Genesis Healthcare, Inc. - Quarter Report: 2012 June (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 June 30, 2012.



£	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 þ 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 þ 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	þ

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 þ

The number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on August 6, 2012, was:

Class A common stock, $0.001 par value – 22,485,366 shares

Class B common stock, $0.001 par value – 16,051,280 shares

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Skilled Healthcare Group, Inc.

Form 10-Q

For the Quarterly Period Ended June 30, 2012

Index



		Page Number
Part I.	Financial Information
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets — June 30, 2012 (unaudited) and December 31, 2011	3
	Condensed Consolidated Statements of Operations — Three and six months ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited)	4
	Condensed Consolidated Statements of Comprehensive Income — Three and six months ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited)	5
	Condensed Consolidated Statements of Cash Flows — Six months ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited)	6
	Notes to Unaudited Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.	Controls and Procedures	47
Part II.	Other Information
Item 1.	Legal Proceedings	49
Item 1A.	Risk Factors	49
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	63
Item 3.	Defaults Upon Senior Securities	63
Item 4.	Mine Safety Disclosures	63
Item 5.	Other Information	63
Item 6.	Exhibits	64
Signatures		65
Exhibit Index		66

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

Skilled Healthcare Group, Inc.

Condensed Consolidated Balance Sheets

(In thousands)



	June 30, 2012			December 31, 2011
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	5,572		$	16,017
Accounts receivable, less allowance for doubtful accounts of $14,989 and $15,238 at June 30, 2012 and December 31, 2011, respectively	108,792			99,764
Deferred income taxes	12,644			11,404
Prepaid expenses	5,255			6,943
Other current assets	10,127			11,402
Total current assets	142,390			145,530
Property and equipment, less accumulated depreciation of $107,090 and $95,954 at June 30, 2012 and December 31, 2011, respectively	370,266			375,502
Leased facility assets, less accumulated depreciation of $3,670 and $3,398 at June 30, 2012 and December 31, 2011, respectively	10,178			10,792
Other assets:
Notes receivable	3,952			5,092
Deferred financing costs, net	7,437			9,837
Goodwill	85,609			84,299
Intangible assets, less accumulated amortization of $4,034 and $7,060 at June 30, 2012 and December 31, 2011, respectively	22,219			22,413
Deferred income taxes	10,381			11,615
Other assets	36,701			32,119
Total other assets	166,299			165,375
Total assets	$	689,133		$	697,199
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	53,192		$	58,713
Employee compensation and benefits	40,104			41,067
Current portion of long-term debt	11,925			4,414
Total current liabilities	105,221			104,194
Long-term liabilities:
Insurance liability risks	29,437			30,567
Other long-term liabilities	17,503			17,773
Long-term debt, less current portion	451,452			471,069
Total liabilities	603,613			623,603
Stockholders’ equity:
Class A common stock, 175,000 shares authorized, $0.001 par value per share; 22,485 and 21,064 at June 30, 2012 and December 31, 2011, respectively	22			21
Class B common stock, 30,000 shares authorized, $0.001 par value per share; 16,051 and 16,937 at June 30, 2012 and December 31, 2011, respectively	16			17
Additional paid-in-capital	373,653			371,753
Accumulated deficit	(287,871		)	(297,705		)
Accumulated other comprehensive loss	(300		)	(490		)
Total stockholders’ equity	85,520			73,596
Total liabilities and stockholders’ equity	$	689,133		$	697,199

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 June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Revenue:
Net patient service revenue	$	216,607		$	214,497		$	435,266		$	436,777
Leased facility revenue	768			746			1,522			746
	217,375			215,243			436,788			437,523
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)	180,215			171,249			363,346			346,710
Rent cost of revenue	4,539			4,547			9,095			9,117
General and administrative	6,427			7,237			12,527			14,130
Depreciation and amortization	6,591			6,432			12,866			12,577
	197,772			189,465			397,834			382,534
Other (expenses) income:
Interest expense	(10,521		)	(9,662		)	(20,086		)	(19,608		)
Interest income	132			208			277			383
Other income (expense)	106			(30		)	77			(354		)
Equity in earnings of joint venture	490			557			961			1,111
Debt retirement costs	(3,958		)	—			(3,958		)	—
Total other (expenses) income, net	(13,751		)	(8,927		)	(22,729		)	(18,468		)
Income before provision for income taxes	5,852			16,851			16,225			36,521
Provision for income taxes	2,355			6,467			6,391			14,476
Net income	$	3,497		$	10,384		$	9,834		$	22,045

Income per share, basic	$	0.09		$	0.28		$	0.26		$	0.59
Income per share, diluted	$	0.09		$	0.28		$	0.26		$	0.59

Weighted-average common shares outstanding, basic	37,400			37,154			37,343			37,117
Weighted-average common shares outstanding, diluted	37,497			37,354			37,489			37,377

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 Comprehensive Income

(In thousands)

(Unaudited)



	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011

Net income	$	3,497		$	10,384		$	9,834		$	22,045
Other comprehensive income (loss):
Unrealized loss on interest rate swap	(4		)	(343		)	(37		)	(325		)
Investment available for sale	7			—			69			—
Reclassification adjustments:
Interest expense on interest rate swap	141			—			279			—
Other comprehensive income (loss), before taxes	144			(343		)	311			(325		)
Income tax expense (benefit) related to items of other comprehensive income	56			(133		)	121			(126		)
Other comprehensive income (loss), net of tax	88			(210		)	190			(199		)
Comprehensive income	$	3,585		$	10,174		$	10,024		$	21,846

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)



	Six Months Ended June 30,
	2012			2011
Cash Flows from Operating Activities
Net Income	9,834			22,045
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	12,866			12,577
Provision for doubtful accounts	3,562			4,395
Non-cash stock-based compensation	2,371			2,187
Excess tax benefits from stock-based payment arrangements	242			(309		)
Disposal of property and equipment	(145		)	293
Amortization of deferred financing costs	1,643			1,651
Deferred income taxes	(369		)	10,117
Amortization of discount on debt	432			292
Debt retirement costs	3,958			—
Changes in operating assets and liabilities:
Accounts receivable	(12,801		)	(11,380		)
Payments on notes receivable	1,482			1,886
Other current and non-current assets	(1,172		)	7,973
Accounts payable and accrued liabilities	(5,330		)	(1,665		)
Employee compensation and benefits	(1,488		)	(3,744		)
Insurance liability risks	(3		)	(1,097		)
Other long-term liabilities	(962		)	9
Net cash provided by operating activities	14,120			45,230
Cash Flows from Investing Activities
Additions to property and equipment	(7,097		)	(6,223		)
Acquisitions	(1,053		)	(350		)
Proceeds from sale of property and equipment	1,050			400
Net cash used in investing activities	(7,100		)	(6,173		)
Cash Flows from Financing Activities
Borrowings under line of credit	162,500			66,500
Repayments under line of credit	(117,000		)	(92,500		)
Repayments of long-term debt	(157,494		)	(1,870		)
Proceeds from issuance of long-term debt	98,000			—
Additions to deferred financing costs	(3,000		)	—
Exercise of stock options	—			26
Excess tax benefits from stock-based payment arrangements	(242		)	309
Taxes paid related to net share settlement of equity awards	(229		)	(699		)
Net cash used in financing activities	(17,465		)	(28,234		)
(Decrease) increase in cash and cash equivalents	(10,445		)	10,823
Cash and cash equivalents at beginning of period	16,017			4,192
Cash and cash equivalents at end of period	$	5,572		$	15,015

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

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	Six Months Ended June 30,
	2012		2011
Supplemental cash flow information
Cash paid for:
Interest expense, net of capitalized interest	$	23,660	$	19,980
Income taxes, net	$	7,211	$	778
Non-cash activities:
Conversion of accounts receivable into notes receivable	$	359	$	1,529
Insurance premium financed	$	1,107	$	1,123
Liabilities issued as purchase consideration for purchase of business	$	261	$	—

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 companies are collectively referred to as the "Company." As of June 30, 2012, the Company operated facilities in California, Iowa, Kansas, Missouri, Nevada, Nebraska, New Mexico and Texas, including 74 skilled nursing facilities ("SNFs"), which offer sub-acute care and rehabilitative and specialty healthcare skilled nursing care, and 22 assisted living facilities ("ALFs"), which provide room and board and assistance with activities of daily living. The Company leases five skilled nursing facilities in California to an unaffiliated third party operator. In addition, through its Hallmark Rehabilitation subsidiary ("Hallmark"), the Company provides a variety of rehabilitative services such as physical, occupational and speech therapy in Company-operated facilities and unaffiliated facilities. Furthermore, as of June 30, 2012, the Company provided hospice care and home health services in Arizona, California, Idaho, Montana, Nevada 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.

2. Correction of Previously Issued Consolidated Financial Statements

The Company recently identified errors related to certain claims under Medicare Part B for blood glucose testing at certain of the Company's affiliated companies. Although blood glucose tests are routinely ordered by physicians to safely monitor vulnerable patients' blood glucose levels, effective January 1, 2007, CMS redefined the criteria for "medical necessity" before a Medicare claim for such a test is payable. The new criteria specifies the nature of a physician order for the blood glucose test, the frequency of a physician's review of the test results and the frequency of a physician's utilization of the test results in a patient's plan of care or treatments. The documentation and other requirements for Medicare Part B billing of blood glucose testing that took effect in January 2007 significantly limited the number of blood glucose tests that are reimbursable compared to those that were previously reimbursable. The Company's internal policies changed at the time to be consistent with new Medicare regulations. Subsequent to January 1, 2007, a number of the Company's affiliated companies incorrectly continued to bill Medicare under the rules that existed prior to January 1, 2007. The billing errors resulted in a cumulative overstatement of consolidated revenue in the amount of $5.8 million for the period from January 1, 2007 to December 31, 2011. The affiliated companies submitted approximately 30,000 claims related to blood glucose testing in the affected period that were not reimbursable under the revised standard. The affected providers have refunded all previously paid, post-2006 Medicare Part B claims for blood glucose tests.

In accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") No. 250-10-S99 ("ASC 250-10-S99"), the Company evaluated these refunds and, based on an analysis of quantitative and qualitative factors, determined that they were not material to any of the prior reporting periods affected and, therefore, amendment of previously filed reports with the Securities and Exchange Commission was not required. However, if the adjustments to correct the cumulative effect of the aforementioned refunds had been recorded in the three and six months ended June 30, 2012, the impact would have been material to those two periods. Therefore, as required by Staff Accounting Bulletin ("SAB") 108, the Company has revised in this filing previously reported financial information for the fiscal years ended December 31, 2011, 2010, 2009, 2008, and 2007, and for the quarterly periods in fiscal years 2011 and 2010. Also, in accordance with SAB 108, the Company will include this revised financial information when the Company files subsequent reports on Form 10-Q and Form 10-K or files a registration statement under the Securities Act of 1933, as amended.

The prior period financial statements included in this filing have been revised to reflect the revisions related to the refunds, the effects of which have been summarized below. The tables below show the previously reported, adjusted, and restated amounts for those line items in the Company's condensed consolidated balance sheets as of December 31, 2011 and 2010, and its condensed consolidated statements of operations for the years ended December 31, 2011, 2010, 2009, 2008, and 2007, as well as for the quarterly periods in fiscal years 2011 and 2010, which were effected by the prior period change. The condensed consolidated statement of operations for the quarter ended March 31, 2012 has not been restated. Revenue for the quarter ended March 31, 2012 was overstated by $0.3 million. This correction has been recorded as an adjustment to revenue in the quarter ended June 30, 2012, as this amount was not material to the operating results for the period then ended.

Despite the fact that the Company's affected subsidiaries have refunded all of the reimbursements they received in

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

connection with the Medicare Part B claims for all blood glucose tests after January 1, 2007, some refunded claims could nonetheless potentially lead to allegations that any of the affected subsidiaries are subject to sanctions under the Federal False Claims Act ("FFCA") or the Federal Civil Monetary Penalties Law. Such sanctions could lead to any combination of a variety of criminal, civil and administrative penalties, which could be material both individually and in the aggregate. The Company cannot determine the likelihood that any penalties might be imposed related to this refund and has not accrued for any such penalties. The FFCA provides for civil fines ranging from $5,500 to $11,000 per claim plus treble damages. The Civil Monetary Penalties Law similarly provides for civil monetary penalties of up to $10,000 per claim plus up to treble damages. The Company and/or certain operating companies could also be subject to exclusion from participation in the Medicare or Medicaid programs in some circumstances as well, in addition to any monetary or other fines, penalties or sanctions that it may incur under applicable federal and/or state law. See "Revenue we receive from Medicare and Medicaid is subject to potential retroactive reduction or repayment" in Part II, Item 1A of this report for additional information.



	December 31, 2011			December 31, 2010
	In thousands
Condensed consolidated balance sheet
As previously reported
Other current assets	$	9,203		$	17,524
Total current assets	143,331			150,530
Total assets	695,000			944,290
Accounts payable and accrued liabilities	52,897			52,602
Total liabilities	617,787			666,710
Accumulated deficit	(294,088		)	(90,822		)
Total stockholders' equity	77,213			277,580
Total liabilities and stockholders' equity	695,000			944,290

Adjustment
Other current assets	2,199			1,708
Total current assets	2,199			1,708
Total assets	2,199			1,708
Accounts payable and accrued liabilities	5,816			4,548
Total liabilities	5,816			4,548
Accumulated deficit	(3,617		)	(2,840		)
Total stockholders' equity	(3,617		)	(2,840		)
Total liabilities and stockholders' equity	2,199			1,708

As corrected
Other current assets	11,402			19,232
Total current assets	145,530			152,238
Total assets	697,199			945,998
Accounts payable and accrued liabilities	58,713			57,150
Total liabilities	623,603			671,258
Accumulated deficit	(297,705		)	(93,662		)
Total stockholders' equity	73,596			274,740
Total liabilities and stockholders' equity	697,199			945,998

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



	Three Months Ended,
	March 31, 2011			June 30, 2011			September 30, 2011			December 31, 2011
	In thousands (except per share data)
Condensed consolidated statements of income
As previously reported
Net patient service revenue	$	222,578		$	214,801		$	216,409		$	213,675
Total revenue	222,578			215,547			217,155			214,421
Income (loss) before provision for income taxes	19,968			17,155			(247,870		)	10,997
Provision (benefit) for income taxes	8,124			6,584			(15,259		)	4,067
Net income (loss)	11,844			10,571			(232,611		)	6,930
Basic earnings (loss) per share	0.32			0.28			(6.26		)	0.19
Diluted earnings (loss) per share	0.32			0.28			(6.26		)	0.19

Adjustment
Net patient service revenue	(298		)	(304		)	(331		)	(335		)
Total revenue	(298		)	(304		)	(331		)	(335		)
Income (loss) before provision for income taxes	(298		)	(304		)	(331		)	(335		)
Provision (benefit) for income taxes	(115		)	(117		)	(128		)	(131		)
Net income (loss)	(183		)	(187		)	(203		)	(204		)
Basic earnings (loss) per share	(0.01		)	—			—			(0.01		)
Diluted earnings (loss) per share	(0.01		)	—			—			(0.01		)

