Genesis Healthcare, Inc. - Quarter Report: 2011 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended September 30, 2011.



£	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 Q 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 Q 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.



Large accelerated filer	£		Accelerated filer	Q

Non-accelerated filer	£	(do not check if smaller reporting company)	Smaller reporting company	£

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on October 28, 2011.

Class A common stock, $0.001 par value – 21,075,798 shares

Class B common stock, $0.001 par value – 16,936,905 shares

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Skilled Healthcare Group, Inc.

Form 10-Q

For the Quarterly Period Ended September 30, 2011

Index



		Page Number
Part I.	Financial Information
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets — September 30, 2011 (unaudited) and December 31, 2010	4
	Condensed Consolidated Statements of Operations — Three and nine months ended September 30, 2011 (unaudited) and September 30, 2010 (unaudited)	5
	Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2011 (unaudited) and September 30, 2010 (unaudited)	6
	Notes to Unaudited Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	50
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	51
Item 4.	Controls and Procedures	51
Part II.	Other Information
Item 1.	Legal Proceedings	52
Item 1A.	Risk Factors	65
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	65
Item 3.	Defaults Upon Senior Securities	65
Item 4.	Reserved	66
Item 5.	Other Information	66
Item 6.	Exhibits	66
Signatures		68
Exhibit Index		69

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

Skilled Healthcare Group, Inc.

Condensed Consolidated Balance Sheets

(In thousands)



	September 30, 2011			December 31, 2010
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	16,442		$	4,192
Accounts receivable, less allowance for doubtful accounts of $15,332 and $17,710 at September 30, 2011 and December 31, 2010, respectively	102,095			98,777
Deferred income taxes	12,512			20,419
Prepaid expenses	8,372			9,618
Other current assets	9,866			15,819
Total current assets	149,287			148,825
Property and equipment, less accumulated depreciation of $90,165 and $76,017 at September 30, 2011 and December 31, 2010, respectively	376,290			387,322
Leased facility assets, less accumulated depreciation of $3,283 at September 30, 2011	10,869			—
Other assets:
Notes receivable	5,862			5,877
Deferred financing costs, net	10,688			13,165
Goodwill	72,847			332,724
Intangible assets, less accumulated amortization of $6,772 and $15,646 at September 30, 2011 and December 31, 2010, respectively	22,452			25,341
Deferred income taxes	11,242			—
Other assets	34,351			31,036
Total other assets	157,442			408,143
Total assets	$	693,888		$	944,290
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	49,259		$	50,898
Employee compensation and benefits	36,056			39,400
Current portion of long-term debt	6,287			5,742
Total current liabilities	91,602			96,040
Long-term liabilities:
Insurance liability risks	30,846			32,034
Deferred income taxes	—			8,431
Other long-term liabilities	16,499			15,984
Long-term debt, less current portion	485,847			514,221
Total liabilities	624,794			666,710
Stockholders’ equity:
Class A common stock, 175,000 shares authorized, $0.001 par value per share; 21,081 and 20,780 at September 30, 2011 and December 31, 2010, respectively	21			21
Class B common stock, 30,000 shares authorized, $0.001 par value per share; 16,937 and 16,994 at September 30, 2011 and December 31, 2010, respectively	17			17
Additional paid-in-capital	370,593			368,582
Accumulated deficit	(301,018		)	(90,822		)
Accumulated other comprehensive loss	(519		)	(218		)
Total stockholders’ equity	69,094			277,580
Total liabilities and stockholders’ equity	$	693,888		$	944,290

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

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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,
	2011			2010			2011			2010
Revenue:
Net patient service revenue	$	216,409		$	209,199		$	653,788		$	599,489
Leased facility revenue	746			—			1,492			—
	217,155			209,199			655,280			599,489
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)	173,548			168,579			520,258			482,291
Rent cost of revenue	4,413			4,796			13,530			14,209
General and administrative	5,423			6,016			19,553			18,479
Litigation settlement costs, (net of recoveries)	(4,488		)	53,505			(4,488		)	53,505
Depreciation and amortization	6,459			6,305			19,036			18,241
Impairment of long-lived assets	270,478			—			270,478			—
	455,833			239,201			838,367			586,725
Other income (expenses):
Interest expense	(9,711		)	(10,086		)	(29,319		)	(26,535		)
Interest income	170			260			553			684
Other (expense) income	(123		)	9			(477		)	588
Equity in earnings of joint venture	472			746			1,583			2,221
Debt retirement costs	—			—			—			(7,010		)
Total other income (expenses), net	(9,192		)	(9,071		)	(27,660		)	(30,052		)
Loss before benefit from income taxes	(247,870		)	(39,073		)	(210,747		)	(17,288		)
Benefit from income taxes	(15,259		)	(13,766		)	(551		)	(5,406		)
Net loss	$	(232,611	)	$	(25,307	)	$	(210,196	)	$	(11,882	)
Loss per share, basic
Loss per share	$	(6.26	)	$	(0.68	)	$	(5.66	)	$	(0.32	)
Loss per share, diluted
Loss per share	$	(6.26	)	$	(0.68	)	$	(5.66	)	$	(0.32	)
Weighted-average common shares outstanding, basic	37,164			36,997			37,133			36,981
Weighted-average common shares outstanding, diluted	37,164			36,997			37,133			36,981

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

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Skilled Healthcare Group, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)



	Nine Months Ended September 30,
	2011			2010
Cash Flows from Operating Activities
Net loss	(210,196		)	(11,882		)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization	19,036			18,241
Provision for doubtful accounts	5,432			7,426
Non-cash stock-based compensation	2,434			2,203
Excess tax benefits from stock-based payment arrangements	(309		)	—
Disposal of property and equipment	293			(479		)
Amortization of deferred financing costs	2,477			3,067
Write-off of deferred financing costs	—			6,574
Deferred income taxes	(11,145		)	(3,387		)
Impairment of long-lived assets	270,478			—
Amortization of discount on debt	437			318
Changes in operating assets and liabilities:
Accounts receivable	(11,808		)	(7,862		)
Payments on notes receivable	4,112			3,400
Other current and non-current assets	3,618			(9,637		)
Accounts payable and accrued liabilities	(3,033		)	(2,982		)
Employee compensation and benefits	(3,415		)	2,812
Insurance liability risks	(1,981		)	(4,700		)
Other long-term liabilities	(239		)	1,110
Net cash provided by operating activities	66,191			4,222
Cash Flows from Investing Activities
Additions to property and equipment	(11,116		)	(23,161		)
Acquisition of healthcare facilities and businesses, net of cash acquired	(13,647		)	(45,380		)
Acquisition of home health licenses	(350		)	—
Proceeds from sale of property and equipment	400			—
Net cash used in investing activities	(24,713		)	(68,541		)
Cash Flows from Financing Activities
Borrowings under line of credit	88,000			155,000
Repayments under line of credit	(114,000		)	(182,000		)
Repayments of long-term debt and capital leases	(2,805		)	(256,018		)
Proceeds from issuance long-term debt	—			357,300
Additions to deferred financing costs	—			(10,207		)
Exercise of stock options	26			—
Excess tax benefits from stock-based payment arrangements	309			—
Taxes paid related to net share settlement of equity awards	(758		)	(84		)
Net cash (used in) provided by financing activities	(29,228		)	63,991
Increase (decrease) in cash and cash equivalents	12,250			(328		)
Cash and cash equivalents at beginning of period	4,192			3,528
Cash and cash equivalents at end of period	$	16,442		$	3,200

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

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	Nine Months Ended September 30,
	2011		2010
Supplemental cash flow information
Cash paid for:
Interest expense, net of capitalized interest	$	32,074	$	23,832
Income taxes paid, net of refunds	$	1,357	$	10,079
Non-cash activities:
Conversion of accounts receivable into notes receivable	$	1,529	$	2,403
Liabilities issued as purchase consideration for purchase of business	$	1,317	$	15,030
Insurance premium financed	$	1,123	$	1,100

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

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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 subsidiaries are collectively referred to as the “Company.” As of September 30, 2011, the Company operated facilities in California, Iowa, Kansas, Missouri, Nebraska, Nevada, New Mexico and Texas, including 74 skilled nursing facilities (“SNFs”), which offer sub-acute care and rehabilitative and specialty healthcare skilled nursing care, and 23 assisted living facilities (“ALFs”), which provide room and board and social services. Effective April 1, 2011, the Company leased five skilled nursing facilities in California to an unaffiliated third party operator. For a detailed discussion of the lease arrangements, see Note 7 - "Property and Equipment." 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, 2011, the Company provided hospice care in Arizona, California, Idaho, Montana, Nevada and New Mexico. Additionally, as of September 30, 2011 the Company operated home health agencies in California, Nevada, Arizona, Idaho, Montana and New Mexico. The Company has an administrative services company that provides a full complement of administrative and consultative services that allows affiliated operators and third-party facility operators with whom the Company contracts to better focus on delivery of healthcare services. The Company currently has one such service agreement with an unrelated skilled nursing 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 July 29, 2011, the Centers for Medicare & Medicaid Services ("CMS") issued a final rule for its fiscal year ending September 30, 2012 for skilled nursing facilities, reducing Medicare reimbursement rates for skilled nursing facilities by 11.1% and also making changes to rehabilitation therapy regulations which will have a significant negative effect on the Company's revenue and costs in Medicare's fiscal year ending September 30, 2012 as compared to Medicare's fiscal year ended September 30, 2011. See Management's Discussion and Analysis of Financial Condition and Results of Operations - "Industry Trends- Medicare and Medicaid Reimbursement," for additional information. As a result of the CMS final rule, the Company recorded a non-cash goodwill and intangible asset impairment charge of $270.5 million for the three and nine months ended September 30, 2011. For additional information see Note 2, “Goodwill and Other Long-Lived Asset Impairment Testing.”

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements as of September 30, 2011 and for the three and nine months ended September 30, 2011 and 2010 (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, 2010, which are included in the Company’s 2010 Annual Report on Form 10-K filed with the Securities Exchange Commission ("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 as of the dates and for the periods presented. 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 Skilled and its consolidated wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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, impairment of long lived assets, the self-insured portion of general and professional liability and workers’ compensation claims and income taxes. Actual results could differ materially from those estimates.

Information regarding the Company’s significant accounting policies is contained in Note 2 - “Summary of Significant Accounting Policies” in the Company’s 2010 Annual Report on Form 10-K filed with the SEC.

Reclassifications

Certain prior year amounts have been reclassified to conform to current year presentation, including excess tax benefits from stock-based payment arrangements in the Condensed Consolidated Statements of Cash Flows of $0.1 million for the nine months ended September 30, 2010 were reclassified from operating activity to financing activity.

Notes Receivable

As of September 30, 2011 and December 31, 2010, notes receivable, net were approximately $8.6 million and $9.7 million, respectively, of which $2.8 million and $3.8 million was reflected as current assets as of September 30, 2011 and December 31, 2010, respectively, with the remaining balances reflected as long-term assets. Interest rates on these notes approximate market rates as of the date the notes were originated.

As of September 30, 2011, two customers of the Company's rehabilitation therapy services business (sometimes referred to herein as the "Hallmark Rehabilitation business") were responsible for $8.6 million, or 97.5% of the total notes receivable balance. These notes receivable as well as the trade receivables from these customers, plus the trade receivable from one additional customer, are personally guaranteed by the principal owners of the customers. As of September 30, 2011, these three customers represented 58.6% of the net accounts receivable for the Company’s rehabilitation therapy services business. For the nine months ended September 30, 2011, these three customers represented approximately 50.8% of the external revenue of the rehabilitation therapy services business. The remaining notes receivable of $0.2 million, or 2.5% 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, 2011 and December 31, 2010 was $0.2 million.

Goodwill and Other Long-Lived 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 a result of the aforementioned July 29, 2011 announcement by CMS regarding the reimbursement reductions and other changes that went into effect on October 1, 2011, and which led to a significant decline in the stock price of the Company, an interim goodwill impairment analysis was conducted as of August 31, 2011.

The Company periodically evaluates the carrying value of our long−lived assets other than goodwill, primarily consisting of our investments in real estate, for impairment indicators. If indicators of impairment are present, the carrying value of the related real estate investments in relation to the future discounted cash flows of the underlying operations is evaluated to assess recoverability of the assets. Measurement of the amount of the impairment, if any, may be based on independent appraisals, established market values of comparable assets or estimates of future cash flows expected. The estimates of these future cash flows are based on assumptions and projections believed by management to be reasonable and supportable. They require management's subjective judgments and take into account assumptions about revenue and expense growth rates. These assumptions may vary by type of long-lived asset.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Goodwill and Long-Lived Asset Impairment Testing

As of August 31, 2011, the Company determined the fair value of the long-term care and therapy services reporting units for goodwill and intangible assets based upon a combination of the discounted cash flow (income approach) and guideline public company method (market approach). After the fair value was determined and compared to the carrying value of each reporting entity, the Company concluded that the carrying value of the long-term care and therapy services reporting units exceeded their fair value and step two of the analysis was performed. The fair value of the hospice and home health reporting units exceeded their carrying value.

Upon completion of step two, the Company recorded a goodwill impairment charge as of and for the period ended September 30, 2011 of $243.2 million and $24.3 million, with respect to the long−term care reporting unit and the therapy services reporting unit, respectively, as the carrying value of goodwill exceeded its implied fair value. These amounts are included within the caption "Impairment of long-lived assets" in the accompanying statement of operations.

Additionally, after evaluating its long-lived assets, an impairment charge of $3.0 million was recognized within the therapy services reporting unit related to the Hallmark Rehabilitation business' trade name and is included within the caption "Impairment of long-lived assets" in the accompanying statement of operations for the three and nine months ended September 30, 2011.

As of September 30, 2011, goodwill in the amount of $72.8 million was recorded on our consolidated balance sheet, of which $9.7 million related to the rehabilitation therapy unit, $42.1 million related to the hospice reporting unit and $21.0 million related to the home health reporting unit.

The Company did not record an impairment charge in 2010.

Recent Accounting Pronouncements

In August 2010, the FASB issued Accounting Standards Update (ASU) No 2010-24, Health Care Entities (Topic 954), Presentation of Insurance Claims and Related Insurance Recoveries (“ASU 2010-24”), which clarifies that companies should not net insurance recoveries against a related claim liability. Additionally, the amount of the claim liability should be determined without consideration of insurance recoveries. The adoption of ASU 2010-24 became effective for the Company beginning January 1, 2011. The Company recorded $6.8 million and $6.6 million in insurance recovery receivables and a corresponding increase in insurance risk liability as of September 30, 2011 and December 31, 2010, respectively. See Note 6, - "Other Current Assets and Other Assets."

In June 2011, the FASB issued ASU No 2011-05, Presentation of Comprehensive Income ("ASU 2011-05"), which revises the manner in which companies present comprehensive income in their financial statements. The new guidance removes the current option to report other comprehensive income and its components in the statement of changes in equity and instead requires presenting in one continuous statement of comprehensive income or two separate but consecutive statements. The adoption of ASU 2011-05 becomes effective for the Company's interim and annual periods beginning January 1, 2012. The Company does not believe the adoption of this guidance will have a material impact on its consolidated financial statements, as it only requires a change in the format of presentation.

In July 2011, the Emerging Issues Task Force (EITF) of the FASB reached a consensus that would require health care entities to separately present bad debt expense related to patient service revenue as a reduction of patient service revenue (net of contractual allowances and discounts) on the income statement for entities that do not assess a patient's ability to pay prior to rendering services. Further, it was determined, net presentation of bad debt expense in revenue would only apply to bad debts that are related to patient service revenue, to entities that do not provide services prior to assessing a patient's ability to pay, or to entities that recognize revenue only after deciding that collection is reasonably assured. In addition, the final consensus requires health care entities to disclose information about the activity in the allowance for doubtful accounts, such as recoveries and write-offs, by using a mixture of qualitative and quantitative data. It will also require disclosure of our policies for (i) assessing the timing and amount of uncollectible revenue recognized as bad debt expense; and (ii) assessing collectability in the timing and amount of revenue (net of contractual allowances and discounts. The final consensus will be applied retrospectively effective for interim and annual periods beginning after December 15, 2011.

In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, (“ASU 2011-08”), which amends the guidance in ASC 350-20, Intangibles – Goodwill and Other. Under ASU 2011-08, entities have the option of performing a qualitative assessment before calculating the fair value of the reporting unit when testing goodwill for impairment. If the fair

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

value of the reporting unit is determined, based on qualitative factors, to be more likely than not less than the carrying amount of the reporting unit, then entities are required to perform the two-step goodwill impairment test. ASU 2011-08 will be effective for the Company’s fiscal year beginning January 1, 2012, with early adoption permitted. The Company is currently evaluating the effect that ASU 2011-08 will have on its consolidated financial statements.

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

The Company computes loss 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 loss is allocated on a proportionate basis to each class of common stock in the determination of loss per share.

Basic loss per share was computed by dividing net income by the weighted-average number of outstanding shares for the period. The following table sets forth the computation of basic and diluted loss per share of Class A common stock and Class B common stock for the three and nine months ended September 30, 2011 and 2010 (amounts in thousands, except per share data):



	Three months ended September 30, 2011									Three months ended September 30, 2010									Nine months ended September 30, 2011									Nine months ended September 30, 2010
	Class A			Class B			Total			Class A			Class B			Total			Class A			Class B			Total			Class A			Class B			Total
Loss per share, basic
Numerator:
Allocation of net loss	$	(126,601	)	$	(106,010	)	$	(232,611	)	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	(114,186	)	$	(96,010	)	$	(210,196	)	$	(6,420	)	$	(5,462	)	$	(11,882	)
Loss per share, diluted
Numerator:
Allocation of net loss	$	(126,601	)	$	(106,010	)	$	(232,611	)	$	(13,678	)	$	(11,629	)	$	(25,307	)	$	(114,186	)	$	(96,010	)	$	(210,196	)	$	(6,420	)	$	(5,462	)	$	(11,882	)
Denominator for basic and diluted loss per share:
Weighted average common shares outstanding, basic	20,227			16,937			37,164			19,996			17,001			36,997			20,172			16,961			37,133			19,980			17,001			36,981
Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable	—			—			—			—			—			—			—			—			—			—			—			—
Adjusted weighted-average common shares outstanding, diluted	20,227			16,937			37,164			19,996			17,001			36,997			20,172			16,961			37,133			19,980			17,001			36,981
Loss per share, basic:
Loss per share	$	(6.26	)	$	(6.26	)	$	(6.26	)	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	(5.66	)	$	(5.66	)	$	(5.66	)	$	(0.32	)	$	(0.32	)	$	(0.32	)
Loss per share, diluted:
Loss per share	$	(6.26	)	$	(6.26	)	$	(6.26	)	$	(0.68	)	$	(0.68	)	$	(0.68	)	$	(5.66	)	$	(5.66	)	$	(5.66	)	$	(0.32	)	$	(0.32	)	$	(0.32	)

The following were excluded from the weighted-average diluted shares computation for the three and nine months ended September 30, 2011 and 2010, as their inclusion would have been anti-dilutive (shares in thousands):



	Three Months Ended September 30,		Nine Months Ended September 30,
	2011	2010	2011	2010
Options to purchase common shares	518	1,015	109	939
Non-vested common shares	538	666	47	5
Total excluded	1,056	1,681	156	944

4. Business Segments

The Company has three reportable operating segments — (i) long-term care (“LTC”), which includes the operation of SNFs and ALFs, which is the most significant portion of the Company’s business, and the facility lease revenue from a third party operator: (ii) therapy services, which includes the Company’s rehabilitation therapy services business; and (iii) hospice and home health services, which includes the Company's hospice and home health businesses. The “other” category in the table below 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.

