ended September 30, 2009.

Interest Income. Interest income decreased by $0.2 million, or 23.6%, to $0.7 million in the nine months ended September 30, 2010 from $0.9 million in the nine months ended September 30, 2009 due to a decrease in outstanding notes receivable.

Equity in Earnings of Joint Venture. Equity earnings of our joint venture was consistent at $2.2 million for the nine months ended September 30, 2010 and 2009.

Debt Retirement Cost. Debt retirement cost was $7.0 million for the nine months ended September 30, 2010 with no comparable amount for the nine months ended September 30, 2009 due to the expensing of deferred financing fees of $6.6 million and $0.4 million of interest rate swap termination costs as the swaps were incompatible with the refinanced credit facility.

Provision for Income Taxes. We had a tax benefit of $5.4 million, or 31.3% of our pre-tax loss, for the nine months ended September 30, 2010 as compared to a tax expense of $14.0 million, or 32.9% of pre-tax earnings for the nine months ended September 30, 2009. The tax benefit for the nine months ended September 30, 2010 is due to the pre-tax loss incurred as a result of the costs incurred for our litigation settlement.

EBITDA. EBITDA decreased by $56.5 million, or 67.8%, to $26.8 million in the nine months ended September 30, 2010, from $83.3 million in the nine months ended September 30, 2009. The $56.5 million decrease was primarily related to the $53.5 million litigation settlement expense, a $0.6 million increase in rent cost, a $1.8 million increase in interest expense, a $0.8 million increase in depreciation and amortization, and a decrease of $0.2 million in interest income, all discussed above.

Loss from Continuing Operations. Income from continuing operations decreased by $59.8 million to a loss of $17.3 million in the nine months ended September 30, 2010 from income of $42.5 million for the nine months ended September 30, 2009. The $59.8 million decrease was related primarily to the $7.0 million debt retirement costs and the $53.5 million litigation settlement expense, all discussed above.

Liquidity and Capital Resources

The following table presents selected data from our condensed consolidated statements of cash flows (in thousands):


	Nine Months Ended September 30,
	2010			2009
Cash Flows from Continuing Operations
Net cash provided by operating activities	$	4,138		$	45,407
Net cash used in investing activities		(68,541	)		(30,832	)
Net cash provided by (used in) financing activities		64,075			(13,777	)
Cash flows from discontinued operations		—			390

Net (decrease) increase in cash and equivalents		(328	)		1,188
Cash and cash equivalents at beginning of period		3,528			2,047

Cash and cash equivalents at end of period	$	3,200		$	3,235

Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Our principal sources of liquidity are cash generated by our operating activities and borrowings under our first lien revolving credit facility.

At September 30, 2010, we had cash of $3.2 million. Our available cash is held in accounts at third-party financial institutions. We have periodically invested in AAA money market funds. To date, we have experienced no loss or lack of access to our invested cash or cash equivalents; however, we can provide no assurances that access to our invested cash or cash equivalents will not be impacted by adverse conditions in the financial markets.

Net cash provided by operating activities from continuing operations primarily consists of net income adjusted for certain non-cash items including depreciation and amortization, provision for doubtful accounts, stock-based compensation, as well as the effect of changes in working capital and other activities. Cash provided by operating activities for the nine months ended September 30, 2010 was $4.1 million and consisted of net loss of $11.9 million, and adjustments for non-cash items of $34.1 million, offset by $18.1 million used for working capital and other activities. Working capital and other activities primarily consisted of a $3.1 million decrease in accounts payable and accrued liabilities, $3.4 million of payments on notes receivable, and a $2.8 million increase in employee compensation and benefits, offset by an increase in accounts receivable of $7.9 million, a $9.6 million increase in other current and non-current assets, a $4.7 million decrease in insurance liability risks and an increase in other long-term liabilities of $0.9 million. Days sales outstanding for continuing operations decreased from 47.0 for the three months ended December 31, 2009 to 41.7 for the three months ended September 30, 2010. The aforementioned legal settlement expense of $53.5 million negatively impacted cash flows from operations for the nine months ended September 30, 2010, as compared to the same period in 2009, because the $50.0 million escrow funds and most of the associated $3.0 million of legal expenses were funded in September 2010 but none of the related tax benefits will be realized until later this year.

