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10-Q 1 d226472d10q.htm FORM 10-Q Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011.

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File Number 333-133319

LIFECARE HOLDINGS, INC.

(Exact name of registrant as specified in its charter)


Delaware		51-0372090
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

5560 Tennyson Parkway Plano, Texas		75024
(Address of Principal Executive Offices)		(Zip Code)

(469) 241-2100

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changes since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x 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. Please see definition of “accelerated and large accelerated filer” in Rule 12b-2 of the Exchange Act.

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

As of November 11, 2011, the registrant had 100 shares of Common Stock, par value $0.01 per share, outstanding.

LIFECARE HOLDINGS, INC.

TABLE OF CONTENTS


PART I: FINANCIAL INFORMATION

ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS	3
	CONDENSED CONSOLIDATED BALANCE SHEETS	3
	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	4
	CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDER’S DEFICIT	5
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	6
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	7
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	34
ITEM 4.	CONTROLS AND PROCEDURES	34

PART II: OTHER INFORMATION		35

ITEM 1.	LEGAL PROCEEDINGS	35
ITEM 1A.	RISK FACTORS	35
ITEM 6.	EXHIBITS	35
SIGNATURES		36

PART 1: FINANCIAL INFORMATION

ITEM 1:

CONSOLIDATED FINANCIAL STATEMENTS

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

September 30, 2011 and December 31, 2010

(In thousands, except share data)

(unaudited)


	September 30, 2011			December 31, 2010
Assets
Current assets:
Cash and cash equivalents	$	21,560		$	54,570
Accounts receivable, net of allowance for doubtful accounts of $9,771 and $11,293, respectively		75,539			67,275
Other current assets		8,659			5,975

Total current assets		105,758			127,820
Property and equipment, net		77,909			76,832
Other assets, net		26,345			8,763
Identifiable intangibles, net		37,429			15,440
Goodwill		255,671			248,342

	$	503,112		$	477,197


Liabilities and Stockholder’s Deficit
Current liabilities:
Current installments of long-term debt	$	3,047		$	1,931
Current installments of obligations under capital leases		620			838
Current installment of lease financing obligation		509			480
Estimated third party payor settlements		9,364			4,318
Accounts payable		28,069			25,452
Accrued payroll		4,112			6,480
Accrued vacation		6,996			4,658
Accrued interest		10,107			6,377
Accrued other		5,766			4,321
Income taxes payable		473			282

Total current liabilities		69,063			55,137
Long-term debt, excluding current installments		426,064			393,981
Obligations under capital leases, excluding current installments		37			425
Lease financing obligation, excluding current installments		19,172			19,558
Accrued insurance		4,824			4,032
Other noncurrent liabilities		16,983			15,544

Total liabilities		536,143			488,677

Commitments and contingencies
Stockholder’s deficit:
Common stock, $0.01 par value, 100 shares authorized, issued and outstanding		—			—
Additional paid-in capital		175,441			175,441
Accumulated deficit		(208,472	)		(186,921	)

Total stockholder’s deficit		(33,031	)		(11,480	)

	$	503,112		$	477,197

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

For the three and nine months ended September 30, 2011 and 2010

(In thousands)

(Unaudited)


	Three Months						Nine Months
	2011			2010			2011			2010
Net patient service revenue	$	102,599		$	85,532		$	293,510		$	271,126

Salaries, wages and benefits		50,526			41,291			139,941			125,461
Supplies		10,540			8,708			29,354			27,260
Rent		8,685			6,498			21,878			19,419
Other operating expenses		26,446			19,558			69,388			60,700
Provision for doubtful accounts		1,781			1,765			4,367			5,183
Loss on early extinguishment of debt		—			—			2,772			—
Depreciation and amortization		2,354			2,376			6,528			7,461
Interest expense, net		15,571			7,184			40,845			21,277

Total expenses		115,903			87,380			315,073			266,761

Operating income (loss)		(13,304	)		(1,848	)		(21,563	)		4,365
Equity in income of joint venture		85			243			562			653

Income (loss) before income taxes		(13,219	)		(1,605	)		(21,001	)		5,018
Provision for income taxes		100			92			550			492

Net income (loss)	$	(13,319	)	$	(1,697	)	$	(21,551	)	$	4,526

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholder’s Deficit

For the nine months ended September 30, 2011

(In thousands)

(Unaudited)


	Common Stock		Additional Paid-in Capital		Accumulated Deficit			Total Stockholder’s Deficit
Balance, December 31, 2010	$	—	$	175,441	$	(186,921	)	$	(11,480	)
Net loss		—		—		(21,551	)		(21,551	)

Balance, September 30, 2011	$	—	$	175,441	$	(208,472	)	$	(33,031	)

See accompanying notes to condensed consolidated financial statements.

LIFECARE HOLDINGS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

For the nine months ended September 30, 2011 and 2010

(In thousands)

(Unaudited)


	2011			2010
Cash flows from operating activities:
Net income (loss)	$	(21,551	)	$	4,526
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization (including amortization of debt issuance cost)		11,879			9,199
Provision for doubtful accounts		4,367			5,183
Paid in kind interest		6,517			—
Equity compensation amortization		—			196
Loss on early extinguishment of debt		2,772			—
Equity in income of joint venture		(562	)		(653	)
Changes in operating assets and liabilities:
Accounts receivable		(12,631	)		2,990
Income taxes		191			(194	)
Other current assets		(1,283	)		(921	)
Other assets		(2,835	)		460
Estimated third party payor settlements		5,046			(6,536	)
Accounts payable and accrued expenses		5,934			(9,349	)
Other noncurrent liabilities		2,231			3,895

Net cash provided by operating activities		75			8,796

Cash flows from investing activities:
Purchases of property and equipment		(3,165	)		(2,626	)
Payments for acquisition		(33,262	)		—

Net cash used in investing activities		(36,427	)		(2,626	)

Cash flows from financing activities:
Deferred financing cost		(22,291	)		—
Payments under the line of credit		(35,000	)		—
Proceeds from long-term debt		304,700			—
Payments of long-term debt		(243,018	)		(1,913	)
Payments on obligations under capital leases		(693	)		(857	)
Payments on lease financing obligation		(356	)		(329	)

Net cash provided by (used in) financing activities		3,342			(3,099	)

Net increase (decrease) in cash and cash equivalents		(33,010	)		3,071
Cash and cash equivalents, beginning of period		54,570			46,681

Cash and cash equivalents, end of period	$	21,560		$	49,752

Supplemental disclosure of cash flow information:
Cash:
Interest paid	$	31,932		$	22,492
Net income taxes paid		359			687
Noncash:
Equipment purchased through capital lease financing		86			599

See accompanying notes to condensed consolidated financial statements.

LifeCare Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

(1) Basis of Presentation

LifeCare Holdings, Inc. (the “Company”) is a wholly owned subsidiary of LCI Holdco, LLC (“Holdco”). Holdco is a wholly owned subsidiary of LCI Intermediate Holdco, Inc. (“Intermediate Holdco”). Intermediate Holdco is a wholly owned subsidiary of LCI Holding Company, Inc. (“Holdings”), which is owned by an investor group that includes affiliates of The Carlyle Group and members of our senior management and board of directors. The investor group acquired Holdings pursuant to a merger that occurred on August 11, 2005 (the “Merger”).

The accompanying unaudited condensed consolidated financial statements and financial information have been prepared in accordance with generally accepted accounting principles, and reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of the results of the interim periods. The accompanying financial statements for the three and nine month periods ended September 30, 2011 and 2010 are not necessarily indicative of annualized financial results.

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated audited financial statements and notes thereto for the year ended December 31, 2010 included in the Form 10-K we filed on March 30, 2011 with the Securities and Exchange Commission. Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by the rules and regulations of the Securities and Exchange Commission, although we believe the disclosure is adequate to make the information presented not misleading.

(2) Liquidity and Uncertainties Related to Going Concern

As of September 30, 2011, we had $429.1 million of long-term debt outstanding consisting of our $30.0 million senior secured revolving credit facility, which matures on February 1, 2015, of which there is no outstanding balance, our senior secured term loan credit facility in an outstanding principal amount of $309.8 million, which matures on February 1, 2016, and our senior subordinated notes in an outstanding principal amount of $119.3 million, which matures on August 11, 2013. Although we are highly leveraged, we believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under our senior secured revolving credit facility will be sufficient to finance our operations and meet our scheduled debt service requirements for at least the next twelve months, absent certain actions of lenders in the case of an event of default under our senior secured credit facility as discussed below.

We are required to comply on a quarterly basis with certain financial and other covenants under our senior secured credit facility, including a minimum consolidated EBITDA requirement through the end of the third fiscal quarter of 2011, and a consolidated cash interest expense coverage ratio test and a maximum senior secured leverage ratio test which will be tested quarterly beginning on the last day of the fourth quarter of 2011. We are currently in compliance with the covenants under our senior secured credit facility for the quarterly period ended September 30, 2011.

These financial covenants, however, become more restrictive beginning with the requirements for the interest coverage ratio and senior secured leverage ratio tests during the fourth quarter of 2011, followed by reductions in the maximum senior secured leverage ratio beginning with the quarterly period ending June 30, 2012, as more fully discussed in note 6.

We may not be able to continue to satisfy the covenant requirements in subsequent periods. In the event we are unable to comply with the covenants under our senior secured credit facility, an event of default may occur. If we are unable to obtain waivers or amendments to cure such event of default, the lenders would be entitled to take various actions, including the acceleration of amounts due under our senior secured credit facility, terminating our access to our revolving credit facility and all actions permitted to be taken by a secured creditor. Acceleration under our senior secured credit facility would further create a cross-default under our senior subordinated notes indenture. Such acceleration would have a material adverse effect on our financial position, results of operations and cash flow and raise substantial doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements and related notes have been prepared assuming we will continue as a going concern and do not include any adjustments to reflect the possible future effects on the recoverability of assets or the amount of liabilities that may result should we be unable to continue as a going concern.

We are continuing to pursue operational and strategic objectives that may result in profitability and lower total indebtedness in order to remain in compliance with the financial covenants under our senior secured credit facility. These objectives include, among other items, increasing the occupancy levels of our hospitals, reducing administrative and operating expenses, and reducing days of net patient service revenue in accounts receivable. We also continue to seek opportunities to refinance our senior subordinated notes and explore various strategic transactions, such as an acquisition, as a means to reduce our leverage and strengthen our operating and financial conditions.

There can be no assurance, however, that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, achieve profitability or be able to successfully execute strategic transactions. In that case, we may be required to consider all of our alternatives in restructuring our business and our capital structure.