As corrected
Net patient service revenue	222,280			214,497			216,078			213,340
Total revenue	222,280			215,243			216,824			214,086
Income (loss) before provision for income taxes	19,670			16,851			(248,201		)	10,662
Provision (benefit) for income taxes	8,009			6,467			(15,387		)	3,936
Net income (loss)	11,661			10,384			(232,814		)	6,726
Basic earnings (loss) per share	0.31			0.28			(6.26		)	0.18
Diluted earnings (loss) per share	0.31			0.28			(6.26		)	0.18

	Three months ended
	March 31, 2010			June 30, 2010			September 30, 2010			December 31, 2010
	In thousands (except per share data)
Condensed consolidated statements of income
As previously reported
Net patient service revenue	$	189,319		$	200,971		$	209,199		$	220,749
Total revenue	189,319			200,971			209,199			220,749
Income (loss) before provision for income taxes	14,475			7,311			(39,073		)	18,718
Provision (benefit) for income taxes	5,594			2,766			(13,766		)	7,878
Net income (loss)	8,881			4,545			(25,307		)	10,840
Basic earnings (loss) per share	0.24			0.12			(0.68		)	0.29
Diluted earnings (loss) per share	0.24			0.12			(0.68		)	0.29

Adjustment

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Net patient service revenue	(310	)	(314	)	(326	)	(326	)
Total revenue	(310	)	(314	)	(326	)	(326	)
Income (loss) before provision for income taxes	(310	)	(314	)	(326	)	(326	)
Provision (benefit) for income taxes	(116	)	(117	)	(122	)	(122	)
Net income (loss)	(194	)	(197	)	(204	)	(204	)
Basic earnings (loss) per share	(0.01	)	—		(0.01	)	—
Diluted earnings (loss) per share	(0.01	)	—		(0.01	)	—

As corrected
Net patient service revenue	189,009		200,657		208,873		220,423
Total revenue	189,009		200,657		208,873		220,423
Income (loss) before provision for income taxes	14,165		6,997		(39,399	)	18,392
Provision (benefit) for income taxes	5,478		2,649		(13,888	)	7,756
Net income (loss)	8,687		4,348		(25,511	)	10,636
Basic earnings (loss) per share	0.23		0.12		(0.69	)	0.29
Diluted earnings (loss) per share	0.23		0.12		(0.69	)	0.29

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



	Twelve months ended December 31,
	2007			2008			2009			2010			2011
	In thousands (except per share data)
Condensed consolidated statements of income
As previously reported
Net patient service revenue	$	634,607		$	729,390		$	756,065		$	820,238		$	867,462
Total revenue	634,607			729,390			756,065			820,238			869,701
Income (loss) before provision for income taxes	27,083			52,177			(114,949		)	1,431			(199,750		)
Provision (benefit) for income taxes	11,801			18,081			17,842			2,472			3,516
Net income (loss)	7,928			34,096			(133,181		)	(1,041		)	(203,266		)
Basic earnings (loss) per share	0.29			0.92			(3.61		)	(0.03		)	(5.47		)
Diluted earnings (loss) per share	0.29			0.92			(3.61		)	(0.03		)	(5.47		)

Adjustment
Net patient service revenue	(1,080		)	(1,040		)	(1,152		)	(1,276		)	(1,268		)
Total revenue	(1,080		)	(1,040		)	(1,152		)	(1,276		)	(1,268		)
Income (loss) before provision for income taxes	(1,080		)	(1,040		)	(1,152		)	(1,276		)	(1,268		)
Provision (benefit) for income taxes	(407		)	(392		)	(432		)	(477		)	(491		)
Net income (loss)	(673		)	(648		)	(720		)	(799		)	(777		)
Basic earnings (loss) per share	(0.02		)	(0.02		)	(0.02		)	(0.02		)	(0.02		)
Diluted earnings (loss) per share	(0.02		)	(0.02		)	(0.02		)	(0.02		)	(0.02		)

As corrected
Net patient service revenue	633,527			728,350			754,913			818,962			866,194
Total revenue	633,527			728,350			754,913			818,962			868,433
Income (loss) before provision for income taxes	26,003			51,137			(116,101		)	155			(201,018		)
Provision (benefit) for income taxes	11,394			17,689			17,410			1,995			3,025
Net income (loss)	7,255			33,448			(133,901		)	(1,840		)	(204,043		)
Basic earnings (loss) per share	0.27			0.90			(3.63		)	(0.05		)	(5.49		)
Diluted earnings (loss) per share	0.27			0.90			(3.63		)	(0.05		)	(5.49		)



	Six months ended June 30, 2011
	As previously reported			Adjustment			As corrected
	In thousands
Condensed consolidated statements of cash flows
Net income	$	22,415		$	(370	)	$	22,045
Other current and non-current assets	8,205			(232		)	7,973
Accounts payable and accrued liabilities	(2,267		)	602			(1,665		)

For the years ended December 31, 2011, 2010, 2009, 2008 and 2007, the Condensed Consolidated Statement of Cash Flow would have been impacted by the adjustments to net income as noted above. The impact to the annual cash flow for those periods would have been a decrease in net income and change in other current and non-current assets and an increase to accounts payable and accrued liabilities, with no net impact to cash provided by operating activities.

By August 3, 2012, the Company's affiliates completed the filing of voluntary disclosure requests with their applicable Medicare Administrative Contractors and refunded all reimbursements that had been collected since January 1, 2007 related to Medicare Part B blood glucose testing.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

3. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements as of June 30, 2012 and for the three and six months ended June 30, 2012 and 2011 (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, 2011, which are included in the Company's 2011 Annual Report on Form 10-K filed with the Securities and 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.

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 revenue and expenses during the reporting period. The most significant estimates in the Interim Financial Statements relate to revenue, allowance for doubtful accounts, the self-insured portion of general and professional liability and workers' compensation claims and income taxes. Actual results could differ 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 2011 Annual Report on Form 10-K filed with the SEC.

Notes Receivable

As of June 30, 2012 and December 31, 2011, net notes receivable were approximately $7.0 million and $8.1 million, respectively, of which $3.0 million was reflected as current assets as of June 30, 2012 and December 31, 2011, 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 June 30, 2012, two of the Company's rehabilitation therapy services business customers were responsible for $6.5 million, or 93.5% of the total notes receivable balance. These notes receivable, as well as the trade receivables from these customers and one additional customer, are secured by the assets of the customers as well as a personal guaranty by the principal owners of the customers. As of June 30, 2012, these three customers represented 65.5% of the net accounts receivable of $21.5 million for the Company's rehabilitation therapy services business and approximately 55.4% of the external revenue of the rehabilitation therapy services business for the six months ended June 30, 2012. The remaining notes receivable of $0.5 million, or 6.5% of the aggregate notes receivable balance, are primarily past due accounts converted from accounts receivable to notes receivable.

The notes receivable allowance for uncollectibility as of June 30, 2012 and December 31, 2011 were $0.3 million and $0.2 million, respectively.

Recent Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS ("ASU 2011-04"). This ASU represents the converged guidance of the FASB and the International Accounting Standards Board on fair value measurement. ASU 2011-04 sets forth common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term "fair value." The adoption of ASU 2011-04 became effective for the Company's interim and annual periods beginning January 1, 2012. and did not have a material impact on the Company's consolidated financial statements as the changes relate only to additional disclosures.

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

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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 became effective for the Company's interim and annual periods beginning January 1, 2012. The Company applied the two-statement approach, presenting components of net income in the statement of income and the components and total of other comprehensive income along with a total for comprehensive income in the statement of comprehensive income.

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 not 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 also requires 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 adoption of this guidance became effective for the Company's interim and annual periods beginning January 1, 2012. As the Company assesses the collectability of revenues at the time of admission, there was no impact to the Company's consolidated financial statements.

In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, ("ASU 2011-08"), which amends the guidance in Accounting Standard Codification ("ASC') 350-20, "Intangibles - Goodwill and Other." Under ASU 2011-08, entities have the option, under certain circumstances, of performing a qualitative assessment before calculating the fair value of the reporting unit when testing goodwill for impairment. If the fair 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. The adoption of ASU 2011-08 became effective for the Company's interim and annual periods beginning January 1, 2012. The Company has not yet determined which method it will use for its annual impairment test at October 1, 2012.

In November 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, ("ASU 2011-11"). This ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The adoption of ASU 2011-11 becomes effective for the Company's interim and annual periods beginning on or after January 1, 2013. The Company does not believe the adoption of this guidance will have a material impact on its consolidated financial statements.

4. Income Per Share of Class A Common Stock and Class B Common Stock

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

Basic income per share was computed by dividing net income by the weighted-average number of outstanding shares for the period. Dilutive earnings per share is computed by dividing net income plus the effect of assumed conversions (if applicable) by the weighted-average number of outstanding shares after giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and convertible preferred stock, if any. The following table sets forth the computation of basic and diluted income per share of Class A common stock and Class B common stock for the three and six months ended June 30, 2012 and 2011 (amounts in thousands, except per share data):



	Three months ended June 30, 2012						Three months ended June 30, 2011						Six months ended June 30, 2012						Six months ended June 30, 2011
	Class A		Class B		Total		Class A		Class B		Total		Class A		Class B		Total		Class A		Class B		Total
Income per share, basic
Numerator:
Allocation of net income	$	1,950	$	1,547	$	3,497	$	5,645	$	4,739	$	10,384	$	5,425	$	4,409	$	9,834	$	11,964	$	10,081	$	22,045
Income per share, diluted
Numerator:
Allocation of net income	$	1,954	$	1,543	$	3,497	$	5,670	$	4,714	$	10,384	$	5,442	$	4,392	$	9,834	$	12,034	$	10,011	$	22,045
Denominator for basic and diluted income per share:
Weighted average common shares outstanding, basic	20,852		16,548		37,400		20,197		16,957		37,154		20,600		16,743		37,343		20,143		16,974		37,117
Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable	97		—		97		200		—		200		146		—		146		260		—		260
Adjusted weighted-average common shares outstanding, diluted	20,949		16,548		37,497		20,397		16,957		37,354		20,746		16,743		37,489		20,403		16,974		37,377

Income per share, basic	$	0.09	$	0.09	$	0.09	$	0.28	$	0.28	$	0.28	$	0.26	$	0.26	$	0.26	$	0.59	$	0.59	$	0.59

Income per share, diluted	$	0.09	$	0.09	$	0.09	$	0.28	$	0.28	$	0.28	$	0.26	$	0.26	$	0.26	$	0.59	$	0.59	$	0.59

The following were excluded from the weighted-average diluted shares computation for the three and six months ended June 30, 2012 and 2011, as their inclusion would have been anti-dilutive (shares in thousands):



	Three Months Ended June 30,		Six Months Ended June 30,
	2012	2011	2012	2011
Options to purchase common shares	464	38	464	939
Non-vested common shares	1,018	261	898	5
Total excluded	1,482	299	1,362	944

5. Business Segments

The Company has three reportable operating segments: (i) long-term care services ("LTC"), which includes the operation of SNFs and ALFs which is the most significant portion of the Company's business, the Company's administrative services provided to an unrelated SNF operator, and the facility lease revenue from a third-party operator; (ii) the Company's rehabilitation therapy services business; and (iii) the Company's hospice and home health businesses. The "other" column 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 June 30, 2012, LTC services included 74 wholly-owned SNF operating companies that offer post-acute, rehabilitative custodial and specialty skilled nursing care, as well as 22 wholly-owned ALF operating companies that provide room and board and social services. Therapy services included 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 the Company's wholly owned subsidiaries to patients.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company evaluates performance and allocates capital resources to each segment based on an operating model that is designed to maximize the quality of care provided and profitability. Accordingly, earnings from operations before net interest, tax, depreciation and amortization, non-core expenses ("Adjusted EBITDA") and rent cost of revenue ("Adjusted EBITDAR") is used as the primary measure of each segment’s operating results because it does not include such costs as interest expense, income taxes, depreciation, amortization and rent cost of revenue which may vary from segment to segment depending upon various factors, including the method used to finance the original purchase of assets within a segment or the tax law of the states in which a segment operates. By excluding these items, the Company is better able to evaluate operating performance of the segment by focusing on more controllable measures. Adjusted EBITDA and Adjusted EBITDAR are non‑GAAP financial measures. For a full discussion of the definitions of these terms and the reasons why the Company utilizes such measures, see Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, of this filing. General and administrative expenses are not allocated to any segment for purposes of determining segment profit or loss, and are included in the "other" category in the selected segment financial data that follows. The accounting policies of the reporting segments are the same as those described in Note 3, "Summary of Significant Accounting Policies." Intersegment sales and transfers are recorded at cost plus standard mark-up; intersegment transactions have been eliminated in consolidation.

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



	Long-Term Care Services		Therapy Services		Hospice & Home Health Services		Other			Elimination			Total
Three months ended June 30, 2012
Net patient service revenue from external customers	$	163,287	$	26,385	$	26,935	$	—		$	—		$	216,607
Leased facility revenue	768		—		—		—			—			768
Intersegment revenue	601		15,818		—		—			(16,419		)	—
Total revenue	$	164,656	$	42,203	$	26,935	$	—		$	(16,419	)	$	217,375
Operating income (loss)	$	18,126	$	3,543	$	4,521	$	(6,587	)	$	—		$	19,603
Interest expense, net of interest income													(10,389		)
Other income													106
Equity in earnings of joint venture													490
Debt retirement costs													(3,958		)
Income before provision for income taxes													$	5,852
Depreciation and amortization	$	5,630	$	164	$	644	$	153		$	—		$	6,591
Segment capital expenditures	$	2,894	$	269	$	114	$	345		$	—		$	3,622
Adjusted EBITDA	$	23,719	$	3,850	$	5,255	$	(6,034	)	$	—		$	26,790
Adjusted EBITDAR	$	27,940	$	3,850	$	5,565	$	(6,026	)	$	—		$	31,329
Three months ended June 30, 2011
Net patient service revenue from external customers	$	171,927	$	23,703	$	18,867	$	—		$	—		$	214,497
Leased facility revenue	746		—		—		—			—			746
Intersegment revenue	501		16,045		—		—			(16,546		)	—
Total revenue	$	173,174	$	39,748	$	18,867	$	—		$	(16,546	)	$	215,243
Operating income (loss)	$	25,109	$	5,111	$	2,979	$	(7,421	)	$	—		$	25,778
Interest expense, net of interest income													(9,454		)
Other expense													(30		)
Equity in earnings of joint venture													557
Income before provision for income taxes													$	16,851
Depreciation and amortization	$	5,673	$	106	$	483	$	170		$	—		$	6,432
Segment capital expenditures	$	3,381	$	88	$	111	$	76		$	—		$	3,656
Adjusted EBITDA	$	31,192	$	5,217	$	3,574	$	(6,334	)	$	—		$	33,649
Adjusted EBITDAR	$	35,491	$	5,217	$	3,810	$	(6,322	)	$	—		$	38,196