Net cash provided by operating activities in the nine months ended September 30, 2009 was $45.4 million and consisted of net income of $28.1 million and adjustments for non-cash items of $33.0 million and $15.7 million used for working capital and other activities. Working capital and other activities primarily consisted of an increase in accounts receivable of $16.7 million, a $2.2 million decrease in insurance liability risks and a $7.1 million decrease in accounts payable and accrued liabilities, offset by a $5.8 million decrease in other current and non-current assets, a $3.4 million decrease in payments on notes receivable, a $0.8 million increase in other long-term liabilities, and a $0.3 million increase in employee compensation benefits.

Net cash used in investing activities for the nine months ended September 30, 2010 was $68.5 million, which consisted of capital expenditures of $23.2 million and $45.3 million of cash consideration paid for the Hospice/Home Health Acquisition in May 2010. The capital expenditures consisted of $7.5 million for construction of new healthcare facilities, $5.2 million for expansion of our Express Recovery™ Unit program and $10.5 million of routine capital expenditures.

Net cash used in investing activities for the nine months ended September 30, 2009 of $30.8 million was primarily attributable to capital expenditures of $29.2 million and acquisitions of healthcare facilities of $1.7 million. The capital expenditures consisted of $7.7 million for construction of new healthcare facilities, $6.5 million for expansion of our Express Recovery™ Unit program and $15.0 million of routine capital expenditures.

The increase in net cash used in investing activities for the nine months ended September 30, 2010 as compared to the nine months ended September 30, 2009 was the result of the cash consideration paid for the Hospice/Home Health Acquisition offset by lower routine capital expenditures for the nine months ended September 30, 2010.

Net cash provided by financing activities for the nine months ended September 30, 2010 of $64.1 million primarily reflects net repayment of borrowings under our line of credit of $27.0 million and repayment of long-term debt of $256.0 million, offset by the $357.3 million of proceeds from issuance of long-term debt and additions to deferred financing fees of $10.2 million. The aforementioned legal settlement expense of $53.5 million accounted for $45.0 million of borrowings for the nine months ended September 30, 2010.

Net cash provided by financing activities for the nine months ended September 30, 2009 of $13.7 million primarily reflects net borrowings under our line of credit of $2.0 million, offset by scheduled debt repayments of $7.8 million and additions to deferred financing fees of $8.0 million.

The change from the net cash used in financing activities of $13.8 million for the nine months ended September 30, 2009 to net cash provided by financing activities of $64.1 million was primarily the result of borrowings used to fund the Hospice/Home Health acquisition and the payment of the $50.0 million litigation settlement as well as the associated legal costs

Principal Debt Obligations

We are significantly leveraged. As of September 30, 2010, we had $544.3.0 million in aggregate indebtedness outstanding, consisting of $129.6 million principal amount of our 11.0% senior subordinated notes (net of the unamortized portion of the original issue discount of $0.4 million), a $355.7 million first lien senior secured term loan (net of the unamortized portion of the original issue discount of $2.5 million), $45.0 million principal amount outstanding under our $100.0 million revolving credit facility, and capital leases and other debt of approximately $14.0 million. Furthermore, we had $4.4 million in outstanding letters of credit against our $100.0 million revolving credit facility, leaving approximately $50.6 million of additional borrowing capacity under our amended senior secured credit facility as of September 30, 2010.

On April 9, 2010, we entered into an up to $360.0 million term loan and a $100.0 million revolving credit facility that replace the senior secured term loan and revolving credit facility that were set to mature in June 2012. The new revolving credit facility was undrawn at closing.

The term loan requires principal payments of 0.25% of the original principal amount issued on the last business day of each of March, June, September and December, commencing on June 30, 2010, with the balance due April 9, 2016. Amounts borrowed under the term loan may be prepaid at any time without penalty except for breakage costs. Commitments under the revolving loan terminate on April 9, 2015. However, if any of our 2014 Notes remain outstanding on October 14, 2013, then the maturity date of the term loan and revolving loan will be October 14, 2013. Amounts borrowed pursuant to the Restated Credit Agreement are secured by substantially all of our assets.