(3) Summary of Significant Accounting Policies

Use of Estimates

The preparation of the financial statements requires us to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the 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. Actual amounts could differ from those estimates.

Goodwill

We review our goodwill annually, or more frequently if circumstances warrant a more timely review, to determine if there has been an impairment. We review goodwill based upon one reporting unit, as our company is managed as one operating segment. In calculating the fair value of the reporting unit, we use various assumptions including estimated cash flows and discount rates. If estimated future cash flows decline from the current amounts projected by management, an impairment charge may be recorded.

Income Taxes

For the nine months ended September 30, 2011, income tax expense recorded represents the estimated income tax liability for certain state income taxes. We believe that it is more likely than not that no benefit or expense will be realized during 2011 for federal income taxes based on estimated federal taxable losses for 2011. We anticipate that federal net operating losses generated during 2011 will be offset by an increase in the valuation allowance against net deferred tax assets.

We follow the threshold of more-likely-than-not for recognition of tax benefits of uncertain tax positions taken or expected to be taken in a tax return. We record accrued interest and penalties associated with uncertain tax positions, if any, as income tax expense in the condensed consolidated statement of operations.

The federal statute of limitations remains open for original tax returns filed for 2007 through 2010. State jurisdictions generally have statutes of limitations ranging from three to five years. The state income tax impact of federal income tax changes remains subject to examination by various states for a period up to one year after formal notification to the states.

Stock Compensation

We estimate the fair value of our equity-based compensation awards on the date of grant, or the date of award modification if applicable, using the Black-Scholes option pricing model. The weighted average fair value of options granted during the nine months ended September 30, 2011 was determined to be nominal and was calculated based on the following assumptions: expected volatility of 40%, expected dividend yield of 0%, expected life of 6.25 years, and a risk-free interest rate of 3.00%. Expected volatility was derived using data drawn from other healthcare public companies for five to seven years prior to the date of grant. The expected life was computed utilizing the simplified method as permitted by the Securities and Exchange Commission’s Staff Accounting Bulletin No. 110, Share-Based Payment. The expected forfeiture rate is 50% and is based upon a review of our recent history and expectations. The risk-free interest rate is based on the approximate yield on seven-year United States Treasury Bonds as of the date of grant. There were 450,000 options granted during the nine months ended September 30, 2011 (see note 7).

Recent Accounting Pronouncements

In July 2011, the Financial Accounting Standards Board issued authoritative guidance for health care entities that recognize significant amounts of patient service revenue at the time the services are rendered even though they do not assess the patient’s ability to pay. These health care entities are required to present the provision for bad debts related to patient service revenue as a deduction from patient service revenue (net of contractual allowances and discounts) on their statement of operations. Additionally, those health care entities are required to provide enhanced disclosure about their policies for recognizing revenue and assessing bad debts. The amendments also require disclosures of patient service revenue (net of contractual allowances and discounts) as well as qualitative and quantitative information about changes in the allowance for doubtful accounts. The guidance is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our business, financial position, results of operations or liquidity.

In September 2011, the Financial Accounting Standards Board issued authoritative guidance that simplifies the goodwill impairment assessment by allowing a company to first review qualitative factors to determine the likelihood of whether the fair value of a reporting unit is less than its carrying amount before applying the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, the company would not be required to perform the two-step goodwill impairment test for that reporting unit. This update is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011 with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our business, financial position, results of operations or liquidity.

Reclassifications

Certain reclassifications have been made to the consolidated financial statements for prior periods to conform to the presentation of the 2011 condensed consolidated financial statements. Such reclassifications had no impact on net income or stockholder’s deficit.

(4) Net Patient Service Revenue

We recognize in our consolidated financial statements the impact of adjustments, if any, to Medicare reimbursement when the amounts can be reasonably determined. Net revenues for the three and nine months ended September 30, 2011 included decreases of $0.2 million and $0.2 million, respectively, related to changes in estimates and settlements on prior year cost reports filed with the Medicare program, compared to an increase of $0.4 million and a decrease of $0.3 million for the three and nine months ended September 30, 2010, respectively. Approximately 59.9% and 59.3% of our total net patient service revenue for the nine months ended September 30, 2011 and 2010, respectively, came from Medicare reimbursement.

(5) Goodwill and Impairment Charges

The Merger agreement provided for additional purchase price considerations that were contingent upon the resolution of certain specific issues. During the nine months ended September 30, 2010, goodwill was increased by $3.0 million due to distributions to the prior stockholders of our company from one of the escrow accounts, as the result of the resolution of a specific matter.

See discussion of the increase to goodwill during the nine months ended September 30, 2011 in note 11.

(6) Long-Term Debt

Long-term debt consists of the following (in thousands):


	September 30, 2011			December 31, 2010
Current senior secured credit facility—term loan	$	309,812		$	—
Previous senior secured credit facility—term loan		—			241,613
9 ¹/4% senior subordinated notes		119,299			119,299
Revolving credit facility		—			35,000

Total long-term debt		429,111			395,912
Current installments of long-term debt		(3,047	)		(1,931	)

Long-term debt, excluding current installments	$	426,064		$	393,981

New Senior Secured Credit Facility

As a result of the impending maturities and increasingly more restrictive covenant requirements under our previous senior secured credit facility, we entered into a new senior secured credit facility on February 1, 2011, that consisted of (a) an initial $257.5 million senior secured term loan (subject to paid in kind interest options as discussed below) and (b) a senior secured revolving credit facility providing for borrowings of up to $30.0 million (the “Credit Agreement”). Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit, which were $3.5 million as of September 30, 2011. The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our previous senior secured credit facility, revolving credit facility and the fees and expenses associated with the new Credit Agreement.

The terms of the Credit Agreement also provide that we have the right to request additional term loan commitments of up to $50.0 million. See note 11 discussing the utilization of this right.

Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. At September 30, 2011 and December 31, 2010, the weighted average interest rate applicable to the outstanding amounts under our term loan facility was 13.50% and 4.54%, respectively.

The applicable margin percentage is 6.75% for revolving loans that are alternate base loans and 7.75% for revolving loans that are based on the LIBOR rate, subject to quarterly adjustments based on our leverage ratio (as defined in the new senior secured credit agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay a commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.

We are required to make scheduled quarterly payments under the senior secured term loan facility equal to 0.25% of the original principal amount of the term loan and the additional principal amount borrowed on August 1, 2011, with the balance payable on February 1, 2016. Additionally, we are required to prepay outstanding term loans under this agreement with (a) 100% of the net cash proceeds of any debt or equity issued by us or our restricted subsidiaries (with exceptions for certain debt permitted to be incurred or equity permitted to be issued under the agreement), (b) commencing with the year ending December 31, 2011, 75% (which percentage will be reduced to 50% if our senior secured leverage ratio (as defined in the Credit Agreement) is less than 4:00 to 1:00) of our annual excess cash flow (as defined in the Credit Agreement), and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us or our restricted subsidiaries, subject to reinvestment rights and certain other exceptions specified in the Credit Agreement. Mandatory prepayments of the term loans, subject to certain exceptions, are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such repayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014.

We may voluntarily prepay outstanding loans under the term loan facility and reduce the unutilized portion of the commitment amount in respect of the senior secured revolving credit facility at any time. Any such voluntary prepayments are subject to a prepayment fee of 3% if such prepayment occurs on or prior to February 1, 2012, 2% if such prepayment occurs after February 1, 2012 and on or prior to February 1, 2013, and 1% if such prepayment occurs after February 1, 2013 and on or prior to February 1, 2014. Other than as described above, prepayments are not subject to any premium or penalty other than customary “breakage” costs with respect to loans based on the LIBOR rate.

The term loan and revolving credit facility under the Credit Agreement have scheduled maturity dates of February 1, 2016, and February 1, 2015, respectively. However, if our outstanding senior subordinated notes are not refinanced, purchased or defeased in full by May 15, 2013, then the term loan and the then outstanding balance under the revolving credit facility will be due in full on May 15, 2013.

The Credit Agreement also imposes certain financial covenants on us including: minimum consolidated EBITDA requirements beginning with the first fiscal quarter of 2011 through the end of the third fiscal quarter of 2011; a maximum ratio of 6.0x consolidated EBITDA to total senior secured indebtedness tested quarterly, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of 1.25x consolidated EBITDA to consolidated cash interest expense, tested quarterly beginning on the last day of the fourth fiscal quarter of 2011. The maximum leverage ratio is scheduled to adjust to 5.75x beginning with the trailing four quarter period ending June 30, 2012. We believe we are currently in compliance with the covenants of our senior secured credit facility.

The Credit Agreement is secured by substantially all of our tangible and intangible assets, except for assets held by subsidiaries that have been designated as nonguarantor subsidiaries. The Credit Agreement also contains certain customary representations and warranties, affirmative covenants and events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross defaults to certain material indebtedness, certain events of bankruptcy, certain events under ERISA, change of control, material judgments, failure of certain guaranty documents to be in full force and effect and failure of a lien to have the priority or otherwise be valid and perfected with respect to material collateral.

(7) Stock Options

At September 30, 2011, there were 2.9 million shares of common stock of Holdings available under the 2005 Equity Incentive Plan (“Plan”) for stock option grants and other incentive awards, including restricted stock units. Options granted generally have an exercise price equal to the fair market value of the shares on the date of grant and expire 10 years from the date of grant. A restricted stock unit is a contractual right to receive one share of Holdings common stock in the future. Options typically vest one-quarter on each of the first four anniversary dates of the grant and restricted stock units typically vest in three equal annual installments.

For the three months and nine months ended September 30, 2011, there was no pre-tax compensation costs related to our stock-based compensation arrangements. Income for the three months and nine months ended September 30, 2010 includes $49,000 and $0.2 million, respectively, of pre-tax compensation costs related to our stock-based compensation arrangements.

The following table summarizes stock option activity during the nine months ended September 30, 2011:


	Number of Shares			Weighted average exercise price
Balance at December 31, 2010		2,277,500		$	2.50
Granted		450,000			2.50
Exercised		—			—
Forfeited		(1,006,250	)		2.50
Expired		(2,500	)		2.50

Balance at September 30, 2011		1,718,750		$	2.50

At September 30, 2011, the weighted average remaining contractual life of outstanding options was 6.8 years. There were 1.0 million stock options exercisable at September 30, 2011. At September 30, 2011, the weighted average exercise price of the vested stock options was $2.50, the remaining weighted average contractual life was 5.8 years and they had no intrinsic value. As of September 30, 2011, there was no unrecognized compensation costs related to stock options.