At September 30, 2011, LTC services were primarily provided by 74 wholly-owned SNF operating companies that offer post-acute, rehabilitative and specialty skilled nursing care, as well as 23 wholly-owned ALF operating companies that provide room and board and social services. Therapy services include rehabilitative services such as physical, occupational and speech therapy provided in the Company’s facilities and in unaffiliated facilities. Hospice and home health services were provided by our wholly owned subsidiary to patients in October 2004 and expanded in May 2010 as a result of the acquisition of substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies by wholly owned subsidiaries (which is sometimes referred to herein as the "Hospice/Home Health Acquisition"). As a result of this acquisition, these wholly owned subsidiaries began providing home health services, which entails direct home nursing and therapy services operations through licensed and Medicare-certified agencies.

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



	Long-term Care Services			Therapy Services			Hospice & Home Health Services		Other			Elimination			Total
Three months ended September 30, 2011
Net patient service revenue from external customers	$	171,800		$	23,158		$	21,451	$	—		$	—		$	216,409
Leased facility revenue	746			—			—		—			—			746
Intersegment revenue	390			15,759			—		—			(16,149		)	—
Total revenue	$	172,936		$	38,917		$	21,451	$	—		$	(16,149	)	$	217,155
Operating income (loss)	$	(214,060	)	$	(23,428	)	$	4,413	$	(5,603	)	$	—		$	(238,678	)
Interest expense, net of interest income															(9,541		)
Other expense															(123		)
Equity in earnings of joint venture															472
Loss before benefit from income taxes															$	(247,870	)
Depreciation and amortization	$	5,755		$	107		$	432	$	165		$	—		$	6,459
Segment capital expenditures	$	4,866		$	286		$	114	$	134		$	—		$	5,400
Adjusted EBITDA	$	29,997		$	3,978		$	4,900	$	(5,020	)	$	—		$	33,855
Adjusted EBITDAR	$	34,181		$	3,978		$	5,115	$	(5,006	)	$	—		$	38,268
Three months ended September 30, 2010
Net patient service revenue from external customers	$	172,591		$	19,160		$	17,448	$	—		$	—		$	209,199
Intersegment revenue	324			17,177			—		—			(17,501		)	—
Total revenue	$	172,915		$	36,337		$	17,448	$	—		$	(17,501	)	$	209,199
Operating income (loss)	$	(31,028	)	$	4,876		$	2,957	$	(6,807	)	$	—		$	(30,002	)
Interest expense, net of interest income															(9,826		)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



	Long-term Care Services			Therapy Services			Hospice & Home Health Services		Other			Elimination			Total
Other income															9
Equity in earnings of joint venture															746
Loss before benefit from income taxes															$	(39,073	)
Depreciation and amortization	$	5,844		$	93		$	120	$	248		$	—		$	6,305
Segment capital expenditures	$	4,461		$	819		$	—	$	80		$	—		$	5,360
Adjusted EBITDA	$	27,810		$	4,969		$	3,194	$	(5,410	)	$	—		$	30,563
Adjusted EBITDAR	$	32,275		$	5,008		$	3,463	$	(5,387	)	$	—		$	35,359
Nine months ended September 30, 2011
Net patient service revenue from external customers	$	526,355		$	69,051		$	58,382	$	—		$	—		$	653,788
Leased facility revenue	1,492			—			—		—			—			1,492
Intersegment revenue	1,281			48,925			—		—			(50,206		)	—
Total revenue	$	529,128		$	117,976		$	58,382	$	—		$	(50,206	)	$	655,280
Operating income (loss)	$	(161,368	)	$	(12,359	)	$	10,723	$	(20,083	)	$	—		$	(183,087	)
Interest expense, net of interest income															(28,766		)
Other expense															(477		)
Equity in earnings of joint venture															1,583
Loss before benefit from income taxes															$	(210,747	)
Depreciation and amortization	$	17,120		$	311		$	1,118	$	487		$	—		$	19,036
Segment capital expenditures	$	9,932		$	489		$	333	$	362		$	—		$	11,116
Adjusted EBITDA	$	94,810		$	15,252		$	12,057	$	(17,511	)	$	—		$	104,608
Adjusted EBITDAR	$	107,612		$	15,252		$	12,743	$	(17,469	)	$	—		$	118,138
Nine months ended September 30, 2010
Net patient service revenue from external customers	$	511,830		$	54,624		33,035		$	—		$	—		$	599,489
Intersegment revenue	1,011			50,629			—		—			(51,640		)	—
Total revenue	$	512,841		$	105,253		33,035		$	—		$	(51,640	)	$	599,489
Operating income (loss)	$	12,639		$	15,505		4,469		$	(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 benefit from income taxes															$	(17,288	)
Depreciation and amortization	$	16,939		$	257		$	261	$	784		$	—		$	18,241
Segment capital expenditures	$	22,124		$	1,245		$	—	$	383		$	—		$	23,752
Adjusted EBITDA	$	82,573		$	15,762		$	5,478	$	(16,573	)	$	—		$	87,240
Adjusted EBITDAR	$	96,001		$	15,905		$	6,051	$	(16,508	)	$	—		$	101,449

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

A reconciliation of Adjusted EBITDA and Adjusted EBITDAR to net loss is as follows (dollars in thousands):



	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Adjusted EBITDAR	$	38,268		$	35,359		$	118,138		$	101,449
Rent cost of revenue	(4,413		)	(4,796		)	(13,530		)	(14,209		)
Adjusted EBITDA	33,855			30,563			104,608			87,240
Depreciation and amortization	(6,459		)	(6,305		)	(19,036		)	(18,241		)
Interest expense	(9,711		)	(10,086		)	(29,319		)	(26,535		)
Interest income	170			260			553			684
Acquisition costs										(400		)
Other expense	265						(27		)	479
Debt retirement costs										(7,010		)
Expenses related to the exploration of strategic alternatives							(716		)
Exit costs related to Northern California divestiture							(820		)
Litigation settlement cost, net of recoveries	4,488			(53,505		)	4,488			(53,505		)
Impairment of long-lived assets	(270,478		)	—			(270,478		)	—
Benefit from income taxes	15,259			13,766			551			5,406
Net loss	$	(232,611	)	$	(25,307	)	$	(210,196	)	$	(11,882	)

The following table presents the segment assets as of September 30, 2011 compared to December 31, 2010 (dollars in thousands):



	Long-term Care Services		Therapy Services		Hospice & Home Health Services	Other		Total
September 30, 2011:
Segment total assets	$	470,455	$	54,202	84,301	$	84,930	$	693,888
Goodwill and intangibles included in total assets	$	2,259	$	23,693	69,347	$	—	$	95,299
December 31, 2010:
Segment total assets	$	717,668	$	81,863	76,950	$	67,809	$	944,290
Goodwill and intangibles included in total assets	$	244,760	$	50,993	62,312	$	—	$	358,065

5. Income Taxes

For the three months ended September 30, 2011 and 2010, the Company recognized an income tax benefit of $15.3 million and $13.8 million, respectively. For the nine months ended September 30, 2011 and 2010, the Company recognized an income tax benefit of $0.6 million and $5.4 million, respectively. Income taxes were determined primarily by applying the Company's statutory tax rate to the Company's pretax loss for each of the periods after adjustment for expenses not deductible for income tax purposes. The effective tax rate for the three and nine months ended September 30, 2011 was below the statutory rate as $211.1 million of the $267.5 million recorded goodwill impairment charge discussed in Note 2 above was not deductible for income tax purposes. The effective tax rate for the three and nine months ended September 30, 2010 was below the statutory rate as a portion of the recorded Humboldt County Action settlement charge discussed in Note 9 below was not deductible for income tax purposes.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

For the nine months ended September 30, 2011, total unrecognized tax benefits, including penalties and interest, was $0.1 million. As of September 30, 2011, $0.1 million of unrecognized tax benefits could reasonably be anticipated to reverse within the 12-month rolling period ending September 30, 2012, all of which would result in a benefit to the provision for income taxes.

A reconciliation of the income tax benefit on loss computed at statutory rates to the Company's actual effective rate is summarized as follows:




	Three Months Ended September 30,
	2011					2010

	Amount			Rate		Amount			Rate
Expected benefit at federal statutory rate	$	86,755		35.0	%	$	13,676		35.0	%
State taxes, net of federal tax benefit	1,366			0.6	%	1,418			3.6	%
Permanent portion of goodwill impairment	(73,881		)	(29.8	)%	—			—	%
Permanent portion of class action settlement	—			—		(1,750		)	(4.5	)%
Federal tax credits	694			0.3	%	266			0.7	%
Other, net	325			0.1	%	156			0.4	%
Tax benefit	$	15,259		6.2	%	$	13,766		35.2	%




	Nine Months Ended September 30,
	2011					2010

	Amount			Rate		Amount			Rate
Expected benefit at federal statutory rate	$	73,762		35.0	%	$	6,051		35.0	%
State taxes, net of federal tax benefit	(37		)	—		894			5.2	%
Permanent portion of goodwill impairment	(73,881		)	(35.1	)%	—			—
Permanent portion of class action settlement	—			—	%	(1,750		)	(10.1	)%
Federal tax credits	954			0.5	%	616			3.6	%
Other, net	(247		)	(0.1	)%	(405		)	(2.3	)%
Tax benefit	$	551		0.3	%	$	5,406		31.4	%

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 2006 forward by the Company's material state jurisdictions. The Internal Revenue Service is conducting a limited scope examination of the Company's 2007 through 2009 tax years.

6. Other Current Assets and Other Assets

Other current assets consisted of the following as of September 30, 2011 and December 31, 2010 (dollars in thousands):



	September 30, 2011		December 31, 2010
Current portion of notes receivable, net	$	2,785	$	3,824
Supplies inventory	2,804		2,809
Income tax refund receivable	2,405		9,074
Other current assets	1,872		112
	$	9,866	$	15,819

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Other assets consisted of the following at September 30, 2011 and December 31, 2010 (dollars in thousands):



	September 30, 2011		December 31, 2010
Equity investment in joint ventures	$	5,415	$	5,379
Restricted cash	17,489		14,502
Insurance recoveries	6,830		6,561
Deposits and other assets	4,617		4,594
	$	34,351	$	31,036

7. Property and Equipment

Property and equipment consisted of the following as of September 30, 2011 and December 31, 2010 (in thousands):



	September 30, 2011			December 31, 2010
Land and land improvements	$	64,984		$	66,753
Buildings and leasehold improvements	321,867			321,726
Furniture and equipment	73,511			70,812
Construction in progress	6,093			4,048
	466,455			463,339
Less accumulated depreciation	(90,165		)	(76,017		)
	$	376,290		$	387,322

Leased facility assets consisted of the following as of September 30, 2011 and December 31, 2010 (in thousands):



	September 30, 2011		December 31, 2010
Leased facility assets	14,152		—
Less accumulated depreciation	(3,283	)	—
	10,869		—

The Company began leasing five skilled nursing facilities in California to an unaffiliated third party operator in April 2011 and signed a 10-year lease with two 10-year extension options excerciable by the lessee.

8. Other Long-Term Liabilities

Other long-term liabilities consisted of the following at September 30, 2011 and December 31, 2010 (dollars in thousands):



	September 30, 2011		December 31, 2010
Deferred rent	$	6,653	$	6,148
Other long-term tax liability	131		18
Asbestos abatement liability	3,976		3,871
Contingent consideration	4,934		5,350
Other noncurrent liabilities	805		597
	$	16,499	$	15,984

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(UNAUDITED)

9. Commitments and Contingencies

Litigation

Humboldt County Injunction

In connection with the September 2010 settlement of certain class action litigation (the “Humboldt County Action”) against Skilled and certain of its subsidiaries, including twenty-two California nursing facilities operated by Skilled's subsidiaries, Skilled and its defendant subsidiaries entered into settlement agreements with the applicable plaintiffs and agreed to an injunction. The settlement was approved by the Superior Court of California, Humboldt County on November 30, 2010. Under the terms of the settlement agreements, the defendant entities 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 and certain other payments. The court subsequently approved payments from the escrow of up to approximately $24.8 million for attorneys' fees and costs and $10,000 to each of the three named plaintiffs. In addition, approximately $9.3 million of settlement proceeds have been distributed to approximately 3,900 of an estimated 43,000 class members. Pursuant to the injunction, 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 an auditor. 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 meet a minimum threshold level pursuant to the settlement agreement, which level, initially $9.6 million, is reduced by the portion attributable to any defendant in the case that no longer operates a skilled nursing facility during the injunction period. 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 the agreed upon threshold amount, the defendants will be required to remit any shortfall to the settlement fund.

BMFEA Matter

On April 15, 2009, two of Skilled's wholly-owned companies, Eureka Healthcare and Rehabilitation Center, LLC, which at the time operated 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 represented less than 1% of the Company's revenue and less than 0.3% of its Adjusted EBITDA in 2010. 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. Eureka Healthcare and Rehabilitation Center, LLC transferred its operations in April 2011 to an unaffiliated third party operator. The Company is committed to working cooperatively with the BMFEA on this matter.

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 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 skilled nursing and assisted living 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 its Kansas, Missouri, Iowa and Nebraska skilled nursing and assisted living businesses, as well as all of its hospice and home health businesses. 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

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(UNAUDITED)

have been sufficient to cover actual claims.

General and Professional Liability. The Company's 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 Company has from time to time been subject to malpractice claims and other litigation in the ordinary course of business.

Effective September 1, 2008, the Company's California-based skilled nursing facility companies purchased individual general and professional liability insurance policies for claims reported through August 31, 2011, 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.

Effective September 1, 2008, the Company also had an excess liability policy for claims reported through August 31, 2011, 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.

Effective September 1, 2011, the Company purchased excess liability policies with a $25.0 million per loss and in annual aggregate limits in excess of $1.0 million per loss for all businesses. These policies will remain in force for an initial period of one year.

The Company retains an unaggregated self-insured retention of $1.0 million per claim for all of its businesses other than its hospice and home health businesses, which are insured under a separate general and professional liability insurance policy with a $1.0 million per loss limit. The excess liability policy referenced above is also applicable to this policy.

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, 2011											As of December 31, 2010
	General and Professional			Employee Medical			Workers’ Compensation			Total		General and Professional			Employee Medical			Workers’ Compensation			Total
Current	$	4,631	⁽¹⁾	$	2,114	⁽²⁾	$	4,405	⁽²⁾	$	11,150	$	4,037	⁽¹⁾	$	1,965	⁽²⁾	$	4,484	⁽²⁾	$	10,486
Non-current	19,414			—			11,432			30,846		20,124			—			11,910			32,034
	$	24,045		$	2,114		$	15,837		$	41,996	$	24,161		$	1,965		$	16,394		$	42,520


(1)	Included in accounts payable and accrued liabilities.


(2)	Included in employee compensation and benefits.

Financial Guarantees

Substantially of all Skilled’s wholly-owned subsidiaries guarantee the Company's 11.0% senior subordinated notes maturing on January 15, 2014 (which are sometimes referred to herein as the "2014 Notes, ") and the Company’s first lien senior secured credit facility. These guarantees are full and unconditional and joint and several. Other subsidiaries of Skilled that are not guarantors of the foregoing debt obligations are considered minor.

10. Stockholders’ Equity

Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss refers to revenue, expenses, gains, and losses that are recorded as an element of stockholders’ equity but are excluded from net income. The Company’s other comprehensive loss consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Other comprehensive loss, net of tax, for the three and nine months ended September 30, 2011, was $0.1 million and $0.5 million compared to other comprehensive income, net of tax, of $0.4 million for the three and nine months ended September 30, 2010, respectively.

2007 Incentive Award Plan

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The fair value of the stock option grants for the nine months ended September 30, 2011 and 2010 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,
	2011			2010
Risk-free interest rate	2.80		%	2.57		%
Expected Life	6.25 years			6.25 years
Dividend yield	—		%	—		%
Volatility	50.00		%	44.18		%
Weighted-average fair value	$	6.61		$	2.81

There were no new stock options granted in the three months ended September 30, 2011 and 2010, respectively. There were 60,491 and 531,339 new stock options granted in the nine months ended September 30, 2011 and 2010, respectively.

There were no options exercised during the three months ended September 30, 2011 and 2,770 options were exercised during the nine months ended September 30, 2011. As of September 30, 2011, there was $1.6 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 2.2 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. There were no options exercised during the three and nine months ended September 30, 2010.

The following table summarizes stock option activity during the nine months ended September 30, 2011 under the Skilled Healthcare Group, Inc. Amended and Restated 2007 Incentive Award Plan:



	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value (in thousands)
Outstanding at January 1, 2011	998,578		$	9.01
Granted	60,491		$	12.87
Exercised	(2,770	)	$	10.04
Forfeited or cancelled	(16,000	)	$	15.74
Outstanding at September 30, 2011	1,040,299		$	9.13	7.69	$	—
Fully vested and expected to vest at September 30, 2011	1,011,926		$	9.17	7.67	$	—
Exercisable at September 30, 2011	442,573		$	10.83	7.01	$	—

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

Compensation related to stock option grants and stock awards included in general and administrative expenses was $0.2 million and $0.6 million for the three months ended September 30, 2011 and 2010, respectively. The amount of compensation included in general and administrative expenses was $1.6 million and $1.4 million for the nine months ended September 30, 2011 and 2010, respectively. The amount of compensation included in cost of services was $0.01 million and $0.4 million for the three months ended September 30, 2011 and 2010, respectively. The amount of compensation included in cost of services was $0.9 million and $0.7 million for the nine months ended September 30, 2011 and 2010.

11. 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

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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 transaction and contingent consideration as of September 30, 2011 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 hedges	$	—	$	(806	)	$	—		$	(806	)
Contingent consideration – acquisitions	$	—	$	—		$	(7,421	)	$	(7,421	)

In June 2010, the Company entered into an interest rate cap agreement and an interest rate swap agreement with a bank 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 a LIBOR rate of 2.3% from January 2012 to June 2013. The Company continues to assess its exposure to interest rate risk on an ongoing basis.

The interest rate swap is required to be measured at fair value on a recurring basis. The fair value of the interest rate swap agreement is determined by calculating the difference between the value of the discounted cash flows of the fixed interest rate of the interest rate swap and the counterparty's forward LIBOR curve, which is the input used in the valuation. The forward LIBOR curve is readily available in public markets or can be derived from information available in publicly quoted markets. Based on this valuation method, the Company has categorized the interest rate swap as Level 2. The Company confirmed that its valuation of the interest rate swap as was in agreement with the counterparty's valuation as of September 30, 2011.

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.

On May 1, 2010, the Company completed the Hospice/Home Health Acquisition, acquiring 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. 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 10-Q filed with the SEC on May 4, 2010. The contingent consideration is up to $7.0 million over a period of 5 years. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs 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 September 30, 2011, the contingent consideration had a fair value of $6.1 million. This is included in the Company’s accounts payable and accrued liabilities on the balance sheet. The change in fair value related to the contingent consideration is included in the Company's depreciation and amortization on the statements of operations. There has been no change in the valuation technique of the contingent consideration from December 31, 2010 to September 30, 2011.

On July 1, 2011, a wholly-owned subsidiary of the Company acquired Altura Homecare & Rehab. The acquisition includes a contingent earn-out consideration which can be earned based on the achievement of an EBITDA threshold over the three years following the closing. The fair value of the earn-out was valued at $1.3 million as of September 30, 2011.

Below is a table listing the Level 3 rollforward as of September 30, 2011 (in thousands):



Level 3 Rollforward
Value at January 1, 2011	$	5,350
Change in fair value	754
Contingent consideration	1,317
Value at September 30, 2011	7,421

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

12. Debt

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



	As of September 30, 2011			As of December 31, 2010
Revolving Credit Facility, interest rate comprised of LIBOR (subject to a 1.50% floor) plus 3.75%, which equaled 5.25% at September 30, 2011; collateralized by substantially all assets of the Company; amount due 2015	$	—		$	26,000
Term Loan, interest rate based on LIBOR (subject to a 1.50% floor) plus 3.75%, which equaled 5.25% at September 30, 2011; net original issue discount of $2,027 and $2,365 at September 30, 2011 and December 31, 2010, respectively; collateralized by substantially all assets of the Company; amount due 2016	352,574			354,935
2014 Senior Subordinated Notes, interest rate 11.0%, with an original issue discount of $251 and $331 at September 30, 2011 and December 31, 2010, respectively, interest payable semiannually, principal due 2014	129,749			129,669
Notes payable, interest rate fixed at 6.5%, payable in monthly installments, collateralized by a first priority deed of trust, due December 2018	1,305			1,411
Hospice/Home Health Acquisition note, interest rate fixed at 6.00%, payable in annual installments	7,968			7,948
Insurance premiums financed	538			—
Total long-term debt	492,134			519,963
Less amounts due within one year	(6,287		)	(5,742		)
Long-term debt, net of current portion	$	485,847		$	514,221

Term Loan and Revolving Loan

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 (“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, 2011, there was zero outstanding on the revolving credit facility. The credit arrangements provided under the Restated Credit Agreement are collectively referred to herein as the Company's senior secured credit facility.

The term loan requires principal payments of 0.25%, or $0.9 million, 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 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

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

unused portion of the revolving line of credit. The Company has the right to increase its borrowings under the senior secured credit facility 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 required 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 11 - 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 2010. 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.

The Company issued $10.0 million of promissory notes as part of the purchase consideration for the Hospice/Home Health Acquisition. The notes bear interest at 6.0% with $2.0 million of principal due annually beginning November 1, 2010. The $10.0 million of promissory notes are payable to the selling entities, of which the President and Chief Operating Officer, and the Senior Vice President, of Signature Hospice & Home Health, LLC are significant shareholders. Signature Hospice & Home Health, LLC became a consolidated subsidiary of Skilled as a result of the Hospice/Home Health Acquisition.

Senior Subordinated Notes

The senior subordinated notes (which are sometimes referred to herein as the "2014 Notes") were issued in December 2005 in the aggregate principal amount of $200.0 million, with an interest rate of 11.0% and a discount of $1.3 million. Interest is payable semiannually in January and July of each year. The 2014 Notes mature on January 15, 2014. The 2014 Notes are unsecured senior subordinated obligations and rank junior to all of the Company's existing and future senior indebtedness, including indebtedness under the Restated Credit Agreement. The 2014 Notes are guaranteed on a senior subordinated basis by certain of the Company's current and future subsidiaries.

On January 15, 2011, the Company became entitled to redeem all or a portion of the 2014 Notes upon not less than 30 nor more than 60 days notice, at a redemption price (expressed in percentages of principal amount on the redemption date) of 102.75% effective January 15, 2011 and 100.0% effective January 15, 2012.

13. Acquisitions

On July 1, 2011, a wholly-owned subsidiary of the Company acquired Altura Homecare & Rehab, which is a home health care agency serving the Albuquerque, New Mexico market.

On July 11, 2011, wholly-owned subsidiaries of the Company acquired the real property and related operations of Willow Creek Memory Care at San Martin in Las Vegas, Nevada, which is currently licensed for 62 memory care assisted living beds. The newly acquired facility now operates as Vintage Park at San Martin.

14. Subsequent events

On October 24, 2011, wholly-owned subsidiaries of the Company acquired substantially all of the assets of Cornerstone Hospice, Inc., which provides hospices services in the Colton, California and Phoenix, Arizona areas.

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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 as of the dates and for the periods presented. 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, 2010 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 affiliated operators and third-party facility operators with whom we contract to better focus on delivery of healthcare services. We currently have one such service agreement with an unrelated skilled nursing facility operator. These subsidiaries focus on providing high-quality care to our patients, and other than our assisted living companies, 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, 2011, we owned or leased 74 skilled nursing facilities and 23 assisted living facilities, together comprising 10,492 licensed beds. We also lease five skilled nursing facilities in California to an unaffiliated third party operator. Our skilled nursing and assisted living facilities, approximately 76.5% of which we own, are located in California, Texas, Iowa, Kansas, Missouri, Nebraska, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. For the nine months ended September 30, 2011, we generated approximately 77.1% 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 and Acquisitions

On July 29, 2011, the Centers for Medicare & Medicaid Services ("CMS") issued a final rule for its fiscal year 2012, which began October 1, 2011. The rule reduced Medicare reimbursement rates for skilled nursing facilities by 11.1% and also made changes to rehabilitation therapy regulations which will have a significant negative effect on the Company's revenue and costs during Medicare's fiscal year ended September 30, 2012 as compared to Medicare's fiscal year ended September 30, 2011. See "- Industry Trends," below for additional information.

As of September 30, 2011, we recorded an impairment charge of $270.5 related to goodwill and intangibles assets primarily as a result of the reduction in anticipated future cash flows from the reduction of reimbursement rates in future periods due to the CMS final rule for Medicare's fiscal year 2012. Additional disclosure and analysis is included below under "Critical Accounting Estimates - Goodwill Impairment Testing."

On July 1, 2011, we acquired Altura Homecare & Rehab, which is a home health care agency serving the Albuquerque, New Mexico market.

On July 11, 2011, we acquired the real property and related operations of Willow Creek Memory Care at San Martin in Las Vegas, Nevada, which is currently licensed for 62 memory care assisted living beds. The facility now operates as Vintage Park at San Martin.

Industry Trends

Medicare and Medicaid Reimbursement

Rising healthcare costs due to a variety of factors, including an aging population and increasing life expectancies, has generated growing demand for post-acute healthcare services in recent years. In an effort to mitigate the cost of providing healthcare benefits, third party payors including Medicare, Medicaid, managed care providers, insurance companies and others have increasingly encouraged the treatment of patients in lower-cost care settings. As a result, in the recent years skilled nursing facilities, which typically have significantly lower cost structures than acute care hospitals and certain other post-acute

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care settings, have generally been serving larger populations of higher-acuity patients than in the past. However, Medicare and Medicaid reimbursement rates are subject to change from time to time and those changes could materially impact our revenue.

Revenue derived directly or indirectly from Medicare reimbursement has historically comprised a substantial portion of our consolidated revenue. Medicare reimburses our skilled nursing facilities under a prospective payment system (PPS) for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group (RUG) category that is based upon each patient's acuity level. In October 2010, the number of RUG categories was expanded from 53 to 66 as part of the implementation of the RUGs IV system and the introduction of a revised and substantially expanded patient assessment tool called the minimum data set (MDS) version 3.0.

On July 29, 2011, the Centers for Medicare & Medicaid Services ("CMS") issued a final rule providing for, among other things, a net 11.1% reduction in PPS payments to skilled nursing facilities for CMS's fiscal year 2012 (which began October 1, 2011) as compared to PPS payments in CMS's fiscal year 2011 (which ended September 30, 2011). The 11.1% reduction is on a net basis, after the application of a 2.7% market basket increase, and reduced by a 1.0% multi-factor productivity adjustment required by the Patient Protection and Affordable Care Act of 2010 ("PPACA"). The final CMS rule also adjusts the method by which group therapy is counted for reimbursement purposes, and changes the timing in which patients who are receiving therapy must be reassessed for purposes of determining their RUG category. We anticipate that, assuming other factors remain constant, CMS's reduced reimbursement rates and other changes effective for its fiscal year 2012 will have a significant and adverse effect on our results of operations when compared to the periods in CMS's fiscal year 2011.

Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels, our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition or results of operation. Our rehabilitation therapy, hospice and home health care businesses are also to a large degree directly or indirectly dependent on (and therefore affected by changes in) Medicare and Medicaid reimbursement rates. For example, our rehabilitation therapy business may have difficulty increasing or maintaining the rates it has negotiated with third party nursing facilities in light of the reduced PPS reimbursement rates that took effect on October 1, 2011 as discussed above.

We also derive a substantial portion of our consolidated revenue from Medicaid reimbursement, primarily through our skilled nursing business. Medicaid programs are administered by the applicable states and financed by both state and federal funds. Medicaid spending nationally has increased significantly in recent years, becoming an increasingly significant component of state budgets. This, combined with slower state revenue growth and other state budget demands, has led both the federal government and many states, including California and other states in which we operate, to institute measures aimed at controlling the growth of Medicaid spending (and in some instances reducing it).

Historically, adjustments to reimbursement under Medicare and Medicaid have had a significant effect on our revenue and results of operations. Recently enacted, pending and proposed legislation and administrative rulemaking at the federal and state levels could have similar effects on our business. Efforts to impose reduced reimbursement rates, greater discounts and more stringent cost controls by government and other payors are expected to continue for the foreseeable future and could adversely affect our business, financial condition and results of operations. Additionally, any delay or default by the federal or state governments in making Medicare and/or Medicaid reimbursement payments could materially and adversely affect our business, financial condition and results of operations.

Federal Health Care Reform

In addition to the matters described above affecting Medicare and Medicaid participating providers, the PPACA enacted several reforms with respect to skilled nursing facilities, home health agencies 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 PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are presently effective.

•

Enhanced CMPs and Escrow Provisions. PPACA includes expanded civil monetary penalty (“CMP”) and related provisions applicable to all Medicare and Medicaid providers. CMS rules adopted to implement applicable provisions of PPACA also provide that assessed CMPs may be collected and placed in whole or in part into an escrow pending final disposition of the applicable administrative and judicial appeals processes. 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 our results of operations.


•	Nursing Home Transparency Requirements. In addition to expanded CMP provisions, PPACA imposes substantial new

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transparency requirements for Medicare-participating nursing facilities. In addition to previously required disclosures regarding a facility's owners, management and secured creditors, PPACA expanded the required disclosures to include information regarding the facility's organizational structure, additional information on officers, directors, trustees and “managing employees” of the facility (including their names, titles, and start dates of services), and information regarding certain parties affiliated with the facility. 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 and management structure.

•

Face-to-Face Encounter Requirements. PPACA imposes new patient face-to-face encounter requirements on home health agencies and hospices to establish a patient's ongoing eligibility for Medicare home health services or hospice services, as applicable. A certifying physician or other designated health care professional must conduct the face-to-face encounters within specified timeframes, and failure of the face-to-face encounter to occur and be properly documented during the applicable timeframes could render the patient's care ineligible for reimbursement under Medicare.

•

Suspension of Payments During Pending Fraud Investigations. PPACA provides the federal government with expanded authority to suspend Medicare and Medicaid payment if a provider is investigated for allegations or issues of fraud. 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 suspension of payments provision is applied to one of our facilities for allegations of fraud, such a suspension could adversely affect our results of operations.

•

Overpayment Reporting and Repayment; Expanded False Claims Act Liability. PPACA enacted several important changes that expand potential liability under the federal False Claims Act. Overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within specified deadlines, or else they are considered obligations of provider 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 False Claims Act exposure.

•

Home and Community Based Services. PPACA provides that, beginning in October 2011, states can provide home and community-based attendant services and supports through the Community First Choice State plan option. States choosing to provide home and community based services under this option must make them available to assist with activities of daily living, instrumental activities of daily living and health related tasks under a plan of care agreed upon by the individual and his/her representative. For states that elect to make coverage of home and community-based services available through the Community First Choice State plan option, the percentage of the state's Medicaid expenses paid by the federal government will increase by 6 percentage points. PPACA also included additional measures related to the expansion of community and home based services and authorized states to expand coverage of community and home-based services to individuals who would not otherwise be eligible for them. The expansion of home and community based services could reduce the demand for the facility based services that we provide.

•

Health Care-Acquired Conditions. PPACA provides that the Secretary of Health and Human Services must prohibit payments to states for any amounts expended for providing medical assistance for certain medical conditions acquired during the patient's receipt of health care services. CMS adopted a final rule to implement this provision of PPACA in the third quarter of 2011. The new rule prohibits states from making payments to providers under the Medicaid program for conditions that are deemed to be reasonably preventable. It uses Medicare's list of preventable conditions in inpatient hospital settings as the base (adjusted for the differences in the Medicare and Medicaid populations) and provides states the flexibility to identify additional preventable conditions and settings for which Medicaid payment will be denied.

The provisions of 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 profession generally and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that other provisions of PPACA may be interpreted, clarified, or applied to our businesses in a way that could have a material adverse impact on the results of operations. Similar federal and/or state legislation that may be adopted in the future could have similar effects.

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Revenue

Revenue by Service Offering

We operate our business in three reportable operating segments: (i) long-term care services, which includes the operation of skilled nursing and assisted living facilities and is the most significant portion of our business; (ii) therapy services, which includes our rehabilitation therapy services business; and (iii) hospice and home health services, which includes our hospice and home health businesses. Our reporting segments are business units that offer different services, and that are managed separately due to the nature of services provided.

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 therapy services segment, we derive revenue by providing rehabilitation therapy services to third-party facilities. In our hospice and home health services segment, we provide hospice and home health services.

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,
	2011				2010
	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	$	164,471	75.8	%	$	165,796	79.3	%	$	(1,325	)	(0.8	)%
Assisted living facilities	7,021		3.3		6,550		3.1		471			7.2
Administration of third party facilities	309		0.1		245		0.1		64			26.1
Facility lease revenue	746		0.3		—		—		746			100.0
Total long-term care services	172,547		79.5		172,591		82.5		(44		)	—
Therapy services:
Third-party rehabilitation therapy services	23,158		10.7		19,160		9.2		3,998			20.9
Total therapy services	23,158		10.7		19,160		9.2		3,998			20.9
Hospice & Home Health services:
Hospice	16,132		7.4		13,858		6.6		2,274			16.4
Home Health	5,318		2.4		3,590		1.7		1,728			48.1
Total hospice & home health services	21,450		9.8		17,448		8.3		4,002			22.9
Total	$	217,155	100.0	%	$	209,199	100.0	%	$	7,956		3.8	%

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	Nine Months Ended September 30,
	2011				2010
	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	$	505,017	77.1	%	$	492,280	82.1	%	$	12,737	2.6	%
Assisted living facilities	20,482		3.1		18,871		3.2		1,611		8.5
Administration of third party facilities	856		0.1		679		0.1		177		26.1
Facility lease revenue	1,492		0.2		—		—		1,492		100.0
Total long-term care services	527,847		80.5		511,830		85.4		16,017		3.1
Therapy services:
Third-party rehabilitation therapy services	69,051		10.6		54,624		9.1		14,427		26.4
Total therapy services	69,051		10.6		54,624		9.1		14,427		26.4
Hospice & Home Health services:
Hospice	46,291		7.1		26,786		4.5		19,505		72.8
Home Health	12,091		1.8		6,249		1.0		5,842		93.5
Total hospice & home health services	58,382		8.9		33,035		5.5		25,347		76.7
Total	$	655,280	100.0	%	$	599,489	100.0	%	$	55,791	9.3	%

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,
	2011				2010
	Revenue Dollars		Percentage of Revenue		Revenue Dollars		Percentage of Revenue
California	$	86,484	39.9	%	$	84,941	40.6	%
Texas	47,109		21.7		47,924		22.9
New Mexico	24,041		11.1		21,816		10.4
Kansas	16,810		7.7		15,837		7.6
Missouri	15,482		7.1		14,101		6.7
Nevada	14,827		6.8		13,884		6.6
Montana	3,495		1.6		2,954		1.4
Iowa	2,842		1.3		2,682		1.3
Arizona	2,683		1.2		2,897		1.4
Idaho	2,567		1.2		2,163		1.1
Nebraska	815		0.4		—		—
Total	$	217,155	100.0	%	$	209,199	100.0	%

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	Nine Months Ended September 30,
	2011				2010
	Revenue Dollars		Percentage of Revenue		Revenue Dollars		Percentage of Revenue
California	$	269,743	41.2	%	$	250,960	41.9	%
Texas	140,180		21.4		142,144		23.7
New Mexico	68,389		10.4		64,101		10.7
Kansas	51,180		7.8		45,712		7.6
Missouri	46,440		7.1		42,805		7.1
Nevada	44,494		6.8		33,307		5.6
Montana	9,559		1.5		4,930		0.8
Iowa	8,498		1.3		7,074		1.2
Arizona	8,170		1.2		4,809		0.8
Idaho	7,008		1.1		3,647		0.6
Nebraska	1,619		0.2		—		—
Total	$	655,280	100.0	%	$	599,489	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. Most of our skilled nursing facilities include our Express Recovery^TM 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,
	2011		2010		2011		2010
Medicare	14.2	%	15.6	%	15.4	%	15.9	%
Managed care	8.5		7.0		8.2		6.9
Skilled mix	22.7		22.6		23.6		22.8
Private pay and other	16.2		16.2		16.0		16.5
Medicaid	61.1		61.2		60.4		60.7
Total	100.0	%	100.0	%	100.0	%	100.0	%

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.

Leased Facility Revenue. We lease five skilled nursing facilities in California to an unaffiliated third party operator. For a detailed discussion of the lease arrangement, see Note 7 - "Property and Equipment."

Therapy Services Segment

As of September 30, 2011, we provided rehabilitation therapy services to a total of 177 healthcare facilities, including 64 of our facilities, as compared to 169 facilities, including 69 of our facilities, as of September 30, 2010. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net increase of 8 facilities serviced was comprised of 23 new facilities serviced, net of 15 cancellations. 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 facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered.

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Hospice and Home Health Services Segment

Hospice. As of September 30, 2011, we provided hospice care in Arizona, California, Idaho, Montana, Nevada, and New Mexico. We derive substantially all of the revenue from our hospice business from Medicare and managed care reimbursement.

Federal law imposes a Medicare payment cap on hospice service programs. We are managing the Medicare cap and its impact on our hospice business by attempting to address 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 in each of our programs.

Home Health. We provided home health care in Arizona, New Mexico, Nevada, Idaho, Montana, New Mexico and California as of September 30, 2011. We derive the majority of the revenue from our home health business from Medicare. Net service revenue is recorded under the Medicare payment program based on a 60-day episodic payment rate that is subject to downward adjustment based on certain variables.

Regulatory and Other Governmental Actions Affecting Revenue

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 primarily funded by these programs. The following table summarizes the amount of revenue that we received from each of our payor classes by segment in the periods presented (dollars in thousands):



	Three Months Ended September 30,
	2011										2010
	Long-term Care Services		Therapy Services		Hospice & Home Health Services		Total Revenue		Revenue Percentage		Long-term Care Services		Therapy Services		Hospice & Home Health Services		Total Revenue		Revenue Percentage
Medicare	$	61,370	$	—	$	19,022	$	80,392	37.0	%	$	62,390	$	—	$	16,197	$	78,587	37.6	%
Medicaid	63,108		—		331		63,439		29.2		65,588		—		288		65,876		31.5
Subtotal Medicare and Medicaid	124,478		—		19,353		143,831		66.2		127,978		—		16,485		144,463		69.1
Managed Care	22,103		—		855		22,958		10.6		18,688		—		205		18,893		9.0
Private pay and other	26,317		23,158		1,243		50,718		23.2		25,925		19,160		758		45,843		21.9
Total	$	172,898	$	23,158	$	21,451	$	217,507	100.0	%	$	172,591	$	19,160	$	17,448	$	209,199	100.0	%



	Nine Months Ended September 30,
	2011										2010
	Long-term Care Services		Therapy Services		Hospice & Home Health Services		Total Revenue		Revenue Percentage		Long-term Care Services		Therapy Services		Hospice & Home Health Services		Total Revenue		Revenue Percentage
Medicare	$	197,657	$	—	$	53,731	$	251,388	38.4	%	$	188,039	$	—	$	30,626	$	218,665	36.5	%
Medicaid	188,145		—		815		188,960		28.8		191,347		—		564		191,911		32.0
Subtotal Medicare and Medicaid	385,802		—		54,546		440,348		67.2		379,386		—		31,190		410,576		68.5
Managed Care	64,595		—		1,154		65,749		10.0		54,851		—		295		55,146		9.2
Private pay and other	77,450		69,051		2,682		149,183		22.8		77,593		54,624		1,550		133,767		22.3
Total	$	527,847	$	69,051	$	58,382	$	655,280	100.0	%	$	511,830	$	54,624	$	33,035	$	599,489	100.0	%

Medicare. Medicare is a federal health insurance program for people age 65 or older, people under age 65 with certain

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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. CMS generally evaluates and adjusts payment rates on an annual basis.

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.

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.

Critical Accounting Estimates

Goodwill and Other Long-Lived 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. We have selected October 1 as the date to test goodwill for impairment on an annual basis. As a result of the July 29, 2011 announcement by CMS regarding the reimbursement reductions that went into effect October 1, 2011, which led to a significant decline in our stock price, we conducted an interim goodwill impairment analysis as of August 31, 2011.

We periodically evaluate the carrying value of our long−lived assets other than goodwill, primarily consisting of our investments in real estate, for impairment indicators. If indicators of impairment are present, we evaluate the carrying value of the related real estate investments in relation to the future discounted cash flows of the underlying operations to assess recoverability of the assets. Measurement of the amount of the impairment, if any, may be based on independent appraisals, established market values of comparable assets or estimates of future cash flows expected. The estimates of these future cash flows are based on assumptions and projections believed by management to be reasonable and supportable. They require management's subjective judgments and take into account assumptions about revenue and expense growth rates. These assumptions may vary by type of long−lived asset.

Goodwill Impairment Testing

We compare the fair value of each reporting unit to its carrying amount on an annual basis to determine whether there is potential goodwill impairment. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent the fair value of goodwill is less than its carrying value.

As of August 31, 2011, after the fair value determined above was compared to the carrying value of each reporting entity, we concluded that the carrying value of the long-term care and therapy services reporting units exceeded their fair value and step two of the analysis was performed. The fair value of the hospice and home health reporting units exceeded their carrying value.

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We assessed the fair value of the long-term care and therapy services reporting units for goodwill impairment based upon a combination of the discounted cash flow (income approach) and guideline public company method (market approach). The income and market approaches were given equal weighting.

The discounted cash flow and market approach methodologies utilized in estimating the fair value of our reporting units for purposes of goodwill impairment testing requires various judgmental assumptions about revenues, EBITDA and operating margins, growth rates, and working capital requirements. In determining those judgmental assumptions, we make a number of judgments regarding a variety of data, including-for each reporting unit, the annual budget for the upcoming year, the longer−term business plan, economic projections, anticipated future cash flows, market data, and historical cash flow growth rates. As we have not yet prepared our budget for the year ended December 31, 2012, our current forecast was utilized for the August 31, 2011 impairment analysis.

Below are the key assumptions used to estimate the fair value for our long−term care reporting unit at the time of our August 31, 2011 goodwill impairment test using the income approach:

•A revenue reduction of 6.1% for the initial 12 month period as a result of the 11.1% Medicare rate reduction effective October 1, 2011;

•2.0% long−term revenue growth rate beginning in 2012; and 9.5% discount rate

Our long−term care reporting unit experienced an average annual compounded growth rate in external revenue from 2007 to 2010 of 7.7%. However, we selected a long term growth rate of 2.0% for the discounted cash flow analysis conducted as part of the impairment analysis because the historical growth rate includes acquisitions, de novo developments and the increase that resulted from RUGs IV being implemented on October 1, 2010. The 2.0% long-term growth rate is our expected long−term growth rate from a combination of reimbursement rate increases, occupancy and skilled mix increases. This growth rate was assumed to be 3.0% in the prior year analysis with a 2.5% growth rate in the terminal year. The reduction in the assumed revenue growth rate in the current year analysis is due to the increased pressure placed on the federal and state governments to limit and even reduce spending.

The operating expenses projected under the discounted cash flow method were based upon our historical expenses as a percentage of long−term care revenue adjusted for known efficiencies or additional costs to be incurred. Capital expenditures were based upon expected expenditures per bed.

The discount rate used to calculate the present value of cash flows under the discounted cash flow method is a significant assumption in the analysis. The discount rate was developed using the capital asset pricing model through which a weighted average cost of capital was derived. The cost of equity was assumed to be 15.6% and the pre-tax cost of debt was assumed to be 9.0%. Assuming a capital structure of 60% debt and 40% equity, the average cost of capital was determined to be 9.5%, which was used as the discount rate. A 0.5% decrease in the discount rate would increase the equity value of the long-term care reporting unit by approximately $48 million, or 38%, using the income approach. Increasing the long term revenue growth rate by 0.5% increases the equity value by approximately $38 million, or 30%, using the income approach.

For the market approach, we compared ourselves to a peer group of other public companies. As several of our peers lease a higher percentage of their skilled nursing facilities than we do, the metric used was total invested capital, or TIC, divided by earnings before interest, tax, depreciation, amortization and rent, or EBITDAR. The average TIC divided by projected 2012 EBITDAR for the peer group, including us, was 6.1. For our market valuation a multiple of 6.5 was selected along with a control premium of 30%, based upon historical transactions. The market valuation multiple used was selected based upon company specific operating statistics as compared to the market participants.

As the result of this evaluation indicated that the reporting unit's carrying value of equity exceeded the fair value of equity, we performed step two of the goodwill impairment analysis for the long−term care reporting unit. In this test, the carrying value of goodwill is adjusted to its fair value. Each asset and liability was ascribed a value based on fair value standards under generally accepted accounting principles. However, no change in book value for any assets or liabilities (other than goodwill) was recognized on our September 30, 2011 balance sheet as we have not elected the fair value option of reporting. We used forecasted occupancy rates, operating income, market rental rates and capitalization rates to calculate the fair value of the skilled nursing and assisted living facilities, the largest non−goodwill asset of the long−term care reporting unit. The assumptions varied by facility. We determined the fair value of the skilled healthcare facilities exceeded their carrying value in the aggregate. The fair value of the long−term care reporting unit was used for the equity value of the long−term care reporting unit in the step two analysis. The fair value of the remaining assets and liabilities (other than goodwill) was substantially equivalent to their carrying value.

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Upon completion of step two, we recorded a goodwill impairment charge of $243.2 million, or all of the goodwill, at our long−term care reporting unit.

Below are the key assumptions used to estimate the fair value for our therapy reporting unit at the time of our August 31, 2011 goodwill impairment test using the income approach:

• 2.0% long−term growth rate; and

• 12.5% discount rate

Our therapy services reporting unit experienced an average annual compounded (negative) growth rate in external revenue from 2007 to 2010 of (2.1%). This decline in revenue was primarily the result of the loss of two customers in the fourth quarter of 2009. As such, we selected a long term growth rate of 2.0% for the discounted cash flow analysis conducted as part of the impairment analysis as the 2.0% long-term growth rate is our expected long−term growth rate from a combination of rate increases as well as occupancy and skilled mix increases at our third party customers. This growth rate was assumed to be 3.0% in the prior year analysis with a 2.5% growth rate in the terminal year. The reduction in the assumed revenue growth rate in the current year analysis is due to the increased pressure placed on the federal and state governments to limit and even reduce spending.

The operating expenses projected under the discounted cash flow method were based upon our historical expenses as a percentage of therapy revenue adjusted for known efficiencies or additional costs to be incurred. Capital expenditures in the therapy services reporting unit have historically been negligible.

The discount rate used to present value cash flows under the discounted cash flow method is a significant assumption in the analysis. The discount rate was developed using the capital asset pricing model through which a weighted average cost of capital was derived. The cost of equity was assumed to be 14.3% and the pre-tax cost of debt was assumed to be 10.0%. Assuming a capital structure of 25% debt and 75% equity, the average cost of capital was determined to be 12.5%, which was used as the discount rate. A 0.5% decrease in the discount rate would increase the equity value of the therapy reporting unit by approximately $2 million, or 8%, using the income approach. Increasing the long term revenue growth rate by 0.5% increases the equity value by approximately $1 million, or 4%, using the income approach.

For the market approach, we compared ourselves to a peer group of other public companies. The metric used was total invested capital, or TIC, divided by earnings before interest, tax, depreciation and amortization, or EBITDA. The average TIC divided by projected 2012 EBITDAR for the peer group, including us, was 4.7. For our market valuation a multiple of 5.0 was selected along with a control premium of 30%, based upon historical transactions.

As the result of this evaluation indicated that the reporting unit's carrying value of equity exceeded the fair value of equity, we performed step two of the goodwill impairment analysis for the therapy services reporting unit. In this test, the carrying value of goodwill is adjusted to its fair value. Each asset and liability was ascribed a value based on fair value standards under generally accepted accounting principles. As a result of this analysis, a $3.0 million impairment charge was recognized related to the Hallmark Rehabilitation business' trade name, a long-lived intangible asset. No other change in book value for any assets or liabilities (other than goodwill) was recognized on our September 30, 2011 balance sheet as we have not elected the fair value option of reporting. The fair value of the therapy services reporting unit was used for the equity value of the long−term care reporting unit in the step two analysis. The fair value of the remaining assets and liabilities (other than goodwill and the trade name) was substantially equivalent to their carrying value.

Upon completion of step two, we recorded a goodwill impairment charge of $24.3 million at our therapy services reporting unit. Prior to the goodwill impairment charge, the therapy reporting unit had goodwill for $34.0 million

Our goodwill impairment analysis is subject to uncertainties due to uncontrollable events, including the strategic decisions made in response to economic or competitive conditions, the general economic environment, and material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows. In addition, our goodwill impairment analysis is subject to current economic uncertainties.

As of September 30, 2011, goodwill in the amount of $72.8 million was recorded in our consolidated balance sheet, of which $9.7 million related to the rehabilitation therapy unit, $42.1 million related to the hospice reporting unit and $21.0 million related to the home health reporting unit.

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Other

Discussion of our other critical accounting estimates is included in the “Management's Discussion and Analysis of Financial Condition and Results of Operations” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, which we filed with the Securities and Exchange Commission on February 14, 2011.

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,
	2011			2010			2011			2010
Occupancy statistics (skilled nursing facilities):
Available beds in service at end of period	8,814			9,378			8,814			9,378
Available patient days	810,670			855,522			2,438,072			2,528,567
Actual patient days	672,636			709,792			2,025,664			2,108,941
Occupancy percentage	83.0		%	83.0		%	83.1		%	83.4		%
Average daily number of patients	7,311			7,715			7,420			7,725
Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)
LTC only Medicare (Part A)	$	572		$	498		$	574		$	497
Medicare blended rate (Part A & B)	636			566			633			560
Managed care	389			374			388			377
Medicaid	153			151			154			149
Private and other	175			168			177			169
Weighted-average for all	$	246		$	234		$	251		$	234

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The following table sets forth details of our revenue, expenses and earnings (loss) as a percentage of total revenue for the periods indicated:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
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)	79.9			80.6			79.4			80.5
Rent cost of revenue	2.0			2.3			2.1			2.4
General and administrative	2.5			2.9			3.0			3.1
Litigation settlement costs, (net of recoveries)	(2.1		)	25.6			(0.7		)	8.9
Depreciation and amortization	2.9			3.0			2.8			3.0
Impairment of long-lived assets	124.6			—			41.3			—
	209.8			114.4			127.9			97.9
Other income (expenses):
Interest expense	(4.5		)	(4.8		)	(4.5		)	(4.4		)
Interest income	0.1			0.1			0.1			0.1
Other income (expense)	(0.1		)	—			(0.1		)	0.1
Equity in earnings of joint venture	0.2			0.4			0.2			0.4
Debt retirement costs	—			—			—			(1.2		)
Total other income (expenses), net	(4.3		)	(4.3		)	(4.3		)	(5.0		)
Loss from continuing operations before benefit from income taxes	(114.1		)	(18.7		)	(32.2		)	(2.9		)
Benefit from income taxes	(7.0		)	(6.6		)	(0.1		)	(0.9		)
Net loss	(107.1		)%	(12.1		)%	(32.1		)%	(2.0		)%

Adjusted EBITDA(1)	15.6		%	14.6		%	16.0		%	14.6		%
Adjusted EBITDAR(2)	17.6		%	16.9		%	18.0		%	16.9		%
	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Reconciliation from net income to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR (in thousands):
Net loss	$	(232,611	)	$	(25,307	)	$	(210,196	)	$	(11,882	)
Interest expense, net of interest income	9,541			9,826			28,766			25,851
Benefit from income taxes	(15,259		)	(13,766		)	(551		)	(5,406		)
Depreciation and amortization expense	6,459			6,305			19,036			18,241
EBITDA	(231,870		)	(22,942		)	(162,945		)	26,804
Rent cost of revenue	4,413			4,796			13,530			14,209
EBITDAR	(227,457		)	(18,146		)	(149,415		)	41,013
EBITDA	(231,870		)	(22,942		)	(162,945		)	26,804
Impairment of long-lived assets	270,478			—			270,478			—
Litigation settlement costs, (net of recoveries)	(4,488		)	53,505			(4,488		)	53,505
Other expense (income)	(265		)	—			27			(479		)
Debt retirement costs	—			—			—			—
Expenses related to the exploration of strategic alternatives	—			—			716			—
Exit costs related to the Northern California divestiture	—			—			820			—
Acquisition costs	—			—			—			400
Adjusted EBITDA	33,855			30,563			104,608			80,230
Rent cost of revenue	4,413			4,796			13,530			14,209
Adjusted EBITDAR	$	38,268		$	35,359		$	118,138		$	94,439

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(1)

We define EBITDA as net income (loss) before depreciation, amortization and interest expense (net of interest income) and the 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 gains or losses on sale of assets, due diligence, impairment of long-lived assets, litigation settlement cost, debt retirement costs, and exit cost (each to the extent applicable in the appropriate period.)


(2)	We define EBITDAR as net income (loss) before depreciation, amortization, interest expense (net of interest income), the provision for income taxes and rent cost of revenue. EBITDAR margin is EBITDAR as a percentage of revenue. Adjusted EBITDAR is EBITDAR adjusted for the Adjusted EBITDA items listed above (each to the extent applicable in the appropriate period.)

We believe that the presentation of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR 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, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR 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, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are 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. GAAP, expenses, revenues and gains (losses) that are unrelated to the day-to-day performance of our business. We also use EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.

Management, including facility based managers, uses EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated and segment level. Segment management uses these metrics to measure performance on a facility-by-facility level. We typically use Adjusted EBITDA and Adjusted EBITDAR for these purposes on a consolidated basis as the adjustments to EBITDA and EBITDAR are not generally allocable to any individual business unit and we typically use EBITDA and EBITDAR to compare the operating performance of each skilled nursing and assisted living facility, as well as to assess the performance of our operating segments. EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR 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, rent cost of revenue (in the case of EBITDAR and Adjusted EBITDAR) 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 the underlying business unit performance. As a result, we believe that the use of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying businesses and facilities between periods by eliminating certain items required by U.S. GAAP which have little or no significance to their day-to-day operations.

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. Our senior secured credit facility 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% senior subordinated notes also uses a substantially similar measurement for determining the amount of additional debt we may incur. For example, both our senior secured credit facility and the indenture governing our 11% senior subordinated notes include the following adjustments to EBITDA for (i) gain or losses on sale of assets, (ii) the write-off of deferred financing costs of extinguished debt, (iii) proforma adjustments for acquisitions to show a full year of EBITDA and interest expense, (iv) sponsorship fees paid to Onex which totals $0.5 million annually and (v) non-cash stock compensation. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our senior secured credit facility. In addition, if we cannot satisfy certain financial covenants under the indenture for our 11% 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, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by

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U.S. GAAP. Therefore, our EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under U.S. GAAP. Some of these limitations are:


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


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


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


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


•	although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements;


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


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


•	other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.

We compensate for these limitations by using EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with U. S. 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 U.S. GAAP as compared to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.

Three Months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010

Revenue. Revenue increased $8.0 million, or 3.8%, to $217.2 million in the three months ended September 30, 2011 from $209.2 million in the three months ended September 30, 2010.

Long term care services



	Three Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars			Percentage
	(dollars in millions)
Skilled nursing facilities	$	164.5	75.8	%	$	165.8	79.3	%	$	(1.3	)	(0.8	)%
Assisted living facilities	7.0		3.3		6.6		3.1		0.5			7.2
Administration of third party facilities	0.3		0.1		0.2		0.1		0.1			26.1
Leased facility revenue	0.7		0.3		$	—	—		0.7			100.0
Total long-term care services	$	172.5	79.5	%	$	172.6	82.5	%	$	—		—	%

Skilled nursing facilities revenue decreased $1.3 million in the third quarter of 2011 as compared to the third quarter of 2010. Revenue increased $8.1 million for skilled nursing facilities operated for all of the three months ended September 30, 2011 and 2010, of which $7.8 million was due to a higher weighted average per patient day rate and a $0.3 million was due to an increase in occupancy rates. Additionally, there were increases of $1.6 million from the opening of the Forth Worth Center of Rehabilitation completed in June 2010 and $0.8 million due to the acquisition of the Rehabilitation Center of Omaha in April 2011, offset by a decrease of $2.6 million of revenue from the sale of Westside Campus of Care in December 2010 and a decrease of $6.9 million of revenue due to the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011. The reduction in revenue related to the transfer of operations of the five skilled nursing facilities was $7.6 million net of the $0.7 million of lease facility revenue. Skilled mix increased to 22.7% in the three months ended September 30, 2011 from 22.6% in the three months ended September 30, 2010. Our average daily Part A Medicare rate increased 14.9% to $572 in the three months ended September 30, 2011 from $498 in the three months ended September 30, 2010, primarily due to the October 2010 implementation of RUGs IV. Our skilled nursing Medicare rates were decreased by 11.1% effective October 1, 2011 which will negatively impact skilled nursing revenues in future periods. Our average daily Medicaid rate increased 1.3% to $153 in the three months ended September 30, 2011 from $151 per day in the three months ended September 30, 2010, primarily due to increased Medicaid rates in California, Kansas, and New Mexico.

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These increases in Medicaid rates were substantially offset by increases in the provider taxes in those states. We expect overall Medicaid rates for the states we operate in to stay flat for the states' fiscal 2012 as compared to fiscal 2011. While same store admission volume has increased, we have experienced a decrease in our patients' average length of stay. We believe this to be primarily attributable to acuity and the economic factors affecting our business and the additional options patients have to return home. Revenue at our assisted living facilities increased to $7.0 million in the three months ended September 30, 2011 from $6.6 million in the three months ended September 30, 2010. The increase was primarily due to the acquisition of Vintage Park at San Martin in July 2011.

Therapy services



	Three Months Ended September 30,
	2011					2010					Increase/(Decrease)
	Revenue Dollars			Revenue Percentage		Revenue Dollars			Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	38.9		17.9	%	$	36.4		17.4	%	$	2.5	6.9	%
Intersegment elimination of services related to affiliated entities	(15.7		)	(7.2	)	(17.2		)	(8.2	)	1.5		(8.7	)
Third party therapy services	$	23.2		10.7	%	$	19.2		9.2	%	$	4.0	20.9	%

Third party rehabilitation therapy services revenue increased $2.5 million for the three months ended September 30, 2011 compared to the three months ended September 30, 2010, primarily as a result of negotiated rate increases and higher Medicare Part B billings.

Hospice & Home Health services



	Three Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Hospice	$	16.1	7.4	%	$	13.9	6.6	%	$	2.2	16.4	%
Home Health	5.3		2.4		3.6		1.7		1.7		48.1
Total hospice & home health services	$	21.4	9.8	%	$	17.5	8.3	%	$	3.9	22.9	%

Hospice and home health services revenue increased $4.0 million in the third quarter of 2011 as compared to the third quarter of 2010, as a result of our completion of our acquisition of Altura Homecare & Rehab in July 2011 (the "Altura Acquisition") and from an increase in the hospice average daily census of 188 from 943 to $1,131 for the three months ended September 30, 2011.

Cost of Services Expenses. Cost of services expenses increased $4.9 million, or 2.9%, to $173.5 million, or 79.9% of revenue, in the three months ended September 30, 2011, from $168.6 million, or 80.6% of revenue, in the three months ended September 30, 2010.

Long term care services

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	Three Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue

									Dollars			Percentage
	(dollars in millions)
Skilled nursing facilities	$	127.5	77.5	%	$	130.4	78.6	%	$	(2.9	)	(2.2	)%
Assisted living facilities	5.1		72.7		4.6		70.5		0.5			12.7
Regional operations support	5.7		n/a		5.5		n/a		0.2			3.9
Total long-term care services	$	138.3	80.2	%	$	140.5	81.4	%	$	(2.2	)	(1.5	)%

Cost of services expenses at our skilled nursing facilities decreased $2.9 million in the third quarter of 2011 as compared to the third quarter of 2010. This decrease was substantially due to a decrease of $6.1 million of expenses related to the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011 and a decrease of $2.1 million due to the sale of Westside Campus of Care in December 2010, offset by an increase of $0.7 million related to the acquisition of the Rehabilitation Center of Omaha in April 2011, and a $4.4 million increase in operating costs at facilities acquired or developed prior to July 1, 2010. This $4.4 million increase resulted from an increase in operating costs of $6.27 per patient day ("PPD"), or 3.4%, to $190.03 PPD in the three months ended September 30, 2011 from $183.76 for the three months ended September 30, 2010. These additional operating costs resulted from a $2.2 million increase in labor costs, which represented an increase of $3.03, or 2.9%, on a PPD basis. A significant portion of the increase in labor costs is attributable to time required to complete the increase in documentation required by MDS 3.0 which was effective October 1, 2010. Additionally, the increase in operating costs resulted from a $1.1 million increase in taxes and licenses, which was primarily due to an increase in provider taxes, $0.4 million of purchased services and a $0.6 million increase in expenses related to food and supplies. Cost of services expenses at our assisted living facilities increased $0.5 million in the three months ended September 30, 2011 compared to the three months ended September 30, 2010. The increase was primarily due to the acquisition of Vintage Park at San Martin in July 2011.

Therapy services



	Three Months Ended September 30,
	2011						`	2010						Increase/(Decrease)
	Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue			Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue

														Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	38.9	$	34.9	89.8	%		$	36.3	$	31.3	86.2	%	$	3.6	11.5	%
Total therapy services	$	38.9	$	34.9	89.8	%		$	36.3	$	31.3	86.2	%	$	3.6	11.5	%

Rehabilitation therapy costs as a percentage of revenue increased in the three months ended September 30, 2011, as compared to the same period in 2010 primarily due to the changes related to concurrent therapy, which has resulted in a requirement for more treatment time by licensed therapists. This, along with the loss of the ability to utilize rehabilitation aides to provide supervised treatments, has created an increase in the demand for therapists which in turn has raised labor costs. As a result, labor and benefit costs per minute of service have increased more than revenue per minute of service. The change in methodology for counting concurrent therapy has created a more challenging operating environment to maintain productivity for the three months ended September 30, 2011 as compared to the prior year. The negative impact to productivity from the concurrent therapy change was partially offset by rate increases and increasing group therapy treatments and an increase in volumes at both affiliated and non-affiliated facilities. CMS rulemaking effective for its fiscal year 2012 (which began October 1, 2011) effectively creates a financial penalty for providing group therapy treatments in contrast to its policy which promoted

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such efficiencies in prior fiscal years. CMS also made changes effective October 1, 2011 which require additional therapy time to provide more frequent assessments of the patients we treat. These two factors will negatively impact the margins of the therapy business in future periods.

Hospice and home health services



	Three Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Cost of Service Dollars		Percentage of Revenue		Cost of Service Dollars		Percentage of Revenue

									Dollars		Percentage
	(dollars in millions)
Hospice	$	11.6	71.9	%	$	10.8	78.1	%	$	0.8	7.2	%
Home Health	4.8		90.1		3.3		91.5		1.5		45.9
Total hospice & home health services	$	16.4	76.4	%	$	14.1	80.8	%	$	2.3	16.2	%

The increase in hospice cost of service is commensurate with the increase in revenue. The improvement in operating our hospice operations is the result of improvements in our legacy hospice operations which leverages fixed overhead costs. The increase in home health cost of services was primarily a result of our completion of the Altura Acquisition in July 2011.

Rent cost of revenue. Rent cost of revenue decreased $0.4 million, or 8.3%, to $4.4 million, or 2.0% of revenue, in the three months ended September 30, 2011 from $4.8 million, or 2.3% of revenue, in the three months ended September 30, 2010. The decrease is primarily related to the purchase of two previously leased facilities in December 2010.

General and Administrative Services Expenses. Our general and administrative services expenses decreased $0.6 million, or 10.0%, to $5.4 million, or 2.5% of revenue, in the three months ended September 30, 2011 from $6.0 million, or 2.9% of revenue, in the three months ended September 30, 2010. The decrease is primarily related to a $0.6 million reversal of stock compensation expense for performance stock awards for which the performance criteria are no longer expected to be met.

Litigation Settlement Costs, net of Recoveries. Litigation settlement expense, net of recoveries for the three months ended September 30, 2011 represented primarily insurance recoveries of $4.5 million related to the $53.5 million in litigation settlement expense that we recorded during the third quarter of 2010 consisting of $50.0 million cash settlement related to the Humboldt County Action, $3.0 million of related legal expenses, and $0.5 million in costs related to a securities class action related to our initial public offering (which was settled in September 2010).

Depreciation and Amortization. Depreciation and amortization increased by $0.2 million, or 3.16%, to $6.5 million in the three months ended September 30, 2011 from $6.3 million in the three months ended September 30, 2010, as additional assets have been placed in service since September 30, 2010.

Impairment of long-lived assets. We recorded a goodwill impairment charge of $267.5 million and a $3.0 million impairment charge related to a long-lived asset in the three months ended September 30, 2011. There was no comparable charge recorded in the three months ended September 30, 2010. See “Management's Discussion and Analysis of Financial Condition and Results of Operations-Goodwill and Other Long-Lived Assets” for a more detailed discussion of the impairment charges.

Interest Expense. Interest expense decreased by $0.4 million, or 4.0%, to $9.7 million in the three months ended September 30, 2011 from $10.1 million in the three months ended September 30, 2010. The decrease in our interest expense was primarily due to a decrease in the average debt outstanding for the three months ended September 30, 2011 of $497.4 million, as compared to $518.0 for the three months ended September 30, 2010.

Interest Income. Interest income remained consistent at $0.2 million for the three months ended September 30, 2011 and 2010.

Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture decreased $0.2 million, or 28.5%, to $0.5 million in the three months ended September 30, 2011 from $0.7 million in the three months ended September 30, 2010.

Benefit from Income Taxes. Tax benefit was $15.3 million, or 6.2% of pre-tax earnings, for the three months ended September 30, 2011, as compared to tax benefit of $13.8 million, or 35.3% of pre-tax loss, for the three months ended

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September 30, 2010. The change in effective tax rate for the three months ended September 30, 2011 compared to the three months ended September 30, 2010 was primarily due to the significant nondeductible portion of the goodwill impairment charge recorded for the three months ended September 30, 2011.

Loss before benefit from income taxes. Loss before provision of incomes taxes increased by $208.8 million to $247.9 million in the three months ended September 30, 2011 from $39.1 million in the three months ended September 30, 2010. The $208.8 million increase was related primarily to the $270.5 million charge of impairment of long lived assets, an increase of $4.9 million in cost of services, an increase of $0.5 million in other (expense) income, offset by an increase in revenue of $8.0 million, a decrease in rent cost of revenue of $0.4 million, a decrease in general and administrative expense of $0.6 million, a increase of depreciation and amortization expense of $0.2 million and a decrease in interest expense of $0.4 million expense and a decrease in litigation settlement cost, net of recoveries of $58.0, million, all discussed above.

EBITDA. EBITDA decreased by $209.0 million to a loss of $231.9 million in the three months ended September 30, 2011 from a loss of $22.9 million in the three months ended September 30, 2010. The $209.0 million decrease was primarily related to the $270.5 impairment of long-lived assets, $8.0 million increase in revenue offset by a $4.9 million increase in cost of services expense, all discussed above.

Nine Months Ended September 30, 2011 Compared to Nine Months Ended September 30, 2010

Revenue. Revenue increased $55.8 million, or 9.3%, to $655.3 million in the nine months ended September 30, 2011 from $599.5 million in the nine months ended September 30, 2010.

Long term care services



	Nine Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Skilled nursing facilities	$	505.0	77.1	%	$	492.3	82.1	%	$	12.7	2.6	%
Assisted living facilities	20.5		3.1		18.9		3.1		1.6		8.5
Administration of third party facilities	0.9		0.1		0.7		0.1		0.2		26.1
Leased facility revenue	1.5		0.2		—		—		1.5		100.0
Total long-term care services	$	527.9	80.5	%	$	511.9	85.3	%	$	16.0	3.1	%

Skilled nursing facilities revenue increased $12.7 million in the nine months ended September 30, 2011 as compared to the nine months ended September 30, 2010. Revenue increased $27.3 million for skilled nursing facilities operated for all of the nine months ended September 30, 2010 and 2011, of which $31.3 million was due to a higher weighted average PPD rate, offset by a $4.0 million decrease due to a decline in occupancy rates, which occurred primarily at our Texas facilities. Additionally, there were increases of $6.0 million from the opening of the Fort Worth Center of Rehabilitation in June 2010 and $1.6 million from the acquisition of the Rehabilitation Center of Omaha in April 2011, offset by a decreases of $8.0 million of revenue from the sale of Westside Campus of Care in December 2010 and $14.0 million from the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011. The reduction in revenue related to the transfer of operations of the five skilled nursing facilities was $12.5 million net of the $1.5 million of lease revenue that we received as a result of leasing the facilities to the third party operator. Skilled mix increased to 23.6% in the nine months ended September 30, 2011 from 22.8% in the nine months ended September 30, 2010. Our average daily Part A Medicare rate increased 15.5% to $574 in the nine months ended September 30, 2011 from $497 in the nine months ended September 30, 2010, primarily due to the October 2010 implementation of RUGs IV. Our skilled nursing Medicare rates were decreased by 11.1% effective October 1, 2011 which will negatively impact skilled nursing revenues in future periods. Our average daily Medicaid rate increased 2.7% to $154 in the nine months ended September 30, 2011 from $149 per day in the nine months ended September 30, 2010, primarily due to increased Medicaid rates in California, Kansas and New Mexico. These increases in Medicaid rates were substantially offset by increases in the provider taxes in those states. We expect overall Medicaid rates for the states we operate in to stay flat for the states' fiscal 2012 as compared to fiscal 2011. While same store admission volume has increased, we have experienced a decrease in our patients' average length of stay. We believe this to be primarily attributable to acuity and the economic factors affecting our business and the additional options patients have to return home. Revenue at our assisted living facilities increased to $20.5 million in the nine months ended September 30, 2011 from $18.9 million in the nine months ended September 30, 2010. Of this $1.6 million increase at our assisted living facilities, $1.3 million was from assisted living facilities that operated for all of the nine months ended September 30, 2010 and 2011.Our revenue related to the administration of third party facilities increased $0.2 million in the nine months ended

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September 30, 2011 and 2010.

Therapy services



	Nine Months Ended September 30,
	2011					2010					Increase/(Decrease)
	Revenue Dollars			Revenue Percentage		Revenue Dollars			Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	118.0		18.0	%	$	105.3		17.7	%	$	12.7	12.1	%
Intersegment elimination services related to affiliated entities	(48.9		)	(7.4	)	(50.7		)	(8.6	)	1.8		3.6
Third party therapy services	$	69.1		10.6	%	$	54.6		9.1	%	$	14.5	26.6	%

Third party rehabilitation therapy services revenue increased $14.5 million for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010, primarily as a result of the negotiated rate increase and higher Medicare Part B billings.

Hospice & Home Health services



	Nine Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Hospice	$	46.3	7.1	%	$	26.8	4.6	%	$	19.5	72.8	%
Home Health	12.1		1.8		6.2		1.0		5.9		93.5
Total hospice & home health services	$	58.4	8.9	%	$	33.0	5.6	%	$	25.4	76.7	%

Hospice and home health services revenue increased in the nine months ended September 30, 2011 as compared to the nine months ended September 30, 2010, as a result of our completion of the Hospice/Home Health Acquisition in May 2010 and from an increase in the average daily census of our hospice businesses, which increased from 621 for the nine months ended September 30, 2010 to 1,070 for the nine months ended September 30, 2011.

Cost of Services Expenses. Cost of services expenses increased $38.0 million, or 7.9.5%, to $520.3 million, or 79.4 of revenue, in the nine months ended September 30, 2011, from $482.3 million, or 80.5% of revenue, in the nine months ended September 30, 2010.

Long-term care services



	Nine Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue

									Dollars		Percentage
	(dollars in millions)
Skilled nursing facilities	$	388.7	77.0	%	$	386.3	78.4	%	$	2.4	0.6	%
Assisted living facilities	14.7		71.6		13.4		70.9		1.3		10.0
Regional operations support	18.6		n/a		16.7		n/a		1.9		10.9
Total long-term care services	$	422.0	79.9	%	$	416.4	81.3	%	$	5.6	1.3	%

Cost of services expenses at our skilled nursing facilities increased $2.4 million in the nine months ended September 30,

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2011 as compared to the nine months ended September 30, 2010. This increase was substantially due to $4.5 million of additional expenses related to the Fort Worth Center of Rehabilitation which opened September 2010, $1.4 million of additional expenses due to the acquisition of the Rehabilitation Center of Omaha in April 2011, and $12.8 million of additional expenses from operating costs increasing at facilities acquired or developed prior to January 1, 2010. This $12.8 million increase resulted from an increase in operating costs of $8.02 PPD, or 4.7%, to $190.95 PPD in the nine months ended September 30, 2011 from $182.93 for the nine months ended September 30, 2010. The increase in cost of services expenses was offset by a decrease of $6.2 million of expenses due to the sale of Westside Campus of Care in December 2010 and a decrease of $10.9 million due to the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011. The $12.8 million increase in operating costs resulted from a $6.2 million increase in labor costs, which represented an increase of $4.00, or 3.8%, on a PPD basis. A significant portion of the increase in labor costs is attributable to the increase in personnel and annual salary increases. Additionally, the increase in operating costs resulted from a $3.6 million increase in taxes and licenses, which was primarily due to an increase in provider taxes, $0.7 million increase in expenses related to rehab/ancillaries, $1.7 million increase in expenses related to food and supplies, $0.9 million in expenses related to purchase services and $0.2 million increase in expenses related to bad debt, offset by a decrease in insurance and other operating expenses of $0.6 million. Cost of services expenses at our assisted living facilities increased $1.3 million in the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010, $1.0 million of which was at assisted living facilities that operated for all of the nine months ended September 30, 2010 and 2011.

Therapy services



	Nine Months Ended September 30,
	2011						`	2010						Increase/(Decrease)
	Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue			Revenue (prior to intersegment eliminations)		Cost of Service Dollars (prior to intersegment eliminations)		Percentage of Revenue

														Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	118.0	$	102.7	87.1	%		$	105.2	$	89.3	84.9	%	$	13.4	15.0	%
Total therapy services	$	118.0	$	102.7	87.1	%		$	105.2	$	89.3	84.9	%	$	13.4	15.0	%

Rehabilitation therapy costs as a percentage of revenue increased from 84.9% to 87.1% in the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010 primarily due to changes related to concurrent therapy, which has resulted in a requirement for more treatment time by licensed therapists. This, along with the loss of the ability to utilize rehabilitation aides to provide supervised treatments, has created an increase in the demand for therapists which has increased labor costs. As a result, labor and benefit costs per minute of service have increased more than revenue per minute of service. The change in methodology for counting concurrent therapy has created a more challenging operating environment to maintain productivity for the nine months ended September 30, 2011 as compared to the prior year. The negative impact to productivity from the concurrent therapy change was partially offset by rate increases and increasing group therapy treatments and an increase in volumes at both affiliated and non-affiliated facilities. CMS rulemaking effective for its fiscal year 2012 (which began October 1, 2011) effectively creates a financial penalty for providing group therapy treatments in contrast to its policy which promoted such efficiencies in prior fiscal years. CMS also made changes effective October 1, 2011 which require additional therapy time to provide more frequent assessments of the patients we treat. These two factors will negatively impact the margins of the therapy business in future periods.

Hospice and home health services

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	Nine Months Ended September 30,
	2011				2010				Increase/(Decrease)
	Cost of Service Dollars		Percentage of Revenue		Cost of Service Dollars		Percentage of Revenue

									Dollars		Percentage
	(dollars in millions)
Hospice	$	34.4	74.3	%	$	22.2	82.9	%	$	12.2	54.9	%
Home Health	11.5		94.9		5.5		88.3		6.0		107.5
Total hospice & home health services	$	45.9	78.5	%	$	27.7	83.9	%	$	18.2	65.4	%

The increase in hospice and home health cost of services was primarily a result of our completion of the Hospice/Home Health Acquisition in May 2010. Cost of services as a percentage of revenue improved as the acquired hospice companies have higher operating margins then our legacy hospice operations, as well as from improved census in our legacy operations, which leverages fixed overhead costs.

Rent cost of revenue. Rent cost of revenue decreased $0.7 million, or 4.9%, to $13.5 million, or 2.1% of revenue, in the nine months ended September 30, 2011 from $14.2 million, or 2.3% of revenue, in the nine months ended September 30, 2010. The decrease is primarily related to the purchase of two previously leased facilities in December 2010.

General and Administrative Services Expenses. Our general and administrative services expenses increased $1.1 million, or 5.9%, to $19.6 million, or 3.0% of revenue, in the nine months ended September 30, 2011 from $18.5 million, or 3.0% of revenue, in the nine months ended September 30, 2010. The increase is primarily related to a $0.5 million increase of cost compensation costs and $0.7 million related to the exploration of strategic alternatives.

Depreciation and Amortization. Depreciation and amortization increased by $0.8 million, or 4.4%, to $19.0 million, or 2.8% of revenue, in the nine months ended September 30, 2011 from $18.2 million, in the nine months ended September 30, 2010. This increase is primarily a result of the change in fair value related to the contingent consideration due to the Hospice/Home Health Acquisition in May 2010, discussed in Note 11, "Fair Value Measurements." Additionally, there was an increase in depreciation and amortization related to the opening of the Fort Worth Center of Rehabilitation in June 2010.

Impairment of long-lived assets. We recorded a goodwill impairment charge of $267.5 million and a $3.0 million impairment charge related to a long-lived asset in the nine months ended September 30, 2011. There was no comparable charge recorded in the nine months ended September 30, 2010. See “Management's Discussion and Analysis of Financial Condition and Results of Operations-Goodwill and Other Long-Lived Assets” for a more detailed discussion of the impairment charges.

Interest Expense. Interest expense increased by $2.8 million, or 10.6%, to $29.3 million in the nine months ended September 30, 2011 from $26.5 million in the nine months ended September 30, 2010. The increase in our interest expense was primarily due to a higher "all-in" interest rate. The "all-in" interest rate inclusive of deferred financing fee amortization for the nine months ended September 30, 2011 was 7.7% compared to 7.2% for the nine months ended September 30, 2010. Average debt outstanding for the nine months ended September 30, 2011 was $506.9 million as compared to $492.6 for the nine months ended September 30, 2010.

Interest Income. Interest income was $0.6 million for the nine months ended September 30, 2011 and 2010.

Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture decreased $0.6 million, or 27.3%, to $1.6 million in the nine months ended September 30, 2011 from $2.2 million in the nine months ended September 30, 2010, primarily due to the decrease in number of facilities serviced by our pharmacy joint venture.

Debt Retirement Cost. Debt Retirement Cost for the nine months ended September 30, 2010 represented the expensing of new and existing deferred financing fees of $6.6 million and $0.4 million of costs associated with the early termination costs of two interest swaps in April 2010, which were incompatible with the refinanced credit facility.

Benefit from Income Taxes. Tax benefit was $0.6 million, or 0.26% of our pre-tax loss, for the nine months ended September 30, 2011, as compared to a tax benefit of $5.4 million, or 31.2% of pre-tax loss, for the nine months ended September 30, 2010. The change in effective tax rate for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010 was primarily due to the significant nondeductible portion of the goodwill impairment charge recorded for the nine months ended September 30, 2011.

Loss before benefit for income taxes. Loss before provision of incomes taxes increased by $193.4 million to a loss of

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$210.7 million in the nine months ended September 30, 2011 from a loss of $17.3 million in the nine months ended September 30, 2010. The $193.4 million increase was related primarily to the $270.5 million charge of impairment of long lived assets, an increase of $38.0 million in cost of services, and increase of $2.8 million in interest expense, an increase of $1.1 in general and administrative, a decrease of $0.6 million in equity in earnings of joint ventures, and an increase of $1.1 of other (expense) income. The increase of $193.4 million is offset by an increase in revenue of $55.8 million, a decrease in rent cost of revenue of $0.7 million, a decrease in litigation settlement cost, net of recoveries of $58.0 million, the $7.0 million decrease in debt retirement cost, all discussed above.

EBITDA. EBITDA decreased by $189.7 million to a loss of $162.9 million in the nine months ended September 30, 2011 from $26.8 million in the nine months ended September 30, 2010. The $189.7 million decrease is related to the impairment of long-lived assets of $270.5 million offset by $55.7 million increase in revenue, a $38.0 million increase in cost of services expense, and a decrease in litigation settlement cost, net of recoveries of $58.0 million, 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,
	2011			2010
Cash Flows from Continuing Operations
Net cash provided by operating activities	$	66,191		$	4,222
Net cash used in investing activities	(24,713		)	(68,541		)
Net cash provided by (used in) financing activities	(29,228		)	63,991
Net increase (decrease) in cash and cash equivalents	12,250			(328		)
Cash and cash equivalents at beginning of period	4,192			3,528
Cash and cash equivalents at end of period	$	16,442		$	3,200

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 senior secured 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 will be subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond our control. For additional discussion, see “Other Factors Affecting Liquidity and Capital Resources” below.

Nine Months Ended September 30, 2011 Compared to Nine Months Ended September 30, 2010

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

At September 30, 2011, we had cash of $16.4 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 impairment of long-lived assets, 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, 2011 was $66.2 million and consisted of net loss of $210.2 million, and adjustments for non-cash items of $289.1 million which included the impairment of long-lived assets of $270.5 million, offset by $12.7 million used for working capital and other activities. Working capital and other activities primarily consisted of $4.1 million of payments received on notes receivable, and a $7.8 million decrease in other current and non-current assets, offset by an increase in accounts receivable of $11.8 million, a $2.0 million decrease in insurance liability risks, a $7.2 million decrease in accounts payable and accrued liabilities, and a $3.4 million decrease in employee compensation benefits. Days sales outstanding increased from 41.2 days at December 31, 2010 to 42.2 days at September 30, 2011.

Net cash provided by operating activities in the nine months ended September 30, 2010 was $4.2 million and consisted of net loss of $11.9 million, and adjustments for non-cash items of $34.1 million, offset by $17.9 million used for working capital

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and other activities. Working capital and other activities primarily consisted of a $3.4 million of payments received on notes receivable, a $2.8 million increase in employee compensation and benefits, and an increase in other long-term liabilities of $1.1 million, 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 a $3.1 million decrease in accounts payable and accrued liabilities.

Net cash used in investing activities for the nine months ended September 30, 2011 consisted of $11.1 million of capital expenditures, $13.6 million used in the acquisition of healthcare facilities and businesses, and $0.4 million to acquire a home health license in California for our hospice and home health services segment offset by $0.4 million received from the sale of a parcel of land. The capital expenditures consisted of $0.1 million for facility renovations, $0.7 million for expansion of our Express Recovery™ Unit program and $10.3 million of routine capital expenditures.

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 by financing activities for the nine months ended September 30, 2011 of $29.2 million primarily reflects net repayment of borrowings under our line of credit of $26.0 million and scheduled debt repayments of $2.8 million.

Net cash provided by financing activities for the nine months ended September 30, 2010 of $64.0 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.

Principal Debt Obligations

Our primary sources of liquidity are our cash on hand, our cash flows from operations and our senior secured credit facility, which is subject to the satisfaction of certain financial covenants therein. Our primary liquidity requirements are for debt service on our first lien senior secured term loan and our 2014 Notes, capital expenditures and working capital.

We are significantly leveraged. As of September 30, 2011, we had $492.1 million in aggregate indebtedness outstanding, consisting of $129.7 million principal amount of our 2014 Notes (net of the unamortized portion of the original issue discount of $0.3 million), a $352.6 million first lien senior secured term loan (net of the unamortized portion of the original issue discount of $2.0 million), and other debt of approximately $9.8 million. Furthermore, we had $4.4 million in outstanding letters of credit against our $100.0 million revolving credit facility, leaving approximately $95.6 million of additional borrowing capacity under our “senior secured credit facility” as of September 30, 2011. Substantially all of our subsidiaries guarantee our 2014 Notes, the first lien senior secured term loan and our revolving credit facility.

If our remaining ability to borrow under our revolving credit facility is insufficient for our capital requirements, we will be required to seek additional sources of financing, including issuing equity, which may be dilutive to our current stockholders, or incurring additional debt. Our ability to incur additional debt is subject to the restrictions in the indenture governing our 2014 Notes and our senior secured credit facility. We cannot assure you that the restrictions contained in these agreements will permit us to borrow the funds that we need to finance our operations, or that additional debt will be available to us on commercially reasonable terms or at all. If we are unable to obtain funds sufficient to finance our capital requirements, we may have to forego opportunities to expand our business, including the acquisition of additional facilities.

Term Loan and Revolving Loan

On April 9, 2010, we entered into an up to $360.0 million term loan and a $100.0 million revolving credit facility (the “Restated Credit Agreement”) that replaced 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. We refer to the senior secured term loan and revolving credit facility provided under the Restated Credit Agreement as our senior secured credit facility.

The term loan requires principal payments of 0.25% of the original principal amount, or $0.9 million 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 11% 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 our assets. Substantially all of

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our companies guarantee our senior secured credit facility.

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. We believe that we were in compliance with our debt covenants as of September 30, 2011. As of September 30, 2011, our fixed charge coverage ratio was 3.46 and our leverage ratio was 3.47 compared to threshold of greater than 1.5 and less than 5.25, respectively.

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.

Senior Subordinated Notes

Our 11.0% senior subordinated notes, which we sometimes refer to as the 2014 Notes, were issued in December 2005 in the aggregate principal amount of $200.0 million, with an interest rate of 11.0% per annum. The 11.0% senior subordinated notes were issued at a discount of $1.3 million. Interest is payable semiannually in January and July of each year. The 11% senior subordinated notes mature on January 15, 2014. The 11.0% senior subordinated notes are unsecured senior subordinated obligations and rank junior to all of our existing and future senior indebtedness, including indebtedness under our senior secured credit facility. The 11.0% senior subordinated notes are guaranteed on a senior subordinated basis by certain of our current and future subsidiaries. There was $130.0 million aggregate principal amount of our 11.0% senior subordinated notes outstanding as of September 30, 2011. Substantially all of our companies guarantee our 11.0% senior subordinated notes.

As of January 15, 2011, we became entitled to redeem all or a portion of the remaining $130.0 million aggregate principal amount of our 11% senior subordinated notes upon not less than 30 nor more than 60 days notice, at a redemption price (expressed in percentages of principal amount on the redemption date) of 102.75% effective January 15, 2011 and 100.0% effective January 15, 2012.

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 $14.0 million in capital expenditures in 2011 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 are in the process of developing an additional two Express Recovery™ units in 2011. We expect total capital expenditures of approximately $15.0 to $18.0 million in 2011.

Other Factors Affecting Liquidity and Capital Resources

Medical and Professional Malpractice and Workers' Compensation Insurance. Our skilled nursing facilities and other businesses, 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 deductibles that we believe to be sufficient for our operations. Historically, unfavorable pricing and availability trends emerged in the professional liability and workers' compensation

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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 experienced substantial changes in our professional liability insurance program beginning in 2001. Specifically, we were required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is a minimum 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 certainty the actual amount of the losses we will assume and pay.

We estimate our self-insured general and professional liability reserves on a quarterly basis and our self-insured 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, 2011, we had reserved $17.2 million net of $6.8 million in insurance recoveries for known or unknown or potential self-insured general and professional liability claims and $15.8 million for self-insured workers' compensation claims. Of these reserves, we estimate that approximately $4.6 million for self-insured general and professional liability claims and $4.4 million for self-insured workers' compensation claims for a total of $9.0 million will be payable within 12 months; however, there are no set payment schedules and there can be no assurance that the payment amount in the next 12 months 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 and 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 2010 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, there can be no assurance that these adjustments will continue in the future and, if received, will reflect the actual increase in our costs for providing healthcare services.

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 or slow growth in most major economies expected to continue throughout the remainder of 2011 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. Furthermore, if the U.S. federal government were to default on its obligations (or have the rating on government debt lowered by credit rating agencies), our business, liquidity and financial condition could be materially and adversely affected. Although we recently were able to extend the maturity of our revolving loan commitments and maintain existing interest rate spreads on that Restated Credit Facility (see "Principal Debt Obligations and Capital Expenditures" above), if these market conditions continue or worsen, 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.

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

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We had outstanding letters of credit of $4.4 million under our $100.0 million revolving credit facility as of September 30, 2011.

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

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 a LIBOR 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, 2011 (dollars in thousands):



	Twelve Months Ending September 30, ⁽¹⁾
	2012			2013			2014			2015			2016			Thereafter			Total		Fair Value
Fixed-rate debt⁽²⁾	$	2,155		$	2,157		$131,614 ⁽³⁾			$	2.146		$	188		$	467		$	139,280	$	139,737
Average interest rate	5.6		%	6.0		%	10.9		%	6.0		%	6.0		%	6.0		%
Variable-rate debt⁽⁴⁾	$	3,600		$	3,600		$	3,600		$	3,600		$	340,200		$	—		$	354,600	$	336,870
Average interest rate⁽¹⁾	5.3		%	5.3		%	5.3		%	5.3		%	5.9		%


(1)	Based on implied forward three-month LIBOR rates in the yield curve as of September 30, 2011.


(2)	Excludes unamortized original issue discount of $0.3 million on our 11.0% senior subordinated notes.


(3)	If the 11% senior subordinated notes remain outstanding on October 14, 2013, then the maturity date of the senior secured credit facility will be October 14, 2013.


(4)	Excludes unamortized original issue discount of $2.0 million on our first lien senior secured term loan debt.

For the nine months ended September 30, 2011, there was no 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. As of September 30, 2011, there was $0.8 million of pre-tax unrealized loss included in accumulated 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, 2011 (dollars in thousands):



Loan	Transaction Type	Notional Amount		Trade Date	Effective Date	Maturity/ Termination Date	Three months Ended September 30, 2011		Fair Value (Pre-tax)
First Lien	cap	$	70,000	6/30/2010	7/2/2010	12/31/2011	$	—	$	—
First Lien	swap	$	70,000	6/30/2010	1/1/2012	6/30/2013	$	—	$	(806	)
							$	—	$	(806	)

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 loss. 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 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.

Item 4. Controls and Procedures

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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.

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Part II. Other Information

Item 1. Legal Proceedings

The information required by this Item is incorporated herein by reference to Note 9, “Commitments and Contingencies—Litigation,” to the unaudited condensed consolidated financial statements under Part I, Item 1 of this report.

We are party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of business, including claims that our services have resulted in injury or death to patients who receive care from our businesses and claims related to employment, staffing requirements and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations and financial condition.

We operate in a highly regulated industry. We are subject to ongoing regulatory oversight by state and federal regulatory authorities. Actual or alleged failure to comply with legal and regulatory requirements could subject us to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could seek the suspension or exclusion of the offending provider or individual from participation in government healthcare programs and could lead to recoupment claims on prior payments by government healthcare programs. Adverse determinations in legal and regulatory investigations, actions and proceedings, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

Item 1A. Risk Factors

Statements made by us in this report and in other reports and statements released by us that are not historical facts constitute “forward-looking statements” within the meaning of Section 21 of the Exchange Act. Disclosures that use words such as we “believe,” “anticipate,” “estimate,” “intend,” “could,” “plan,” “expect,” “project” or the negative of these, as well as similar expressions, are intended to identify forward-looking statements. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management based on our current estimates, expectations, forecasts and projections, and include comments that express our current opinions about trends and factors that may impact future operating results. Such statements rely on a number of assumptions concerning future events, many of which are outside of our control, and involve known and unknown risks and uncertainties that could cause our actual results, performance or achievements, or industry results, to differ materially from any future results, performance or achievements, expressed or implied by such forward-looking statements. Any such forward-looking statements, whether made in this report or elsewhere, should be considered in the context of the various disclosures made by us about our business and other matters including, without limitation, the risk factors discussed below. We expressly disclaim any duty to update the forward-looking statements and other information contained in this report, except as required by law.

We operate in a rapidly changing and highly regulated environment that involves a number of risks and uncertainties. The following discussion highlights some of these risks and uncertainties, and others are discussed elsewhere in this report. These and other risks and uncertainties could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. The following risk factors are not an exhaustive list of the risks and uncertainties associated with our business. New considerations may emerge or changes to the risks and uncertainties described below could occur that could materially and adversely affect our business.

Risks Related to Our Business

Reductions in Medicare reimbursement rates, or changes in the rules governing the Medicare program could have a material adverse effect on our revenue, financial condition and results of operations.

Medicare is our largest source of revenue, accounting for 37.6% and 37.0% of our consolidated revenue during 2010 and the first nine months of 2011, respectively. In addition, many private payors base their reimbursement rates on the published Medicare rates or, in the case of our rehabilitation therapy services customers, are themselves reimbursed by Medicare. Accordingly, if Medicare reimbursement rates are reduced or fail to increase as quickly as our costs, or if there are changes in the rules governing the Medicare program that are disadvantageous to our business or industry, our business and results of operations will be adversely affected.

The Medicare program and its reimbursement rates and rules are subject to frequent change. These include statutory and regulatory changes, rate adjustments (including retroactive adjustments), administrative or executive orders and government funding restrictions, all of which may materially adversely affect the rates at which Medicare reimburses us for our services.

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For example, CMS has implemented a net 11.1% reduction in its reimbursement rates to skilled nursing facilities effective October 1, 2011. Budget pressures often lead the federal government to reduce or place limits on reimbursement rates under Medicare. Implementation of these and other types of measures has in the past and could in the future result in substantial reductions in our revenue and operating margins. Prior reductions in governmental reimbursement rates partially contributed to our predecessor's bankruptcy filing under Chapter 11 of the United States Bankruptcy Code in October 2001.

In addition, the federal government often changes the rules governing the Medicare program, including those governing reimbursement. Changes that could adversely affect our business include:


•	administrative or legislative changes to base rates or the bases of payment;


•	limits on the services or types of providers for which Medicare will provide reimbursement;


•	changes in methodology for patient assessment and/or determination of payment levels;


•	the reduction or elimination of annual rate increases; or


•	an increase in co-payments or deductibles payable by beneficiaries.

Given the history of frequent revisions to the Medicare program and its reimbursement rates and rules, we may not continue to receive reimbursement rates from Medicare that sufficiently compensate us for our services or, in some instances, cover our operating costs. Limits on reimbursement rates or the scope of services being reimbursed could have a material adverse effect on our revenues, financial condition and results of operations. Additionally, any delay or default by the federal or state governments in making Medicare and/or Medicaid reimbursement payments could materially and adversely affect our business, financial condition and results of operations.

We are subject to a Medicare cap amount for our hospice business. Our net patient service revenue and profitability could be adversely affected by limitations on Medicare payments.

Overall payments made by Medicare to us on a per hospice basis are subject to an annual cap amount. Total Medicare payments received for services rendered during the applicable Medicare hospice cap year by each of our Medicare-certified programs during this period are compared to the cap amount for the relevant period. Payments in excess of the cap are subject to recoupment by Medicare.

We monitor the Medicare cap amount and seek to implement corrective measures as necessary. We maintain what we believe are adequate allowances in the event that we exceed the Medicare hospice cap in any given fiscal year. However, many of the variables involved in estimating the Medicare hospice cap contractual adjustment are beyond our control, and we cannot assure you that we will not increase or decrease our estimated contractual allowance in the future., or that we will not be required to surrender amounts we received from Medicare that were in excess of the Medicare hospice cap for any particular period(s).

Certain of our hospice agencies have exceed the Medicare hospice cap in prior periods. Our ability to comply with the cap limitation depends on a number of factors relating to a given hospice program, including number of admissions, average length of stay, mix in level of care and Medicare patients that transfer into and out of our hospice programs. Our revenue and profitability may be materially reduced if we are unable to comply with this and other Medicare payment limitations. We cannot assure you that our hospice programs will not exceed the cap amount in the future or that our estimate of the Medicare cap contractual adjustment will not differ materially from the actual Medicare cap amount.

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.

We receive a significant portion of our revenue from Medicaid, which accounted for 31.5% and 29.2% of our consolidated revenue during 2010 and the first nine months of 2011, respectively. In addition, many private payors for our third-party rehabilitation therapy services are reimbursed under the Medicaid program for services that we provided to patients. Medicaid is a state-administered program financed by both state funds and matching federal funds. Medicaid spending has increased rapidly in recent years, becoming a significant component of state budgets. This, combined with slower state revenue growth, has led both the federal government and many states (including California and Texas, where significant portions of our Medicaid-related business is located) to institute measures aimed at controlling the growth of Medicaid spending, and in some instances reducing aggregate Medicaid spending. We expect these state and federal efforts to continue for the foreseeable future. If Medicaid reimbursement rates are reduced or fail to increase as quickly as our costs, or if there are changes in the rules governing the Medicaid program that are disadvantageous to our businesses or professions our business and results of operations could be adversely affected.

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Recent federal government proposals could limit the states' use of provider tax programs to generate revenue for their Medicaid expenditures, which could result in a reduction in our reimbursement rates under Medicaid.

To generate funds to pay for the increasing costs of the Medicaid program, many states utilize financial arrangements commonly referred to as “provider taxes.” Under provider tax arrangements, states collect taxes from healthcare providers and then use the revenue to pay the providers as a Medicaid expenditure, which allows the states to then claim additional federal matching funds on the additional reimbursements. Current federal law provides for a cap on the maximum allowable provider tax as a percentage of the provider's total revenue. There can be no assurance that federal law will continue to provide matching federal funds on state Medicaid expenditures funded through provider taxes, or that the current caps on provider taxes will not be reduced. Any discontinuance or reduction in federal matching of provider tax-related Medicaid expenditures could have a significant and adverse effect on states' Medicaid expenditures, and as a result could have a material and adverse effect on our financial condition and results of operations.

Revenue we receive from Medicare and Medicaid is subject to potential retroactive reduction.

Payments we receive from Medicare and Medicaid can be retroactively adjusted after examination during the claims settlement process or as a result of post-payment audits. Payors may disallow our requests for reimbursement, or recoup amounts previously reimbursed, based on determinations by the payors or third-party recovery audit contractors that certain costs are not reimbursable because either adequate or additional documentation was not provided or because certain services were not covered or deemed to be medically necessary. Significant adjustments to or recoupments of our Medicare or Medicaid revenue could adversely affect our financial condition and results of operations.

Health reform legislation could adversely affect our revenue and financial condition.

In recent years, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for, the availability of and reimbursement for healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including the provision of comprehensive healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs. The Patient Protection and Affordable Care Act, which was passed in 2010 and has implementation timing and costs and regulatory implications that are still uncertain in many respects, is among the most comprehensive and notable of these legislative efforts, and its full effects on us and others in our industry are still in many ways difficult to predict. The content or timing of any future health reform legislation, and its impact on us, is impossible to predict. If significant reforms are made to the U.S. healthcare system, those reforms may have an adverse effect on our financial condition and results of operations.

In addition, we incur considerable administrative costs in monitoring the changes made within the various reimbursement programs in which we participate, determining the appropriate actions to be taken in response to those changes, and implementing the required actions to meet the new requirements and minimize the repercussions of the changes to our organization, reimbursement rates and costs.

We are subject to extensive and complex laws and government regulations. If we are not operating in compliance with these laws and regulations or if these laws and regulations change, we could be required to make significant expenditures or change our operations in order to bring our facilities and operations into compliance.

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


•	licensure and certification;


•	adequacy and quality of healthcare services;


•	qualifications of healthcare and support personnel;


•	quality of medical equipment;


•	confidentiality, maintenance and security issues associated with medical records and claims processing;


•	relationships with physicians and other referral sources and recipients;


•	constraints on protective contractual provisions with patients and third-party payors;


•	operating policies and procedures;


•	addition of facilities and services; and


•	billing for services.

Many of these laws and regulations are expansive, and we do not always have the benefit of significant regulatory or

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judicial interpretation of these laws and regulations. In addition, many of these laws and regulations evolve to include additional obligations and restrictions. Certain other regulatory developments, such as revisions in the building code requirements for assisted living and skilled nursing facilities, mandatory increases in scope and quality of care to be offered to residents, revisions in licensing and certification standards, and regulations restricting those we can hire, could also have a material adverse effect on us. In the future, different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses.

One development potentially restricting those we may hire was a decision on November 3, 2010 by the Physical Therapy Board of California (“PT Board”) to rescind a 1990 PT Board resolution which determined that the offering of physical therapy services by a corporation, not organized as a professional corporation, was permitted by the Physical Therapy Practice Act, which is the California statute governing the provision of physical therapy within the state. This rescission purports to prohibit employment of a physical therapist to provide physical therapy services by any professional corporation except those owned by physical therapists and Naturopaths. Lay corporations that hold themselves out as physical therapy corporations would be similarly prohibited. We have a subsidiary that employs physical therapists in California, but is not owned by physical therapists. Our subsidiary contracts with nursing facilities to provide the facilities with personnel who are licensed to provide rehabilitation therapy services, including physical therapy, occupational therapy and/or speech language pathology services. Our therapists then provide rehabilitation therapy services to the nursing facilities' patients under the skilled nursing facilities' licenses that authorize the provision of physical therapy (and other rehabilitation therapy services, if applicable). In this relationship, the nursing facilities retain the patient relationship, remain professionally responsible for the healthcare services including therapy, and bill the patient and/or third party payors for the services rendered to their patients. We are unaware of any enforcement actions by the PT Board to date and it is not clear whether the applicable law would ultimately be interpreted to mean that our rehabilitation therapy subsidiary cannot employ and provide physical therapists to nursing facilities in California as it currently does. Nevertheless, the PT Board could seek an enforcement action against our rehabilitation therapy subsidiary and its physical therapists employees and we may have to significantly restructure operations of our California rehabilitation therapy operations to conform to the PT Board's revised interpretation of the law.

In addition, federal and state government agencies have increased and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare companies and, in particular, skilled nursing facilities. This includes investigations of:


•	fraud and abuse;


•	quality of care;


•	financial relationships with referral sources; and


•	the medical necessity of services provided.

We are unable to predict the future course of federal, state and local regulation or legislation, including Medicare and Medicaid statutes and regulations, the intensity of federal and state enforcement actions or the extent and size of any potential sanctions, fines or penalties. Changes in the regulatory framework, our failure to obtain or renew required regulatory approvals or licenses or to comply with applicable regulatory requirements, the suspension or revocation of our licenses or our disqualification from participation in federal and state reimbursement programs, or the imposition of other enforcement sanctions, fines or penalties could have a material adverse effect upon our results of operations, financial condition and liquidity. Furthermore, should we lose licenses or certifications for a number of our facilities as a result of regulatory action or otherwise, we could be deemed to be in default under some of our agreements, including agreements governing outstanding indebtedness and the report of such issues at one of our facilities could harm our reputation for quality care and lead to a reduction in our patient referrals and ultimately our revenue and operating income.

We face periodic reviews, audits and investigations under federal and state government programs and contracts. These audits could have adverse findings that may negatively affect our business.

As a result of our participation in the Medicare and Medicaid programs, we are subject to various governmental reviews, audits and investigations to verify our compliance with these programs and applicable laws and regulations. Managed care payors may also reserve the right to conduct audits. An adverse review, audit or investigation could result in:


•	refunding amounts we have been paid pursuant to the Medicare or Medicaid programs or from managed care payors;


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


•	temporary suspension of payment for new patients to the facility or agency;


•	decertification or exclusion from participation in the Medicare or Medicaid programs or one or more managed care payor networks;

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•	damage to our reputation;


•	the revocation of a facility's or agency's license; and


•	loss of certain rights under, or termination of, our contracts with managed care payors.

We have in the past and will likely in the future be required to refund amounts we have been paid as a result of these reviews, audits and investigations. If adverse reviews, audits or investigations occur and any of the results noted above occur, it could have a material adverse effect on our business and operating results.

Significant legal actions, which are commonplace in our professions, could subject us to increased operating costs and substantial uninsured liabilities, which would materially and adversely affect our results of operations, liquidity and financial condition.

The long-term care profession has experienced an increasing trend in the number and severity of litigation claims involving punitive damages and settlements. We believe that this trend is endemic to the industry and is a result of the increasing number of large judgments, including large punitive damage awards, against long-term care providers in recent years resulting in an increased awareness by plaintiffs' lawyers of potentially large recoveries. While some states have enacted tort reform legislation that limits plaintiffs' recoveries in some respects, should our professional liability and general liability increase significantly in the future, we may not be able to increase our revenue sufficiently to cover the cost increases, our operating income could suffer, and we may not be able to meet our obligations to repay our liabilities. For a discussion of recent litigation claims against us, including the Humboldt County Action, see “Commitments and Contingencies-Litigation” in the notes to the consolidated financial statements included elsewhere in this report.

We also may be subject to lawsuits under the federal False Claims Act and comparable state laws for submitting allegedly fraudulent or otherwise inappropriate bills for services to the Medicare and Medicaid programs. These lawsuits, which may be initiated by regulatory authorities as well as private party whistleblowers, can involve significant monetary damages, fines, attorney fees and the award of bounties to private plaintiffs who successfully bring these suits, as well as to the government programs.

We may incur significant liabilities in conjunction with legal actions against us, including as a result of damages, fines and penalties that may be assessed against us, as well as a result of the sometimes significant commitments of financial and management resources that are often required to defend against such legal actions. The incurrence of such liabilities and related commitments of resources could materially and adversely affect our business, financial condition and results of operations.

We could face significant financial difficulties as a result of one or more of the risks discussed in this report, which could cause us to significantly alter our business and/or seek protection under bankruptcy laws or could cause our creditors or government authorities to have a receiver appointed on our behalf.

We could face significant financial difficulties if Medicare or Medicaid reimbursement rates are reduced, patient demand for our services is reduced or we incur unexpected liabilities or expenses, including in connection with legal actions, sanctions, penalties or fines or the other risks discussed in this report. This financial difficulty could cause us to significantly alter our business and/or seek protection under bankruptcy laws or could cause our creditors or government authorities to have a receiver appointed on our behalf.

A significant portion of our business is concentrated in certain geographical markets, and an economic downturn or changes in the laws affecting our business in those markets could have a material adverse effect on our operating results.

In 2010, we received approximately 41.9% and 23.7% of our consolidated revenue from operations in California and Texas, respectively, and in 2009, we received approximately 44.3% and 25.2% of our consolidated revenue from operations in California and Texas, respectively. We have continued to receive significant portions of our consolidated revenue from those states in 2011 as well. Accordingly, economic conditions and changes in state healthcare spending prevailing in either of these markets could affect the ability of our patients and third-party payors to reimburse us for our services, either through a reduction of the tax base used to generate state funding of Medicaid programs, an increase in the number of indigent patients eligible for Medicaid benefits, changes in state funding levels or healthcare programs or other factors. A continued or prolonged economic downturn, significant changes in state healthcare spending, or changes in the laws affecting our business in these markets could have a material adverse effect on our financial position, results of operations and cash flows. For example, in July 2011 due to the economic downturn in California and the resultant budget deficit, California passed a budget that included a payment reduction of 10% effective June 1, 2011 through July 2012. The payments are to be restored retroactively to June 2011, sometime prior to the end of 2012.

Failure to maintain effective internal control over our financial reporting could have an adverse effect on our ability to

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report our financial results on a timely and accurate basis.

We produce our consolidated financial statements in accordance with the requirements of GAAP. Effective internal control over financial reporting is necessary for us to provide reliable financial reports, to help mitigate the risk of fraud and to operate successfully. We are required by federal securities laws to document and test our internal control procedures in order to satisfy the requirements of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal control over financial reporting.

Testing and maintaining our internal control over financial reporting can be expensive and divert our management's attention from other matters that are important to our business. We may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with applicable law, or our independent registered public accounting firm may not be able or willing to issue an unqualified attestation report if we conclude that our internal control over financial reporting is not effective. If we fail to maintain effective internal control over financial reporting, or our independent registered public accounting firm is unable to provide us with an unqualified attestation report on our internal control, we could be required to take costly and time-consuming corrective measures, be required to restate the affected historical financial statements, be subjected to investigations and/or sanctions by federal and state securities regulators, and be subjected to civil lawsuits by security holders. Any of the foregoing could also cause investors to lose confidence in our reported financial information and in our company and would likely result in a decline in the market price of our stock and in our ability to raise additional financing if needed in the future.

Possible changes in the acuity mix of patients as well as payor mix and payment methodologies may significantly reduce our profitability or cause us to incur losses.

Our revenue is affected by our ability to attract a favorable patient acuity mix, and by our mix of payment sources. Changes in the type of patients we attract, as well as our payor mix among private payors, managed care companies, Medicare and Medicaid, significantly affect our profitability because not all payors reimburse us at the same rates. Particularly, if we fail to maintain our proportion of high-acuity patients or if there is any significant increase in the percentage of our population for which we receive Medicaid reimbursement, our financial position, results of operations and cash flow may be adversely affected.

It is difficult to attract and retain qualified nurses, therapists, healthcare professionals and other key personnel, which increases our costs related to these employees and could cause us to fail to comply with state staffing requirements at one or more of our facilities.

Our employees are our most important asset. We rely on our ability to attract and retain qualified nurses, therapists and other healthcare professionals. The market for these key personnel is highly competitive, and we could experience significant increases in our operating costs due to shortages in their availability. Like other healthcare providers, we have experienced difficulties in attracting and retaining qualified personnel, especially facility administrators, nurses, therapists, certified nurses' aides and other important healthcare personnel. We may continue to experience increases in our labor costs, primarily due to higher wages and greater benefits required to attract and retain qualified healthcare personnel, and such increases may adversely affect our profitability.

This tight labor market and high demand for such employees contributes to the high turnover among clinical professional staff. A shortage of qualified personnel at a facility could result in significant increases in labor costs and increased reliance on overtime and expensive temporary nurse staffing agencies, and could otherwise adversely affect operations at the affected facilities. If we are unable to attract and retain qualified professionals, our ability to adequately provide services to our residents and patients may decline and our ability to grow may be constrained.

If we are unable to comply with state minimum staffing requirements at one or more of our facilities, we could be subject to fines or other sanctions.

Increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate, and other states to consider mandating, staffing laws that require minimum nursing hours of direct care per resident per day. These minimum staffing requirements further increase the gap between demand for and supply of qualified professionals, and lead to higher labor costs.

We operate a number of facilities in California, which enacted legislation aimed at establishing minimum staffing requirements for facilities operating in that state. This legislation required that the California Department of Public Health, or DPH, promulgate regulations requiring each skilled nursing facility to provide a minimum of 3.2 nursing hours per patient day. The DPH finalized regulations in 2009 that required three 8-hour shifts for nurse-to-patient staffing, described documentation and notice requirements, and specified procedures for obtaining a waiver from per-shift staffing requirements at skilled nursing

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facilities. Although DPH finalized the regulations, initial implementation of the statute authorizing the regulations is contingent on an appropriation in the state's annual budged legislation or another statute. Because no appropriation was made and no additional statutes were enacted, the regulations did not become operational. Therefore, DPH will continued its practice of determining a facility's compliance with the 3.2 hour of nursing services per patient day measure in accordance with its internal policy and through on-site reviews conducted during periodic licensing and certification surveys and in response to complaints. If the DPH determines that a facility is out of compliance with this staffing measure, the DPH may issue a notice of deficiency, or a citation, depending on the impact on patient care. A citation carries with it the imposition of monetary fines that can range from $100 to $100,000 per citation. DPH has issued guidelines, implementing the provisions of newly enacted California laws, for state audits that verify compliance with the 3.2 nursing hour per patient day staffing requirements. If DPH determines under an audit that a facility has failed to meet the minimum staffing requirement for between 5% and 49% of the audited days, an administrative penalty of $15,000 will be assessed. If DPH determines that a facility has failed to meet the minimum staffing requirement for more than 49% of the audited days, then an administrative penalty of $30,000 will be assessed. The issuance of either a notice of deficiency or a citation requires the facility to prepare and implement an acceptable plan of correction. The Humboldt County Action included allegations that certain of our California skilled nursing facilities failed to meet state-mandated minimum staffing requirements. The Humboldt County Action resulted in a jury verdict against us and certain of our affiliated skilled nursing companies that awarded $677 million in damages. The case was ultimately settled in September 2010, pursuant to which we were required to deposit into escrow a total of $50 million to cover certain settlement costs, and we may be required to pay additional funds into the escrow to the extent that our costs of complying with the injunction issued against us as part of the settlement is less than the agreed threshold amount. For more information regarding the Humboldt County Action and the settlement, see “Commitments and Contingencies-Litigation” in the notes to the consolidated financial statements included elsewhere in this report.

Our ability to satisfy any minimum staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse's assistants and other personnel. Attracting and retaining these personnel is difficult, given existing shortages of these employees in many of the labor markets in which we operate. Furthermore, if states do not appropriate additional funds (through Medicaid program appropriations or otherwise) sufficient to pay for any additional operating costs resulting from minimum staffing requirements, our profitability may be materially adversely affected.

If we fail to attract patients and residents and to compete effectively with other healthcare providers, our revenue and profitability may decline and we may incur losses.

The healthcare services professions are highly competitive. Our skilled nursing facilities compete primarily on a local and regional basis with many long-term care providers, from national and regional chains to smaller providers owning as few as a single nursing center. We also compete under certain circumstances with inpatient rehabilitation facilities and long-term acute care hospitals. Our hospices and home health agencies also compete with local regional and national companies. Increased competition could limit our ability to attract and retain patients, maintain or increase rates or to expand our business. Our ability to compete successfully varies from location to location and depends on a number of factors, including the number of competing competitors in the local market, the types of services available, our local reputation for quality care of patients, the commitment and expertise of our staff and physicians, our local service offerings and treatment programs, the cost of care in each locality, and the physical appearance, location, age and condition of our facilities. If we are unable to attract patients to our facilities and agencies, particularly the high-acuity patients, then our revenue and profitability will be adversely affected. Some of our competitors may have greater recognition and be more established in their respective communities than we are, and may have greater financial and other resources than we have. Competing long-term care companies may also offer newer facilities or different programs or services than we do, which, combined with the foregoing factors, may result in our competitors being more attractive to our current patients, to potential patients and to referral sources. Some of our competitors may accept lower profit margins than we do, which could present significant price competition, particularly for managed care and private pay patients. We attempt to utilize a conservative approach in complying with laws prohibiting kickbacks and referral payments to referral sources. However, some of our competitors may use more aggressive methods than we do with respect to obtaining patient referrals, and as a result competitors may from time to time obtain patient referrals that are not otherwise available to us.

The primary competitive factors for these other healthcare services are similar to those for our skilled nursing businesses and include reputation, the cost of services, the quality of services, responsiveness to patient/resident needs and the ability to provide support in other areas such as third-party reimbursement, information management and patient recordkeeping. Furthermore, given the relatively low barriers to entry and continuing healthcare cost containment pressures, we expect that the markets we service will become increasingly competitive in the future. Increased competition in the future could limit our ability to attract and retain patients and residents, maintain or increase our fees, or expand our business.

Insurance coverage may become increasingly expensive and difficult to obtain for health care companies, and our self-insurance may expose us to significant losses.

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It may become more difficult and costly for us to obtain coverage for patient care liabilities and certain other risks, including property and casualty insurance. Insurance carriers may require health care companies to significantly increase their self-insured retention levels and/or pay substantially higher premiums for reduced coverage for most insurance coverages, including workers' compensation, employee healthcare and patient care liability.

We self-insure a significant portion of our potential liabilities for several risks, including certain types of professional and general liability, workers' compensation and employee healthcare benefits. Due to our self-insured retentions under many of our professional and general liability, workers' compensation and employee healthcare benefits programs, including our election to self-insure against workers' compensation claims in Texas, there is no limit on the maximum number of claims or amount for which we can be liable in any policy period. We base our loss estimates and related accruals on actuarial analyses, which determine expected liabilities on an undiscounted basis, including incurred but not reported losses, based upon the available information on a given date. It is possible, however, for the ultimate amount of losses to exceed our estimates and related accruals, as well as our insurance limits as applicable. In the event our actual liability exceeds our estimates for any given period, our results of operations and financial condition could be materially adversely impacted. Additionally, we may from time to time need to increase our accruals as a result of future actuarial reviews and claims that may develop. Such increases could have an adverse impact on our business and results of operations. An adverse determination in legal proceedings, whether currently asserted or arising in the future, could have a material adverse effect on our business and results of operations.

If our referral sources fail to view us as an attractive health care provider, our patient base would likely decrease.

We rely significantly on appropriate referrals from physicians, hospitals and other healthcare providers in the communities in which we deliver our services to attract the kinds of patients we target. Our referral sources are not obligated to refer business to us and generally also refer business to other healthcare providers. We believe many of our referral sources refer business to us as a result of the quality of our patient service and our efforts to establish and build a relationship with them. If we lose, or fail to maintain, existing relationships with our referral resources, fail to develop new relationships or if we are perceived by our referral sources for any reason as not providing high quality patient care, our volume of referrals would likely decrease, the quality of our patient mix could suffer and our revenue and results of operations could be adversely affected.

If we do not achieve or maintain a reputation for providing high quality of care, our business may be negatively affected.

Our ability to achieve and maintain a reputation for providing high quality of care to our patients at each of our skilled nursing and assisted living facilities, or through our rehabilitation therapy, hospice and home health businesses, is important to our ability to attract and retain patients, particularly high-acuity patients. We believe that the perception of our quality of care by a potential patient or potential patient's family seeking to contract for our services is influenced by a variety of factors, including doctor and other healthcare professional referrals, community information and referral services, newspapers and other print and electronic media, results of patient surveys, recommendations from family and friends, and quality care statistics or rating systems compiled and published by CMS or other industry data. Through our focus on retaining high quality staffing, reviewing feedback and surveys from our patients and referral sources to highlight areas of improvement and integrating our service offerings at each of our facilities, we seek to maintain and improve on the outcomes from each of the factors listed above in order to build and maintain a strong reputation at our facilities. If any of our companies fail to achieve or maintain a reputation for providing high-quality care, or is perceived to provide a lower quality of care than competitors within the same geographic area, our ability to attract and retain patients would be adversely affected. If our businesses fail to maintain a strong reputation in the areas in which we operate, our business, revenue and profitability could be adversely affected.

We may be unable to reduce costs to offset decreases in our patient census levels or other expenses completely.

We depend on implementing adequate cost management initiatives in response to fluctuations in levels of patient census in our businesses in order to maintain our current cash flow and earnings levels. Fluctuation in our patient census levels may become more common as we increase our emphasis in our skilled nursing facilities on patients with shorter stays but higher acuities. A decline in patient our census levels would likely result in decreased revenue. If we are unable to put in place corresponding reductions in costs in response to decreases in our patient census or other revenue shortfalls, our financial condition and operating results could be adversely affected.

Consolidation of managed care organizations and other third-party payors or reductions in reimbursement from these payors may adversely affect our revenue and income or cause us to incur losses.

Managed care organizations and other third-party payors have continued to consolidate in order to enhance their ability to

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influence the delivery of healthcare services. Consequently, the healthcare needs of a large percentage of the United States population are increasingly served by a small number of managed care organizations. These organizations generally enter into service agreements with a limited number of providers for needed services. These organizations have become an increasingly important source of revenue and referrals for us. To the extent that such organizations terminate us as a preferred provider or engage our competitors as a preferred or exclusive provider, our business could be materially adversely affected.

In addition, private third-party payors, including managed care payors, are continuing their efforts to control healthcare costs through direct contracts with healthcare providers, increased utilization reviews, or reviews of the propriety of, and charges for, services provided, and greater enrollment in managed care programs and preferred provider organizations. As these private payors increase their purchasing power, they are demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk associated with the provision of care. Significant reductions in reimbursement from these sources could materially adversely affect our business and financial condition.

Delays in reimbursement may cause liquidity problems.

If we have information systems problems or payment or other issues arise with Medicare, Medicaid or other payors that affect the amount or timeliness of reimbursements, we may encounter delays in our payment cycle. Any significant payment timing delay could cause us to experience working capital shortages. As a result, working capital management, including prompt and diligent billing and collection, is an important factor in our consolidated results of operations and liquidity. Our working capital management procedures may not successfully mitigate the effects of any delays in our receipt of payments or reimbursements. Accordingly, such delays could have an adverse effect on our liquidity and financial condition.

Our rehabilitation and other related healthcare services are also subject to delays in reimbursement, as we act as vendors to other providers who in turn must wait for reimbursement from other third-party payors. Each of these customers is therefore subject to the same potential delays to which our nursing homes are subject, meaning any such delays would further delay the date we would receive payment for the provision of our related healthcare services. To the extent we grow and expand the rehabilitation and other complementary services that we offer to third parties, we may incur increasing delays in payment for these services, and these payment delays could have an adverse effect on our liquidity and financial condition. We may also experience delays in reimbursement related to change of ownership applications for our acquired facilities, as well as changes in fiscal intermediaries.

Our success is dependent upon retaining key personnel.

Our senior management team has extensive experience in the healthcare industry. We believe that they have been instrumental in guiding our businesses, instituting valuable performance and quality monitoring, and driving innovation. Accordingly, our future performance is substantially dependent upon the continued services of our senior management team. The loss of the services of any of these persons could have a material adverse effect upon us.

Future acquisitions may use significant resources, may be unsuccessful and could expose us to unforeseen liabilities.

We intend to selectively pursue acquisitions of skilled nursing facilities, assisted living facilities and other related healthcare operations. Acquisitions may involve significant cash expenditures, debt incurrence, operating losses and additional expenses that could have a material adverse effect on our financial position, results of operations and liquidity. Acquisitions involve numerous risks, including:


•	difficulties integrating acquired operations, personnel and accounting and information systems, or in realizing projected efficiencies and cost savings;


•	diversion of management's attention from other business concerns;


•	potential loss of key employees or customers of acquired companies;


•	entry into markets in which we may have limited or no experience;


•	increasing our indebtedness and limiting our ability to access additional capital when needed;


•	assumption of unknown material liabilities or regulatory issues of acquired companies, including failure to comply with healthcare regulations or to establish internal financial controls; and


•	straining of our resources, including internal controls relating to information and accounting systems, regulatory compliance, logistics and others.

Furthermore, certain of the foregoing risks could be exacerbated when combined with other growth measures that we may pursue.

Global economic conditions may impact our ability to obtain additional financing on commercially reasonable terms or at

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all and our ability to expand our business may be harmed.

Recent global market and economic conditions have been very challenging with tight credit conditions and slow or negative economic growth in most major economies generally expected to continue in 2011 and possibly beyond. Ongoing concerns about the systemic impact of potential long-term and widespread recession, energy costs, geopolitical issues, the availability and cost of credit, and the global real estate and mortgage markets have contributed to increased market volatility, uncertainty and liquidity issues for both borrowers and investors. These conditions, combined with volatile energy and food prices, unstable business and consumer confidence, and significant unemployment, have contributed to pronounced economic volatility.

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, interest rate fluctuations 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 businesses and consumers. 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 or stagnation in business and consumer spending may adversely affect our liquidity and financial condition, and the liquidity and financial condition of our customers, including our ability to refinance maturing liabilities and access the capital markets to meet liquidity needs.

If our ability to borrow under our senior secured credit facility is insufficient for our capital requirements, we will be required to seek additional sources of financing, including issuing equity, which may be dilutive to our current stockholders or incurring additional debt. Our ability to incur additional debt is subject to the restrictions in the indenture governing our 11% senior subordinated notes and our senior secured credit facility. There can be no assurance that the restrictions contained in these agreements will permit us to borrow the funds that we need to finance our operations, or that additional debt will be available to us on commercially reasonable terms or at all. Furthermore, market conditions may impede our ability to secure additional sources of financing, whether through the extension of our existing senior secured credit facility or by accessing the debt and/or equity markets. If we are unable to obtain funds sufficient to finance our capital requirements, we may have to forego opportunities to expand our business, including the acquisition or development of additional or expanded facilities.

Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our financial obligations.

We have now and will for the foreseeable future continue to have a significant amount of indebtedness. At September 30, 2011, our total indebtedness was approximately $492.1 million. Our substantial indebtedness could have important consequences to you. For example, it could:


•	increase our vulnerability to adverse economic and industry conditions;


•	require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes;


•	limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;


•	place us at a competitive disadvantage compared to our competitors that have less debt;


•	increase the cost or limit the availability of additional financing, if needed or desired, to fund future working capital, capital expenditures and other general corporate requirements, or to carry out other aspects of our business plan;


•	require us to maintain debt coverage and financial ratios at specified levels, reducing our financial flexibility; and


•	limit our ability to make strategic acquisitions and develop new or expanded facilities.

In addition, if we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required debt payments, or if we fail to comply with the various covenants and requirements of our 11% senior subordinated notes, our senior secured credit facility or other existing or future indebtedness, we would be in default, which could permit the holders of our 11% senior subordinated notes and the holders of our other indebtedness, including our senior secured credit facility, to accelerate the maturity of the notes or such other indebtedness, as the case may be. Any default under our 11% senior subordinated notes, our senior secured credit facility, or our other existing or future indebtedness, as well as any of the above-listed factors, could have a material adverse effect on our business, operating results, liquidity and financial condition.

Despite our substantial indebtedness, we may still be able to incur more debt. This could intensify the risks associated with this indebtedness.

The terms of the indenture governing our 11% senior subordinated notes and our senior secured credit facility contain

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restrictions on our ability to incur additional indebtedness. These restrictions are subject to a number of important qualifications and exceptions, and the indebtedness incurred in compliance with these exceptions could be substantial. Accordingly, we could incur significant additional indebtedness in the future. The more we become leveraged, the more we become exposed to the risks described above under “Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our financial obligations.”

Floating rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase.

Borrowings under our senior secured credit facility are subject to floating rates of interest over an interest rate floor of 1.5%. If interest rates increase over the floor, our debt service obligations on our variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash flows would correspondingly decrease. We have entered into interest rate cap agreement with a notional amount of $70.0 million with a cap on 1 month LIBOR of 2.0% from July 2010 to December 2011. We have entered into an interest rate swap agreement with a notional amount of $70.0 million, which effectively fixes the interest rate on that portion of our borrowings under our first lien credit agreement at 6.0% from January 1, 2012 through June 30, 2013. There can be no assurance that when the interest rate cap and swap agreements expire we will be able to enter into similar replacement hedging arrangements on favorable terms or at all. As of September 30, 2011, $282.6 million of borrowings under our senior secured credit facility is not hedged and is currently subject to floating rates of interest.

Our operations are subject to environmental and occupational health and safety regulations, which could subject us to fines, penalties and increased operational costs.

We are subject to a wide variety of federal, state and local environmental and occupational health and safety laws and regulations. Regulatory requirements faced by healthcare providers such as us include those relating to air emissions, wastewater discharges, air and water quality control, occupational health and safety (such as standards regarding blood-borne pathogens and ergonomics), management and disposal of low-level radioactive medical waste, biohazards and other wastes, management of explosive or combustible gases, such as oxygen, specific regulatory requirements applicable to asbestos, lead-based paints, polychlorinated biphenyls and mold, other occupational hazards associated with our workplaces, and providing notice to employees and members of the public about our use and storage of regulated or hazardous materials and wastes. Failure to comply with these requirements could subject us to fines, penalties and increased operational costs. Moreover, changes in existing requirements or more stringent enforcement of them, as well as discovery of currently unknown conditions at our owned or leased facilities, could result in additional cost and potential liabilities, including liability for conducting clean-up, and there can be no guarantee that such increased expenditures would not be significant.

A portion of our workforce has unionized and our operations may be adversely affected by work stoppages, strikes or other collective actions.

As of September 30, 2011, approximately 575 of our 13,353 full time employees were represented by unions and covered by collective bargaining agreements. In addition, certain labor unions have publicly stated that they are concentrating their organizing efforts within the long-term healthcare industry. We cannot predict the effect that continued union representation or future organizational activities will have on our business or future operations. There can be no assurance that we will not experience a material work stoppage in the future.

Disasters and similar events may seriously harm our business.

Natural and man-made disasters and similar events, including terrorist attacks and acts of nature such as hurricanes, tornados, earthquakes, floods and wildfires, may cause damage or disruption to us, our employees and our facilities, which could have an adverse impact on our patients and our business. In order to provide care for our patients, we are dependent on consistent and reliable delivery of food, pharmaceuticals, utilities and other goods to our facilities, and the availability of employees to provide services at our facilities and other locations. If the delivery of goods or the ability of employees to reach our facilities and patients were interrupted in any material respect due to a natural disaster or other reasons, it would have a significant impact on our business. For example, in connection with Hurricane Katrina in New Orleans, several nursing home operators unaffiliated with us have been accused of not properly caring for their residents, which has resulted in, among other things, criminal charges being filed against the proprietors of those facilities. Furthermore, the impact, or impending threat, of a natural disaster has in the past and may in the future require that we evacuate one or more facilities, which would be costly and would involve risks, including potentially fatal risks, for the patients. The impact of disasters and similar events is inherently uncertain. Such events could harm our patients and employees, severely damage or destroy one or more of our facilities, harm our business, reputation and financial performance, or otherwise cause our business to suffer in ways that we currently cannot predict.

The efficient operation of our business is dependent on our information systems.

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We depend on several information technology systems for the efficient functioning of our business. The software programs supporting these systems are licensed to us by independent software developers. Our inability or the inability of these developers, to continue to maintain and upgrade these information systems and software programs could disrupt or reduce the efficiency of our operations. In addition, costs and potential problems and interruptions associated with the implementation of new or upgraded systems and technology or with maintenance or adequate support of existing systems could also disrupt or reduce the efficiency of our operations.

Risks Related to Ownership of Our Class A Common Stock

We are controlled by Onex Corporation, whose interests may conflict with yours.

Our Class A common stock has one vote per share, while our Class B common stock has ten votes per share on all matters to be voted on by our stockholders. As of December 31, 2010, Onex Corporation, its affiliates and certain of our directors and members of our senior management who are party to a voting agreement with an affiliate of Onex Corporation owned shares of common stock representing over 75.0% of the combined voting power of our outstanding common stock. Accordingly, Onex Corporation generally has the power to control the outcome of matters on which stockholders are entitled to vote. Such matters include the election and removal of directors, the adoption or amendment of our certificate of incorporation and bylaws, possible mergers, corporate control contests and significant transactions. Through its control of elections to our board of directors, Onex Corporation may also have the ability to appoint or replace our senior management and cause us to issue additional shares of our common stock or repurchase common stock, declare dividends or take other actions. Onex Corporation may make decisions regarding our company and business that are opposed to our other stockholders' interests or with which they disagree. Onex Corporation may also delay or prevent a change of control of us, even if the change of control would benefit our other stockholders, which could deprive our other stockholders of the opportunity to receive a premium for their Class A common stock. The significant concentration of stock ownership and voting power may also adversely affect the trading price of our Class A common stock due to investors' perception that conflicts of interest may exist or arise. To the extent that the interests of our public stockholders are harmed by the actions of Onex Corporation, the price of our Class A common stock may be harmed.

Additionally, Onex Corporation is in the business of making investments in companies and currently holds, and may from time to time in the future acquire, controlling interests in businesses engaged in the healthcare industries that complement or directly or indirectly compete with certain portions of our business. Further, if it pursues such acquisitions in the healthcare industry, those acquisition opportunities may not be available to us.

If our stock price is volatile, purchasers of our Class A common stock could incur substantial losses.

Our stock price has been and is likely to continue to be volatile. The stock market in general often experiences substantial volatility that is seemingly unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our Class A common stock. The price for our Class A common stock may be influenced by many factors, including:


•	the depth and liquidity of the market for our Class A common stock;


•	developments generally affecting the healthcare industry or our business' professions;


•	investor perceptions of us and our businesses;


•	actions by institutional or other large stockholders;


•	strategic actions, such as acquisitions or restructurings, or the introduction of new services by us or our competitors;


•	new laws or regulations or new interpretations of existing laws or regulations applicable to our businesses;


•	litigation and governmental investigations;


•	changes in accounting standards, policies, guidance, interpretations or principles;


•	adverse conditions in the financial markets or general economic conditions, including those resulting from war, incidents of terrorism and responses to such events;


•	sales of Class B common stock by Onex, its affiliates, us or members of our management team;


•	additions or departures of key personnel; and


•	our results of operations, financial performance and future prospects.

These and other factors may cause the market price and demand for our Class A common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of Class A common stock and may otherwise negatively affect the liquidity of our Class A common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending or settling the lawsuit. Such a

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lawsuit could also divert the time and attention of our management from our business.

If securities or industry analysts do not publish research or reports about our business, if they change their recommendations regarding our stock adversely or if our operating results do not meet their expectations, our stock price and trading volume could decline.

The trading market for our Class A common stock is significantly influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover us downgrade our stock or if our operating results do not meet their expectations, our stock price could decline.

We do not intend to pay dividends on our common stock.

We do not anticipate paying any cash dividends on our common stock in the foreseeable future. We currently anticipate that we will retain all of our available cash, if any, for use as working capital and for other general purposes, including to service or repay our debt and to fund the operation and expansion of our business. Any payment of future dividends will be at the discretion of our board of directors and will depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that our board of directors deems relevant.

We are a “controlled company” within the meaning of NYSE rules and, as a result, qualify for and rely on exemptions from certain corporate governance requirements.

Onex Corporation and its affiliates continue to control a majority of the voting power of our outstanding common stock and we are a “controlled company” within the meaning of NYSE corporate governance standards. Under the NYSE rules, a company of which more than 50% of the voting power is held by another person or group of persons acting together is a “controlled company” and may elect not to comply with certain NYSE corporate governance requirements, including the requirements that:


•	a majority of the board of directors consist of independent directors;


•	the nominating and corporate governance committee be entirely composed of independent directors with a written charter addressing the committee's purpose and responsibilities;


•	the compensation committee be entirely composed of independent directors with a written charter addressing the committee's purpose and responsibilities; and


•	there be an annual performance evaluation of the nominating and corporate governance and compensation committees.

We elect to be treated as a controlled company and thus utilize some of these exemptions. In addition, although we currently have a board composed of a majority of independent directors and have adopted charters for our audit, corporate governance, quality and compliance and compensation committees, and intend to conduct annual performance evaluations for these committees, none of these committees are composed entirely of independent directors, except for our audit committee. Accordingly, you may not have the same protections afforded to stockholders of companies that are subject to all of NYSE corporate governance requirements.

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

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


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


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

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number of outstanding shares of our Class B common stock is less than 10% of the total number of shares of common stock outstanding, which we refer to as the “Transition Date,” no such requirement is required for holders of at least 10% of our outstanding Class B common stock;


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


•	following the Transition Date, stockholder action by written consent will be prohibited;


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


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


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


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


•	stockholders are permitted to amend our bylaws only upon receiving at least 66 2/3% of the votes entitled to be cast by holders of all outstanding shares then entitled to vote generally in the election of directors, voting together as a single class.

After the Transition Date, we will also be subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our amended and rested certificate of incorporation, amended and restated bylaws and Delaware law could discourage acquisition proposals and make it more difficult or expensive for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including delaying or impeding a merger, tender offer or proxy contest involving us. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our Class A common stock to decline.

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

The table below sets forth information with respect to purchases of our Class A common stock made by us or on our behalf during the quarter ended September 30, 2011:



Period	Total Number of Shares Purchased ₍₁₎	Average Price Paid per Share		Total Number of Shares Purchase as Part of Publicly Announced Plans or Programs	Maximum Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
July 1 - 31, 2011	—	$	—	n/a	n/a
August 1 - 31, 2011	3,352	$	4.52	n/a	n/a
September 1 - 30, 2011	—	$	—	n/a	n/a
Total:	3,352	$	4.52	n/a	n/a

(1) Reflects shares forfeited to us upon the vesting of restricted stock granted to participants in our 2007 Incentive Award Plan, to satisfy applicable tax withholding obligations with respect to such vesting. We did not have any publicly announced plans or programs to purchase our Class A common stock in the quarter ended September 30, 2011.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Reserved

None.

Item 5. Other Information

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None.

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Item 6. Exhibits


(a)	Exhibits.




Number		Description

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.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		SKILLED HEALTHCARE GROUP, INC.

Date:	October 31, 2011	/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

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EXHIBIT INDEX



Number		Description

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.