Under the Restated Credit Agreement, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum fixed charge coverage ratio (with a range of 1.5:1 to 2:1 as set forth in further detail in the Restated Credit Agreement) as well as a maximum leverage ratio (with a range of 5.5:1 to 4:1 as set forth in further detail in the Restated Credit Agreement). The Restated Credit Agreement also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the Restated Credit Agreement, subject to certain exceptions and minimum thresholds, we are required to apply all of the proceeds from any issuance of debt, half of the proceeds from any issuance of equity, half (or one quarter if our Consolidated Leverage Ratio, as defined in the Restated Credit Agreement, for such fiscal year is less than 3:1) of our annual Consolidated Excess Cash Flow, as defined in the Restated Credit Agreement, and, subject to permitted reinvestments, all amounts received in connection with any sale of our assets and casualty insurance and condemnation or eminent domain proceedings, in each case to repay the outstanding amounts under the Restated Credit Agreement.

Loans outstanding under the Restated Credit Agreement bear interest, at our election, either at the prime rate plus an initial margin of 2.75% or the London Interbank Offered Rate (“LIBOR”) plus an initial margin of 3.75%. Under the terms of the Restated Credit Agreement there is a LIBOR floor of 1.50%. We have a 0.5% commitment fee on the unused portion of the revolving line of credit. The interest rate margin on the loans can be reduced by 0.25% based on our Consolidated Leverage Ratio, as defined in the Restated Credit Agreement, for the applicable four-quarter period. Furthermore, we have the right to increase our borrowings under the term loan and/or the revolving loan up to an aggregate amount of $150.0 million provided that we are in compliance with the Restated Credit Agreement, that the additional debt would not cause any covenant violation of the Restated Credit Agreement, and that existing or new lenders within the Restated Credit Agreement or new lenders agree to increase their commitments.

In addition, we expensed deferred financing fees in the amount of $6.6 million. In conjunction with the closing of the refinancing, we terminated our existing swap agreements as they were incompatible with the new financing due to the existence of the LIBOR floor. The termination of the swap agreements cost $0.4 million.

Under the terms of our amended senior secured credit facility, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum interest coverage minimum ratio as well as a maximum leverage ratio. The covenants also include annual and lifetime limitations, including the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Furthermore, in addition to a $2.6 million annual permanent reduction requirement, we must permanently reduce the principal amount of debt outstanding by applying the proceeds from any asset sale, insurance or condemnation payments, issuance of additional indebtedness or equity, and 25% to 50% of excess cash flows from operations based on the leverage ratio then in effect.

Substantially all of our companies guarantee our 11.0% senior subordinated notes, the first lien senior secured term loan and our revolving credit facility.

Capital Expenditures

We intend to invest in the maintenance and general upkeep of our facilities on an ongoing basis. We also expect to perform renovations of our existing facilities every five to ten years to remain competitive. Combined, we expect that these activities will amount to approximately $1,500 per bed, or approximately $15.0 million in capital expenditures in 2010 on our existing facilities. In addition, we have substantially completed the expansion of our Express Recovery™ Units. These units cost, on average, between $0.4 million and $0.6 million each. We completed two Express Recovery™ Units during the three months ended September 30, 2010. We are in the process of developing one additional Express Recovery™ Unit that is scheduled to be completed by December 31, 2010.

Our relationship with Baylor Healthcare System offers us the ability to build long-term care facilities selectively on Baylor acute campuses. In the first quarter of 2009, we completed a 136-bed skilled nursing facility in downtown Dallas. In the second quarter of 2010, we completed a 136-bed skilled nursing facility in downtown Forth Worth, Texas. We currently have a facility we are planning and/or developing at or near Baylor Hospitals in Texas– located in Garland, Texas (a northern suburb of Dallas). The Garland, Texas site consists of land we recently acquired that is adjacent to the Baylor Garland Hospital. The Garland, Texas site is currently in the design and site preparation phase.