Restricted Stock Awards

In connection with the appointment of our new chairman and chief executive officer, on March 3, 2011, a restricted stock award covering 100,000 shares of our common stock was granted. There was determined to be no grant-date per share fair value for these awards. The shares vest in three equal annual installments beginning on March 24, 2010. On March 17, 2011, we entered into a separation agreement with our previous chief executive officer, whereby his restricted stock awards vested upon his last day of employment in June 2011.

As of September 30, 2011, there was no unrecognized compensation costs related to restricted stock awards.

Warrants

In connection with the acquisition, as discussed in note 11, we granted warrants to purchase 1.3 million shares , or 6.25%, of Holdings’ common stock, with an exercise price of $0.01 per share to HealthCare REIT, Inc. The warrants expire on the later of December 31, 2026 or the termination of the lease agreement. There was determined to be no grant-date per share fair value for these warrants.

(8) Regulatory Matters

All healthcare providers are required to comply with a significant number of laws and regulations at the federal and state government levels. These laws are extremely complex, and in many instances, providers do not have the benefit of significant regulatory or judicial interpretation as to how to interpret and/or apply these laws and regulations. The U.S. Department of Justice and other federal and state agencies are increasing resources dedicated to regulatory investigations and compliance audits of healthcare providers. As a healthcare provider, we are subject to these regulatory efforts. Healthcare providers that do not comply with these laws and regulations may be subject to civil or criminal penalties, the loss of their licenses, or restriction in their ability to participate in various federal and state healthcare programs. We endeavor to conduct our business in compliance with applicable laws and regulations, including healthcare fraud and abuse laws.

As a result of our hospital’s state licensures and certifications under the Medicare and various Medicaid programs, we are subject to regular reviews, surveys, audits and investigations conducted by, or on the behalf of, the federal and state agencies, including the Centers for Medicare & Medicaid Services (“CMS”), that are responsible for the oversight of these programs. These agencies’ reviews may include reviews or surveys of our compliance with required conditions of participation regulations. The purpose of these surveys is to ensure that healthcare providers are in compliance with governmental requirements, including requirements such as adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse. These surveys may identify deficiencies with conditions of participation which require corrective actions to be made by the hospital within a given timeline. If a hospital is not successful in addressing the deficiencies and conditions in a timely manner, then CMS reserves the right to deem the hospital to be out of compliance with Medicare conditions of participation and may terminate the hospital from participation in the Medicare program.

participation in the Medicare program as a result of the hospital being out of compliance with certain Medicare conditions of participation. We are in the process of correcting the deficiencies and conditions cited in the notification in a timely manner and believe these issues will be successfully resolved and that the hospital will continue to comply with the conditions of participation as set forth by CMS. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.

(9) Commitments and Contingencies

All claims raised in connection with Hurricane Katrina have been settled with no significant impact to us, except as follows. We maintained $15.0 million of general and professional liability insurance during this period, subject to a $1.0 million per claim retention. We believed that under our insurance policies, only one retention was applicable to the Hurricane Katrina matters since these matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for an additional $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.

We have certain other pending and threatened litigation and claims incurred in the ordinary course of business. We believe (based, in part, on the advice of legal counsel) that the probable resolution of such contingencies will not exceed our insurance coverage and will not materially affect our consolidated financial position, results of operations or liquidity.

(10) Fair Value of Financial Instruments

The carrying amount of cash and cash equivalents, accounts receivable, third-party payor settlements, and accounts payable and accrued expenses approximates fair value because of the short-term maturity of these instruments. The carrying amount of these obligations is a reasonable estimate of fair value.

We follow the guidance for the fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of subjective inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:

Level 1—Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

Level 2—Inputs (other than prices included in Level 1) are either directly or indirectly observable, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Inputs are unobservable and reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The Senior Secured Credit Facility and the Senior Subordinated Notes are traded in private institutional markets. The carrying amounts of the Senior Secured Credit Facility and the Senior Subordinated Notes were $309.8 million and $119.3 million, respectively, at September 30, 2011. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $291.2 million and $92.5 million, respectively, at September 30, 2011. The carrying amounts of the Senior Secured Credit Facility and the Senior Subordinated Notes were $241.6 million and $119.3 million, respectively, at December 31, 2010. Using available quoted market prices, the fair values of the Senior Secured Credit Facility and the Senior Subordinated Notes were approximately $233.8 million and $85.9 million, respectively, at December 31, 2010. The fair values are based on quoted market prices at each balance sheet date; however, these quoted market prices represent Level 2 inputs as the markets in which the Senior Secured Credit Facility and the Senior Subordinated Notes trade are not active. The revolving credit facility had a carrying value of $35.0 million at December 31, 2010. Using available quoted market prices for the Senior Secured Credit Facility as a basis, we estimated the fair market value of the revolving credit facility at $34.5 million at December 31, 2010. This valuation is categorized as a Level 2 in the valuation hierarchy.

(11) Acquisition

On August 1, 2011, we purchased five long-term acute care hospitals (the “Facilities”), which operate at seven locations, from HealthSouth Corporation and certain affiliates of HealthSouth Corporation (collectively, the “Sellers”), pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). According to the Purchase Agreement, we acquired substantially all of the non-real estate assets (excluding accounts receivable and certain other components of working capital) in exchange for a cash purchase price of approximately $42.5 million less the value of working capital associated with the Facilities. We financed the acquisition with a combination of an incremental term loan from our existing senior secured credit facility and cash on hand. In addition, Health Care REIT, Inc. purchased the real estate assets associated with four of these Facilities from the Sellers for $75.0 million. We simultaneously entered into a lease with Health Care REIT, Inc. for these properties as discussed below.

On May 17, 2011, we entered into an amendment, (the “Incremental Amendment”), to our current credit agreement (the “Credit Agreement”), with JPMorgan Chase Bank, N.A., the lenders party thereto, and the other agents named therein. The Incremental Amendment provided for an additional $47.2 million in new senior secured term loans. Proceeds were restricted to (i) payment of consideration for the acquisition of the Facilities, (ii) payment of fees and expenses in connection with the acquisition of the Facilities and (iii) working capital purposes of the Company and its subsidiaries. The new senior secured term loans have the same terms as the outstanding senior secured term loans, including with respect to interest rate, amortization, maturity date and optional and mandatory prepayments. On August 1, 2011, in connection with the completion of the acquisition and the funding of the additional term loan proceeds, we paid a consent fee of $1.4 million to the lenders under the Credit Agreement for consenting to the Incremental Amendment.

On August 1, 2011, we entered into a Second Amended and Restated Master Lease Agreement (the “Second Amended and Restated Lease”) with Health Care REIT, Inc., which includes the real estate properties for two of our existing operations and the four new Facilities discussed previously. The Second Amended and Restated Lease became effective with respect to the hospitals on August 1, 2011 and its initial 15-year term ends on July 31, 2026. The Second Amended and Restated Lease contains an option to renew for one 14-year, 11-month renewal term. The rent for the hospitals under the Second Amended and Restated Lease is computed based upon the Health Care REIT, Inc.’s investment amount allocated to the hospitals multiplied by the greater of (i) a spread over the trading yield on 10-year U.S. Treasury Notes, or (ii) 9.71%, and is subject to an annual inflation adjustment. The Second Amended and Restated Lease is an “absolute net lease.” In addition, on August 1, 2011 we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of Holdings’ common stock on August 1, 2011, with an exercise price of $0.01 per share.

The assets acquired and liabilities assumed of the Facilities have been recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed of the Facilities (and the related estimated lives of depreciable tangible and identifiable intangible assets) requires a significant amount of judgment. The initial allocation of the purchase price has been determined based upon the analysis performed, and the final analysis is expected to be completed no later than July 31, 2012. The final allocation is not expected to differ materially from the amounts reflected herein. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale, and market diversification. No goodwill associated with this transaction is deductible for income tax purposes.

In connection with this transaction, we recorded acquisition-related expenses of approximately $2.2 million and $2.8 million in the three and nine months ended September 30, 2011, respectively. Acquisition-related expenses are included in other operating expenses in our consolidated statements of earnings.

The following table presents the amounts we recognized as of the acquisition date for each major class of assets acquired and liabilities assumed in the transaction. Amounts are in thousands of dollars.


Consideration Transferred:
Base purchase price	$	42,500
Working capital adjustment		(9,238	)

Total purchase price	$	33,262

Allocation of Purchase Price:
Accounts receivable	$	122
Other current assets		1,295
Equipment		4,343
Identifiable intangible assets, principally Medicare licenses, trade name and certificates of need		22,000
Accrued employee paid-time-off		(1,654	)
Other current liabilities		(174	)

Total identifiable net assets		25,932
Goodwill		7,330

Fair value of total consideration transferred	$	33,262

The Facilities’ results of operations have been included in our consolidated financial statements prospectively beginning August 1, 2011. Our statement of earnings for the nine months ended September 30, 2011 includes net patient service revenues and operating net income of approximately $16.1 million and $0.1 million, respectively, related to the Facilities. The following pro forma information assumes the acquisition had occurred at the beginning of the period being reported on. Such results have been prepared by adjusting our historical results to include the Facilities’ results of operations, depreciation, amortization of acquired definite-lived

intangibles and incremental interest related to acquisition debt. The pro forma results do not include any cost savings that may result from the combination of the Company’s and Facilities’ operations. The pro forma results may not necessarily reflect the consolidated operations that would have existed had the acquisition been completed at the beginning of such period nor are they necessarily indicative of future results. Amounts are in thousands of dollars.


	Nine Months ended September 30, 2011				Nine Months ended September 30, 2010
		Pro Forma				Pro Forma
Net patient service revenues		$	327,097			$	349,952
Net income (loss)		$	(16,306	)		$	2,830

(12) Subsequent Event

(13) Financial Information for Subsidiary Guarantors and Nonguarantor Subsidiaries under the Senior Subordinated Notes

The senior subordinated notes are fully and unconditionally guaranteed by substantially all of our wholly-owned subsidiaries (the “Subsidiary Guarantors”), however, certain of our subsidiaries did not guarantee the senior subordinated notes (the Nonguarantor Subsidiaries”).

Presented below is condensed consolidating financial information for LifeCare Holdings, Inc., the Subsidiary Guarantors, and the Nonguarantor Subsidiaries for the three and nine months ended at September 30, 2011 and 2010. The equity method has been used with respect to investments in subsidiaries. Separate financial statements of the Subsidiary Guarantors are not presented.

LifeCare Holdings, Inc.