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



	Long-Term Care Services		Therapy Services		Hospice & Home Health Services		Other			Elimination			Total
Six months ended June 30, 2012
Net patient service revenue from external customers	$	329,625	$	52,501	$	53,140	$	—		$	—		$	435,266
Leased facility revenue	1,522		—		—		—			—			1,522
Intersegment revenue	1,355		31,799		—		—			(33,154		)	—
Total revenue	$	332,502	$	84,300	$	53,140	$	—		$	(33,154	)	$	436,788
Operating income (loss)	$	36,264	$	6,491	$	9,053	$	(12,854	)	$	—		$	38,954
Interest expense, net of interest income													(19,809		)
Other income													77
Equity in earnings of joint venture													961
Debt retirement costs													(3,958		)
Income before provision for income taxes													$	16,225
Depreciation and amortization	$	11,301	$	332	$	921	$	312		$	—		$	12,866
Segment capital expenditures	$	5,299	$	546	$	317	$	935		$	—		$	7,097
Adjusted EBITDA	$	47,499	$	6,966	$	10,123	$	(11,730	)	$	—		$	52,858
Adjusted EBITDAR	$	55,955	$	6,966	$	10,747	$	(11,715	)	$	—		$	61,953
Six months ended June 30, 2011
Net patient service revenue from external customers	$	353,952	$	45,893	36,932		$	—		$	—		$	436,777
Leased facility revenue	746		—		—		—			—			746
Intersegment revenue	891		33,166		—		—			(34,057		)	—
Total revenue	$	355,589	$	79,059	36,932		$	—		$	(34,057	)	$	437,523
Operating income (loss)	$	52,087	$	11,070	6,311		$	(14,479	)	$	—		$	54,989
Interest expense, net of interest income													(19,225		)
Other expense													(354		)
Equity in earnings of joint venture													1,111
Income before provision for income taxes													$	36,521
Depreciation and amortization	$	11,366	$	204	$	686	$	321		$	—		$	12,577
Segment capital expenditures	$	5,449	$	208	$	338	$	228		$	—		$	6,223
Adjusted EBITDA	$	64,211	$	11,274	$	7,158	$	(12,491	)	$	—		$	70,152
Adjusted EBITDAR	$	72,829	$	11,274	$	7,629	$	(12,463	)	$	—		$	79,269

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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



	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Adjusted EBITDAR	$	31,329		$	38,196		$	61,953		$	79,269
Rent cost of revenue	(4,539		)	(4,547		)	(9,095		)	(9,117		)
Adjusted EBITDA	26,790			33,649			52,858			70,152
Depreciation and amortization	(6,591		)	(6,432		)	(12,866		)	(12,577		)
Interest expense	(10,521		)	(9,662		)	(20,086		)	(19,608		)
Interest income	132			208			277			383
Disposal of property and equipment	—			(3		)	—			(293		)
Debt retirement costs	(3,958		)	—			(3,958		)	—
Expenses related to the exploration of strategic alternatives	—			(474		)	—			(716		)
Exit costs related to Northern California divestiture	—			(435		)	—			(820		)
Provision for income taxes	(2,355		)	(6,467		)	(6,391		)	(14,476		)
Net income	$	3,497		$	10,384		$	9,834		$	22,045

The following table presents the segment assets as of June 30, 2012 compared to December 31, 2011 (dollars in thousands):



	Long-Term Care Services		Therapy Services		Hospice & Home Health Services		Other		Total
June 30, 2012:
Segment total assets	$	449,791	$	54,649	$	102,722	$	81,971	$	689,133
Goodwill and intangibles included in total assets	$	1,827	$	23,693	$	82,308	$	—	$	107,828
December 31, 2011:
Segment total assets	$	461,225	$	53,927	$	97,913	$	84,134	$	697,199
Goodwill and intangibles included in total assets	$	1,994	$	23,693	$	81,025	$	—	$	106,712

6. Property and Equipment

Property and equipment consisted of the following as of June 30, 2012 and December 31, 2011 (in thousands):



	June 30, 2012			December 31, 2011
Land and land improvements	$	64,984		$	64,984
Buildings and leasehold improvements	327,983			323,887
Furniture and equipment	78,161			75,497
Construction in progress	6,228			7,088
	477,356			471,456
Less accumulated depreciation	(107,090		)	(95,954		)
	$	370,266		$	375,502

Leased facility assets consisted of the following as of June 30, 2012 and December 31, 2011 (in thousands):



	June 30, 2012		December 31, 2011
Leased facility assets	13,848		14,190
Less accumulated depreciation	(3,670	)	(3,398	)
	10,178		10,792

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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 exercisable by the lessee.

7. 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 from the escrow 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 a court-appointed 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 defendants are 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. In April 2011, five of the subsidiary defendants transferred their operations to an unaffiliated third party skilled nursing facility operator. The remaining defendants continue to monitor their compliance with the terms of the injunction and to provide the applicable reports and information to the court-appointed auditor.

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 BMFEA could pursue a wide range of legal remedies if it believes that applicable laws were broken, including criminal and civil fines, penalties and other sanctions. Violations could also lead to fines, penalties and sanctions, including exclusion from participation in federal healthcare programs, under federal laws such as the Federal False Claims Act and the Civil Monetary Penalty Law. The Facility represented less than 1% of the Company's revenue and less than 0.3% of Adjusted EBITDA in 2010. Nevertheless, although the Company is unable to assess the potential exposure, any fines, penalties or other sanctions that may result from the BMFEA's investigation and any related or resulting legal matters could be significant. Eureka Healthcare and Rehabilitation Center, LLC transferred its operations in April 2011 to an unaffiliated third party skilled nursing facility 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 appropriate, 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.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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. For the policy periods up to December 31, 2011, 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. Beginning January 1, 2012, the Company self insures the first $0.25 million for these businesses. The Company recognizes a liability in its consolidated financial statements for its estimated self-insured workers' compensation risks. Historically, estimated liabilities have been sufficient to cover actual claims.

General and Professional Liability. The Company's services subject it to certain liability risks. Malpractice and similar claims may be asserted against the Company if its services are alleged to have resulted in patient injury or other adverse effects. The Company is subject to malpractice and similar 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 $25.0 million per loss and annual aggregate limits for claims in excess of $1.0 million per loss for all businesses. These policies will remain in force for an initial period of one year. Effective September 1, 2011, the Company also self-insures professional liability claims at its California based SNF subsidiaries through its wholly-owned offshore captive insurance company, Fountain View Reinsurance, Ltd., for claims up to $1.0 million.

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 deductible for most participants 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 June 30, 2012											As of December 31, 2011
	General and Professional			Employee Medical			Workers’ Compensation			Total		General and Professional			Employee Medical			Workers’ Compensation			Total
Current	$	6,773	⁽¹⁾	$	2,419	⁽²⁾	$	4,604	⁽²⁾	$	13,796	$	4,955	⁽¹⁾	$	2,083	⁽²⁾	$	4,416	⁽²⁾	$	11,454
Non-current	17,345			—			12,092			29,437		19,042			—			11,525			30,567
	$	24,118		$	2,419		$	16,696		$	43,233	$	23,997		$	2,083		$	15,941		$	42,021


(1)	Included in accounts payable and accrued liabilities.


(2)	Included in employee compensation and benefits.

Hallmark Indemnification

Hallmark, the Company's wholly-owned rehabilitation services company, provides physical, occupational and speech therapy services to various unaffiliated skilled nursing facilities. These unaffiliated skilled nursing facilities are reimbursed for these services from the Medicare Program and other third-party payors. Hallmark has indemnified these unaffiliated skilled nursing facilities from a portion of certain disallowances of these services. Additionally, to the extent a Recovery Audit Contractor ("RAC") or other regulatory authority or contractor is successful in making a claim for recoupment of revenue from any of these skilled nursing facilities, Hallmark will typically be required to indemnify them against their charges associated with this loss.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Financial Guarantees

Substantially of all Skilled's wholly-owned subsidiaries guarantee 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 are considered minor. On May 12, 2012, the Company redeemed the entire $130.0 million of its then outstanding 11.0% senior subordinated notes due 2014 (the "2014 Notes"). The 2014 Notes were guaranteed by substantially all of Skilled's wholly-owned subsidiaries on terms similar to their guarantees of the Company's first lien senior secured credit facility.

8. 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 income consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and gains and losses from investments available for sale. Details of other comprehensive income are included in the Company's Statement of Comprehensive Income.

2007 Incentive Award Plan

The fair value of the stock option grants for the six months ended June 30, 2012 and 2011 under FASB ASC Topic 718, Compensation – Stock Compensation, was estimated on the dates of the grants using the Black-Scholes option pricing model with the following assumptions:



	Six Months Ended June 30,
	2012			2011
Risk-free interest rate	1.75		%	2.80		%
Expected Life	6.25 years			6.25 years
Dividend yield	—		%	—		%
Volatility	70.81		%	50.00		%
Weighted-average fair value	$	5.44		$	6.61

There were no new stock options granted in the three months ended June 30, 2012 and 2011. There were 106,748 and 60,491 new stock options granted in the six months ended June 30, 2012 and 2011, respectively.

There were no options exercised during the three and six months ended June 30, 2012. As of June 30, 2012, there was $1.4 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 2.1 years. To the extent the forfeiture rate is different than the Company has anticipated, stock-based compensation related to these awards will be different from the Company's expectations.

The following table summarizes stock option activity during the six months ended June 30, 2012 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, 2012	1,033,299		$	9.10
Granted	106,748		$	6.74
Exercised	—		$	—
Forfeited or cancelled	(4,000	)	$	15.50
Outstanding at June 30, 2012	1,136,047		$	8.85	7.23	$	164
Fully vested and expected to vest at June 30, 2012	1,114,466		$	8.88	7.20	$	162
Exercisable at June 30, 2012	667,399		$	9.92	6.63	$	82

Aggregate intrinsic value represents the value of Skilled's closing stock price on the New York Stock Exchange on the last

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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 $0.8 million and $0.7 million for the three months ended June 30, 2012 and 2011, respectively. The amount of compensation included in general and administrative expenses was $1.5 million and $1.3 million for the six months ended June 30, 2012 and 2011, respectively. The amount of compensation included in cost of services was $0.4 million and $0.5 million for the three months ended June 30, 2012 and 2011. The amount of compensation included in cost of services was $0.9 million and $0.8 million for the six months ended June 30, 2012 and 2011, respectively.

9. Fair Value Measurements

Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions. The following table summarizes the valuation of the Company’s interest rate hedge transaction and contingent consideration as of June 30, 2012 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	$	—	$	(559	)	$	—		$	(559	)
Available for sale securities	$	—	$	1,069		$	—		$	1,069
Contingent consideration – acquisitions	$	—	$	—		$	(7,952	)	$	(7,952	)

In June 2010, the Company entered into an interest rate cap agreement (which expired December 31, 2011) and an interest rate swap agreement in order to manage fluctuations in cash flows resulting from interest rate risk. The interest rate swap agreement is for a notional amount of $70.0 million with a LIBOR rate not to exceed 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 contract is determined by calculating the value of the discounted cash flows of the difference between 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. Therefore, the Company has categorized the interest rate swap as Level 2. The Company obtained the counterparty’s calculation of the valuation of the interest rate swap as well as a forward LIBOR curve from another investment bank and recalculated the valuation of the interest rate swap, which agreed with the counterparty’s calculation.

The Company's wholly owned offshore captive insurance company is required by regulatory agencies to set aside assets to comply with the laws of the jurisdiction in which it operates. These assets consist of restricted cash and available for sale securities, which are included in other assets in the Company's consolidated June 30, 2012 balance sheet. The Company's available for sale securities are U.S. government securities with an amortized cost basis and aggregate fair value of $1.0 million and $1.1 million, respectively, as of June 30, 2012. Net unrealized gains included in other comprehensive income on the Company's available for sale securities totaled $0.1 million for the six months ended June 30, 2012.

On May 1, 2010, the Company acquired substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada (which is sometimes referred to herein as the "Hospice/Home Health Acquisition"). As part of the purchase agreement, the purchase consideration included cash, promissory notes, contingent consideration, and deferred cash payments. The contingent consideration arrangement requires the Company to pay contingent payments should the acquired operations achieve certain financial targets based on EBITDA of the acquired businesses, as defined in the acquisition agreement, which was filed as Exhibit 2.1 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 following the closing. 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 June 30, 2012, the contingent consideration had a fair value of $5.1 million. This is included in the Company’s accounts payable and accrued liabilities and other long-term 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, 2011 to June 30, 2012.

On July 1, 2011, a wholly-owned subsidiary of the Company acquired Altura Homecare & Rehab ("Altura"). The acquisition includes contingent earn-out consideration which can be earned based on the acquired business's achievement of an

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 3 years following the closing. 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 fair value of the earn-out at the acquisition date and at June 30, 2012 was $1.4 million.

On October 24, 2011, wholly-owned subsidiaries of the Company acquired substantially all of the assets of Cornerstone Hospice, Inc. ("Cornerstone"). The acquisition includes contingent earn-out consideration which can be earned based on the acquired business's achievement of an EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 5 years following the closing. 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 fair value of the earn-out at the acquisition date and at June 30, 2012 was $1.3 million.

On May 13, 2012, a wholly-owned subsidiary of the Company acquired substantially all of the assets of A Better Care Home Health, Inc. ("ABC"). The acquisition includes contingent earn-out consideration which can be earned based on the acquired operations' achievement of an EBITDA threshold. The contingent consideration spans 3 years following the closing. 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 fair value of the earn-out at the acquisition date and at June 30, 2012 was $0.1 million.

As discussed above, EBITDA is the basis for calculating the contingent consideration. The unobservable inputs to the determination of the fair value of the contingent consideration include assumptions as to the ability of the acquired businesses to meet their EBITDA targets and discount rates used in the calculation. Should the actual EBITDA generated by the acquired businesses increase or decrease as compared to our assumptions, the fair value of the contingent consideration obligations would increase or decrease, up to the contracted limit, as applicable. As the timing of contingent payments go further into the future, discount rate assumptions increase due to the increased uncertainty of the EBITDA that may be generated in those periods.

The Company's assumptions range from the acquired businesses achieving none, a portion, or all of the consideration, and discount rates range from 4%- 7%.

Below is a table listing the Level 3 rollforward as of June 30, 2012 (in thousands):



Level 3 Rollforward
Value at January 1, 2012	$	7,210
Contingent Consideration - ABC	112
Change in fair value	630
Value at June 30, 2012	$	7,952

10. Debt

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

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



	As of June 30, 2012			As of December 31, 2011
Revolving Credit Facility due 2015, interest rate comprised of LIBOR plus 4.50% or 4.74% at June 30, 2012	35,000			—
Revolving Credit Facility due 2015, interest rate comprised of the Prime rate of 3.25% plus 3.50%, or 6.75%, at June 30, 2012	10,500
Term Loan, due 2016, interest rate based on LIBOR (subject to a 1.50% floor) plus 5.25% or 6.75%, at June 30, 2012; collateralized by substantially all assets of the Company	416,844			—
Term Loan, due 2016, interest rate based on LIBOR (subject to a 1.50% floor) plus 3.75% or 5.25% at December 31, 2011; collateralized by substantially all assets of the Company	—			337,100
Term Loan due 2016, interest rate based on the Prime rate of 3.25% plus 2.75%, or 6.00%, at December 31, 2011; collateralized by substantially all assets of the Company	—			6,600
Term Loan original issue discount	(3,493		)	(1,893		)
Senior Subordinated Notes due 2014, interest rate 11.00% at December 31, 2011; interest payable semiannually	—			130,000
Senior Subordinated Notes original issue discount	—			(224		)
Notes payable due December 2018, interest rate fixed at 6.50%, payable in monthly installments, collateralized by a first priority deed of trust	1,195			1,269
Hospice/Home Health Acquisition note, interest rate fixed at 6.00%, payable in annual installments	1,478			1,474
Other	1,145			993
Insurance premiums financed	708			164
Total long-term debt	463,377			475,483
Less amounts due within one year	(11,925		)	(4,414		)
Long-term debt, net of current portion	$	451,452		$	471,069

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 (the "Prior Credit Agreement") that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. On April 12, 2012, the Company entered into an Amendment and Restatement and Additional Term Loan Assumption Agreement (“Restated Credit Agreement”) that amended and restated the Prior Credit Agreement and pursuant to which, among other things, the size of the Company's existing senior secured term loan was increased by $100.0 million (hereinafter referred to as the incremental senior secured term loan). The credit arrangements provided under the Restated Credit Agreement are collectively referred to herein as the Company's senior secured credit facility.

The incremental senior secured term loan bears interest, at our option, at the London Interbank Offered Rate ("LIBOR") (subject to a floor of 1.50%) plus a margin of 5.25% or the prime rate (subject to a floor of 2.50%) plus a margin of 4.25%. As part of the refinancing, the interest rate on the existing senior secured term loan was amended to match the interest rate of the incremental senior secured term loan. The interest rate on the existing revolving credit facility was also amended to be, at our option, LIBOR plus a margin of between 4.50% and 4.25% (based upon consolidated senior leverage) or the prime rate plus a margin of between 3.50% and 3.25% (based upon consolidated senior leverage). There is no longer a LIBOR or prime rate floor with respect to the revolving credit facility. Pursuant to the Restated Credit Agreement, the quarterly term loan amortization payments increased to $2.6 million beginning June 30, 2012 compared to $0.9 million under the Prior Credit Agreement. Additionally, the maximum portion of the annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement) to be applied to term debt reductions increased to 75% from 50%, subject to stepdowns to 50% and 25% based on consolidated leverage. The Company also increased its ability to refinance a portion of its credit facility with Housing and Urban Development ("HUD") debt up to $250 million, subject to certain credit facility covenants. In addition, the Company expensed fees paid in connection with the refinancing in the amount of $2.0 million in conjunction with the amended senior secured credit facility. Substantially all of the Company's assets are pledged as collateral under the senior secured credit facility. Amounts borrowed under the senior secured term loan may be prepaid at any time without penalty, except for LIBOR breakage costs. Commitments under the revolving credit facility terminate on April 9, 2015. The senior secured term loan matures on April 9, 2016.

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SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company has the right to increase its borrowings under the revolving 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 agree to increase their commitments. To reduce the risk related to interest rate fluctuations, the Prior Credit Agreement required the Company to enter into, and the Restated Credit Agreement requires us to continue to maintain, an interest rate swap, cap or similar agreement to effectively fix or cap the interest rate on 40% of its funded long-term debt within three months of the April 2010 commencement of the senior secured credit facility. The Company entered into two interest rate hedge transactions, as described in Note 9 - "Fair Value Measurements," in order to comply with this requirement.

Under the senior secured credit facility, the Company must maintain compliance with specified financial covenants measured on a quarterly basis. The senior secured credit facility 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 senior secured credit facility, 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, as much as 75% 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.

Senior Subordinated Notes

On May 12, 2012, the Company redeemed the entire $130.0 million of the 2014 Notes. The proceeds from the incremental senior secured term loan (as well as a draw on the revolving portion of the senior secured credit facility) were used to fund the redemption of the outstanding 2014 Notes at par plus accrued interest. In addition, the Company expensed unamortized deferred financing fees and original issue discount ("OID") in the amount of $1.9 million in conjunction with the redemption of the 2014 Notes.

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 was payable semiannually in January and July of each year. The 2014 Notes were to mature on January 15, 2014. The 2014 Notes were unsecured senior subordinated obligations and ranked junior to all of the Company's existing and future senior indebtedness, including indebtedness under the senior secured credit facility. The 2014 Notes were guaranteed on a senior subordinated basis by certain of the Company's subsidiaries.

Other Debt

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. During 2011, the notes were substantially paid down leaving a remaining balance of $1.5 million. The 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 is a consolidated subsidiary of Skilled holding 100% interests in the operating companies for the Hospice/Home Health Acquisition.

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, 2011 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 subsidiaries. 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 with 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 operators with

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whom we contract to better focus on delivery of healthcare services. We have one such service agreement with an unrelated facility operator. These subsidiaries focus on providing high-quality care to our patients. Our subsidiaries that operate skilled nursing facilities 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 June 30, 2012, we owned or leased 74 skilled nursing facilities and 22 assisted living facilities, together comprising 10,409 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 77.2% 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 six months ended June 30, 2012, we generated approximately 72.2% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, hospice care and home health services, and or lease of five skilled nursing facilities to an unaffiliated third party operators.

Revisions to Prior Period Amounts

We recently identified errors related to certain claims under Medicare Part B for blood glucose testing at certain of our affiliated companies. Although blood glucose tests are routinely ordered by physicians to safely monitor vulnerable patients' blood glucose levels, effective January 1, 2007, CMS redefined the criteria for "medical necessity" before a Medicare claim for such a test is payable. The new criteria specifies the nature of a physician order for the blood glucose test, the frequency of a physician's review of the test results and the frequency of a physician's utilization of the test results in the patient's plan of care or treatments. The documentation and other requirements for Medicare Part B billing of blood glucose testing that took effect in January 2007 significantly limited the number of blood glucose tests that are reimbursable compared to those that were previously reimbursable. Our internal policies changed at the time to be consistent with new Medicare regulations. Subsequent to January 1, 2007, a number of our affiliated companies incorrectly continued to bill Medicare under the rules that existed prior to January 1, 2007. The billing errors resulted in a cumulative overstatement of consolidated revenue in the amount of $5.8 million for the period from January 1, 2007 to December 31, 2011. The affiliated companies submitted approximately 30,000 claims related to blood glucose testing in the affected period that were not reimbursable under the revised standard. The affected providers have refunded all previously paid post 2006 Medicare Part B claims for blood glucose tests.

In accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") No. 250-10-S99 ("ASC 250-10-S99"), we evaluated these refunds and, based on an analysis of quantitative and qualitative factors, determined that they were not material to any of the prior reporting periods affected and, therefore, amendment of previously filed reports with the Securities and Exchange Commission was not required. However, if the adjustments to correct the cumulative effect of the aforementioned refunds had been recorded in the three and six months ended June 30, 2012, the impact would have been material to those two periods. Therefore, as required by Staff Accounting Bulletin ("SAB") 108, we have revised in this filing previously reported financial information for the fiscal years ended December 31, 2011, 2010, 2009, 2008, and 2007, and for the quarterly periods in fiscal years 2011 and 2010. Also, in accordance with SAB 108, we will include this revised financial information when we file subsequent reports on Form 10-Q and Form 10-K or files a registration statement under the Securities Act of 1933, as amended.

The prior period financial statements included in this filing have been revised to reflect the correction of the aforementioned errors, see Note 2 - "Correction of Previously Issued Consolidated Financial Statements," to our Condensed Consolidated Financial Statements included in Item 1 for additional information on these revisions. The condensed consolidated statement of operations for the quarter ended March 31, 2012 has not been restated. Revenue for the quarter ended March 31, 2012 was overstated by $0.3 million. This correction has been recorded as an adjustment to revenue in the quarter ended June 30, 2012, as this amount was not material to the operating results for the period then ended.

Despite the fact that our affected subsidiaries have refunded all of the reimbursements they received in connection with the Medicare Part B claims for all blood glucose tests after January 1, 2007, some refunded claims could nonetheless potentially lead to allegations that any of the affected subsidiaries are subject to sanctions under the Federal False Claims Act or the Federal Civil Monetary Penalties Law. Such sanctions could lead to any combination of a variety of criminal, civil and administrative penalties, which could be material both individually and in the aggregate. We cannot determine the likelihood that any penalties might be imposed related to this refund and has not accrued for any such penalties. See "Revenue we receive from Medicare and Medicaid is subject to potential retroactive reduction or repayment" in Part II, Item 1A of this report for additional information.

Industry Trends

Medicare and Medicaid Reimbursement

Rising healthcare costs due to a variety of factors, including an aging population and increasing life expectancies, has in

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recent years increased demand for post-acute healthcare services, such as skilled nursing, assisted living, home health care, hospice care and rehabilitation therapy. 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 recent years skilled nursing facilities, which typically have significantly lower cost structures than acute care hospitals and certain other post-acute care settings, have generally been serving larger populations of higher-acuity patients than in the past. Despite this growth in demand, uncertainty over Medicare and Medicaid reimbursement rates persists. Medicare and Medicaid reimbursement rates are subject to change from time to time and, because revenue derived directly or indirectly from Medicare and Medicaid reimbursement has historically comprised the most significant portion of our consolidated revenue, a reduction in rates could materially and adversely impact our revenue.

Medicare reimburses our skilled nursing facilities under a prospective payment system ("PPS") for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group ("RUG") category that is based upon each patient's acuity level. 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 was 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 adjusted the method by which group therapy is counted for reimbursement purposes, and changed the timing in which patients who are receiving therapy must be reassessed for purposes of determining their RUG category.

On July 27, 2012, CMS issued a final rule providing for, among other things, a net 1.8% increase in PPS payments to skilled nursing facilities for CMS's fiscal year 2013 (which begins October 1, 2012) as compared to PPS payments in CMS's fiscal year 2012 (which ends September 30, 2012). The 1.8% increase was on a net basis, after the application of a 2.5% market basket increase, and reduced by a 0.7% multi-factor productivity adjustment required by PPACA.

In July 2012, CMS issued its final rule for hospice services its the 2013 fiscal year. The rule includes a market basket increase of 2.6% less 0.3% reduction in the market basket as a result of the ACA and a 0.7% reduction due to productivity adjustment. After adjusting for the wage index in our hospice agencies, we estimate that the net impact on our hospice service operations will be a decrease of 0.7% in our reimbursement rates effective October 1, 2012.

Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels (including as a result of automatic cuts tied to federal deficit cut efforts or otherwise), 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 and 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 or future reductions in reimbursement rates.

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 substantially 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, PPACA enacted several reforms with respect to skilled nursing facilities, home health agencies and hospices, including payment measures to

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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 businesses 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 new 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 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 businesses 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 the 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 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 includes additional measures related to the expansion of community and home based services and authorizes 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 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.

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•

Value-Based Purchasing. PPACA requires the Secretary of Health and Human Services to develop a plan to implement a value-based purchasing (“VBP”) program for payments under the Medicare program for skilled nursing facilities and to submit a report containing the plan to Congress. The intent of the provision is to potentially reconfigure how Medicare pays for health care services, moving the program towards rewarding better value, outcomes, and innovations, instead of volume. According to the plan submitted to Congress in June 2012, the funding for the VBP program could come from payment withholds from poor-performing skilled nursing facilities or by holding back a portion of the base payment rate or the annual update for all skilled nursing facilities. If a VBP program is ultimately implemented, it is uncertain what effect it would have upon skilled nursing facilities, but its funding or other provisions could negatively affect skilled nursing facilities.

•

Anti-Kickback Statute Amendments. PPACA amended the Anti-Kickback Statute so that (i) a claim that includes items or services violating the Anti-Kickback Statute also would constitute a false or fraudulent claim under the federal False Claims Act and (ii) the intent required to violate the Anti-Kickback Statute is lowered such that a person need not have actual knowledge or specific intent to violate the Anti-Kickback Statute in order for a violation to be deemed to have occurred. These modifications of the Anti-Kickback Statute could expose us to greater risk of inadvertent violations of the statute and to related liability under the federal False Claims Act.

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 our business, financial condition and results of operations. Similar federal and/or state legislation that may be adopted in the future could have similar effects.

Revenue

Revenue by Service Offering

We operate our business in three reportable operating segments: (i) long-term care services, which includes the operation skilled nursing and assisted living facilities and is the most significant portion of our business; (ii) our rehabilitation therapy services business; and (iii) 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 affiliated skilled nursing facilities. The remainder of our long-term care segment revenue is generated by our assisted living facilities, by our administration of an unaffiliated third party skilled nursing facility, and from our leasing of five skilled nursing facilities to an unaffiliated third party operator. 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):

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	Three Months Ended June 30,
	2012				2011
	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	$	156,267	71.9	%	$	164,899	76.6	%	$	(8,632	)	(5.2	)%
Assisted living facilities	6,895		3.2		6,737		3.1		158			2.3
Administration of third party facility	125		0.1		291		0.1		(166		)	(57.0	)
Facility lease revenue	768		0.3		746		0.4		22			2.9
Total long-term care services	164,055		75.5		172,673		80.2		(8,618		)	(5.0	)
Therapy services:
Third-party rehabilitation therapy services	26,385		12.1		23,703		11.0		2,682			11.3
Total therapy services	26,385		12.1		23,703		11.0		2,682			11.3
Hospice & home health services:
Hospice	20,576		9.5		15,832		7.4		4,744			30.0
Home Health	6,359		2.9		3,035		1.4		3,324			109.5
Total hospice & home health services	26,935		12.4		18,867		8.8		8,068			42.8
Total	$	217,375	100.0	%	$	215,243	100.0	%	$	2,132		1.0	%



	Six Months Ended June 30,
	2012				2011
	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	$	315,251	72.2	%	$	339,945	77.7	%	$	(24,694	)	(7.3	)%
Assisted living facilities	13,809		3.2		13,461		3.1		348			2.6
Administration of third party facility	565		0.1		546		0.1		19			3.5
Facility lease revenue	1,522		0.3		746		0.2		776			104.0
Total long-term care services	331,147		75.8		354,698		81.1		(23,551		)	(6.6	)
Therapy services:
Third-party rehabilitation therapy services	52,501		12.1		45,893		10.5		6,608			14.4
Total therapy services	52,501		12.1		45,893		10.5		6,608			14.4
Hospice & home health services:
Hospice	40,330		9.2		30,159		6.9		10,171			33.7
Home Health	12,810		2.9		6,773		1.5		6,037			89.1
Total hospice & home health services	53,140		12.1		36,932		8.4		16,208			43.9
Total	$	436,788	100.0	%	$	437,523	100.0	%	$	(735	)	(0.2	)%

Sources of Revenue

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

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	Three Months Ended June 30,
	2012				2011
	Revenue Dollars		Percentage of Revenue		Revenue Dollars		Percentage of Revenue
California	$	88,694	40.8	%	$	87,759	40.8	%
Texas	44,134		20.3		46,293		21.5
New Mexico	24,299		11.2		22,682		10.5
Nevada	16,209		7.5		14,706		6.8
Kansas	15,690		7.2		16,434		7.6
Missouri	14,286		6.6		15,583		7.2
Montana	3,996		1.8		3,189		1.5
Arizona	3,044		1.4		2,594		1.2
Iowa	2,739		1.3		2,683		1.3
Idaho	2,474		1.1		2,250		1.0
Nebraska	1,083		0.5		804		0.5
Other	727		0.3		266		0.1
Total	$	217,375	100.0	%	$	215,243	100.0	%



	Six Months Ended June 30,
	2012				2011
	Revenue Dollars		Percentage of Revenue		Revenue Dollars		Percentage of Revenue
California	$	176,922	40.5	%	$	182,696	41.8	%
Texas	89,794		20.6		92,402		21.1
New Mexico	48,900		11.2		44,853		10.3
Nevada	31,557		7.2		29,425		6.7
Kansas	31,393		7.2		34,246		7.8
Missouri	29,406		6.7		30,902		7.1
Montana	7,637		1.8		6,064		1.4
Arizona	7,042		1.6		5,487		1.3
Iowa	5,666		1.3		5,654		1.3
Idaho	4,897		1.1		4,441		1.0
Nebraska	1,942		0.4		804		0.2
Other	1,632		0.4		549		0.1
Total	$	436,788	100.0	%	$	437,523	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 specifically designed to serve high-acuity patients.

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 additional information on the lease arrangement, see Note 6 - "Property and Equipment."

Therapy Services Segment

As of June 30, 2012, we provided rehabilitation therapy services to a total of 182 healthcare facilities, including 64 of our

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facilities, as compared to 176 facilities, including 64 of our facilities, as of June 30, 2011. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net increase of 6 facilities serviced was comprised of 28 new facilities serviced, net of 22 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. As of June 30, 2012, we provided rehabilitation therapy services to facilities in California, Nevada, New Mexico, Texas, Missouri, Nebraska, Iowa, and Indiana.

Hospice and Home Health Services Segment

Hospice. As of June 30, 2012, 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 monitor the impact of the Medicare cap on our hospice business by attempting to address our average length-of-stay on an agency-by-agency basis. A key component of this strategy is to analyze each hospice agency's mix of patients and referral sources to achieve a desirable mix of the types of patients and referral sources that we serve in each of our agencies.

Home Health. We provided home health care in Arizona, California, Idaho, Montana, Nevada and New Mexico as of June 30, 2012. 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 or reimbursed 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 June 30,
	2012										2011
	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 Part A	$	45,476	$	—	$	23,299	$	68,775	31.6	%	$	58,617	$	—	$	17,809	$	76,426	35.5	%
Medicare Part B	4,806		—		—		4,806		2.2		5,605		—		—		5,605		2.6
Medicaid	64,159		—		639		64,798		29.8		61,215		—		275		61,490		28.6
Subtotal Medicare and Medicaid	114,441		—		23,938		138,379		63.6		125,437		—		18,084		143,521		66.7
Managed Care Part A	23,302		—		1,153		24,455		11.3		20,489		—		108		20,597		9.6
Managed Care Part B	542		—		—		542		0.2		443		—		—		443		0.2
Private pay and other	25,770		26,385		1,844		53,999		24.9		26,304		23,703		675		50,682		23.5
Total	$	164,055	$	26,385	$	26,935	$	217,375	100.0	%	$	172,673	$	23,703	$	18,867	$	215,243	100.0	%

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	Six Months Ended June 30,
	2012										2011
	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 Part A	$	94,663	$	—	$	46,541	$	141,204	32.3	%	$	126,560	$	—	$	34,710	$	161,270	36.8	%
Medicare Part B	9,076		—		—		9,076		2.1		8,299		—		—		8,299		1.9
Medicaid	129,003		—		1,058		130,061		29.8		125,037		—		484		125,521		28.7
Subtotal Medicare and Medicaid	232,742		—		47,599		280,341		64.2		259,896		—		35,194		295,090		67.4
Managed Care Part A	46,216		—		2,258		48,474		11.1		42,491		—		299		42,790		9.8
Managed Care Part B	1,001		—		—		1,001		0.2		826		—		—		826		0.2
Private pay and other	51,188		52,501		3,283		106,972		24.5		51,485		45,893		1,439		98,817		22.6
Total	$	331,147	$	52,501	$	53,140	$	436,788	100.0	%	$	354,698	$	45,893	$	36,932	$	437,523	100.0	%

Medicare. Medicare is a federal health insurance program for people age 65 or older, people under age 65 with certain disabilities, and people of all ages with End-Stage Renal Disease. Part A of the Medicare program includes hospital insurance that helps to cover hospital inpatient care and skilled nursing facility inpatient care under certain circumstances (e.g., up to 100 days of inpatient skilled nursing coverage following a 3-day qualifying hospital stay, and no custodial or long-term care). It also helps cover hospice care and some home health care. Skilled nursing facilities are paid under Medicare Part A 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 the 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. PPACA provides for increased financial participation by the federal government in a state's Medicaid program if the state chooses to expand its Medicaid program as contemplated by PPACA. However, states are not required to expand their Medicaid programs and it is uncertain as to which states, including states in which we operate, will choose to expand their programs.

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

Discussion of our critical accounting policies and estimates is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which we filed with the SEC on February 13, 2012.

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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 June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Occupancy statistics (skilled nursing facilities):
Available beds in service at end of period	8,805			8,819			8,805			8,819
Available patient days	801,743			802,649			1,603,269			1,627,402
Actual patient days	665,486			662,220			1,333,679			1,353,028
Occupancy percentage	83.0		%	82.5		%	83.2		%	83.1		%
Average daily number of patients	7,313			7,277			7,328			7,475

Hospice average daily census	1,402			1,085			1,389			1,039
Home health episodic-based admissions	2,099			874			4,084			1,855
Home health episodic-based recertifications	360			151			693			298

Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)
LTC only Medicare (Part A)	$	513		$	572		$	509		$	572
Medicare blended rate (Part A & B)	567			627			571			625
Managed care (Part A)	385			383			384			387
Managed care blended rate (Part A & B)	394			391			392			395
Medicaid	157			154			157			154
Private and other	173			175			181			178
Weighted-average for all	$	237		$	251		$	239		$	252

Patient days by payor (skilled nursing facilities):
Medicare	88,690			102,444			181,724			215,727
Managed care	60,464			53,467			120,486			109,684
Skilled Mix	149,154			155,911			302,210			325,411
Private pay and other	107,242			109,050			211,442			215,104
Medicaid	409,090			397,259			820,027			812,513
Total	665,486			662,220			1,333,679			1,353,028

Patient days as a percentage of total patient days (skilled nursing facilities):
Medicare	13.3		%	15.5		%	13.6		%	15.9		%
Managed care	9.1			8.0			9.0			8.2
Skilled Mix	22.4			23.5			22.6			24.1
Private pay and other	16.1			16.5			15.9			15.8
Medicaid	61.5			60.0			61.5			60.1
Total	100		%	100		%	100		%	100		%

Revenue for total company:
Medicare	33.8		%	38.1		%	34.4		%	38.7		%
Managed care, private pay, and other	36.4			33.3			35.8			32.6
Quality mix	70.2			71.4			70.2			71.3
Medicaid	29.8			28.6			29.8			28.7
Total	100		%	100		%	100		%	100		%

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The following table sets forth details of our revenue, expenses, and net income and other items as a percentage of total revenue for the periods indicated:



	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
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)	82.9			79.6			83.2			79.2
Rent cost of revenue	2.1			2.1			2.1			2.1
General and administrative	3.0			3.4			2.8			3.2
Depreciation and amortization	3.0			3.0			3.0			2.9
	91.0			88.1			91.1			87.4
Other income (expenses):
Interest expense	(4.8		)	(4.5		)	(4.6		)	(4.5		)
Interest income	0.1			0.1			0.1			0.1
Other income (expense)	—			—			—			(0.1		)
Equity in earnings of joint venture	0.2			0.3			0.2			0.3
Debt retirement costs	(1.8		)	—			(0.9		)	—
Total other income (expenses), net	(6.3		)	(4.1		)	(5.2		)	(4.2		)
Income from continuing operations before provision for income taxes	2.7			7.8			3.7			8.4
Provision for income taxes	1.1			3.0			1.5			3.3
Net income	1.6		%	4.8		%	2.2		%	5.1		%

Adjusted EBITDA(1)	12.3		%	15.6		%	12.1		%	16.0		%
Adjusted EBITDAR(2)	14.4		%	17.8		%	14.2		%	18.1		%

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Reconciliation from net income to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR (in thousands):
Net income	$	3,497		$	10,384		$	9,834		$	22,045
Interest expense, net of interest income	10,389			9,454			19,809			19,225
Provision for income taxes	2,355			6,467			6,391			14,476
Depreciation and amortization expense	6,591			6,432			12,866			12,577
EBITDA(1)	22,832			32,737			48,900			68,323
Rent cost of revenue	4,539			4,547			9,095			9,117
EBITDAR(2)	27,371			37,284			57,995			77,440
EBITDA(1)	22,832			32,737			48,900			68,323
Debt retirement costs	3,958			—			3,958			—
Disposals of property and equipment	—			3			—			293
Expenses related to the exploration of strategic alternatives	—			474			—			716
Exit costs related to the Northern California divestiture	—			435			—			820
Adjusted EBITDA(1)	26,790			33,649			52,858			70,152
Rent cost of revenue	4,539			4,547			9,095			9,117
Adjusted EBITDAR(2)	$	31,329		$	38,196		$	61,953		$	79,269

(1)

We define EBITDA as net income (loss) before depreciation, amortization and interest expense (net of interest income) and the provision for income taxes. Adjusted EBITDA is EBITDA adjusted for non-core business items, which for the periods presented in this report includes gains or losses on debt retirement costs, the disposal of property and equipment, expenses related to the exploration of strategic alternatives, and exit costs related to the disposition of certain of our operations in Northern California (each to the extent applicable in the appropriate period.)

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(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. Adjusted EBITDAR is EBITDAR adjusted for the non-core business items listed above for the definition of Adjusted EBITDA (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 accounting principles generally accepted in the United States of America ("U.S. GAAP"), expenses, revenues and gains (losses) that we believe 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 operating company based management, 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 business-by-business 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 facility, assisted living facility, or other business unit 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. We believe 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. For example, the senior secured credit facility includes adjustments to EBITDA for (i) gain or losses on sale of assets, (ii) the write-off of deferred financing costs of extinguished debt, (iii) pro forma 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, (v) non-cash stock compensation and (vi) impairment of long-lived assets. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our senior secured credit facility.

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 individual business level basis, EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by 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;

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


•	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. Furthermore, the non-GAAP financial measures that we present may be different from the presentation of similar measures by other companies, so the comparability of the measures among companies may be limited. 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 June 30, 2012 Compared to Three Months Ended June 30, 2011

Revenue. Revenue increased by $2.2 million, or 1.0%, to $217.4 million in the three months ended June 30, 2012 from $215.2 million in the three months ended June 30, 2011.

Long term care services



	Three Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars			Percentage
	(dollars in millions)
Skilled nursing facilities	$	156.3	71.9	%	$	164.9	76.6	%	$	(8.6	)	(5.2	)%
Assisted living facilities	6.9		3.2		6.7		3.1		0.2			2.3
Administration of third party facility	0.1		0.1		0.3		0.1		(0.2		)	(57.0	)
Leased facility revenue	0.7		0.3		0.7		0.4		—			2.9
Total long-term care services	$	164.0	75.5	%	$	172.6	80.2	%	$	(8.6	)	(5.0	)%

Skilled nursing facilities revenue decreased $8.6 million in the first quarter of 2012 as compared to the first quarter of 2011, with the decrease coming from skilled nursing facilities operated for all of the three months ended June 30, 2012 and 2011. The decrease resulted primarily from a $9.3 million decrease in revenue due to a lower weighted average per patient day ("PPD") Medicare reimbursement rate, offset by a $0.7 million increase in revenue due to higher occupancy rates. We experienced an increase in our average daily census ("ADC") and average length of stay ("ALOS") in our same store skilled nursing facilities in the second quarter of 2012 as compared to the second quarter of 2011. The decrease in PPD rates was primarily a result of the Medicare rate cut discussed below as well as a shift from Medicare days to Managed Medicare days as more seniors elect Medicare Advantage. Medicare Advantage plans are operated by private companies, to which Medicare pays a fixed monthly amount per enrollee to provide the enrollees healthcare services that would otherwise be reimbursed through Medicare's standard PPS system. A decrease in our skilled mix also contributed to the decline in PPD rates. Our average daily Part A Medicare rate decreased 10.3% to $513 in the three months ended June 30, 2012 from $572 in the three months ended June 30, 2011, primarily due to the decrease of our skilled nursing Medicare rates by 11.1%, effective October 1, 2011, which will continue to negatively impact skilled nursing revenues in future periods. Our average daily Medicaid rate increased 2.0% to $157 per day in the three months ended June 30, 2012 from $154 per day in the three months ended June 30, 2011, primarily due to increased Medicaid rates in California, Kansas, Missouri and Nevada. These increases in Medicaid rates were substantially offset by increases in the provider taxes in those states. We expect moderate weighted average Medicaid rate increases in the second half for 2012. The increase of $0.2 million at our assisted living facilities in the second quarter of 2012 as compared to the second quarter of 2011 was due primarily to the July 2011 acquisition of Vintage Park at San Martin in Las Vegas, Nevada. Our revenue related to the administration of a third party facility decreased $0.2 million in the second quarter of 2012 as compared to the second quarter of 2011.

Therapy services

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	Three Months Ended June 30,
	2012					2011					Increase/(Decrease)
	Revenue Dollars			Revenue Percentage		Revenue Dollars			Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	42.2		19.2	%	$	39.7		18.4	%	$	2.5	6.3	%
Intersegment elimination of services related to affiliated entities	(15.8		)	(7.3	)	(16.0		)	(7.4	)	0.2		(1.3	)
Third party therapy services	$	26.4		11.9	%	$	23.7		11.0	%	$	2.7	11.3	%

Of the $2.7 million increase in third party therapy services revenue, $0.7 million was related to the net addition of new third party contracts added since the second quarter of 2011. The remaining balance of the increase resulted primarily from an increase in Medicare Part B growth at third party facilities serviced for all of the three months ended June 30, 2012 and 2011.

Hospice & Home Health services



	Three Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Hospice	$	20.6	9.5	%	$	15.8	7.4	%	$	4.7	30.0	%
Home Health	6.3		2.9		3.0		1.4		3.4		109.5
Total hospice & home health services	$	26.9	12.4	%	$	18.8	8.7	%	$	8.1	42.8	%

Hospice and home health services revenue increased $8.1 million in the second quarter of 2012 as compared to the second quarter of 2011. Hospice revenue increased by $4.7 million, with $1.8 million of the increase coming from hospice businesses operated for all of the three months ended June 30, 2012 and 2011. An increase in average daily census accounted for $1.5 million of the increase, with the remaining $0.3 million increase resulting from a higher weighted average PPD rate. Additionally, there was an increase of $2.9 million due to the acquisition of Cornerstone Hospice ("Cornerstone") in October 2011. For the quarters ended June 30, 2012 and 2011, we recorded hospice Medicare cap expenses of $0.3 million and $0.1 million, respectively, as adjustments to revenue. The increase of $3.4 million at our home health business in the second quarter of 2012 as compared to the second quarter of 2011 was primarily due to the acquisition of Altura Homecare & Rehab in July 2011 ("Altura").

Cost of Services Expenses. Cost of services expenses increased $9.0 million, or 5.2%, to $180.2 million, or 82.9% of revenue, in the three months ended June 30, 2012, from $171.2 million, or 79.5% of revenue, in the three months ended June 30, 2011. The increase in cost of services expense as a percentage of revenue is primarily attributable to the impact of the Medicare rate cut previously discussed.

Long term care services



	Three Months Ended June 30,
	2012				2011				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	$	126.9	81.2	%	$	126.8	76.9	%	$	0.1		0.1	%
Assisted living facilities	4.7		68.8		4.8		70.5		(0.1		)	(0.1	)
Regional operations support	5.0		n/a		6.5		n/a		(1.5		)	(22.6	)
Total long-term care services	$	136.6	83.3	%	$	138.1	80.0	%	$	(1.5	)	(1.0	)%

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Cost of services expenses at our skilled nursing facilities increased $0.1 million in the second quarter of 2012 as compared to the second quarter of 2011. The $0.1 million increase was related to operating costs at facilities acquired or developed prior to January 1, 2011 and resulted from an increase in patient days offset by a 0.4% decrease in operating costs, which dropped to $190.50 PPD in the three months ended June 30, 2012 from $191.34 PPD for the three months ended June 30, 2011. These additional operating costs resulted from a $0.9 million increase in labor costs, which represented an increase of $0.74, or 0.7%, on a PPD basis offset by a decrease of $0.8 million in insurance, bad debt, and other operating expenses. Cost of services expenses at our assisted living facilities decreased $0.1 million in the three months ended June 30, 2012 compared to the three months ended June 30, 2011. Cost of services expenses for our regional operations support decreased $1.5 million in the three months ended June 30, 2012 compared to the three months ended June 30, 2011 primarily due to a decrease in severance expense, headcount reduction, and a decrease in purchased services.

Therapy services



	Three Months Ended June 30,
	2012						`	2011						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	$	42.2	$	38.5	91.2	%		$	39.7	$	34.5	86.9	%	$	4.0	11.5	%
Total therapy services	$	42.2	$	38.5	91.2	%		$	39.7	$	34.5	86.9	%	$	4.0	11.5	%

Rehabilitation therapy costs of services as a percentage of revenue increased in the three months ended June 30, 2012, as compared to the same period in 2011, primarily due to regulatory changes to group therapy discussed below, which has resulted in a requirement for more treatment time by licensed therapists. CMS rulemaking effective for its fiscal year 2012 (which began October 1, 2011) effectively creates a disincentive for providing group therapy treatments in contrast to its policies that promoted such efficiencies in prior fiscal years. CMS also made changes effective October 1, 2011 that require additional therapy time to provide more frequent assessments of the patients we treat. These two factors have negatively impacted the margins of the therapy business. Though these factors have increased our operating costs we have seen improvements in our rehabilitation therapy costs as a percentage of revenue as the result of increased productivity efficiencies gained through using technology to reduce the time therapists must spend on administrative tasks.

Hospice and home health services



	Three Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Cost of Service Dollars		Percentage of Revenue		Cost of Service Dollars		Percentage of Revenue

									Dollars		Percentage
	(dollars in millions)
Hospice	$	15.8	76.6	%	$	11.9	74.9	%	$	3.9	33.0	%
Home Health	5.7		89.5		3.3		109.2		2.4		71.7
Total hospice & home health services	$	21.5	79.7	%	$	15.2	80.4	%	$	6.3	41.5	%

Cost of services expenses related to our hospice business increased $3.9 million in the second quarter of 2012 as compared to the second quarter of 2011. The change was primarily due to an increase of $2.2 million due to the acquisition of Cornerstone and $1.7 million of additional expenses at our existing hospice business. The $1.7 million increase resulted from an increase in operating costs of $5.01 PPD, or 4.2%, to $125.06 PPD in the three months ended June 30, 2012 from $120.05 for the three months ended June 30, 2011. These additional operating costs resulted from a $1.0 million increase in labor costs, which represented an increase of $2.46, or 3.0%, on a PPD basis. Additionally, the increase in operating costs resulted from a $0.9 million increase in supplies, purchased services, and other operating expenses. Cost of services related to our home health

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business increased $2.4 million in the second quarter of 2012 as compared to the second quarter of 2011 primarily due to the acquisition of Altura in July 2011.

Rent cost of revenue. Rent cost of revenue remained consistent at $4.5 million in the three months ended June 30, 2012 and June 30, 2011.

General and Administrative Services Expenses. Our general and administrative services expenses decreased $0.8 million, or 11.2%, to $6.4 million, or 3.0% of revenue, in the three months ended June 30, 2012 from $7.2 million, or 3.4% of revenue, in the three months ended June 30, 2011. The decrease is primarily a result of a decrease in purchased services. In the second quarter of 2011 we incurred costs relating to exploring strategic alternatives.

Depreciation and Amortization. Depreciation and amortization increased by $0.2 million, or 2.5%, to $6.6 million, or 3.0% of revenue, in the three months ended June 30, 2012 from $6.4 million, or 3.0% of revenue, in the three months ended June 30, 2011. 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 2010, Altura acquisition in July 2011, and the Cornerstone acquisition in October 2011. Additionally, there was an increase in depreciation expense from more assets being placed into service during 2011 and 2012, offset by a decrease of intangible amortization.

Interest Expense. Interest expense increased by $0.8 million, or 8.4%, to $10.5 million, or 4.8% of revenue, in the three months ended June 30, 2012 from $9.7 million, or 4.5% of revenue, in the three months ended June 30, 2011. The increase in our interest expense was primarily due to an increase in the average debt outstanding for the three months ended June 30, 2012 to $518.8 million from $500.2 million for the three months ended June 30, 2011. The increase in average debt outstanding was a result of having the senior subordinated notes outstanding for 30 days after we completed the $100.0 million expansion of our term debt as we were required to provide a 30 day redemption notice for the senior subordinated notes. This also resulted in increasing the average rate by 1.5% for the period as the senior subordinated notes had a higher interest rate than our credit facility.

Interest Income. Interest income decreased $0.1 million, to $0.1 million, or 0.1% of revenue in the three months ended June 30, 2012 from $0.2 million, or 0.1% of revenue for the three months ended June 30, 2011.

Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture remained consistent at $0.5 million in the three months ended June 30, 2012 and June 30, 2011.

Debt Retirement Costs. Debt retirement costs of $4.0 million for the three months ended June 30, 2012 was due to the expensing of fees paid in connection with the refinancing and existing deferred financing fees of $3.8 million and original issue discount of $0.2 million both associated with the redemption of the 2014 Notes in May 2012 and the $100 million expansion of our term debt.

Income before provision for income taxes. Income before provision for incomes taxes decreased by $11.0 million to $5.9 million in the three months ended June 30, 2012 from $16.9 million in the three months ended June 30, 2011. The $11.0 million decrease was related primarily to an increased cost of services of $9.0 million, an increase in debt retirement costs of $4.0 million, and an increase in interest expense of $0.8 million offset by a decrease in general and administrative expense of $0.8 million and an increase in revenue of $2.1 million, all discussed above.

Provision for Income Taxes. We recorded a tax expense of $2.4 million, or 40.2% of pre-tax earnings, for the three months ended June 30, 2012, as compared to a tax expense of $6.5 million, or 38.4% of pre-tax earnings, for the three months ended June 30, 2011. The decrease in tax expense was primarily a result of the decrease in pre-tax earnings for the three months ended June 30, 2012, as compared to the three months ended June 30, 2011 which influenced the tax rate for the three months ended June 30, 2012.

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011

Revenue. Revenue decreased by $0.7 million, or 0.2%, to $436.8 million in the six months ended June 30, 2012 from $437.5 million in the six months ended June 30, 2011.

Long term care services

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	Six Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars			Percentage
	(dollars in millions)
Skilled nursing facilities	$	315.2	72.2	%	$	339.9	77.7	%	$	(24.7	)	(7.3	)%
Assisted living facilities	13.8		3.2		13.5		3.1		0.3			2.6
Administration of third party facility	0.6		0.1		0.5		0.1		0.1			3.5
Leased facility revenue	1.5		0.3		0.7		0.2		0.8			104.0
Total long-term care services	$	331.1	75.8	%	$	354.6	81.1	%	$	(23.5	)	(6.6	)%

Skilled nursing facilities revenue decreased $24.7 million in the first six months of 2012 as compared to the first six months of 2011. Revenue decreased $17.7 million for skilled nursing facilities operated for all of the six months ended June 30, 2012 and 2011, primarily as a result of a $19.5 million decrease to a lower weighted average PPD rate, offset by a $1.8 million increase due to higher occupancy rates. We experienced an increase in our ADC and ALOS in our same store skilled nursing facilities in the first six months of 2012 as compared to the first six months of 2011. The decrease in PPD rates was the result of the Medicare rate cut discussed below, a decrease in our skilled mix, and a shift from Medicare days to Managed Medicare days as more seniors elect Medicare Advantage. Additionally, there was an increase of $0.8 million in revenue from our commencement of operations at the Rehabilitation Center of Omaha in April 2011 offset by a decrease of $7.8 million in revenue from the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011. Our average daily Part A Medicare rate decreased 11.0% to $509 in the six months ended June 30, 2012 from $572 in the six months ended June 30, 2011, primarily due to the decrease of our skilled nursing Medicare rates by 11.1%, effective October 1, 2011, which will continue to negatively impact skilled nursing revenues in future periods. Our average daily Medicaid rate increased 2.0% to $157 per day in the six months ended June 30, 2012 from $154 per day in the six months ended June 30, 2011, primarily due to increased Medicaid rates in California, Kansas, Missouri, and Nevada. These increases in Medicaid rates were substantially offset by increases in the provider taxes in those states. As discussed above, we expect moderate weighted average Medicaid rate increases in the second half for 2012. The increase of $0.3 million at our assisted living facilities in the first six months of 2012 as compared to the six months of 2011 was due to the July 2011 acquisition of Vintage Park at San Martin in Las Vegas, Nevada.

Therapy services



	Six Months Ended June 30,
	2012					2011					Increase/(Decrease)
	Revenue Dollars			Revenue Percentage		Revenue Dollars			Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Rehabilitation therapy services	$	84.3		19.2	%	$	79.1		17.7	%	$	5.2	7.1	%
Intersegment elimination of services related to affiliated entities	(31.8		)	(7.3	)	(33.2		)	(7.7	)	1.4		(6.4	)
Third party therapy services	$	52.5		12.1	%	$	45.9		10.5	%	$	6.6	14.4	%

Of the $6.6 million increase, $0.9 million was related to therapy services provided at the five Northern California facilities at which operations were transferred to an independent third party operator in April 2011 and $2.8 million was related to the net addition of new third party contracts added since the second quarter of 2011. The remaining balance of the increase resulted primarily from an increase in Medicare Part B growth at third party facilities operated for all of the six months ended June 30, 2012 and 2011.

Hospice & Home Health services



	Six Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Revenue Dollars		Revenue Percentage		Revenue Dollars		Revenue Percentage		Dollars		Percentage
	(dollars in millions)
Hospice	$	40.3	9.2	%	$	30.2	6.9	%	$	10.2	33.7	%
Home Health	12.8		2.9		6.8		1.5		6.0		89.1
Total hospice & home health services	$	53.1	12.1	%	$	37.0	8.4	%	$	16.2	43.9	%

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Hospice and home health services revenue increased $16.2 million in the first six months of 2012 as compared to the first six months of 2011. Revenue increased $4.2 million for hospice business operated for all of the six months ended June 30, 2012 and 2011, as a result of a $4.4 million increase due to an increase in average daily census, offset by a $0.2 million decrease due to a lower weighted average PPD rate. Additionally, there was an increase of $6.0 million due to the acquisition of Cornerstone. For the first six months ended June 30, 2012 and 2011, we recorded hospice Medicare cap expenses of $0.8 million and $0.1 million, respectively, as adjustments to revenue. Revenue increased $6.0 million at our home health businesses in the six months ended June 30, 2012 as compared to the same period in 2011. Of the $6.0 million increase, $1.6 million was from home health agencies operated for all of both periods, with a $2.6 million increase from an increase in episodes, offset by a $1.0 million decrease in rate per episode. The decrease in rate per episode was due to a patient mix increase of commercial insurance payor versus Medicare payor. The remaining balance of the increase in home health revenue was due to acquisitions.

Cost of Services Expenses. Cost of services expenses increased $16.6 million, or 4.8%, to $363.3 million, or 83.2% of revenue, in the six months ended June 30, 2012, from $346.7 million, or 79.2% of revenue, in the six months ended June 30, 2011. The increase in cost of services expense as a percentage of revenue is primarily attributable to the impact of the Medicare rate cut previously discussed.

Long term care services



	Six Months Ended June 30,
	2012				2011				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	$	256.0	81.2	%	$	261.1	76.8	%	$	(5.1	)	(1.9	)%
Assisted living facilities	9.9		71.4		9.6		71.0		0.4			3.7
Regional operations support	10.6		n/a		12.8		n/a		(2.3		)	(17.7	)
Total long-term care services	$	276.5	83.5	%	$	283.5	79.9	%	$	(7.0	)	(2.5	)%

Cost of services expenses at our skilled nursing facilities decreased $5.1 million in the first six months of 2012 as compared to the first six months of 2011. This decrease was substantially due to a decrease of $7.1 million in expenses resulting from the transfer of operations of five skilled nursing facilities in northern California to an unaffiliated third party operator in April 2011 offset by $0.7 million of additional expenses due to the acquisition of a leasehold interest by the Rehabilitation Center of Omaha in April 2011 and $1.3 million of additional expenses from operating costs increasing at facilities acquired or developed prior to January 1, 2011. The $1.3 million increase resulted from an increase in patient days at our facilities operated for all of both periods offset by a decrease in operating costs of $0.11 PPD, or 0.1%, to $192.13 PPD in the six months ended June 30, 2012 from $192.24 PPD for the six months ended June 30, 2011. These additional operating costs resulted from a $3.0 million increase in labor costs, which represented an increase of $1.67, or 1.5%, on a PPD basis offset by a decrease of $1.7 million in insurance, bad debt, and other operating expenses. Cost of services expenses at our assisted living facilities increased $0.4 million in the six months ended June 30, 2012 compared to the six months ended June 30, 2011. The increase was primarily due to the July 2011 acquisition of Vintage Park at San Martin in Las Vegas, Nevada. Cost of services expenses for our regional operations support decreased $2.3 million in the six months ended June 30, 2012 compared to the six months ended June 30, 2011 primarily due to a decrease in severance expense, a headcount reduction, and a decrease in purchased services.

Therapy services

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	Six Months Ended June 30,
	2012						`	2011						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	$	84.3	$	77.5	91.9	%		$	79.1	$	67.8	85.7	%	$	9.7	14.3	%
Total therapy services	$	84.3	$	77.5	91.9	%		$	79.1	$	67.8	85.7	%	$	9.7	14.3	%

Rehabilitation therapy costs as a percentage of revenue increased in the six months ended June 30, 2012, as compared to the same period in 2011, primarily due to regulatory changes to group therapy, which has resulted in a requirement for more treatment time by licensed therapists. 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 policies that promoted such efficiencies in prior fiscal years. CMS also made changes effective October 1, 2011 that require additional therapy time to provide more frequent assessments of the patients we treat. These two factors will continue to negatively impact the margins of the therapy business in future periods. Though these factors have increased our operating costs we have seen improvements in our rehabilitation therapy costs as a percentage of revenue as the result of increased productivity efficiencies gained through using technology to reduce the time therapists must spend on administrative tasks.

Hospice and home health services



	Six Months Ended June 30,
	2012				2011				Increase/(Decrease)
	Cost of Service Dollars		Percentage of Revenue		Cost of Service Dollars		Percentage of Revenue

									Dollars		Percentage
	(dollars in millions)
Hospice	$	31.4	77.8	%	$	22.8	75.6	%	$	8.6	37.7	%
Home Health	11.1		87.1		6.7		98.4		4.4		67.4
Total hospice & home health services	$	42.5	80.1	%	$	29.5	79.8	%	$	13.0	44.4	%

Cost of services expenses related to our hospice business increased $8.6 million in the first six months of 2012 as compared to the first six months of 2011. The change was primarily due to an increase of $4.4 million due to the acquisition of Cornerstone and $4.2 million of additional expenses at our existing hospice business. The $4.2 million increase resulted from an increase in operating costs of $3.86 PPD, or 3.2%, to $125.13 PPD in the three months ended June 30, 2012 from $121.27 for the six months ended June 30, 2011. These additional operating costs resulted from a $2.8 million increase in labor costs, which represented an increase of $2.09, or 2.5%, on a PPD basis. Additionally, the increase in operating costs resulted from a $1.4 million increase in supplies, purchased services, and other operating expenses. Cost of services related to our home health business increased $4.4 million in the first six months of 2012 as compared to the first six months of 2011 primarily due to the acquisition of Altura in July 2011.

Rent cost of revenue. Rent cost of revenue remained consistent at $9.1 million in the six months ended June 30, 2012 and June 30, 2011.

General and Administrative Services Expenses. Our general and administrative services expenses decreased $1.6 million, or 11.3%, to $12.5 million, or 2.8% of revenue, in the six months ended June 30, 2012 from $14.1 million, or 3.2% of revenue, in the six months ended June 30, 2011. The decrease is primarily a result of a decrease in compensation expense and purchased services. Also, in the first six months of 2011 we incurred costs relating to exploring strategic alternatives.

Depreciation and Amortization. Depreciation and amortization increased by $0.3 million, or 2.3%, to $12.9 million, or 2.9% of revenue, in the six months ended June 30, 2012 from $12.6 million, or 3.0% of revenue, in the six months ended June 30, 2011. This increase is primarily a result of the change in fair value related to the contingent consideration due to the

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Hospice/Home Health acquisition in 2010, Altura acquisition in July 2011, and the Cornerstone acquisition in October 2011. Additionally, there was an increase in depreciation expense from more assets being placed into service during 2011 and 2012, offset by a decrease of intangible amortization.

Interest Expense. Interest expense increased by $0.5 million, or 2.4%, to $20.1 million, or 4.6% of revenue, in the six months ended June 30, 2012 from $19.6 million or 4.5% of revenue, in the six months ended June 30, 2011. The increase in interest expense was primarily due to senior subordinated notes being outstanding for 30 days after we completed the $100.0 million expansion of our term debt as we were required to provide a 30 day redemption notice for the senior subordinated notes which resulted in increasing the average rate for the period as the senior subordinated notes had a higher interest rate than our credit facility. This increase was offset by the decrease in the average debt outstanding for the six months ended June 30, 2012 to $501.2 million from $512.2 million for the six months ended June 30, 2011. The decrease in average debt outstanding was the result of the use of operating cash flows to reduce debt.

Interest Income. Interest income remained consistent at $0.3 million for the six months ended June 30, 2012 and 2011.

Equity in Earnings of Joint Venture. Equity earnings of our pharmacy joint venture decreased $0.1 million, or 13.5%, to $1.0 million for the six months ended June 30, 2012 from $1.1 million in the six months ended June 30, 2011.

Debt Retirement Costs. Debt retirement costs of $4.0 million for the six months ended June 30, 2012 was due to the expensing of fees paid in connection with the refinancing and existing deferred financing fees of $3.8 million and original issue discount of $0.2 million associated with the redemption of the 2014 Notes in May 2012 and the $100 million expansion of our term debt.

Income before provision for income taxes. Income before provision for incomes taxes decreased by $20.3 million to $16.2 million in the six months ended June 30, 2012 from $36.5 million in the six months ended June 30, 2011. The $20.3 million decrease was related primarily to a decrease in revenue of $0.7 million, an increase of $16.6 million in cost of services, an increase in debt retirement costs of $4.0 million and increased interest expense of $0.5 million offset by a decrease in general and administrative services expenses of $1.6 million, all discussed above.

Provision for Income Taxes. We recorded a tax expense of $6.4 million, or 39.4% of pre-tax earnings, for the six months ended June 30, 2012, as compared to a tax expense of $14.5 million, or 39.6% of pre-tax earnings, for the six months ended June 30, 2011. The decrease in tax expense was primarily a result of the decrease in pre-tax earnings for the six months ended June 30, 2012, as compared to the six months ended June 30, 2011.

Liquidity and Capital Resources

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



	Six Months Ended June 30,
	2012			2011
Cash Flows from Continuing Operations
Net cash provided by operating activities	$	14,120		$	45,230
Net cash used in investing activities	(7,100		)	(6,173		)
Net cash used in financing activities	(17,465		)	(28,234		)
Net (decrease) increase in cash and cash equivalents	(10,445		)	10,823
Cash and cash equivalents at beginning of period	16,017			4,192
Cash and cash equivalents at end of period	$	5,572		$	15,015

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 our incurrence or assumption of additional indebtedness. We assess our capital needs on an ongoing basis and may from time to time 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, and participation in Housing and Urban Development ("HUD") or other government loan programs, as considered necessary to fund capital expenditures and potential acquisitions, refinance existing debt, 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.

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011

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At June 30, 2012, we had cash and cash equivalents of $5.6 million. Our available cash is held in accounts at third-party financial institutions. We have periodically invested in AAA-rated 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 used in operating activities in the six months ended June 30, 2012 was $14.1 million, compared to the $45.2 million provided by operating activities in the six months ended June 30, 2011. The change was primarily due to a decrease in net income in 2011 and to a benefit received in the first quarter of 2011 from deferred income tax assets in relation to the legal settlement of $53.5 million for the year ended December 31, 2010. The legal settlement was not distributed from escrow until 2011 and as a result the tax benefit was not realized until 2011.

Net cash used in investing activities in the six months ended June 30, 2012 was $7.1 million, compared to the $6.2 million in the six months ended June 30, 2011. The capital expenditures for the six months ended June 30, 2012 was primarily related to routine capital expenditures.

Net cash used in financing activities in the six months ended June 30, 2012 was $17.5 million, compared to the $28.2 million in the six months ended June 30, 2011. The higher operating cash flows in the first half of 2011 were used to reduce outstanding borrowings on the revolving credit facility

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, capital expenditures and working capital.

We are significantly leveraged. As of June 30, 2012, we had $463.4 million in aggregate indebtedness outstanding, consisting of $413.3 million first lien senior secured term loan (net of the unamortized portion of the original issue discount ("OID") of $3.5 million), $45.5 million principal amount outstanding under our $100.0 million revolving credit facility, and other debt of approximately $4.6 million. Furthermore, we had $3.9 million in outstanding letters of credit against our $100.0 million revolving credit facility, leaving approximately $50.6 million of additional borrowing capacity under our senior secured credit facility as of June 30, 2012. Substantially all of our subsidiaries guarantee 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 our senior secured credit facility. We cannot assure you that the restrictions contained in the senior secure credit facility 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 senior secured term loan and a $100.0 million revolving credit facility ("Prior Credit Agreement") that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. On April 12, 2012, we entered into an Amendment and Restatement and Additional Term Loan Assumption Agreement (“Restated Credit Agreement”) that amended and restated the Prior Credit Agreement and pursuant to which, among other things, the size of our existing senior secured term loan was increased by $100.0 million (hereinafter referred to as the incremental senior secured term loan). The credit arrangements provided under the Amended and Restated Credit Agreement are collectively referred to herein as the senior secured credit facility.

The incremental senior secured term loan bears interest, at our option, at the London Interbank Offered Rate ("LIBOR") (subject to a floor of 1.50%) plus a margin of 5.25% or the prime rate (subject to a floor of 2.50%) plus a margin of 4.25%. As part of the refinancing, the interest rate on the existing senior secured term loan was amended to match the interest rate of the incremental senior secured term loan. The interest rate on the existing revolving credit facility was also amended to be, at our option, LIBOR plus a margin of between 4.50% and 4.25% (based upon consolidated senior leverage) or the prime rate plus a margin of between 3.50% and 3.25% (based upon consolidated senior leverage). There is no longer a LIBOR or prime rate floor with respect to the revolving credit facility. Pursuant to the Restated Credit Agreement, the quarterly term loan amortization payments increased to $2.6 million beginning June 30, 2012, compared to $0.9 million previously under the Prior Credit Agreement. Additionally, the maximum portion of the annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement) to be applied to term debt reductions increased to 75% from 50%, subject to stepdowns to 50% and 25% based on consolidated leverage. We also increased our ability to refinance a portion of our credit facility with Housing and Urban Development (HUD) insured loans up to $250 million, subject to certain credit facility covenants. We have applied for a corporate credit approval from HUD which, if approved, would permit our individual facilities to apply for loans at an interest

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rate that is currently below our senior secured credit facility interest rate. The Restated Credit Agreement requires that all of the net proceeds from any HUD-insured loans be used to pay down the term portion of our senior secured credit facility. In addition, the terms of the Restated Credit Agreement permit us to expense unamortized deferred financing fees in the amount of $2.0 million. Substantially all of our assets are pledged as collateral under the senior secured credit facility. Amounts borrowed under the senior secured term loan may be prepaid at any time without penalty, except for LIBOR breakage costs. Commitments under the revolving credit facility terminate on April 9, 2015. The senior secured term loan matures on April 9, 2016.

We have the right to increase our borrowings under the revolving credit facility up to an aggregate amount of $150 million provided that the 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 agree to increase their commitments. To reduce the risk related to interest rate fluctuations, the Prior Credit Agreement required us to enter into, and the Restated Credit Agreement requires us to continue to maintain, an interest rate swap, cap or similar agreement to effectively fix or cap the interest rate on 40% of our funded long-term debt within three months of the April 2010 commencement of the senior secured credit facility. See Item 3, Quantitative and Qualitative Disclosures About Market Risk, for information about our interest rate swap agreement.

Under the senior secured credit facility, we must maintain compliance with specified financial covenants measured on a quarterly basis. The senior secured credit facility 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 senior secured credit facility, subject to certain exceptions and minimum thresholds, we are required to apply all of the proceeds from any issuance of debt, as much as half of the proceeds from any issuance of equity, as much as 75% of our annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement), and amounts received in connection with any sale of our assets to repay the outstanding amounts under the Restated Credit Agreement. We believe that we were in compliance with our debt covenants as of June 30, 2012. As of June 30, 2012, our fixed charge coverage ratio was 3.0, which compares to a minimum requirement of 1.6 and our leverage ratio was 3.8, as compared to an allowed maximum of 5.0.

Senior Subordinated Notes

On May 12, 2012, the Company redeemed the entire $130.0 million of the 2014 Notes. The proceeds from the incremental senior secured term loan (as well as a draw on the revolving portion of the senior secured credit facility) were used to fund the redemption of the outstanding 2014 Notes at par plus accrued interest. In addition, the Company expensed unamortized deferred financing fees and OID in the amount of $1.9 million in conjunction with the redemption.

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. In addition, we are continuing with the expansion of our Express Recovery™ units. These units cost, on average, between $0.4 million and $0.6 million each. We completed one Express Recovery™ unit in the first six months of 2012. We are in the process of developing one additional Express Recovery™ unit during the remainder of 2012.

We anticipate that we will have capital expenditures in 2012 of approximately $17.0 million to $20.0 million. We will continue to assess our capital spending plans on an ongoing basis.

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 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

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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 June 30, 2012, we had reserved $18.9 million net of $5.2 million in insurance recoveries for known or unknown or potential self-insured general and professional liability claims and $16.7 million for self-insured workers' compensation claims. Of these reserves, we estimate that a total of $10.7 million, consisting of approximately $6.1 million (net of $0.7 million in current insurance recoveries for self-insured general and professional liability claims) and $4.6 million for self-insured workers' compensation claims, 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 additional information on our general and professional liability and workers’ compensation reserve, see "Business — Insurance" in Part 1, Item 1 in our Annual Report on Form 10-K filed with the SEC on February 13, 2012.

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 through 2012 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. If adverse 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 senior secured credit facility, resulting in an adverse effect on our financial condition, including liquidity, capital resources and results of operations.

Recent Accounting Standards

The information required by this item is incorporated herein by reference to Note 3, "Summary of Significant Accounting Policies," to the consolidated financial statements included under Part I, Item 1 of this report.

Off-Balance Sheet Arrangements

We had outstanding letters of credit of $3.9 million under our $100.0 million revolving credit facility as of June 30, 2012.

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, which will make our interest payments and funding our other fixed costs more expensive, 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

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Our first lien credit agreement exposes us to variability in interest payments due to changes in interest rates. We entered into 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 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 (dollars in thousands):



	Twelve Months Ending June 30, ⁽¹⁾
	2013			2014			2015			2016			2017			Thereafter			Total		Fair Value
Fixed-rate debt	$	1,438		$	734		$	1.653		$	185		$	197		$	318		$	4,526	$	4,526
Average interest rate	4.4		%	5.6		%	6.0		%	6.0		%	6.0		%	6.0		%
Variable-rate debt	$	10,487		$	10,487		$	55,987		$ 381,890⁽²⁾			$	—		$	—		$	458,851	$	441,501
Average interest rate⁽¹⁾	6.8		%	6.8		%	5.2		%	5.3		%


(1)	Based on implied forward three-month LIBOR rates in the yield curve as of June 30, 2012.


(2)	Excludes unamortized original issue discount of $3.5 million on our first lien senior secured term loan debt.

For the six months ended June 30, 2012, 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 June 30, 2012, there was $0.6 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 June 30, 2012 (dollars in thousands):



Loan	Transaction Type	Notional Amount		Trade Date	Effective Date	Maturity/ Termination Date	Six months ended June 30, 2012			Fair Value (Pre-tax)
First Lien	swap	$	70,000	6/30/2010	1/1/2012	6/30/2013	$	(279	)	$	(559	)
							$	(279	)	$	(559	)

The fair value of interest rate hedge agreements designated as hedging instruments against the variability of cash flows associated with floating-rate, long-term debt obligations are reported in accumulated other comprehensive income. These amounts subsequently are reclassified into interest expense as a yield adjustment in the same period in which the related interest on the floating-rate debt obligation affects earnings. We evaluate the effectiveness of the cash flow hedge, in accordance with FASB ASC Topic 815, Derivatives and Hedging, on a quarterly basis. Should the hedge become ineffective, the change in fair value would be recognized in our consolidated statements of operations. Should the counterparty’s credit rating deteriorate to the point at which it would be likely that the counterparty would default, the hedge would then be ineffective.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

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

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

We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief

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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 7, "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 without limitation claims that our services have resulted in injury or death to patients who receive care from our businesses, as well as 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. Statements that use words such "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 and expectations 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 34.4% of our consolidated revenue during the six months ended June 30, 2012 and 37.4% in the fiscal year of 2011. 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 for the services we provide. 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. For example, CMS implemented a net 11.1% reduction in its reimbursement rates to skilled nursing facilities effective October 1, 2011. Based on current federal law, an automatic 2% reduction in Medicare spending will be imposed beginning in 2013

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unless Congress takes further action to stay the automatic reduction or authorize spending increases. 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 revenue, 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 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 29.8% and 29.2% of our consolidated revenue for the six months ended June 30, 2012 and in fiscal year 2011, respectively. 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, our business and results of operations could be materially and adversely affected.

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 or repayment.

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 their third-party 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 not be medically necessary. Significant adjustments, recoupments or repayments of our Medicare or Medicaid revenue, and the costs associated with complying with investigative audits by regulatory and governmental authorities, could adversely affect our financial condition and results of operations.

Additionally, from time to time we become aware, either based on information provided by third parties and/or the results of internal audits, of payments from payor sources that were either wholly or partially in excess of the amount that we should have been paid for the service provided. For example, as discussed in Note 2 - "Correction of Previously Issued Consolidated Financial Statements," to our Consolidated Financial Statements included in this report, in 2012 we became aware of a

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significant amount of reimbursements for blood glucose testing billed by a number of our skilled nursing subsidiaries from 2007 through early 2012, which those subsidiaries determined to refund. Overpayments may result from a variety of factors, including insufficient documentation supporting the services rendered or medical necessity of the services, other failures to document the satisfaction of the necessary conditions of payment, or in some cases for providing services that are deemed to be worthless. We are required by law in most instances to refund the full amount of the overpayment after becoming aware of it, and failure to do so within requisite time limits imposed by the law could lead to significant fines and penalties being imposed on us. Furthermore, our initial billing of and payments for services that are unsupported by the requisite documentation and satisfaction of any other conditions of payment, regardless of our awareness of the failure at the time of the billing or payment, could expose us to significant fines and penalties, including pursuant to the Federal False Claims Act ("FFCA") and the Federal Civil Monetary Penalties Law ("FCMPL"). Violations of the FFCA could lead to any combination of a variety of criminal, civil and administrative fines and penalties. The FFCA provides for civil fines ranging from $5,500 to $11,000 per claim plus treble damages. The Civil Monetary Penalties Law similarly provides for civil monetary penalties of up to $10,000 per claim plus up to treble damages. We and/or certain of our operating companies could also be subject to exclusion from participation in the Medicare or Medicaid programs in some circumstances as well, in addition to any monetary or other fines, penalties or sanctions that we may incur under applicable federal and/or state law. Our repayment of any such amounts, as well as any fines, penalties or other sanctions that we may incur, could be significant and could have a material and adverse effect on our results of operations and financial condition.

From time to time we are also involved in various external governmental investigations, audits and reviews. Reviews, audits and investigations of this sort can lead to government actions, which can result in the assessment of damages, civil or criminal fines or penalties, or other sanctions, including restrictions or changes in the way we conduct business, loss of licensure or exclusion from participation in government programs. For example, the Office of the Inspector General (“OIG”) conducts a variety of routine, regular and special investigations, audits and reviews across our industry. Failure to comply with applicable laws, regulations and rules could have a material and adverse effect on our results of operations and financial condition.

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 ("PPACA") was enacted in 2010 and is among the most comprehensive and notable of these legislative efforts. The impact of PPACA remains uncertain to a large degree due to various implementation, timing, cost and regulatory requirements imposed by the legislation. The content or timing of any future health reform legislation, and its impact on us is impossible to predict. However, it is likely that certain provisions in the Patient Protection and Affordable Care act will impose significant costs on us, including with respect to the health insurance options that we provide our employees, that will negatively affect our operations. 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.

Annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary may negatively affect our results of operations.

Some of our rehabilitation therapy revenue is paid by the Medicare Part B program under a fee schedule. There are annual caps that limit, subject to certain exceptions, the amounts that can be paid (including deductible and coinsurance amounts) for rehabilitation therapy services rendered to any Medicare beneficiary under Medicare Part B. There is a combined cap for physical therapy and speech-language pathology and a separate cap for occupational therapy that apply subject to certain exceptions. The discontinuation or change in the current cap exception process or future modifications of the Part B cap structure could have an adverse effect on the revenue that we generate through our rehabilitation therapy business. This could in turn have a negative effect on our 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 hospice programs during this period are compared to the cap amount for the relevant period. Payments in excess of the cap are

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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 our individual hospice agencies 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).

Our hospice program exceeded the Medicare cap limit in 2009 by $2.1 million. In 2011 and 2010 certain of our hospice programs exceeded the Medicare cap limit but the majority of the amounts by which the hospice programs exceeded the cap were indemnified by the entities from which we purchased the hospice programs. For the six months ended June 30, 2012, we recorded hospice Medicare cap expense of $0.8 million, as an adjustment to revenue. 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 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 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, mandatory staffing levels, regulations regarding conditions for payment 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

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California as it currently does. Nevertheless, the PT Board could seek an enforcement action against our rehabilitation therapy subsidiary and its physical therapist employees and we may have to significantly restructure 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, including skilled nursing facilities, home health agencies and hospice agencies. 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 or other businesses 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. We also periodically conduct internal audits and reviews of our regulatory compliance. 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;


•	self-disclosure of violations to applicable regulatory authorities;


•	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 a variety of factors, including the 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 Note 7, "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 FFCA 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

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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 fiscal year 2011, we received approximately 40.8% of our consolidated revenue from operations in California and 21.4% from Texas, and in the six months ended June 30, 2012, we received approximately 40.5% of our consolidated revenue from operations in California and 20.6% from Texas. We expect to continue to receive significant portions of our consolidated revenue from those states in the future as well. Accordingly, economic conditions and changes in state healthcare spending prevailing in either of these markets or other markets in which we have significant concentrations 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. Due to the economic downturn in California and the state's budget deficit, the California budget that passed in July 2011 included a Medicaid payment reduction effective April 2012. The payments are to be restored retroactively to April 2012 and to be reimbursed sometime prior to the end of 2012, but in the meantime will contribute to a reduction in cash flows from operations in California. We estimate the amount to be approximately $2.8 million.

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

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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 increase 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.

The tight labor market and high demand for such employees contributes to 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 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 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 continue 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 significant monetary fines. DPH has issued guidelines, implementing the provisions of newly enacted California laws, for state audits that verify compliance with the 3.2 nursing hours 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, a significant administrative monetary penalty 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 a larger administrative monetary penalty 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 across our business line 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 Note 7, "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 a tight labor market for these employees in many of the markets in which we operate. Furthermore, if states do not appropriate additional funds (through Medicaid program appropriations or otherwise) sufficient to pay for any

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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 industry is 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. We anticipate additional competition in the future from accountable care organizations, as well as HMO's and similar healthcare systems that seek to provide a wider variety of healthcare services to their patients/members. 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 competitors in the local market, the types of services available, our local reputation for quality care of patients, achieve or maintain desired census levels, 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 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 believe we 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 our assisted living, rehabilitation therapy, hospice and home health care 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.

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

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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. In some instances, our referral sources are affiliated with health care systems that may have affiliated businesses that offer services that compete with ours, and the frequency of this occurring may increase in the future as accountable care organizations are formed in the markets we serve. 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 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.

We may not be fully reimbursed for all services that our skilled nursing facilities are able to bill through Medicare's consolidated billing requirements.

Skilled nursing facilities are required to bill Medicare on a consolidated basis for certain items and services that they furnish to patients and residents, regardless of the amount or costs of services that the patients and residents actually receive. The consolidated billing requirement essentially confers on the skilled nursing facility itself the Medicare billing responsibility for the entire package of care that its residents receive in these situations. Federal law also requires that post-hospitalization skilled nursing services be “bundled” into the hospital's Diagnostic Related Group (DRG) payment in certain circumstances. Where this rule applies, the hospital and the skilled nursing facility must, in effect, divide the payment which otherwise would have been paid to the hospital alone for the patient's treatment, and no additional funds are paid by Medicare for skilled nursing care of the patient. This requirement may, in instances where it is applicable, have a negative effect on skilled nursing facility utilization/census and payments, either because hospitals may find it difficult to place patients in skilled nursing facilities which will not be paid as they previously were, or because hospitals are reluctant to discharge patients to skilled nursing facilities and lose a portion of the payment that the hospital would otherwise receive. This bundling requirement could be extended to more DRGs in the future, which could accentuate the potentially negative impact on skilled nursing facility utilization/census and payments. As a result of the bundling requirements we may not be fully reimbursed for all services that a facility bills through consolidated billing, which could adversely affect our results of operations and financial condition.

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 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

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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, home health companies, hospice agencies 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 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 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 2012 and possibly beyond. Ongoing concerns about the systemic impact of potential long-term and widespread economic recession or stagnation, energy costs, geopolitical issues, sovereign debt 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 prices for energy, food and other commodities, 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

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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 we are not able to timely retire or refinance our senior secured credit facility on acceptable terms at or before its stated maturity in April 2015 (for the revolving portion) and April 2016 (for the term portion), due to market conditions or otherwise, our liquidity, financial condition, business and operating results could be materially and adversely affected.

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 our senior secured credit facility. There can be no assurance that the restrictions contained in our senior secured credit facility 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 June 30, 2012, our total indebtedness was approximately $463.4 million. Our substantial indebtedness could have important consequences. 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 senior secured credit facility or other existing or future indebtedness, we would be in default, which could permit the holders of our indebtedness, including our senior secured credit facility, to accelerate the maturity of indebtedness, as the case may be. Any default under 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 our senior secured credit facility contain 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 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 June 30, 2012, $343.4 million of borrowings under our senior secured credit facility is not hedged and is currently subject to floating rates of interest. As of April 12, 2012, we increased the size of the term loan by $100.0 million. The incremental term loan bears interest at LIBOR (subject to a floor

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of 1.50%) plus a margin of 5.25%. As part of the refinancing, the interest rate on the existing term loan was amended to match the interest rate of the incremental term loan. The interest rate on the existing revolving credit facility was also amended to LIBOR plus a margin of 4.50%. There is no longer a LIBOR floor on the revolving credit facility.

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 is unionized and our operations may be adversely affected by work stoppages, strikes or other collective actions.

As of June 30, 2012, approximately 650 of our 14,950 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 were accused of not properly caring for their residents, which 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 and employees. 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 operation of our business is dependent on effective and secure information systems.

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.

Additionally, we maintain information necessary to conduct our business, including confidential and proprietary information as well as personal information regarding our patients, employees and others with whom we do business, in digital form. Data maintained in digital form is subject to the risk of tampering, theft and unauthorized access. We develop and maintain systems to prevent this from occurring, but the development and maintenance of these systems is costly and requires ongoing monitoring and updating as technologies change and efforts to overcome security measures become more sophisticated. Moreover, despite our efforts, the possibility of tampering, theft and other unauthorized access cannot be eliminated entirely, and risks associated with each of these remain. If our information technology systems are compromised and personal or other protected information regarding patients, employees or others with whom we do business is stolen, tampered with or otherwise improperly accessed, our ability to conduct our business and our reputation may be impaired. If personal or other protected information of our patients, employees or others with whom we do business is tampered with, stolen or

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otherwise improperly accessed, and we may incur significant costs to remediate possible injury to the affected persons, compensate the affected persons, pay any applicable fines, or take other action with respect to judicial or regulatory actions arising out of the incident, including under HIPAA or the Hi-Tech Act, as applicable.

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 voted on by our stockholders. As of June 30, 2012, 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;


•	investor perceptions of us and our business;


•	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 business;


•	litigation and governmental investigations;


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


•	adverse conditions in the financial markets, state and federal government or general economic conditions, including those resulting from statewide, national or global financial and deficit considerations, overall market conditions, war, incidents of terrorism and responses to such events;


•	sales of Class B common stock by Onex, 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 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.

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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 control a majority of the voting power of our outstanding common stock. 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 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 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;

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•	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

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

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 June 30, 2012:



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
April 1 - 30, 2012	—	$	—	n/a	n/a
May 1 - 31, 2012	1,792	$	7.05	n/a	n/a
June 1 - 30, 2012	—	$	—	n/a	n/a
Total:	1,792	$	7.05	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 June 30, 2012.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

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Item 6. Exhibits


(a)	Exhibits.




Number			Description

10.1			Amendment and Restatement and Additional Term Loan Assumption Agreement, dated as of April 12, 2012, among us, the subsidiary guarantors listed on the signature pages thereto, the lenders listed on the signature pages thereto, Credit Suisse AG, as administrative agent for the lenders and as collateral agent for the lenders, and J.P. Morgan Securities LLC and Credit Suisse Securities (USA) LLC, as amendment arrangers, which amended and restated in its entirety the Original Credit Agreement, as set forth in the Fourth Amended and Restated Credit Agreement in Exhibit A to such Amendment and Restatement and Additional Term Loan Assumption Agreement (incorporated herein by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on April 18, 2012).

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.

101*			The following financial information from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, as filed with the SEC on August 8, 2012, formatted in Extensible Business Reporting Language (XBRL): (i) the condensed consolidated balance sheets at June 30, 2012 and December 31, 2011, and (ii) the condensed consolidated statements of operations for the three and six months ended June 30, 2012 and March 31, 2011, and (iii) the condensed consolidated statements of comprehensive income for the three months ended March 31, 2012 and June 30, 2011, and (iv) the condensed consolidated statements of cash flows the six months ended June 30, 2012 and June 30, 2011, and (v) the Notes to Condensed Consolidated Financial Statements.

* 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:	August 8, 2012	/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

10.1			Amendment and Restatement and Additional Term Loan Assumption Agreement, dated as of April 12, 2012, among us, the subsidiary guarantors listed on the signature pages thereto, the lenders listed on the signature pages thereto, Credit Suisse AG, as administrative agent for the lenders and as collateral agent for the lenders, and J.P. Morgan Securities LLC and Credit Suisse Securities (USA) LLC, as amendment arrangers, which amended and restated in its entirety the Original Credit Agreement, as set forth in the Fourth Amended and Restated Credit Agreement in Exhibit A to such Amendment and Restatement and Additional Term Loan Assumption Agreement (incorporated herein by reference to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on April 18, 2012).
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.
101*			The following financial information from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, as filed with the SEC on August 8, 2012, formatted in Extensible Business Reporting Language (XBRL): (i) the condensed consolidated balance sheets at June 30, 2012 and December 31, 2011, and (ii) the condensed consolidated statements of operations for the three and six months ended June 30, 2012 and March 31, 2011, and (iii) the condensed consolidated statements of comprehensive income for the three months ended March 31, 2012 and June 30, 2011, and (iv) the condensed consolidated statements of cash flows the six months ended June 30, 2012 and June 30, 2011, and (v) the Notes to Condensed Consolidated Financial Statements.

* Filed herewith.

** Furnished herewith.