We may also invest in expansions of our existing facilities and the acquisition or development of new facilities. We currently anticipate that we will have capital expenditures in 2010 of approximately $26 million. We currently estimate that we will incur approximately $25.0 million of capital expenditures in 2011. Due to the proposed slowdown in the growth of Medicare and Medicaid spending, we will continue to assess our capital spending plans going forward. For more detailed information regarding the slowdown in growth of Medicare and Medicaid spending, see “Sources of Revenue—Medicare” in Part I, Item 2.

Based upon our current level of operations, we believe that cash generated from operations, cash on hand and borrowings available to us will be adequate to meet our anticipated debt service requirements, capital expenditures and working capital needs for at least the next 12 months. One element of our business strategy is to selectively pursue acquisitions and strategic alliances. Any acquisitions or strategic alliances may result in the incurrence of, or assumption by us, of additional indebtedness. We continually assess our capital needs and may seek additional financing through a variety of methods including through an extension of our revolving credit facility or by accessing available debt and equity markets, as considered necessary to fund capital expenditures and

potential acquisitions or for other purposes. Our future operating performance, ability to service or refinance our 11.0% senior subordinated notes and ability to service and extend or refinance our senior secured credit facilities and our 11.0% senior subordinated notes will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control. For additional discussion, see “Other Factors Affecting Liquidity and Capital Resources—Global Market and Economic Conditions” below in Part 1, Item 2 of this Quarterly Report.

Other Factors Affecting Liquidity and Capital Resources

Medical and Professional Malpractice and Workers’ Compensation Insurance. Skilled nursing facilities, like physicians, hospitals and other healthcare providers, are subject to a significant number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain professional liability and general liability as well as workers’ compensation insurance in amounts and with self-insured retentions and deductibles that we believe to be appropriate for our operations. Historically, unfavorable pricing and availability trends emerged in the professional liability and workers’ compensation insurance market and the insurance market in general that caused the cost of these liability coverages to generally increase dramatically. Many insurance underwriters became more selective in the insurance limits and types of coverage they would provide as a result of rising settlement costs and the significant failures of some nationally known insurance underwriters. As a result, we were required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is an amount of damages and expenses (including legal fees) that we must pay for each claim. We use actuarial methods to estimate the value of the losses that may occur within this self-insured retention level and we are required under our workers’ compensation insurance agreements to post a letter of credit or set aside cash in trust funds to securitize the estimated losses that we may incur. Because of the high retention levels, we cannot predict with absolute certainty the actual amount of the losses we will assume and pay.

We estimate our general and professional liability reserves on a quarterly basis and our workers’ compensation reserve on a semiannual basis, based upon actuarial analyses using the most recent trends of claims, settlements and other relevant data from our own and our industry’s loss history. Based upon these analyses, at September 30, 2010, we had reserved $18.0 million for known or unknown or potential uninsured general and professional liability claims and $15.8 million for workers’ compensation claims. We have estimated that we may incur approximately $4.2 million for general and professional liability claims and $4.2 million for workers’ compensation claims for a total of $8.4 million to be payable within 12 months; however, there are no set payment schedules and we cannot assure you that the payment amount in 2010 will not be significantly larger or smaller. To the extent that subsequent claims information varies from loss estimates, the liabilities will be adjusted to reflect current loss data. There can be no assurance that in the future general and professional liability or workers’ compensation insurance will be available at a reasonable price or that we will not have to further increase our levels of self-insurance. For a detailed discussion of our general and professional liability and workers’ compensation reserve, see “Business — Insurance” in Part 1, Item 1 in our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Inflation. We derive 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. However, we cannot assure you that these adjustments will continue in the future and, if received, will reflect the actual increase in our costs for providing healthcare services. See Part I, Item 2 – Regulatory and Other Governmental Actions Affecting Revenue for more detailed information.

Labor and supply expenses make up a substantial portion of our operating expenses. 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 cannot assure you that we will be successful in offsetting future cost increases.

Global Market and Economic Conditions. Recent global market and economic conditions have been unprecedented and challenging with tight credit conditions and recession in most major economies expected to continue throughout the remainder of 2010 and possibly longer.