Condensed Consolidating Balance Sheet

September 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals
Assets
Current assets:
Cash and cash equivalents	$	—		$	21,559		$	1		$	—		$	21,560
Accounts receivable, net of allowance for doubtful accounts		—			72,799			2,740			—			75,539
Due to/from related parties		48,525			(45,751	)		(2,774	)		—			—
Other current assets		—			7,888			771			—			8,659

Total current assets		48,525			56,495			738			—			105,758
Investment in subsidiaries		344,346			—			—			(344,346	)		—
Property and equipment, net		—			57,295			20,614			—			77,909
Other assets, net		18,981			4,421			2,943			—			26,345
Identifiable intangibles, net		—			37,429			—			—			37,429
Goodwill		—			255,671			—			—			255,671

Total assets	$	411,852		$	411,311		$	24,295		$	(344,346	)	$	503,112

Liabilities and Stockholder’s Equity (Deficit)
Current liabilities:
Current installments of long-term debt	$	3,047		$	—		$	—		$	—		$	3,047
Current installments of obligations under capital leases		—			579			41			—			620
Current installments of lease financing obligation		—			—			509			—			509
Estimated third party payor settlements		—			6,622			2,742			—			9,364
Accounts payable		165			26,582			1,322			—			28,069
Accrued payroll		—			3,992			120			—			4,112
Accrued vacation		—			6,786			210			—			6,996
Accrued interest		10,107			—			—			—			10,107
Accrued other		—			5,575			191			—			5,766
Income taxes payable		—			479			(6	)		—			473

Total current liabilities		13,319			50,615			5,129			—			69,063

Long-term debt, excluding current installments		426,064			—			—			—			426,064
Obligations under capital leases, excluding current installments		—			30			7			—			37
Lease financing obligation, excluding current installments		—			—			19,172			—			19,172
Accrued insurance		—			4,824			—			—			4,824
Other noncurrent liabilities		5,500			11,483			—			—			16,983

Total liabilities		444,883			66,952			24,308			—			536,143

Stockholder’s equity (deficit):

Common stock		—			—			—			—			—
Additional paid-in capital		175,441			63			12,580			(12,643	)		175,441
Retained earnings (accumulated deficit)		(208,472	)		344,296			(12,593	)		(331,703	)		(208,472	)

Total stockholder’s equity (deficit)		(33,031	)		344,359			(13	)		(344,346	)		(33,031	)

	$	411,852		$	411,311		$	24,295		$	(344,346	)	$	503,112

LifeCare Holdings, Inc.

Condensed Consolidating Balance Sheet

December 31, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals
Assets
Current assets:
Cash and cash equivalents	$	—		$	54,569		$	1		$	—		$	54,570
Accounts receivable, net of allowance for doubtful accounts		—			61,661			5,614			—			67,275
Due to/from related parties		71,188			(65,528	)		(5,660	)		—			—
Other current assets		—			5,551			424			—			5,975

Total current assets		71,188			56,253			379			—			127,820
Investment in subsidiaries		321,277			—			—			(321,277	)		—
Property and equipment, net		—			55,338			21,494			—			76,832
Other assets, net		4,023			2,356			2,384			—			8,763
Identifiable intangibles, net		—			15,440			—			—			15,440
Goodwill		—			248,342			—			—			248,342

Total assets	$	396,488		$	377,729		$	24,257		$	(321,277	)	$	477,197

Liabilities and Stockholder’s Equity (Deficit)
Current liabilities:
Current installments of long-term debt	$	1,931		$	—		$	—		$	—		$	1,931
Current installments of obligations under capital leases		—			690			148			—			838
Current installments of lease financing obligation		—			—			480			—			480
Estimated third party payor settlements		—			2,058			2,260			—			4,318
Accounts payable		382			24,183			887			—			25,452
Accrued payroll		—			6,224			256			—			6,480
Accrued vacation		—			4,486			172			—			4,658
Accrued interest		6,377			—			—			—			6,377
Accrued other		—			4,170			151			—			4,321
Income taxes payable		(203	)		485			—			—			282

Total current liabilities		8,487			42,296			4,354			—			55,137

Long-term debt, excluding current installments		393,981			—			—			—			393,981
Obligations under capital leases, excluding current installments		—			399			26			—			425
Lease financing obligation, excluding current installments		—			—			19,558			—			19,558
Accrued insurance		—			4,032			—			—			4,032
Deferred income taxes		5,500			—			—			—			5,500
Other noncurrent liabilities		—			10,044			—			—			10,044

Total liabilities		407,968			56,771			23,938			—			488,677

Stockholder’s equity (deficit):

Common stock		—			—			—			—			—
Additional paid-in capital		175,441			63			12,580			(12,643	)		175,441
Retained earnings (accumulated deficit)		(186,921	)		320,895			(12,261	)		(308,634	)		(186,921	)

Total stockholder’s equity (deficit)		(11,480	)		320,958			319			(321,277	)		(11,480	)

	$	396,488		$	377,729		$	24,257		$	(321,277	)	$	477,197

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Operations

For the Three Months Ended September 30, 2011

(in thousands)


				Guarantor			Nonguarantor						Consolidated
	Parent			Subsidiaries			Subsidiaries			Eliminations			Totals
Net patient service revenue	$	—		$	98,363		$	4,236		$	—		$	102,599

Salaries, wages and benefits		3			48,461			2,062			—			50,526
Supplies		—			10,159			381			—			10,540
Rent		—			8,444			241			—			8,685
Other operating expenses		240			25,055			1,151			—			26,446
Provision for doubtful accounts		—			1,706			75			—			1,781
Depreciation and amortization		—			2,047			307			—			2,354
Intercompany (income) expenses		308			(549	)		241			—			—
Interest expense, net		15,145			20			406			—			15,571

Total expenses		15,696			95,343			4,864			—			115,903

Operating income (loss)		(15,696	)		3,020			(628	)		—			(13,304	)
Earnings in investments in subsidiaries		(2,377	)		—			—			2,377			—
Equity in income of joint venture		—			—			85			—			85

Income (loss) before income taxes		(13,319	)		3,020			(543	)		(2,377	)		(13,219	)
Provision for income taxes		—			100			—			—			100

Net income (loss)	$	(13,319	)	$	2,920		$	(543	)	$	(2,377	)	$	(13,319	)

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Operations

For the Nine Months Ended September 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated Totals
Net patient service revenue	$	—		$	279,084		$	14,426		$	—		$	293,510

Salaries, wages and benefits		9			133,766			6,166			—			139,941
Supplies		—			28,216			1,138			—			29,354
Rent		—			21,196			682			—			21,878
Other operating expenses		613			65,138			3,637			—			69,388
Provision for doubtful accounts		—			4,129			238			—			4,367
Loss on early extinguishment of debt		2,772			—			—			—			2,772
Depreciation and amortization		—			5,596			932			—			6,528
Intercompany (income) expenses		1,976			(2,908	)		932			—			—
Interest expense, net		39,636			(1	)		1,210			—			40,845

Total expenses		45,006			255,132			14,935			—			315,073

Operating income (loss)		(45,006	)		23,952			(509	)		—			(21,563	)
Earnings in investments in subsidiaries		(23,455	)		—			—			23,455			—
Equity in income of joint venture		—			—			562			—			562

Income (loss) before income taxes		(21,551	)		23,952			53			(23,455	)		(21,001	)
Provision for income taxes		—			550			—			—			550

Net income (loss)	$	(21,551	)	$	23,402		$	53		$	(23,455	)	$	(21,551	)

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Operations

For the Three Months Ended September 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries		Eliminations			Consolidated Totals
Net patient service revenue	$	—		$	80,446		$	5,086	$	—		$	85,532

Salaries, wages and benefits		52			39,395			1,844		—			41,291
Supplies		—			8,335			373		—			8,708
Rent		—			6,242			256		—			6,498
Other operating expenses		261			18,138			1,159		—			19,558
Provision for doubtful accounts		—			1,682			83		—			1,765
Depreciation and amortization		—			2,045			331		—			2,376
Intercompany (income) expenses		341			(649	)		308		—			—
Interest expense, net		6,674			108			402		—			7,184

Total expenses		7,328			75,296			4,756		—			87,380

Operating income (loss)		(7,328	)		5,150			330		—			(1,848	)
Earnings in investments in subsidiaries		(5,631	)		—			—		5,631			—
Equity in income of joint venture		—			—			243		—			243

Income (loss) before income taxes		(1,697	)		5,150			573		(5,631	)		(1,605	)
Provision for income taxes		—			54			38		—			92

Net income (loss)	$	(1,697	)	$	5,096		$	535	$	(5,631	)	$	(1,697	)

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Operations

For the Nine Months Ended September 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries		Eliminations			Consolidated Totals
Net patient service revenue	$	—		$	253,582		$	17,544	$	—		$	271,126

Salaries, wages and benefits		204			119,859			5,398		—			125,461
Supplies		—			26,094			1,166		—			27,260
Rent		—			18,712			707		—			19,419
Other operating expenses		808			56,293			3,599		—			60,700
Provision for doubtful accounts		—			4,887			296		—			5,183
Depreciation and amortization		—			6,465			996		—			7,461
Intercompany (income) expenses		4,188			(5,408	)		1,220		—			—
Interest expense, net		19,721			361			1,195		—			21,277

Total expenses		24,921			227,263			14,577		—			266,761

Operating income (loss)		(24,921	)		26,319			2,967		—			4,365
Earnings in investments in subsidiaries		(29,447	)		—			—		29,447			—
Equity in income of joint venture		—			—			653		—			653

Income (loss) before income taxes		4,526			26,319			3,620		(29,447	)		5,018
Provision for income taxes		—			454			38		—			492

Net income (loss)	$	4,526		$	25,865		$	3,582	$	(29,447	)	$	4,526

LifeCare Holdings, Inc.

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2011

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	(21,551	)	$	23,402		$	53		$	(23,455	)	$	(21,551	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization (including amortization of debt issuance cost)		5,351			5,596			932			—			11,879
Provision for doubtful accounts		—			4,129			238			—			4,367
Paid in kind interest		6,517			—			—			—			6,517
Loss on early extinguishment of debt		2,772			—			—			—			2,772
Equity in income of joint venture		—			—			(562	)		—			(562	)
Changes in operating assets and liabilities:
Accounts receivable		—			(15,267	)		2,636			—			(12,631	)
Income taxes		—			191			—			—			191
Other current assets		—			(936	)		(347	)		—			(1,283	)
Change in investments in subsidiaries		(23,455	)		—			—			23,455			—
Other assets		—			(2,835	)		—			—			(2,835	)
Due to/from related parties		22,454			(19,176	)		(3,278	)		—			—
Estimated third party payor settlements		—			4,564			482			—			5,046
Accounts payable and accrued liabilities		3,521			2,033			380			—			5,934
Other noncurrent liabilities		—			2,231			—			—			2,231

Net cash provided by (used in) operating activities		(4,391	)		3,932			534			—			75

Cash flows from investing activities:
Purchases of property and equipment		—			(3,113	)		(52	)		—			(3,165	)
Payments for acquisition		—			(33,262	)		—			—			(33,262	)

Net cash used in investing activities		—			(36,375	)		(52	)		—			(36,427	)


Cash flows from financing activities:
Deferred financing costs		(22,291	)		—			—			—			(22,291	)
Payments under the line of credit		(35,000	)		—			—			—			(35,000	)
Proceeds from long–term debt		304,700			—			—			—			304,700
Payments of long–term debt		(243,018	)		—			—			—			(243,018	)
Payments on obligations under capital leases		—			(567	)		(126	)		—			(693	)
Payments on lease financing obligation		—			—			(356	)		—			(356	)

Net cash provided by (used in) financing activities		4,391			(567	)		(482	)		—			3,342

Net decrease in cash and cash equivalents		—			(33,010	)		—			—			(33,010	)
Cash and cash equivalents, beginning of period		—			54,569			1			—			54,570

Cash and cash equivalents, end of period	$	—		$	21,559		$	1		$	—		$	21,560

LifeCare Holdings, Inc. and Subsidiaries

Condensed Consolidating Statement of Cash Flows

For the Nine Months Ended September 30, 2010

(in thousands)


	Parent			Guarantor Subsidiaries			Nonguarantor Subsidiaries			Eliminations			Consolidated
Cash flows from operating activities:
Net income (loss)	$	4,526		$	25,865		$	3,582		$	(29,447	)	$	4,526
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		1,739			6,464			996			—			9,199
Provision for doubtful accounts		—			4,887			296			—			5,183
Equity compensation amortization		196			—			—			—			196
Equity in income of joint venture		—			—			(653	)		—			(653	)
Changes in operating assets and liabilities:
Accounts receivable		—			2,575			415			—			2,990
Income taxes		—			(194	)		—			—			(194	)
Prepaid expenses and other current assets		—			(987	)		66			—			(921	)
Change in investments in subsidiaries		(29,447	)		—			—			29,447			—
Other assets		—			460			—			—			460
Due to/from related parties		27,662			(23,696	)		(3,966	)		—			—
Estimated third party payor settlements		—			(6,654	)		118			—			(6,536	)
Accounts payable and accrued expenses		(2,763	)		(6,364	)		(222	)		—			(9,349	)
Other liabilities		—			3,895			—			—			3,895

Net cash provided by operating activities		1,913			6,251			632			—			8,796

Cash flows from investing activities:
Purchases of property and equipment		—			(2,470	)		(156	)		—			(2,626	)

Net cash used in investing activities		—			(2,470	)		(156	)		—			(2,626	)

Cash flows from financing activities:
Payments of long-term debt		(1,913	)		—			—			—			(1,913	)
Payments on obligations under capital leases		—			(710	)		(147	)		—			(857	)
Payments on lease financing obligation		—			—			(329	)		—			(329	)

Net cash used in financing activities		(1,913	)		(710	)		(476	)		—			(3,099	)

Net increase in cash and cash equivalents		—			3,071			—			—			3,071
Cash and cash equivalents, beginning of period		—			46,680			1			—			46,681

Cash and cash equivalents, end of period	$	—		$	49,751		$	1		$	—		$	49,752

ITEM 2:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and the accompanying notes.

Company Overview

We began operations in 1993 and have grown our business through developing and acquiring hospitals to become a leading operator of long-term acute care (“LTAC”) hospitals in the United States. As of September 30, 2011, we operated 27 hospitals located in ten

states, consisting of eight “hospital within a hospital” facilities (20% of beds) and 19 freestanding facilities (80% of beds). Through these 27 long-term acute care hospitals, we operate a total of 1,432 licensed beds and employ approximately 4,400 people, the majority of whom are registered or licensed nurses and respiratory therapists. Additionally, we hold a 50% investment in a joint venture for a 51-bed LTAC hospital located in Muskegon, Michigan.

We believe we have developed a reputation for excellence in providing treatment for patients with complex medical needs requiring extended treatment. Our patients have serious medical conditions such as respiratory failure, chronic pulmonary disease, nervous system disorders, infectious diseases and severe wounds. They generally require a high level of monitoring and specialized care, yet may not require the continued services of an intensive care unit. Due to their serious medical conditions, our patients are generally not clinically appropriate for admission to a skilled nursing facility or inpatient rehabilitation facility. By combining general acute care services with a focus on long-term treatment, we believe that our hospitals provide medically complex patients with better and more cost-effective outcomes.

Liquidity and Uncertainties Related to Going Concern

As of September 30, 2011, we had $429.1 million of long-term debt outstanding consisting of our $30.0 million senior secured revolving credit facility, which matures on February 1, 2015, of which there is no outstanding balance , our senior secured term loan credit facility in an outstanding principal amount of $309.8 million, which matures on February 1, 2016, and our senior subordinated notes in an outstanding principal amount of $119.3 million, which matures on August 11, 2013. Although we are highly leveraged, we believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under our senior secured revolving credit facility will be sufficient to finance our operations and meet our scheduled debt service requirements for at least the next twelve months, absent certain actions of lenders in the case of an event of default under our senior secured credit facility as discussed below.

Recent Trends and Events

Hospital Openings and Closings

The results of operations of the Facilities are included in our consolidated results of operations beginning August 1, 2011. The assets acquired and liabilities assumed of the Facilities were recognized at their acquisition date fair values. The allocation of the purchase price to the assets acquired and liabilities assumed of the Facilities (and the related estimated lives of depreciable tangible and identifiable intangible assets) required a significant amount of judgment. The initial allocation of the purchase price has been determined based upon the analysis performed, and the final analysis is expected to be completed no later than July 31, 2012. The final allocation is not expected to differ materially from the amounts reflected herein. Any premium paid by us in this transaction is attributable to strategic benefits, including enhanced financial and operational scale, and market diversification. No goodwill associated with this transaction is deductible for income tax purposes.

On August 1, 2011, we entered into a Second Amended and Restated Master Lease Agreement (the “Second Amended and Restated Lease”) with Health Care REIT, Inc., which includes the real estate properties for two of our existing operations and the four new Facilities discussed previously. The Second Amended and Restated Lease became effective with respect to the hospitals on August 1, 2011 and its initial 15-year term ends on July 31, 2026. The Second Amended and Restated Lease contains an option to renew for one 14-year, 11-month renewal term. The rent for the hospitals under the Second Amended and Restated Lease is computed based upon the Health Care REIT, Inc.’s investment amount allocated to the hospitals multiplied by the greater of (i) a spread over the trading yield on 10-year U.S. Treasury Notes, or (ii) 9.71%, and is subject to an annual inflation adjustment. The Second Amended and Restated Lease is an “absolute net lease.” In addition, on August 1, 2011 we paid a transaction fee of $750,000 to Health Care REIT, Inc., and an indirect parent of the Company granted a warrant to HealthCare REIT, Inc. to purchase 6.25% of the shares of Parent’s common stock on August 1, 2011, with an exercise price of $0.01 per share.

On September 6, 2011 we opened a new 40 bed transitional care unit located at one of our Pittsburgh, PA hospital locations. This unit operates as a sub-provider of an existing Pittsburgh, PA operation.

On October 16, 2010, we relocated an existing campus including 35 beds in our Pittsburgh market to a new location in the market, and on November 19, 2010, we opened a third hospital campus in Pittsburgh with 32 beds that we reallocated from our existing licensed and LTAC certified beds in the market.

On November 11, 2011, we entered into an agreement with Vibra Specialty Hospital located in Dallas, TX to acquire selected assets of their long-term acute care hospital operation. We will merge their operations into our existing hospital operations in the market and will simultaneously relocate into their current operating location. The facility will be leased from an independent third party. The acquisition includes the operating assets of their existing operation and also includes a 5 year non-compete, among other items. The purchase price will be financed using available cash on hand and a seller financed promissory note. This transaction is expected to be immediately deleveraging, on a pro forma basis, to our balance sheet. The agreement is subject to customary closing conditions and is expected to be completed during 2011.

Regulatory Changes

Approximately 59.9% and 59.3% of our total net patient service revenue for the nine months ended September 30, 2011 and 2010, respectively, came from Medicare reimbursement. Our industry is subject to extensive government regulation, including regulation of the Medicare reimbursement process. Changes in these regulations can have a material impact on the way we operate our business and on our results of operations.

The 2011 Final Rule

On August 1, 2011, the Centers for Medicare & Medicaid Services (“CMS”) published their annual payment update for LTAC hospitals for the 2012 rate year, which became effective for all discharges on or after October 1, 2011 (the “2011 Final Rule”). The 2011 Final Rule includes a net increase in the standard federal rate of $623 to $40,222, or 1.6%, which is based on a market basket update of 2.9% less a 0.22% area wage level budget neutrality factor and the two adjustments required by the Patient Protection and Affordable Care Act: the multifactor productivity (“MFP”) adjustment of 1.0% and statutory payment rate reduction of 0.1%. The 2011 Final Rule also includes a decrease in the high-cost outlier fixed-loss amount to $17,931 from $18,785. Additionally, the 2011 Final Rule includes updates to the weighting of Medicare-Severity Diagnosis Related Groups (“MS-LTC-DRG”). CMS has estimated that the changes outlined above for the 2012 rate year, taken as a whole, will result in an increase of 2.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2011 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location. The 2011 Final Rule also establishes a new quality reporting program for LTAC hospitals in accordance with provisions of the Affordable Care Act and clarifies CMS’ position that Medicare Advantage (“MA”) days, along with traditional Medicare fee-for-service program days, are to be included in the determination of whether an LTAC hospital meets the greater than 25 day average length of stay requirement. Furthermore, the 2011 Final Rule extends the application of the LTAC bed moratorium to LTAC hospitals developed under exceptions to the LTAC facility moratorium and proposes a rebasing of the market basket used by LTCH hospitals.

The 2010 Final Rule

On July 30, 2010, CMS published their annual payment update for LTAC hospitals for the 2011 rate year, which became effective for all discharges on or after October 1, 2010 (the “2010 Final Rule”). The 2010 Final Rule included a net decrease in the standard federal rate of $195, or 0.5%, to $39,600, which was based on a market basket update of 2.5% less an adjustment of 0.5% as required by the Patient Protection and Affordable Care Act (“PPACA”) of 2010, discussed below, and less an adjustment of 2.5% to account for changes in documentation and coding practices. The 2010 Final Rule also included an increase in the high-cost outlier fixed-loss amount to $18,785 from $18,615. Additionally, the 2010 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS also estimated that the changes for the 2011 rate year, taken as a whole, including changes to the area wage adjustments for the 2011 rate year, an increase in high-cost outlier payments and an increase in short-stay outlier payments, would result in an increase of 0.5% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of the 2010 Final Rule depending upon their Medicare patient population and their specific base rate changes due to geographical location.