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 generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to borrowers. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in the U.S. and international markets and economies and prolonged declines in business and consumer spending may adversely affect our liquidity and financial condition. Although we recently were able to extend the maturity of our revolving loan commitments and maintain existing interest rate spreads on that credit facility (see –”Principal Debt Obligations and Capital Expenditures” above), if these market conditions continue, they may impact our ability in the future to timely replace maturing liabilities, access the capital markets to meet liquidity needs, and service or refinance our 11.0% senior subordinated notes and our senior secured credit facilities, resulting in an adverse effect on our financial condition, including liquidity, capital resources and results of operations.

Medicare and Medicaid Reimbursement Climate. Recently proposed slowdowns in the growth of Medicare and Medicaid spending may result in an increase in our costs for providing healthcare services and have an adverse impact on our financial condition, including results of operations. For more detailed information regarding the slowdown in growth of Medicare and Medicaid spending, see “Sources of Revenue—Medicare” in Part I, Item 2 and “Risk Factors — We expect the federal and state governments to continue their efforts to contain growth in Medicaid expenditures, which could adversely affect our revenue and profitability” in Part 1, Item 1A of our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Recent Accounting Standards

See Item 1 of Part I, “Financial Statements — Note 2 — Summary of Significant Accounting Policies — Recent Accounting Pronouncements.”

Off-Balance Sheet Arrangements

We have outstanding letters of credit of $4.4 million under our $100.0 million revolving credit facility as of September 30, 2010.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

In the normal course of business, our operations are exposed to risks associated with fluctuations in interest rates. To the extent these interest rates increase, our interest expense will increase, in which event we may have difficulties making interest payments and funding our other fixed costs, and our available cash flow may be adversely affected. We routinely monitor our risks associated with fluctuations in interest rates and consider the use of derivative financial instruments to hedge these exposures. We do not enter into derivative financial instruments for trading or speculative purposes nor do we enter into energy or commodity contracts.

Interest Rate Exposure — Interest Rate Risk Management

We use our senior secured credit facility and 11.0% senior subordinated notes to finance our operations. Our first lien credit agreement exposes us to variability in interest payments due to changes in interest rates. We entered into an interest rate cap agreement and an interest rate swap agreement on June 30, 2010 in order to manage fluctuations in cash flows resulting from interest rate risk. The interest rate cap agreement is for a notional amount of $70.0 million with a cap rate on 1 month LIBOR of 2.0% from July 2010 to December 2011. The interest rate swap agreement is for a notional amount of $70.0 million with an interest rate of 2.3% from January 2012 to June 2013.

The table below presents the principal amounts, weighted-average interest rates and fair values by year of expected maturity to evaluate our expected cash flows and sensitivity to interest rate changes of our debt that was outstanding as of September 30, 2010 (dollars in thousands):


	Twelve Months Ending September 30, ⁽³⁾
	2011			2012			2013			2014			2015			Thereafter			Total		Fair Value
Fixed-rate debt ⁽¹⁾	$	2,506		$	2,148		$	2,157		$	132,167		$	2,177		$	655		$	141,811	$	140,511
Average interest rate		5.6	%		6.0	%		6.0	%		10.9	%		6.0	%		6.0	%

Variable-rate debt ⁽²⁾	$	3,600		$	3,600		$	3,600		$	3,600		$	48,600		$	340,200		$	403,200	$	391,559
Average interest rate⁽³⁾		5.3	%		5.3	%		5.3	%		5.9	%		6.5	%		7.0	%

(1)	Excludes unamortized original issue discount of $0.4 million on our 11.0% senior subordinated notes.

(2)	Excludes unamortized original issue discount of $2.5 million on our first lien senior secured term loan debt.

(3)	Based on implied forward three-month LIBOR rates in the yield curve as of September 30, 2010.