2010 Healthcare Reform Law

On March 23, 2010, the President signed into law the PPACA. This act made dramatic changes to the Medicare and Medicaid programs by adopting numerous initiatives intended to improve the quality of healthcare, promote patient safety, reduce the cost of healthcare, increase transparency and reduce fraud and abuse of federal healthcare programs. Additionally, on March 30, 2010, the President signed the Health Care and Education Affordability Reconciliation Act of 2010, which made certain amendments to the law signed by the President on March 23, 2010.

The PPACA, together with the Health Care and Education Affordability Reconciliation Act of 2010, also made changes to the Medicare program relevant to the LTAC industry, including the following key provisions, among other things:

•

a two-year extension of the LTAC provisions originally included in the Medicare, Medicaid and SCHIP Extension Act of 2007 (the “SCHIP Extension Act”),

•

the implementation of quality reporting requirements for LTAC hospitals beginning in rate year 2014,

•

reductions in the annual market basket rate increases of 0.25% for rate year 2010, and ranging from 0.1% to 0.75% for rate years beginning 2011 through 2019,

•

additional reductions in the annual market basket rate increases as the result of productivity adjustments beginning in 2012, which are expected to approximate 1% annually, and

•

the development of a new hospital wage index system to replace the current system of calculating the hospital wage index based on cost report data.

In addition, the PPACA created an “Independent Payment Advisory Board” to develop and submit proposals to the President and Congress designed to reduce Medicare spending, and provided for pilot programs to explore a bundled payment system for an episode of care that includes an inpatient stay in a hospital and post-acute care provided within 30 days after discharge.

The 2009 Final Rule

On July 31, 2009, CMS issued its final annual payment update for LTAC hospitals for the 2010 rate year, which became effective for all discharges on or after October 1, 2009 (the “2009 Final Rule”). The 2009 Final Rule included a net increase in the standard federal rate of $783 to $39,897, or 2.0%, which was based on a market basket update of 2.5% less an adjustment of 0.5% to account for changes in documentation and coding practices. The 2009 Final Rule also included a decrease in the high-cost outlier fixed-loss amount to $18,425 from $22,960. Additionally, the 2009 Final Rule included updates to the weighting of MS-LTC-DRGs, which CMS indicated will be budget neutral for aggregate LTAC hospital payments. CMS estimated that the changes for the 2010 rate year, taken as a whole, will result in an increase of 3.3% in Medicare reimbursement to LTAC hospitals. Individual hospitals, however, may see varying effects of this rule depending upon their Medicare patient population and changes to their specific standard federal rate due to geographical location.

The 2009 Final Rule also finalized the interim final rule issued on June 3, 2009, as well as the June 3, 2009 supplement to the proposed rule previously published by CMS on May 1, 2009. This rule updated the rate year 2010 LTAC- Prospective Payment System (“PPS”) payments by revising the table of MS-LTC-DRG relative weights for the rate year 2010, which was based on the amended fiscal year 2009 weights. These changes have been taken into account in CMS’s impact calculations outlined above.

Regulatory Matters

Periodically CMS will conduct surveys of hospitals and other health care providers as a condition of participation in the Medicare program. The purpose of these surveys is to ensure that healthcare providers are in compliance with various governmental requirements related to adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, compliance with building codes and environmental protection and healthcare fraud and abuse.

On October 24, 2011, one of our hospitals received a notice from a surveying agency pursuant to an unannounced recertification survey that cited certain operational deficiencies and conditions existed at the time of their survey which must be corrected in a timely manner. If the hospital is not successful in correcting or having an approved corrective action in place regarding the deficiencies and conditions set forth in the notification by December 14, 2011, CMS will have the right to terminate the hospital from participation in the Medicare program as a result of the hospital being out of compliance with certain Medicare conditions of participation. We are in the process of correcting the deficiencies and conditions cited in the notification in a timely manner and believe these issues will be successfully resolved and that the hospital will continue to comply with the conditions of participation as set forth by CMS. Termination of a hospital from the Medicare program would have a material adverse effect on our results of operations and cash flows.

Sources of Revenue

We are reimbursed for our services provided to patients by a number of sources, including the federal Medicare program and commercial payors. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem rates. Our net patient service revenue consists of the amounts that we estimate to be reimbursable from each of the applicable non-governmental payors and the Medicare and Medicaid programs. We account for the differences between the estimated reimbursement rates and our standard billing rates as contractual adjustments, which are deducted from gross revenues to arrive at net revenues. We record accounts receivable resulting from such payment arrangements net of contractual allowances. Net patient service revenues generated directly from the Medicare program approximated 59.9% and 59.3% of total net patient service revenue for the nine months ended September 30, 2011 and 2010, respectively. Net patient service revenues generated from non-Medicare payors were substantially from commercial payors.

Laws and regulations governing provider reimbursement pursuant to the Medicare program are complex and subject to interpretation. The Medicare reimbursement amounts reported in our financial statements are based upon estimates and, as such, are subject to adjustment until such time as our billings and cost reports are filed and settled with the appropriate regulatory authorities. Federal regulations require that providers participating in the Medicare program submit annual cost reports associated with services provided to program beneficiaries. In addition, payments under LTAC hospital PPS are subject to review by the regulatory authorities, including enhanced medical necessity reviews pursuant to the SCHIP Extension Act and the Recovery Audit Contractor (“RAC”) program pursuant to the Tax Relief and Health Care Act of 2006. These reviews primarily focus on the accuracy of the MS-LTC-DRG assigned to each discharged patient and normally occur after the completion of the billing process.

The annual cost reports are subject to review and adjustment by CMS through its fiscal intermediaries. These reviews may not occur until several years after a provider files its cost reports and often results in adjustments to amounts reported by providers in their cost reports as a result of the complexity of the regulations and the inherent judgment that is required in the application of certain provisions of provider reimbursement regulations. Since these reviews of filed cost reports occur periodically, there is a possibility that recorded estimated Medicare reimbursement reflected in our consolidated financial statements and previously filed cost reports may change by a material amount in future periods. We recognize in our consolidated financial statements the impact of adjustments, if any, to estimated Medicare reimbursement when the amounts can be reasonably determined.

Total Expenses

Total expenses consist of salaries, wages and benefits, supplies, which includes expenses related to drug and medical supplies, rent, other operating expenses, provision for doubtful accounts, depreciation and amortization and interest expense. Other operating expenses include expenses such as contract labor, legal and accounting fees, insurance and contracted services purchased from host hospitals.

Other Operating Metrics

We use certain operating metrics in the management of our facility operations. These include:

Licensed beds. Licensed beds represent beds for which a facility has been granted approval to operate from the applicable state licensing agency. These licensed beds are used in the determination of average licensed beds and occupancy rates.

Average licensed beds. We compute average licensed beds by computing a weighted average based upon the number of licensed beds in place for each month within the reporting period.

Admissions. Admissions are the total number of patients admitted to our facilities during the reporting period.

Patient days. Patient days are the cumulative number of days that licensed beds are occupied in our facilities for the entire reporting period. We also refer to patient days as our census.

Average length of stay (days). We compute average length of stay in days by dividing patient days for discharged patients by discharges.

Occupancy rates. We compute our occupancy rate by determining the percentage of average licensed beds that are occupied for a 24-hour period during a reporting period. The occupancy rate provides a measure of the utilization of inpatient rooms.

Net patient service revenue per patient day. This measure is determined by dividing our total net patient service revenue by the number of patient days in a reporting period. We use this metric to provide a measure of the net patient service revenue generated for each patient day.

Critical Accounting Matters

This discussion and analysis of our financial condition and results of operation is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of those financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. We rely on historical experience and other assumptions that we believe are reasonable at the time in forming the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual amounts may differ from these estimates.

We believe that the following critical accounting policies as more fully described in our annual financial statements as of December 31, 2010 as filed in the Form 10-K, affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

•

Revenue recognition

•

Accounts receivable and allowance for doubtful accounts

•

Insurance risks

•

Impairment of long-lived assets

•

Accounting for income taxes

•

Goodwill

Results of Operations

The following table sets forth operating results for each of the periods presented (in thousands):


	Three Months Ended September 30				Nine Months Ended September 30
	2011		2010		2011		2010
Net patient service revenue	$	102,599	$	85,532	$	293,510	$	271,126
Salaries, wages and benefits		50,526		41,291		139,941		125,461
Supplies		10,540		8,708		29,354		27,260


	Three Months Ended September 30						Nine Months Ended September 30
	2011			2010			2011			2010
Rent		8,685			6,498			21,878			19,419
Other operating expenses		26,446			19,558			69,388			60,700
Provision for doubtful accounts		1,781			1,765			4,367			5,183
Loss on early extinguishment of debt		—			—			2,772			—
Depreciation and amortization		2,354			2,376			6,528			7,461
Interest expense, net		15,571			7,184			40,845			21,277

Total expenses		115,903			87,380			315,073			266,761

Operating income (loss)		(13,304	)		(1,848	)		(21,563	)		4,365
Equity in income of joint venture		85			243			562			653

Income (loss) before income taxes		(13,219	)		(1,605	)		(21,001	)		5,018
Provision for income taxes		100			92			550			492

Net income (loss)	$	(13,319	)	$	(1,697	)	$	(21,551	)	$	4,526

Operating Statistics

The following table sets forth operating statistics for each of the periods presented.


	Three Months Ended September 30						Nine Months Ended September 30
	2011			2010			2011			2010
Number of hospitals within hospitals (end of period)		8			8			8			8
Number of freestanding hospitals (end of period)		19			11			19			11
Number of total hospitals (end of period)		27			19			27			19
Licensed beds (end of period)		1,432			1,057			1,432			1,057
Average licensed beds ⁽¹⁾		1,294			1,057			1,136			1,058
Admissions		2,371			1,993			6,507			6,083
Patient days		66,939			56,217			186,833			173,465
Occupancy rate		56.2	%		57.8	%		60.2	%		60.1	%
Percent net patient service revenue from Medicare		60.1	%		60.8	%		59.9	%		59.3	%
Percent net patient service revenue from commercial payors and Medicaid ⁽²⁾		39.9	%		39.2	%		40.1	%		40.7	%
Net patient service revenue per patient day	$	1,533		$	1,521		$	1,571		$	1,563

(1)	The average licensed beds are only calculated on the beds at locations that were open for operations during the applicable periods.

(2)	The percentage of net patient service revenue from Medicaid is less than three percent for each of the periods presented.

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

Net Revenues

Our net patient service revenue of $102.6 million for the three months ended September 30, 2011, increased $17.1 million, or 20.0%, from $85.5 million in the comparable period in 2010. Patient days in the 2011 period increased 10,722, or 19.1%, from the same period in 2010, while admissions were 378, or 19.0%, greater than the same period in 2010. On a same store basis, patient days decreased by 384, or 0.7%, while admissions were essentially flat, as compared to the same period in 2010.

The increase of $17.1 million in net patient service revenues was attributable to an increase of $16.1 million from the recently acquired hospitals and an increase of $1.0 million on a same store basis. The net increase on a same store basis was comprised of a favorable variance of $1.2 million attributable to an increase in net patient service revenue on a per patient day basis and a net increase of $0.3 million attributable to a decrease in adjustments related to changes in estimates and settlements on cost reports filed with the Medicare program, offset by an unfavorable variance of $0.5 million as the result of the decrease in patient days. During the three months ended September 30, 2011 and 2010, we recorded reductions in net patient service revenue of $0.2 million and $0.5 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program.

Our net patient service revenue per patient day during the three months ended September 30, 2011 and 2010, was $1,533 and $1,521, respectively. However, exclusive of the cost report reimbursement adjustments and results of the recently acquired hospitals, net patient service revenue per patient day for the three months ended September 30, 2011 and 2010 was $1,551 and $1,530, respectively, or an increase of 1.4%, primarily a result of marginal increases in reimbursement from Medicare and Medicare replacement payors during the period.

Total Expenses

Total expenses increased by $28.5 million to $115.9 million for the three months ended September 30, 2011, as compared to the same period in 2010. This increase was primarily attributable to the addition of the recently acquired hospitals. Excluding the operational results of these acquired hospitals, total expenses increased $13.4 million for the three months ended September 30, 2011, as compared to the same period in 2010.

The remaining $13.4 million increase in expenses was primarily attributable to an increase of $8.4 million in net interest expense, $2.2 million of expenses associated with the acquisition of the new hospitals and $0.5 million in start-up expenses associated with the opening of a new 40-bed transitional care unit. The increase in net interest expense was the result of the higher margin rate associated with the new senior secured credit agreement and interest on the additional borrowing related to the purchase of the additional hospitals. Salary, wages and benefits increased by $1.5 million during the 2011 period, excluding the impact of the recently acquired hospitals and the new transitional care unit. This increase was primarily attributable to higher employee healthcare costs during the period and annual inflationary increases.

Income Tax Expense

For the three months ended September 30, 2011, income tax expense recorded represents the estimated income tax liability for certain state income taxes. We believe that it is more likely than not that no benefit or expense will be realized during 2011 for federal income taxes based on estimated federal taxable losses for 2011. We anticipate that federal net operating losses generated during 2011 will be offset by an increase in the valuation allowance against net deferred tax assets.

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

Net Revenues

Our net patient service revenue of $293.5 million for the nine months ended September 30, 2011, increased $22.4 million, or 8.3%, from the comparable period in 2010. Patient days in the 2011 period were 13,368, or 7.7%, greater than the same period in 2010, while admissions were 424, or 7.0%, more than the same period in 2010. On a same store basis, patient days increased by 2,262, or 1.3%, and admissions increased by 45, or 0.7%, as compared to the same period in 2010.

The increase of $22.4 million in net patient service revenues was attributable to an increase of $16.1 million from the recently acquired hospitals and an increase of $6.3 million on a same store basis. The net increase on a same store basis was comprised of a favorable variance of $3.6 million as the result of the increase in patient days and a net increase of $2.8 million attributable to a decrease in adjustments related to changes in estimates and settlements on cost reports filed with the Medicare program, offset by an unfavorable variance of $0.1 million attributable to a decrease in net patient service revenue on a per patient day basis. During the nine months ended September 30, 2011 and 2010, we recorded reductions in net patient service revenue of $1.3 million and $4.1 million, respectively, related to changes in estimates and settlements on cost reports filed with the Medicare program.

Our net patient service revenue per patient day was $1,571 and $1,563, for the nine months ended September 30, 2011 and 2010, respectively. However, exclusive of the cost report reimbursement adjustments and the results of the recently acquired hospitals, net patient service revenue per patient day for the nine months ended September 30, 2011 and 2010, was $1,586 for both periods.

Total Expenses

Total expenses increased by $48.3 million to $315.1 million for the nine months ended September 30, 2011, as compared to the same period in 2010. A portion of this increase was attributable to the addition of the recently acquired hospitals. Excluding the operational results of these acquired hospitals, total expenses increased $33.2 million for the nine months ended September 30, 2011, as compared to the same period in 2010.

The $33.2 million increase in expenses was primarily attributable to an increase of $19.6 million in net interest expense, a $2.8 million loss related to the write-off of deferred financing cost as a result of the refinancing of the senior secured credit facility during the period, $2.8 million of expenses associated with the acquisition of the new hospitals and $0.6 million in start-up expenses associated with the opening of a new 40-bed transitional care unit. The remaining $7.4 million increase in expenses was principally attributable to an increase of $6.7 million in salary, wages and benefits during the 2011 period, excluding the impact of the recently acquired hospitals and the new transitional care unit. This increase was the result of an increase of $1.8 million in employee healthcare cost during the period, the increase in patient days during the period and other annual inflationary increases. The $19.6 million increase in net interest expense was the result of the higher margin rate associated with the new senior secured credit agreement and interest on the additional borrowing related to the purchase of the new hospitals.

Income Tax Expense

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, expected cash flows generated by operations, and availability of borrowings under a revolving credit facility. Availability of borrowings under our revolving credit facility are generally dependent upon our ability to meet the maximum leverage ratio test included in the senior secured credit facility. Our primary liquidity requirements are for debt service on our senior secured credit facilities and the notes, capital expenditures and working capital.

As a result of the impending maturities and increasingly more restrictive covenant requirements under our previous senior secured credit facility, we completed a refinancing of our previous senior secured credit facility with a new senior secured credit facility that consisted of an initial $257.5 million senior secured term loan (subject to paid-in-kind interest options as discussed below) and a new $30.0 million senior secured revolving credit facility on February 1, 2011 (the “Credit Agreement”). The proceeds of this new Credit Agreement along with available cash on hand were utilized to pay off our existing senior secured credit facility and revolving credit facility and the fees and expenses associated with the new Credit Agreement.

The terms of the Credit Agreement also provide that we have the right to request additional term loan commitments of up to $50.0 million. This right was exercised in connection with the HealthSouth acquisition, which occurred on August 1, 2011, as previously discussed.

At September 30, 2011, our debt structure consisted of $119.3 million aggregate principal amount of senior subordinated notes, a senior secured credit facility, consisting of (i) a term loan facility in an outstanding principal amount of $309.8 million, which matures on February 1, 2016, and (ii) a $30.0 million revolving credit facility, subject to availability, of which none was outstanding, including sub-facilities for letters of credit, of which $3.5 million was outstanding, which matures on February 1, 2015. Availability of borrowings under the revolving credit facility are reduced by outstanding letters of credit. We also had capital lease obligations of $0.7 million with varying maturities. The full amount available under the initial term loan facility was used in connection with the February 1, 2011 refinancing.

Borrowings under the term loan facility of the Credit Agreement bear interest at a rate per annum equal to an applicable margin plus, at our option, either (a) an alternate base rate determined by reference to the highest of (1) the prime rate of JPMorgan Chase Bank, N.A., (2) the federal funds rate in effect on such date plus 1/2 of 1% and (3) the LIBOR rate for a one month interest period plus 1% or (b) a LIBOR rate determined by reference to the cost of funds for U.S. dollar deposits for the relevant interest period adjusted for certain additional costs. The applicable margin percentage is 12.25% for term loans that are alternate base rate loans and 13.25% for term loans based on the LIBOR rate. For the term loans, we may, in our discretion, elect for the relevant interest period (a) to pay the entire amount of interest in cash or (b) to pay 5.50% of such interest “in-kind” by adding such interest to the outstanding principal of the term loans as of the applicable interest payment date. At September 30, 2011, the weighted average interest rate applicable to the $309.8 million outstanding under our term loan facility was 13.50%.

The applicable margin percentages for the revolving loans are 6.75% for alternate base loans and 7.75% for loans that are based on the LIBOR rate, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). In addition to paying interest on outstanding principal under the senior secured credit agreement, we are required to pay a commitment fee of 0.50% per annum in respect of the unutilized commitments under the revolving credit facility, subject to quarterly adjustment based on our leverage ratio (as defined in the Credit Agreement). We are also required to pay annual customary agency fees.

The Credit Agreement also imposes certain financial covenants on us including: minimum cumulative consolidated EBITDA requirements beginning with the first fiscal quarter of 2011 through the end of the third fiscal quarter of 2011; a maximum ratio of 6.0x consolidated EBITDA to total senior secured indebtedness tested quarterly on a trailing 12 month basis, beginning on the last day of the fourth quarter of 2011; and a minimum ratio of 1.25x consolidated EBITDA to consolidated cash interest expense, tested quarterly on a trailing 12 month basis beginning on the last day of the fourth fiscal quarter of 2011. The maximum leverage ratio is scheduled to adjust to 5.75x beginning with the trailing four quarter period ending June 30, 2012.

We believe that our cash on hand, expected cash flows from operations, and potential availability of borrowings under the revolving portion of our senior secured credit facilities will be sufficient to finance our operations, and meet our scheduled debt service requirements for at least the next twelve months, absent an acceleration of repayment due to an event of default as discussed in the previous paragraph.

We actively seek to identify and evaluate potential acquisition candidates and, from time to time, we review potential acquisitions of businesses. Any acquisitions may require us to issue additional equity or incur additional indebtedness, subject to the limitations contained in our senior secured credit facility. We intend to seek opportunities to refinance our senior subordinated notes, subject to financial performance and market conditions, and we continue to explore various strategic transactions, including an acquisition, as a means to reduce our leverage and strengthen our operating and financial condition. However, there is no assurance that we will be able to refinance our senior subordinated notes on commercially reasonable terms or at all, or to complete an acquisition on desirable terms.

We and our subsidiaries, affiliates or significant stockholders may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.

Capital Expenditures

We anticipate that we may incur capital expenditures of approximately $2.0 million during the remainder of 2011 based on our current plans of ongoing capital maintenance expenditure requirements at our facilities, including those related to the LTAC hospitals acquired during the year, as previously discussed. We may enter into lease arrangements to finance a portion of these equipment expenditures.