For the nine months ended September 30, 2010, the total net loss recognized from converting from floating rate (one-month LIBOR) to fixed rate for a portion of the interest payments under our long-term debt obligations was approximately $0.3 million. As of September 30, 2010, there was $0.4 million of unrealized gains included in other comprehensive income. Below is a table listing the interest expense exposure detail and the fair value of the interest rate hedge transactions as of September 30, 2010 (dollars in thousands):


Loan	Transaction Type		Notional Amount		Trade Date		Effective Date		Maturity/ Termination Date		Nine months Ended September 30, 2010			Fair Value (Pre-tax)
First Lien		swap	$	145,000		12/7/09		12/31/09		4/9/10	$	(148	)	$	—
First Lien		swap	$	100,000		12/7/09		01/31/10		4/9/10	$	(116	)	$	—
First Lien		cap	$	70,000		6/30/10		7/2/10		12/31/11	$	—		$	31
First Lien		swap	$	70,000		6/30/10		1/1/12		6/30/13	$	—		$	(522	)

											$	(264	)	$	(491	)

The fair value of interest rate swap and cap agreements designated as hedging instruments against the variability of cash flows associated with floating-rate, long-term debt obligations are reported in accumulated other comprehensive income. These amounts subsequently are reclassified into interest expense as a yield adjustment in the same period in which the related interest on the floating-rate debt obligation affects earnings. We evaluate the effectiveness of the cash flow hedge, in accordance with FASB ASC Topic 815, “Derivatives and Hedging,” on a quarterly basis. Should the hedge become ineffective, the change in fair value would be recognized in our consolidated statements of operations. Should the counterparty’s credit rating deteriorate to the point at which it would be likely that the counterparty would default, the hedge would then be ineffective. We terminated the foregoing interest rate swap agreements in conjunction with the closing of the refinancing described in Part I, Item I, Note 12, but we continue to assess our exposure to interest rate risk on an ongoing basis.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

As required by Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report.

Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and implementing possible controls and procedures.

We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon their evaluation and subject to the foregoing, the Chief Executive Officer and Chief Financial Officer have concluded that, as of end of the period covered by this report, the disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required.

Changes in Internal Control Over Financial Reporting

Management determined that there were no changes in our internal control over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

Item 1. Legal Proceedings

The information required by this Item is incorporated herein by reference to Note 8, “Commitments and Contingencies—Litigation,” to the unaudited condensed consolidated financial statements under Part I, Item 1 of this report.

Item 1A. Risk Factors

For a detailed discussion of the risk factors that should be understood by any investor contemplating investment in our stock, please refer to Part II, Item 1A, Risk Factors, in our Form 10-K for the year ended December 31, 2009, and our subsequent Quarterly Reports on Form 10-Q that have been filed with the Securities and Exchange Commission.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Reserved

Item 5. Other Information

Item 6. Exhibits

(a)

Exhibits.


Number		Description

10.1		Class Settlement Agreement and Release, dated as of September 7, 2010 (filed as Exhibit 10.1 to our Current Report on Form 8-K filed on September 8, 2010 and incorporated herein by reference).

10.2		Settlement Agreement and Release with The People of the State of California, by and through Intervenor, the Humboldt County District Attorney’s Office, dated as of September 7, 2010 (filed as Exhibit 10.2 to our Current Report on Form 8-K filed on September 8, 2010 and incorporated herein by reference).

31.1*		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32**		Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Filed herewith.

**	Furnished herewith.

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.


		SKILLED HEALTHCARE GROUP, INC.

Date: November 2, 2010		/s/ Devasis Ghose
		Devasis Ghose
		Executive Vice President, Treasurer and Chief Financial Officer
		(Principal Financial Officer and Authorized Signatory)

		/s/ Christopher N. Felfe
		Christopher N. Felfe
		Senior Vice President, Finance and Chief Accounting Officer

EXHIBIT INDEX


Number		Description

10.1		Class Settlement Agreement and Release, dated as of September 7, 2010 (filed as Exhibit 10.1 to our Current Report on Form 8-K filed on September 8, 2010 and incorporated herein by reference).

10.2		Settlement Agreement and Release with The People of the State of California, by and through Intervenor, the Humboldt County District Attorney’s Office, dated as of September 7, 2010 (filed as Exhibit 10.2 to our Current Report on Form 8-K filed on September 8, 2010 and incorporated herein by reference).

31.1*		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32**		Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Filed herewith.

**	Furnished herewith.