Historical Cash Flow

The following table summarizes the net cash provided by (used in) the statement of cash flows (in thousands):


	Nine Months Ended September 30
	2011			2010
Operating activities	$	75		$	8,796
Investing activities		(36,427	)		(2,626	)
Financing activities		3,342			(3,099	)

For the nine months ended September 30, 2011, operating activities provided $0.1 million of cash as compared to $8.8 million in cash for the comparable period in 2010. For the nine months ended September 30, 2011, we had a net loss of $21.6 million as compared to net income of $4.5 million for the same period in 2010.

Accounts receivable increased by $12.6 million for the nine months ended September 30, 2011 as compared to a decrease of $3.0 million for the same period during 2010. Days of net patient service revenue in accounts receivable at September 30, 2011 had decreased to 67.6 as compared to 70.6 at December 31, 2010. The increase in accounts receivable during the 2011 period includes an increase of $15.6 million attributable to the recently acquired hospitals offset by a decrease of $3.0 million in accounts receivable from existing operations. Collections during the 2011 period on the recently acquired hospitals were nominal as a result of the timing required by CMS to process the transfer of the Medicare provider agreements, which we expect to be completed during the fourth quarter of 2011.

Estimated third party payor settlements provided cash of $5.0 million as compared to a net use of cash of $6.5 million for the nine months ended September 30, 2010. The use of cash during the 2010 period was principally due to the repayment to Medicare of amounts received as interim payments during 2009 in excess of revenues ultimately recognized.

Cash used in investing activities was $36.4 million for the nine months ended September 30, 2011 as compared to $2.6 million in 2010. Cash used in investing activities during 2011 was principally for the hospitals acquired from HealthSouth, which occurred on August 1, 2011, as previously discussed. Cash used in investing activities during 2010 period was principally for recurring maintenance capital expenditures.

Cash provided by financing activities for the nine months ended September 30, 2011 was $3.3 million as compared to a used of cash of $3.1 million for the same period in 2010. The nine months ended September 30, 2011 included proceeds of $257.5 million from the refinancing of the senior secured credit facility and an additional $47.2 million in new senior secured term loans in relation to the HealthSouth acquisition previously discussed, offset by outflows to pay down the previous senior secured credit facility and scheduled payments on the current secured credit facility. We also paid down the $35.0 million for the outstanding balance under the previous revolving line of credit. During 2011 we made payments of $22.3 million for deferred financing cost associated with the debt refinance and new senior secured term loans utilized for the hospitals acquired from HealthSouth.

Contractual Obligations

The following table summarizes our contractual obligations as of September 30, 2011 (in thousands):


					Payments Due by Year
Contractual Obligation⁽¹⁾	Total		Payments due for the remainder of 2011		2012		2013-2014		2015-2016		2017 and beyond
Senior secured credit facility⁽³⁾	$	309,812	$	762	$	3,047	$	6,094	$	299,909	$	—
9¹/4% senior subordinated notes		119,299		—		—		119,299		—		—
Capital lease obligations		636		210		401		25		—		—

Total debt		429,747		972		3,448		125,418		299,909		—
Interest⁽²⁾		198,551		13,204		52,556		89,165		43,626		—
Operating leases		574,832		5,594		30,969		55,970		44,892		437,407
Other obligations		562		161		247		154		—		—

Total contractual obligations	$	1,203,692	$	19,931	$	87,220	$	270,707	$	388,427	$	437,407

⁽¹⁾

This table does not include payments that we are required to make under a management agreement with an affiliate of The Carlyle Group. Under that agreement we pay an annual management fee initially set at $500,000. See “Certain Relationships and Related Transactions—Management Agreement” included in the Form 10-K we filed on March 30, 2011.

⁽²⁾	The interest obligations were calculated using the interest rate of our new senior secured credit agreement of 13.50% for the senior secured term loan and the stated interest rate of 9 1/4% for the senior subordinated notes. See the “Liquidity and Capital Resources” section.

⁽³⁾

This table does not reflect future excess cash flow prepayments, if any, that may be required under our new senior secured term loan or additional principal amounts that could become outstanding as a result of any future paid in kind interest elections that we may make under our new secured term loan. See the “Liquidity and Capital Resources” section.

Seasonality

Our business experiences seasonality resulting in variation in census levels, with the highest census historically occurring in the first quarter of the year and the lowest census occurring in the third quarter of the year.

Inflation

We derive a substantial portion of our revenue from the Medicare program. LTAC hospital PPS payments are subject to fixed payments that generally are adjusted annually for inflation. However, there can be no assurance that these adjustments, 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 expense structure. The expenses can be subject to increase in periods of rising inflation.

Forward Looking Statements

This quarterly report contains forward-looking statements regarding, among other things, our financial condition, results of operations, plans, objectives, future performance and business. All statements contained in this document other than historical information are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs concerning future operations, strategies, financial results or other developments, and contain words and phrases such as “may,” “expects,” “believes,” “anticipates,” “estimates,” “should,” or similar expressions. Because these forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Important factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to:

•

the failure to maintain compliance with our financial covenants could be costly or have a material adverse effect on us;

•

the amount of outstanding indebtedness and the restrictive covenants in the agreements governing our indebtedness may limit our operating and financial flexibility;

•

the condition of the financial markets, including volatility and deterioration in the capital and credit markets, could have a material adverse effect on the availability and terms of financing sources;

•

development or acquisition of new facilities may prove difficult or unsuccessful, use significant resources or expose us to unforeseen liabilities;

•

the failure to comply with the provisions of any of our Master Lease Agreements could materially adversely affect our financial position, results of operations and liquidity;

•

changes in government reimbursement for our services may have an adverse effect on our future revenues and profitability including, for example, the changes described under “Regulatory Changes”;

•

healthcare reform may have an adverse effect on our future revenues and profitability;

•

a government investigation or assertion that we have violated applicable regulations may result in increased costs or sanctions that reduce our revenues and profitability;

•

periodic reviews, surveys, audits and investigations by federal and state government agencies and private payors could result in adverse findings and may negatively impact our revenues and profitability;

•

actions that may be brought by individuals on the government’s behalf under the False Claims Act’s qui tam or whistleblower provisions may expose us to unforeseen liabilities;

•

the failure of our long-term acute care hospitals to maintain their qualification would cause our revenues and profitability to decline;

•

the failure of our “satellite” facilities to qualify for provider-based status with the applicable “main” facilities may adversely affect our results of operations;

•

private third party payors for our services may merge or undertake future cost containment initiatives that limit our future revenues and profitability;

•

an increase in uninsured and underinsured patients in our hospitals or the deterioration in the collectability of the accounts of such patients could harm our results of operations;

•

the failure to maintain established relationships with the physicians in our markets could reduce our revenues and profitability;

•

shortages in qualified nurses, therapists and other healthcare professionals or union activity may significantly increase our operating costs;

•

competition may limit our ability to grow and result in a decrease in our revenues and profitability;

•

the loss of key members of our management team could significantly disrupt our operations;

•

the geographic concentration of our facilities in Texas and Pennsylvania makes us sensitive to economic, regulatory, environmental and other developments in these states;

•

adverse changes in individual markets could significantly affect operating results;

•

the effect of legal actions asserted against us or lack of adequate available insurance could subject us to substantial uninsured liabilities;

•

an inability to ensure and maintain an effective system of internal controls over financial reporting could expose us to liability; and,

•

the failure to prevent damage or interruption to our systems and operations or to conform to regulatory standards for electronic health records could result in improper functioning, security breaches of our information systems, additional expenses or penalties.

Consequently, such forward-looking statements should be regarded solely as our current plans, estimates and beliefs. We do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of this report.

ITEM 3:

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At September 30, 2011, we had $309.8 million in senior term loans outstanding and a borrowing availability of $26.5 million under our revolving credit facility, each bearing interest at variable rates. Each 0.125% point change in interest rates would result in a $0.4 million annual change in interest expense on our term loans and revolving credit facility loans, assuming that our revolving credit facility is fully drawn.

ITEM 4:

CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered in this report. The disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within required time periods, and include controls and disclosures designed to ensure that this information is accumulated and communicated to the company’s management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer have concluded that as of September 30, 2011 our disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our periodic Securities and Exchange Commission reports is recorded accurately, processed, summarized and reported within the time periods specified in the relevant Securities and Exchange Commission rules and forms.

In addition, we reviewed our internal controls, and there have been no changes in our internal controls over financial reporting identified in connection with an evaluation that occurred during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1:

LEGAL PROCEEDINGS

We are a party to several legal actions that arose in the ordinary course of business. The majority of these actions are related to malpractice claims that are covered under various insurance policies; however, there may be some actions which are not insured. We are unable to predict the ultimate outcome of pending litigation and government investigations, nor can there be any guarantee that the resolution of any litigation or investigation, either individually or in the aggregate, would not have a material adverse effect on our financial position, results of operations or liquidity. However, in our opinion, the outcome of these actions will not have a material adverse effect on the financial position, results of operations or liquidity of our company.

All claims raised in connection with Hurricane Katrina have been settled with no significant impact to us, except as follows. We maintained $15.0 million of general and professional liability insurance during this period, subject to a $1.0 million per claim retention. We believe that under our insurance policies, only one retention was applicable to the Hurricane Katrina matters since these matters all arose from a single event, process or condition. However, our insurance carrier sent reservation of rights letters which challenged, among other things, the application of one retention to the Hurricane Katrina related matters. On June 5, 2009, we reached an agreement with the insurance carrier regarding the reservation of rights matters whereby they would continue to pay all costs, indemnification and related expenses for the Hurricane Katrina claims in consideration for an additional $1.0 million, which was paid by us in three equal installments, on July 1, 2009, March 31, 2010, and March 31, 2011.

ITEM 1A:

RISK FACTORS

No changes.

ITEM 6:

EXHIBITS

The exhibits to this report are listed in the Exhibit Index.

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.


LifeCare Holdings, Inc

By:		/s/ Phillip B. Douglas
		Phillip B. Douglas
		Chief Executive Officer

By:		/S/ CHRIS A. WALKER
		Chris A. Walker
		Chief Financial Officer

Dated: November 14, 2011

EXHIBIT INDEX


Exhibit		Description

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS		XBRL Instance Document*

101.SCH		XBRL Taxonomy Extension Schema Document*

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document*

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document*

101.LAB		XBRL Taxonomy Extension Label Linkbase Document*

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document*

These interactive data files are being submitted electronically with this report and, in accordance with Rule 406T of Regulation S-T, are not deemed filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, are not deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

Large Accelerated Filer:

Accelerated Filer:

Non-Accelerated Filer:

Smaller Reporting Company: