10-Q 1 form10q.htm form10q.htm

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

or

o     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.
(Exact name of Registrant as specified in its charter)

Delaware
13-4230695
(State of Incorporation)
(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400
Irvine, CA  92612
(949) 255-7100
(Address, zip code and telephone number of Registrant)


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  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer    o
Accelerated filer    x
   
Non-accelerated filer    o
Smaller reporting company    o
(Do not check if a smaller reporting company)
 

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

As of November 1, 2011, there were 25,146,378 shares of the Registrant’s $.01 par value Common Stock outstanding.


 
1

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index
   
Page
Numbers
PART I.  FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements:
 
     
 
Consolidated Balance Sheets (unaudited)
3-4
 
As of September 30, 2011
 
 
As of December 31, 2010
 
     
 
Consolidated Income Statements (unaudited)
5-6
 
For the three months ended September 30, 2011 and 2010
 
 
For the nine months ended September 30, 2011 and 2010
 
     
 
Consolidated Statements of Cash Flows (unaudited)
7
 
For the three months ended September 30, 2011 and 2010
 
 
For the nine months ended September 30, 2011 and 2010
 
     
 
Notes to Consolidated Financial Statements (unaudited)
8-25
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
26-46
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
46
     
Item 4.
Controls and Procedures
47
     
Item 5.
Other Information
47
     
PART II.  OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
47
     
Item 1A.
Risk Factors
47-48
     
Item 6.
Exhibits
48
     
Signature
 
48

References throughout this document to the Company, “we,” “our” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Quarterly Report on Form 10-Q (this “Form 10-Q”) contain “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”) and the federal securities laws.  Any statements that do not relate to historical or current facts or matters are forward-looking statements. Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs,  the scope, timing and effectiveness of our efforts to mitigate the impact on our business of the CMS Final Rule (described below), the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations, and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions, although not all forward-looking statements contain these identifying words.
 
The forward-looking statements are based on the information currently available and are applicable only as of the date of this report. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements.  You are urged to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in Item 1A of this Form 10-Q and in our other reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution you that any forward-looking statements made in this Form 10-Q are not guarantees of future performance and that you should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this document.  There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.
_______________________

 
2

 

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS
(in thousands)


   
September 30, 2011
   
December 31, 2010
 
             
Current assets:
           
Cash and cash equivalents
  $ 91,179     $ 81,163  
Restricted cash
    16,382       15,329  
Accounts receivable, net of allowance for doubtful accounts of $67,501
           
and $66,607 at September 30, 2011 and December 31, 2010, respectively
213,858       218,040  
Prepaid expenses and other assets
    26,380       16,859  
Deferred tax assets
    71,996       69,800  
                 
Total current assets
    419,795       401,191  
                 
Property and equipment, net
    145,611       139,860  
Intangible assets, net
    35,317       41,967  
Goodwill
    35,679       348,047  
Restricted cash, non-current
    352       350  
Deferred tax assets
    115,243       126,540  
Other assets
    45,606       23,803  
Total assets
  $ 797,603     $ 1,081,758  




See accompanying notes.


 
3

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY
(in thousands, except per share data)

   
September 30, 2011
   
December 31, 2010
 
             
Current liabilities:
           
Accounts payable
  $ 49,659     $ 49,993  
Accrued compensation and benefits
    49,328       61,518  
Accrued self-insurance obligations, current portion
    62,038       52,093  
Other accrued liabilities
    56,457       53,945  
Current portion of long-term debt and capital lease obligations
    11,033       11,050  
                 
Total current liabilities
    228,515       228,599  
                 
Accrued self-insurance obligations, net of current portion
    153,471       133,405  
Long-term debt and capital lease obligations, net of current portion
    131,548       144,930  
Unfavorable lease obligations, net
    7,771       9,815  
Other long-term liabilities
    52,394       52,566  
                 
Total liabilities
    573,699       569,315  
                 
Commitments and contingencies (Note 6)
               
                 
Stockholders' equity:
               
Preferred stock of $.01 par value, authorized 3,333
               
shares, zero shares issued and outstanding as of
               
September 30, 2011 and December 31, 2010
    -       -  
Common stock of $.01 par value, authorized  41,667
               
shares, 25,146 and 24,974 shares issued and outstanding
               
as of September 30, 2011 and December 31, 2010, respectively
    251       250  
Additional paid-in capital
    724,814       720,854  
Accumulated deficit
    (500,008 )     (208,661 )
Accumulated other comprehensive loss, net
    (1,153 )     -  
Total stockholders' equity
    223,904       512,443  
Total liabilities and stockholders' equity
  $ 797,603     $ 1,081,758  





See accompanying notes.

 
4

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Three Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
             
Total net revenues
  $ 485,850     $ 473,411  
Costs and expenses:
               
Operating salaries and benefits
    273,223       268,501  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    15,250       14,531  
Operating administrative expenses
    13,157       13,343  
Other operating costs
    100,636       97,333  
Center rent expense
    37,184       18,954  
General and administrative expenses
    14,825       14,146  
Depreciation and amortization
    8,295       12,639  
Provision for losses on accounts receivable
    4,916       5,098  
Interest, net of interest income of $103 and $59, respectively
    4,835       10,527  
Transaction costs
    -       4,747  
Loss on sale of assets, net
    809       -  
Restructuring costs
    2,426       -  
    Loss on asset impairment
    317,091       -  
Total costs and expenses
    792,647       459,819  
                 
(Loss) income before income taxes and discontinued operations
    (306,797 )     13,592  
    Income tax expense
    1,569       5,559  
(Loss) income from continuing operations
    (308,366 )     8,033  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (359 )     (477 )
Loss on disposal of discontinued operations, net of related taxes
    (681 )     -  
Loss from discontinued operations, net
    (1,040 )     (477 )
                 
Net (loss) income
  $ (309,406 )   $ 7,556  
                 
                 
                 
Basic earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.77 )   $ 0.39  
Loss from discontinued operations, net
    (0.04 )     (0.02 )
Net (loss) income
  $ (11.81 )   $ 0.37  
                 
Diluted earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.77 )   $ 0.39  
Loss from discontinued operations, net
    (0.04 )     (0.02 )
Net (loss) income
  $ (11.81 )   $ 0.37  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    26,203       20,529  
Diluted
    26,203       20,550  


See accompanying notes.

 
5

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
             
Total net revenues
  $ 1,457,421     $ 1,415,734  
Costs and expenses:
               
Operating salaries and benefits
    818,248       799,603  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    45,779       43,433  
Operating administrative expenses
    39,913       38,932  
Other operating costs
    298,213       289,079  
Center rent expense
    111,110       56,306  
General and administrative expenses
    45,156       44,570  
Depreciation and amortization
    23,636       37,449  
Provision for losses on accounts receivable
    14,960       15,811  
Interest, net of interest income of $244 and $222, respectively
    14,689       34,105  
Transaction costs
    -       6,995  
    Loss on sale of assets, net
    809       -  
Restructuring costs
    2,728       -  
    Loss on asset impairment
    317,091       -  
Total costs and expenses
    1,732,332       1,366,283  
                 
(Loss) income before income taxes and discontinued operations
    (274,911 )     49,451  
Income tax expense
    14,642       19,990  
(Loss) income from continuing operations
    (289,553 )     29,461  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (1,113 )     (1,734 )
Loss on disposal of discontinued operations, net
    (681 )     -  
Loss from discontinued operations, net
    (1,794 )     (1,734 )
                 
Net (loss) income
  $ (291,347 )   $ 27,727  
                 
                 
                 
Basic earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.12 )   $ 1.69  
Loss from discontinued operations, net
    (0.07 )     (0.10 )
Net (loss) income
  $ (11.19 )   $ 1.59  
                 
Diluted earnings per common and common equivalent share:
               
Income from continuing operations
  $ (11.12 )   $ 1.68  
Loss from discontinued operations, net
    (0.07 )     (0.09 )
Net (loss) income
  $ (11.19 )   $ 1.59  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    26,038       17,418  
Diluted
    26,038       17,485  


See accompanying notes.

 
6

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)


   
For the
   
For the
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30, 2011
 
September 30, 2010
 
September 30, 2011
 
September 30, 2010
Cash flows from operating activities:
                       
Net (loss) income
  $ (309,406 )   $ 7,556     $ (291,347 )   $ 27,727  
Adjustments to reconcile net (loss) income to net cash provided by
                       
operating activities, including discontinued operations:
                               
Depreciation and amortization
    8,335       12,736       23,879       37,744  
Amortization of favorable and unfavorable lease intangibles
(492 )     (504 )     (1,466 )     (1,452 )
Provision for losses on accounts receivable
    4,975       5,289       15,479       16,428  
Loss on sale of assets, including discontinued operations, net
1,925       -       1,925       -  
Loss on asset impairment
    317,091       -       317,091       -  
Stock-based compensation expense
    2,359       1,661       5,160       4,748  
Deferred taxes
    (105 )     3,286       9,871       14,976  
Changes in operating assets and liabilities, net of acquisitions:
                   
Accounts receivable
    23       (1,307 )     (12,555 )     (12,500 )
Restricted cash
    52       2,769       (1,876 )     5,040  
Prepaid expenses and other assets
    (1,600 )     5,399       (1,410 )     8,012  
Accounts payable
    1,595       (4,909 )     (1,906 )     (3,628 )
Accrued compensation and benefits
    (11,717 )     (2,117 )     (12,298 )     1,945  
Accrued self-insurance obligations
    3,618       199       (294 )     5,041  
Income taxes payable
    -       1,267       -       1,605  
Other accrued liabilities
    2,104       4,429       1,158       4,442  
Other long-term liabilities
    (880 )     (676 )     (2,098 )     (5,775 )
Net cash provided by operating activities
    17,877       35,078       49,313       104,353  
                                 
Cash flows from investing activities:
                               
Capital expenditures
    (14,190 )     (13,774 )     (32,346 )     (41,488 )
Proceeds from sale of assets
    1,809       -       1,809       -  
Acquisitions, net of cash acquired
    -       -       (356 )     -  
Net cash used for investing activities
    (12,381 )     (13,774 )     (30,893 )     (41,488 )
                                 
Cash flows from financing activities:
                               
Borrowings of long-term debt
    -       20,500       -       20,500  
Principal repayments of long-term debt and capital lease
                               
obligations
    (2,806 )     (234,116 )     (8,404 )     (271,093 )
Payment to non-controlling interest
    -       -       -       (2,025 )
Distribution to non-controlling interest
    -       -       -       (69 )
    Net proceeds from issuance of common stock
    -       226,001       -       226,001  
    Deferred financing costs
    -       (2,312 )     -       (2,312 )
Net cash (used for) provided by financing activities
    (2,806 )     10,073       (8,404 )     (28,998 )
                                 
Net increase in cash and cash equivalents
    2,690       31,377       10,016       33,867  
Cash and cash equivalents at beginning of period
    88,489       106,973       81,163       104,483  
Cash and cash equivalents at end of period
  $ 91,179     $ 138,350     $ 91,179     $ 138,350  
                                 
 
 
See accompanying notes.

 
7

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
(UNAUDITED)

(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this report has been written in the first person. In this document, the words “we,” “our” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 199 healthcare centers in 25 states as of September 30, 2011.

Restructuring Costs

On July 29, 2011, the Centers for Medicare and Medicaid Services (“CMS”) released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which became effective on October 1, 2011 (the “CMS Final Rule”).  After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates is 11.1%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  As a result of the expected negative impact of the CMS Final Rule on our business, we commenced a broad-based mitigation initiative, which includes infrastructure cost reductions without affecting the quality of our patient care.  During our third quarter ended September 30, 2011, we incurred $2.4 million of restructuring costs in connection with our mitigation initiative, which consisted primarily of severance benefits resulting from reductions of staff.  We will continue to focus on reducing costs to further mitigate the impact on our business of the reduced Medicare reimbursement rates.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at September 30, 2011, and our consolidated results of operations and cash flows for the three-month and nine-month periods ended September 30, 2011 and 2010, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2010, which are included in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”).

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of impairment for goodwill and other long-lived assets, third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals and income taxes. Actual results could differ from those estimates.

 
8

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Recent Accounting Pronouncements

The Emerging Issues Task Force of the FASB issued an Accounting Standards Update in August 2010 regarding the balance sheet presentation of medical malpractice claims and similar contingent liabilities and related insurance recoveries.  The updated guidance requires the insurance recovery receivable to be presented as a gross asset instead of netting it against the related liability.  The updated presentation was effective for us on January 1, 2011, is reflected in the accompanying consolidated balance sheet and has resulted in the reclassification of anticipated insurance recoverables to assets as of January 1, 2011 of $2.1 million and $28.1 million for general and professional liabilities and workers’ compensation liabilities, respectively.  There was no impact on our accumulated deficit due to adoption of this new standard.  See the Insurance portion of Note 6 – “Commitments and Contingencies” for additional information.

The FASB issued an Accounting Standards Update in June 2011 regarding the presentation of comprehensive income within financial statements.  GAAP now requires that comprehensive income and its components of net income and other comprehensive income be presented in either (1) a single continuous statement of comprehensive income or (2) two separate but consecutive statements.  This new guidance will be effective for us beginning with our March 31, 2012 interim reporting with retrospective presentation.

The FASB issued an Accounting Standards Update in September 2011 regarding the testing of goodwill for impairment.  The update permits the assessment of qualitative factors, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. This new guidance is effective for periods beginning after December 15, 2011.  Early adoption is permitted.

Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2011 financial statement presentation.  We have reclassified the results of operations of the nurse practitioner services group and one skilled nursing center of our Inpatient Services segment (see Note 5 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

(2)  Asset Impairment

In addition to the annual testing requirements discussed in Note 6 – “Goodwill, Intangible Assets and Long-Lived Assets” of our 2010 Form 10-K, GAAP requires that goodwill, intangible assets and other long-lived assets be evaluated for potential impairment when a triggering event occurs during an interim time period.  As a result of the CMS Final Rule, the prospective net decrease in Medicare reimbursement rates is 11.1%, after the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  We determined that the CMS Final Rule announcement constituted a triggering event for evaluating whether the recoverability of goodwill, intangible assets and other long-lived assets in the operating segments of our Inpatient Services reportable segment affected by the CMS Final Rule was impaired.

During the three months ended September 30, 2011, we recognized $317.1 million of non-cash loss on asset impairment for the healthcare facilities operating segments in our Inpatient Services reportable segment.  The non-cash charges consisted of $314.7 million of goodwill impairment and $2.4 million of asset impairment for intangible assets for favorable lease obligations.  The charges were determined in the following manner:

 
9

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Finite-Lived Intangibles

Our finite-lived intangibles include tradenames and favorable lease obligations.

When evaluating the recoverability of tradenames, we considered projections of future profitability and undiscounted cash flows for the affected portions of the Inpatient Services operating segments as compared to the carrying value of the tradenames assets.  We determined that projected undiscounted cash flows were sufficient to recover the assets’ carrying value.  As a result, there was no impairment of tradenames during the three months ended September 30, 2011.

When evaluating the recoverability of favorable lease obligations, we considered projections of future profitability and undiscounted cash flows for the affected portions of the Inpatient Services operating segments as compared to the carrying value of the favorable lease obligation intangible assets.  We determined that projected undiscounted cash flows were not sufficient to recover the full carrying value of the assets and proceeded to determine a fair value of each asset.

We determined fair value based upon estimates of market rental values for the centers associated with the favorable lease intangibles using valuations techniques broadly accepted by the long-term care industry in which we operate.  We applied an industry average discount factor to the difference of this estimated market rental values to our contractually obligated lease payments over the remaining term of the leases, resulting in an appropriate estimate of fair value for the favorable lease intangible.  We determined that certain favorable lease obligations had fair values less than their carrying values and recognized the $2.4 million loss on asset impairment described above.

Indefinite-Lived Intangibles

Our indefinite-lived intangibles consist of certificates of need (“CON”) obtained through our acquisitions.  We evaluate the recoverability of our CON intangibles by comparing the assets' respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place coupled with estimates of market pricing to determine the highest and best use for purposes of determining fair value.  The resulting fair values exceeded the assets’ carrying value and thus no impairment was recognized.

Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows associated with these assets are not sufficient to recover the assets' carrying amounts.  In estimating the undiscounted projected cash flows for our impairment assessment, we primarily used our internally prepared projections and forecast information, including adjustments for the estimated impact of the CMS Final Rule.  We determined that undiscounted projected cash flows were sufficient to ensure recoverability of our long-lived assets.

Goodwill

GAAP requires that impairment be assessed for reporting units of the affected operating segments.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment.  For our Inpatient Services reportable segment, the reporting units for our annual goodwill impairment analysis were determined to be at the operating segment level, which were the divisional operating levels.  The divisional operating levels of the Inpatient Services reportable segment include the northeast, southeast, central and west geographic divisions of SunBridge Healthcare Corporation (“SunBridge”) as well as the SolAmor Hospice Corporation (“SolAmor”) division and the Americare nutritional supplement division.
 
We determine potential impairment by comparing the net assets of each reporting unit to their respective fair values, which GAAP describes as Step 1 of goodwill impairment testing. We determine the estimated fair value of each reporting
 
10

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

unit using a discounted projected cash flow analysis and other appropriate valuation methodologies.  In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit, which is referred to in GAAP as Step 2 of the impairment analysis. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill.  An impairment loss is measured by the difference between the goodwill’s carrying value and its implied fair value.

In estimating the projected cash flows for our impairment assessment, we primarily used our internally prepared projections and forecast information including adjustments for the estimated impact of the CMS Final Rule.  Other factors in the cash flow projections include anticipated funding from other payor sources such as Medicaid funding plus our plans to manage overhead costs, capital expenditures and patient care liability costs.

The discounted cash flow model utilizes five years of projected cash flows for each reporting unit. The projected financial results are created from critical assumptions and estimates based upon management’s business plan and historical trends while giving consideration to the overall economic environment. Determining fair value requires the exercise of significant judgments about appropriate discount rates, business growth rates, the amount and timing of expected future cash flows and market information relevant to our overall company value. In addition, to validate the reasonableness of our assumptions, we utilized our discounted cash flow model on a consolidated basis and compared the estimated fair value to our market capitalization as of September 30, 2011.  Key assumptions in the discounted cash flow model are as follows:

Business Growth Assumptions – In determining our projected Inpatient Services revenue growth rates for our discounted cash flow model, we focus on the two primary drivers: average daily census (“ADC”) and reimbursement rates, particularly those rates impacted by the CMS Final Rule. Key revenue inputs include historical ADC adjusted for known trends and current Medicare and Medicaid rates adjusted for anticipated changes. ADC trends have been reasonably constant within a narrow range and may be influenced over the long run by a number of factors, including demographic changes in the population we serve and our ability to deliver quality service in an attractive environment. Generally long term care reimbursement rates are set annually by the payor. To estimate these rates, we evaluate the current reimbursement climate and adjust historical trends where appropriate. Significant adverse rate changes in any one year would cause us to reevaluate our projected rates.  In recent years we have generated historical revenue growth of 1.4% to 6.2% annually.  Expenses generally vary with ADC and have historically grown by approximately 2.9% to 5.6% annually.  Labor is the largest component of our expenses.  We consider labor market trends and staffing needs for the projected ADC levels in determining labor growth rates to be used in our projections. The projected growth rates used in our discounted cash flow model took into account the potential adverse effects of the current economic downturn on our projected revenue and expenses.

Terminal Value EBITDAR Multiple – Consistent with commonly accepted valuation techniques, a terminal multiple for the final year’s projected results is applied to estimate our value in the final year of the analysis. That multiple is applied to the final year’s projected EBITDAR from continuing operations.

Discount Rate – Market conditions indicated that a discount rate of 10.5% was appropriate at September 30, 2011.  This discount rate is consistent with our overall market capitalization comparison. We consistently apply the same discount rate to the evaluation of each reporting unit.

The goodwill impairment analysis is subject to impact from uncertainties arising from such events as changes in economic or competitive conditions, the current general economic environment, material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows, and the impact of strategic decisions.  The results of our interim 2011 impairment analysis showed that goodwill in each of reporting units tested was impaired.  Based on the analysis performed, we recognized a loss on impairment of $314.7 million for the three months ended September 30, 2011, which represents the full carrying value of goodwill for the SunBridge divisional operating segments of our Inpatient Services reportable segment.  The SolAmor division’s prospective Medicare reimbursement rates were not impacted by the CMS Final Rule and thus no interim 2011 impairment event arose for SolAmor and Americare.

 
11

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(3)  Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):

   
September 30, 2011
   
December 31, 2010
 
             
Revolving loans
  $ -     $ -  
Mortgage notes payable due monthly through 2014, interest at
               
a rate of 8.5%, collateralized by real property with
               
carrying values totaling $1.8 million
    2,260       7,979  
Term loans
    139,922       147,492  
Capital leases
    399       509  
Total long-term obligations
    142,581       155,980  
Less amounts due within one year
    (11,033 )     (11,050 )
Long-term obligations, net of current portion
  $ 131,548     $ 144,930  

The scheduled or expected maturities of long-term obligations as of September 30, 2011, were as follows (in thousands):

For the twelve months ending September 30:
 
       
2012
  $ 11,033  
   2013
    10,947  
   2014
    10,679  
   2015
    10,000  
   2016
    10,000  
Thereafter
    89,922  
    $ 142,581  


We manage interest expense using a mix of fixed and variable rate debt, and, to help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount.   We also may enter into interest rate cap agreements that effectively limit the maximum interest rate that we pay on an agreed to notional principal amount.  We use interest rate hedges to manage interest rate risk related to borrowings.  Our intent is to only enter into such arrangements that qualify for hedge accounting treatment in accordance with GAAP.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive income.  Ineffectiveness, if any, would be recognized in earnings.

Our credit agreement requires that at least 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011; a two-year interest rate cap and a two-year “forward starting” interest rate swap.  The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 7.5% for two years.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935% for this portion of the term loans.  There was no fee for this swap agreement.  Both arrangements qualify for hedge accounting treatment.
 
12

 
 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The fair values of our hedging agreements as presented in the consolidated balance sheets are as follows (in thousands):

   
Derivatives
   
September 30, 2011
 
December 31, 2010
   
Balance Sheet
       
Balance Sheet
       
   
Location
   
Fair Value
 
Location
   
Fair Value
 
Derivatives designated as
                     
hedging instruments:
                     
Interest rate hedging
 
Other Long-Term
                 
agreements
 
Liabilities
 
$
1,922
 
N/A
 
$
-
 

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended September 30 is as follows (in thousands):

         
Gain Reclassified from Accumulated
 
   
Amount of (Loss)/Gain in
   
Other Comprehensive Income
 
   
Other Comprehensive (Loss)/Income
   
to Income (ineffective portion)
 
   
2011
   
2010
   
2011
   
2010
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate hedging agreements
$
(535
)
$
1,020
 
$
-
 
$
-
 

The effect of the interest rate hedging agreements on our consolidated comprehensive income, net of related taxes, for the nine months ended September 30 is as follows (in thousands):

         
Gain Reclassified from Accumulated
 
   
Amount of (Loss)/Gain in
   
Other Comprehensive Income
 
   
Other Comprehensive (Loss)/Income
   
to Income (ineffective portion)
 
   
2011
   
2010
   
2011
   
2010
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate hedging agreements
$
(1,153
)
$
3,029
 
$
-
 
$
-
 

The amounts stated above for (loss)/gain from changes in the fair value of our hedging agreements are our only sources of other comprehensive (loss)/income, resulting in comprehensive income of $4.6 million and $22.1 million for the three and nine months ended September 30, 2011, respectively.  Comprehensive income for the three and nine months ended September 30, 2010 was $8.6 million and $30.8 million, respectively.
 
 
13

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
(4)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments were as follows (in thousands):

   
September 30, 2011
   
December 31, 2010
 
   
Carrying
         
Carrying
       
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
                         
Cash and cash equivalents
  $ 91,179     $ 91,179     $ 81,163     $ 81,163  
Restricted cash
  $ 16,734     $ 16,734     $ 15,679     $ 15,679  
Long-term debt and capital lease obligations,
                               
including current portion
  $ 142,581     $ 110,972     $ 155,980     $ 156,084  
Interest rate hedging agreements
  $ 1,922     $ 1,922     $ -     $ -  

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At September 30, 2011 and December 31, 2010, the fair value of our long-term debt, including current maturities, and our interest rate hedging agreements was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

GAAP establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  The applicable guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:
Unadjusted quoted market prices in active markets for identical assets or liabilities.
   
Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
   
Level 3:
Unobservable inputs for the asset or liability.

We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above pricing levels as of September 30, 2011 and December 31, 2010, respectively (in thousands):

   
September 30, 2011
 
       
Unadjusted Quoted
 
Significant Other
 
       
Market Prices
 
Observable Inputs
 
   
Total
 
(Level 1)
 
(Level 2)
 
               
Interest rate hedging agreements – liability
$
1,922
$
-
$
1,922
 

   
December 31, 2010
 
       
Unadjusted Quoted
 
Significant Other
 
       
Market Prices
 
Observable Inputs
 
   
Total
 
(Level 1)
 
(Level 2)
 
               
Restricted cash – money market funds
$
1,465
$
1,465
$
-
 

We currently have no other financial instruments subject to fair value measurement on a recurring basis.
 
14

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
(5) Discontinued Operations

The results of operations of assets to be disposed of, disposed assets and the losses related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

During the nine months ended September 30, 2011, we disposed of a Maryland skilled nursing center in our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.  The disposition, which was effective on August 1, 2011, resulted in cash proceeds to us of $1.8 million, net of the payoff of the $5.2 million mortgage payable for the center.  During August 2011, we also divested two hospice operations in Oklahoma for a nominal price plus the assumption of certain liabilities by the buyer. The disposition resulted in a net loss of $0.7 million, net of related tax benefit.

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

   
For the Three Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
   
Inpatient
               
Inpatient
             
   
Services
   
Other
   
Total
   
Services
   
Other
   
Total
 
                                     
Net operating revenues
$
823
 
$
-
 
$
823
 
$
2,865
 
$
-
 
$
2,865
 
                                     
Loss from discontinued operations, net (1)
$
(1,029
)
$
(11
)
$
(1,040
)
$
(468
)
$
(9
)
$
(477
)
   
(1)
Net of related tax benefit of $679 and $307, respectively


   
For the Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
   
Inpatient
               
Inpatient
             
   
Services
   
Other
   
Total
   
Services
   
Other
   
Total
 
                                     
Net operating revenues
$
5,813
 
$
-
 
$
5,813
 
$
8,442
 
$
-
 
$
8,442
 
                                     
Loss from discontinued operations, net (1)
$
(1,764
)
$
(30
)
$
(1,794
)
$
(1,674
)
$
(60
)
$
(1,734
)
   
(1)
Net of related tax benefit of $1,203 and $721, respectively


 
15

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(6)  Commitments and Contingencies

(a) Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Insurance reserves represent estimates of future claims payments.  This liability includes an estimate of the development of reported losses and losses incurred but not reported.  Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements.  The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting from such reviews are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure.  Paid loss methods focus on development of claims actually paid to date.  Expected loss methods are based upon an anticipated loss per unit of measure.  The Bornhuetter-Ferguson method is a combination of loss development methods and expected methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls.  We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses.  The TPAs are under the oversight of our in-house risk management and legal functions.  The purpose of these functions is to properly administer the claims so that the historical data is reliable for estimation purposes.  Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims.  In instances where our historical data are not statistically credible, stable, or mature, we supplement our experience with skilled nursing industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have.  Management’s judgment based upon each method’s inherent limitation is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which include the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported. These results are compared by accident year, and an estimated unpaid loss and allocated loss adjustment expense is determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.
 
16

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
Activity in our professional liability and workers’ compensation self-insurance reserves as of and for the periods ended September 30, 2011 and 2010 is as follows (in thousands):

   
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
                   
Balance as of January 1, 2010
$
94,930
 
$
67,506
 
$
162,436
 
Current year provision, continuing operations
 
7,341
   
7,100
   
14,441
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(4,219
)
 
(4,555
)
 
(8,774
)
Claims paid, discontinued operations
 
(563
)
 
(633
)
 
(1,196
)
Amounts paid for administrative services and other
 
(850
)
 
(1,696
)
 
(2,546
)
Balance as of March 31, 2010
$
96,682
 
$
67,776
 
$
164,458
 
                   
Current year provision, continuing operations
 
7,339
   
7,122
   
14,461
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(3,605
)
 
(3,906
)
 
(7,511
)
Claims paid, discontinued operations
 
(1,552
)
 
(690
)
 
(2,242
)
Amounts paid for administrative services and other
 
(724
)
 
(1,620
)
 
(2,344
)
Balance as of June 30, 2010
$
98,183
 
$
68,736
 
$
166,919
 
                   
Current year provision, continuing operations
 
7,128
   
7,403
   
14,531
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(5,533
)
 
(5,376
)
 
(10,909
)
Claims paid, discontinued operations
 
(378
)
 
(438
)
 
(816
)
Amounts paid for administrative services and other
 
(489
)
 
(1,585
)
 
(2,074
)
Balance as of September 30, 2010
$
98,954
 
$
68,794
 
$
167,748
 
                   

 
17

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
   
For the Three Months Ended
   
For the Nine Months Ended
 
   
September 30, 2011
   
September 30, 2011
 
   
Professional
   
Workers’
         
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
   
Liability
   
Compensation
   
Total
 
                                     
Gross balance, beginning of period
$
109,315
 
$
96,186
 
$
205,501
 
$
113,971
 
$
96,585
 
$
210,556
 
Less: anticipated insurance recoveries
(2,273
)
 
(26,150
)
 
(28,423
)
 
(2,100
)
 
(28,100
)
 
(30,200
)
Net balance, beginning of period
$
107,042
 
$
70,036
 
$
177,078
 
$
111,871
 
$
68,485
 
$
180,356
 
                                     
Current year provision, continuing
                                   
operations
 
8,056
   
7,194
   
15,250
   
24,189
   
21,590
   
45,779
 
Current year provision, discontinued
                                   
operations
 
90
   
75
   
165
   
255
   
222
   
477
 
Claims paid, continuing operations
 
(6,959
)
 
(3,944
)
 
(10,903
)
 
(25,890
)
 
(12,817
)
 
(38,707
)
Claims paid, discontinued operations
 
(27
)
 
(281
)
 
(308
)
 
(614
)
 
(986
)
 
(1,600
)
Amounts paid for administrative
                                   
services and other
 
(790
)
 
(1,717
)
 
(2,507
)
 
(2,399
)
 
(5,131
)
 
(7,530
)
                                     
Net balance, end of period
$
107,412
 
$
71,363
 
$
178,775
 
$
107,412
 
$
71,363
 
$
178,775
 
Plus: anticipated insurance recoveries
2,273
   
26,150
   
28,423
   
2,273
   
26,150
   
28,423
 
Gross balance, end of period
$
109,685
 
$
97,513
 
$
207,198
 
$
109,685
 
$
97,513
 
$
207,198
 
 
    The anticipated insurance recoveries relate primarily to our workers’ compensation programs associated with policy years 1996 through 2001 where the claim losses have exceeded the policies' aggregate retention limits. Obligations above these retention limits are covered by our excess insurance carriers, which all have carrier ratings of at least “A,” “XIV” or better.

 
18

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
A summary of the assets and liabilities related to insurance risks at September 30, 2011 and December 31, 2010 is as indicated below (in thousands):

   
September 30, 2011
     
December 31, 2010
 
   
Professional
   
Workers’
       
|
 
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
|
 
Liability
   
Compensation
   
Total
 
Assets:
                 
|
                 
Restricted cash (1)
             
|
                 
Current
$
6,232
 
$
10,056
 
$
16,288
 
|
$
3,659
 
$
10,864
 
$
14,523
 
Non-current
 
-
   
-
   
-
 
|
 
-
   
-
   
-
 
 
$
6,232
 
$
10,056
 
$
16,288
 
|
$
3,659
 
$
10,864
 
$
14,523
 
                   
|
                 
Anticipated insurance recoveries (2)
       
|
                 
Current
$
573
 
$
3,750
 
$
4,323
 
|
$
-
 
$
-
 
$
-
 
Non-current
 
1,700
   
22,400
   
24,100
 
|
 
-
   
-
   
-
 
 
$
2,273
 
$
26,150
 
$
28,423
 
|
$
-
 
$
-
 
$
-
 
                                       
Total Assets
$
8,505
 
$
36,206
 
$
44,711
 
|
$
3,659
 
$
10,864
 
$
14,523
 
                                       
Liabilities (3)(4):
             
|
                 
Self-insurance liabilities
             
|
                 
Current
$
30,763
 
$
22,964
 
$
53,727
 
|
$
25,942
 
$
21,009
 
$
46,951
 
Non-current
 
78,922
   
74,549
   
153,471
 
|
 
85,929
   
47,476
   
133,405
 
Total Liabilities
$
109,685
 
$
97,513
 
$
207,198
 
|
$
111,871
 
$
68,485
 
$
180,356
 
 
(1)
 
Total restricted cash includes cash collateral deposits and other cash held by third parties.  Total restricted cash above excludes $446 and $1,156 at September 30, 2011 and December 31, 2010, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
     
(2)
 
Anticipated insurance recovery assets are presented as Other Assets (both current and long-term) in our September 30, 2011 consolidated balance sheet.  See the Recent Accounting Pronouncements discussed in Note 1- “Nature of Business” for additional information.
     
(3)
 
Total self-insurance liabilities above exclude $8,311 and $5,142 at September 30, 2011 and December 31, 2010, respectively, related to our employee health insurance liabilities.
     
(4)
 
Total self-insurance liabilities for workers’ compensation claims are collateralized, in addition to the restricted cash, by letters of credit of $58,077 as of September 30, 2011 and $59,066 as of December 31, 2010.

(b)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters.  The ability to predict the ultimate outcome of such matters involves judgments, estimates and inherent uncertainties.  Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition or cash flows.

We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, the industries in which we operate are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there

 
19

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations or cash flows.

In September 2010, a lawsuit was filed in the Superior Court of California, County of Los Angeles, by a former employee of a subsidiary of our medical staffing company, alleging violation of various wage and hour provisions of the California Labor Code. We deny all of the allegations in the employee’s complaint.  The lawsuit, which was filed as a purported class action on behalf of the former employee and all those similarly situated, has been settled. The terms of the settlement are confidential pending court approval. We believe our reserves are adequate for this matter.

In November 2010, a jury verdict was rendered in a Kentucky state court against us for $2.75 million in compensatory damages and $40 million in punitive damages. On February 25, 2011, the trial court judge reduced the punitive damage award to $24.75 million.  The case involves claims for professional negligence resulting in wrongful death.  We disagree with the jury’s verdict and believe that it is not supported by the facts of the case or applicable law.  We have appealed this judgment to the Kentucky Court of Appeals.  We believe our reserves are adequate for this matter.

(c)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time, we are unable to predict the outcome of any existing or future examinations.

(7)  Income Taxes

       The provision for income taxes totaled $1.6 million and $14.6 million for the three and nine months ended September 30, 2011, respectively. The loss on asset impairment was substantially nondeductible for tax purposes, thereby significantly impacting the income tax expense shown on the accompanying statements of operations relative to the pre-tax loss for the three and nine months ended September 30, 2011.  Excluding the impact of the $317.1 million loss on asset impairment (see Note 2 – “Asset Impairment”) and its related $1.8 million income tax benefit, the effective tax rates would have been 33% and 39% for the three and nine months ended September 30, 2011, respectively. The provision for income taxes of $5.6 million and $20.0 million for the three and nine months ended September 30, 2010 resulted in effective tax rates of approximately 41% and 40%, respectively.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  The valuation allowance of $18.1 million at September 30, 2011 and December 31, 2010 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

After consideration of the November 2010 restructuring of our former parent company, which, among other matters resulted in Sabra Health Care REIT, Inc. holding substantially all of our former parent’s owned real property, and utilization of NOL carryforwards through 2010, the Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $7.4 million. Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, we estimate there is approximately $65.1 million of NOLs which can be used to offset U.S. taxable income in 2011.  Considering annual IRC Section 382 limitations and built-in gains, we estimate a total of approximately $170.8 million of utilizable NOL carryforwards to offset taxable income in 2011 and future years.

 
20

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
(8)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.  Our reportable segments are composed of operating segments, which are aggregated, comprising strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  More complete descriptions and accounting policies of the segments are described in Note 13 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2010 Form 10-K.  The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

As of and for the
                                   
Three Months Ended
                                   
September 30, 2011
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
435,271
 
$
29,568
 
$
20,996
 
$
15
 
$
-
 
$
485,850
 
                                     
Intersegment revenues
 
-
   
32,791
   
757
   
-
   
(33,548
)
 
-
 
                                     
Total net revenues
 
435,271
   
62,359
   
21,753
   
15
   
(33,548
)
 
485,850
 
                                     
Operating salaries and benefits
 
202,694
   
54,298
   
16,231
   
-
   
-
   
273,223
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
14,206
   
633
   
344
   
67
   
-
   
15,250
 
                                     
Other operating costs
 
128,821
   
2,374
   
2,989
   
-
   
(33,548
)
 
100,636
 
                                     
General and administrative expenses(1)
 
10,308
   
2,309
   
540
   
14,825
   
-
   
27,982
 
                                     
Provision for losses on
                                   
accounts receivable
 
4,772
   
73
   
71
   
-
   
-
   
4,916
 
                                     
Segment operating income (loss)
$
74,470
 
$
2,672
 
$
1,578
 
$
(14,877
)
$
-
 
$
63,843
 
                                     
Center rent expense
 
36,874
   
140
   
170
   
-
   
-
   
37,184
 
                                     
Depreciation and amortization
 
6,902
   
236
   
187
   
970
   
-
   
8,295
 
                                     
Interest, net
 
(32
)
 
-
   
-
   
4,867
   
-
   
4,835
 
                                     
Net segment income (loss)
$
30,726
 
$
2,296
 
$
1,221
 
$
(20,714
)
$
-
 
$
13,529
 
                                     
Identifiable segment assets
$
395,840
 
$
16,254
 
$
20,039
 
$
343,550
 
$
20,881
 
$
796,564
 
                                     
Goodwill
$
31,071
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
35,679
 
                                     
Segment capital expenditures
$
12,934
 
$
149
 
$
63
 
$
1,044
 
$
-
 
$
14,190
 
______________________________________
 
(1) General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.

 
21

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
As of and for the
                                   
Three Months Ended
                                   
September 30, 2010
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
421,573
 
$
30,343
 
$
21,481
 
$
14
 
$
-
 
$
473,411
 
                                     
Intersegment revenues
 
-
   
21,397
   
724
   
-
   
(22,121
)
 
-
 
                                     
Total net revenues
 
421,573
   
51,740
   
22,205
   
14
   
(22,121
)
 
473,411
 
                                     
Operating salaries and benefits
 
209,375
   
42,860
   
16,266
   
-
   
-
   
268,501
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
13,712
   
435
   
323
   
61
   
-
   
14,531
 
                                     
Other operating costs
 
114,253
   
1,952
   
3,249
   
-
   
(22,121
)
 
97,333
 
                                     
General and administrative expenses(1)
 
10,778
   
1,939
   
627
   
18,892
   
-
   
 32,236
 
                                     
Provision for losses on
                                   
accounts receivable
 
4,639
   
297
   
162
   
-
   
-
   
5,098
 
                                     
Segment operating income (loss)
$
68,816
 
$
4,257
 
$
1,578
 
$
(18,939
)
$
-
 
$
55,712
 
                                     
Center rent expense
 
18,629
   
123
   
202
   
-
   
-
   
18,954
 
                                     
Depreciation and amortization
 
11,536
   
173
   
181
   
749
   
-
   
12,639
 
                                     
Interest, net
 
2,483
   
-
   
-
   
8,044
   
-
   
10,527
 
                                     
Net segment income (loss)
$
36,168
 
$
3,961
 
$
1,195
 
$
(27,732
)
$
-
 
$
13,592
 
                                     
Identifiable segment assets
$
1,174,539
 
$
15,047
 
$
20,631
 
$
329,881
 
$
20,867
 
$
1,560,965
 
                                     
Goodwill
$
332,140
 
$
75
 
$
4,533
 
$
1,616
 
$
-
 
$
338,364
 
                                     
Segment capital expenditures
$
12,738
 
$
370
 
$
41
 
$
625
 
$
-
 
$
13,774
 
 
______________________________________
 
(1) General and administrative expenses include operating administrative expenses and transaction costs.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.

 
22

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



As of and for the
                                   
Nine Months Ended
                                   
September 30, 2011
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,302,431
 
$
89,645
 
$
65,309
 
$
36
 
$
-
 
$
1,457,421
 
                                     
Intersegment revenues
 
-
   
98,710
   
2,079
   
-
   
(100,789
)
 
-
 
                                     
Total net revenues
 
1,302,431
   
188,355
   
67,388
   
36
   
(100,789
)
 
1,457,421
 
                                     
Operating salaries and benefits
 
605,534
   
161,925
   
50,789
   
-
   
-
   
818,248
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
42,614
   
1,918
   
1,043
   
204
   
-
   
45,779
 
                                     
Other operating costs
 
383,372
   
7,082
   
8,548
   
-
   
(100,789
)
 
298,213
 
                                     
General and administrative expenses(1)
 
30,970
   
7,139
   
1,804
   
45,156
   
-
   
85,069
 
                                     
Provision for losses on
                                   
accounts receivable
 
14,200
   
713
   
47
   
-
   
-
   
14,960
 
                                     
Segment operating income (loss)
$
225,741
 
$
9,578
 
$
5,157
 
$
(45,324
)
$
-
 
$
195,152
 
                                     
Center rent expense
 
110,203
   
394
   
513
   
-
   
-
   
111,110
 
                                     
Depreciation and amortization
 
19,726
   
689
   
561
   
2,660
   
-
   
23,636
 
                                     
Interest, net
 
(68
)
 
-
   
1
   
14,756
   
-
   
14,689
 
                                     
Net segment income (loss)
$
95,880
 
$
8,495
 
$
4,082
 
$
(62,740
)
$
-
 
$
45,717
 
                                     
Identifiable segment assets
$
395,840
 
$
16,254
 
$
20,039
 
$
343,550
 
$
20,881
 
$
796,564
 
                                     
Goodwill
$
31,071
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
35,679
 
                                     
Segment capital expenditures
$
27,310
 
$
1,102
 
$
135
 
$
3,799
 
$
-
 
$
32,346
 
 
______________________________________
 
(1) General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.


 
23

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


As of and for the
                                   
Nine Months Ended
                                   
September 30, 2010
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,258,271
 
$
89,723
 
$
67,712
 
$
28
 
$
-
 
$
1,415,734
 
                                     
Intersegment revenues
 
-
   
63,584
   
1,364
   
-
   
(64,948
)
 
-
 
                                     
Total net revenues
 
1,258,271
   
153,307
   
69,076
   
28
   
(64,948
)
 
1,415,734
 
                                     
Operating salaries and benefits
 
622,489
   
126,670
   
50,444
   
-
   
-
   
799,603
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
40,999
   
1,298
   
953
   
183
   
-
   
43,433
 
                                     
Other operating costs
 
338,182
   
5,947
   
9,898
   
-
   
(64,948
)
 
289,079
 
                                     
General and administrative expenses(1)
 
30,907
   
6,065
   
1,959
   
51,566
   
-
   
90,497
 
                                     
Provision for losses on
                                   
accounts receivable
 
14,904
   
722
   
185
   
-
   
-
   
15,811
 
                                     
Segment operating income (loss)
$
210,790
 
$
12,605
 
$
5,637
 
$
(51,721
)
$
-
 
$
177,311
 
                                     
Center rent expense
 
55,326
   
364
   
616
   
-
   
-
   
56,306
 
                                     
Depreciation and amortization
 
34,037
   
484
   
543
   
2,385
   
-
   
37,449
 
                                     
Interest, net
 
7,826
   
-
   
(1
)
 
26,280
   
-
   
34,105
 
                                     
Net segment income (loss)
$
113,601
 
$
11,757
 
$
4,479
 
$
(80,386
)
$
-
 
$
49,451
 
                                     
Identifiable segment assets
$
1,174,539
 
$
15,047
 
$
20,631
 
$
329,881
 
$
20,867
 
$
1,560,965
 
                                     
Goodwill
$
332,140
 
$
75
 
$
4,533
 
$
1,616
 
$
-
 
$
338,364
 
                                     
Segment capital expenditures
$
38,609
 
$
700
 
$
190
 
$
1,989
 
$
-
 
$
41,488
 
 
______________________________________
 
(1) General and administrative expenses include operating administrative expenses and transaction costs.
 
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.

 
24

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Measurement of Segment Income

We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items. The following table reconciles net segment income to consolidated income before income taxes and discontinued operations (in thousands):

   
For the Three Months Ended
 
   
September 30,
 
   
2011
   
2010
 
             
Net segment income
$
13,529
 
$
13,592
 
Loss on sale of assets, net
 
809
   
-
 
Restructuring costs
 
2,426
   
-
 
   Loss on asset impairment
 
317,091
   
-
 
Consolidated (loss) income before income taxes and
           
discontinued operations
$
(306,797
)
$
13,592
 

   
For the Nine Months Ended
 
   
September 30,
 
   
2011
   
2010
 
             
Net segment income
$
45,717
 
$
49,451
 
Loss on sale of assets, net
 
809
   
-
 
Restructuring costs
 
2,728
   
-
 
   Loss on asset impairment
 
317,091
   
-
 
Consolidated (loss) income before income taxes and
           
discontinued operations
$
(274,911
)
$
49,451
 


(9)  Subsequent Event

On October 1, 2011, we acquired the operating assets of Harbinger Hospice, Inc., a privately-held, Medicare-certified hospice company that provides services to patients in Ohio, for $1.1 million in cash, excluding transaction costs of $0.1 million, consisting primarily of broker success fees, that we will expense during the fourth quarter of 2011 in accordance with GAAP. 
 
25

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Our subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 165 skilled nursing centers, 14 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers with 22,860 licensed beds located in 25 states as of September 30, 2011. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

In March 2010, the Patient Protection and Affordable Care Act (the “PPACA”) and the Health Care and Education Reconciliation Act of 2010 were signed into law. The combined laws create the Affordable Care Act (the “ACA”). Together, these two measures make the most sweeping and fundamental changes to the U.S. health care system since the creation of Medicare and Medicaid. These new laws include a large number of health-related provisions that are scheduled to take effect over the next four years, including expanding Medicaid eligibility, requiring most individuals to have health insurance, establishing new regulations on health plans, establishing health insurance exchanges, and modifying certain payment systems to encourage more cost-effective care and a reduction of inefficiencies and waste, including through new tools to address fraud and abuse. We cannot predict the effect these laws or any future legislation or regulation will have on our future operations, including future reimbursement rates and occupancy in our inpatient facilities.

Asset Impairment

In addition to the annual testing requirements discussed in Note 6 – “Goodwill, Intangible Assets and Long-Lived Assets” of our 2010 Form 10-K, U.S. generally accepted accounting principles (“GAAP”) requires that goodwill, intangible assets and other long-lived assets be evaluated for potential impairment when a triggering event occurs during an interim time period.  On July 29, 2011, CMS released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which commences on October 1, 2011 (the “CMS Final Rule”).  After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates is 11.1%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  We determined that the CMS Final Rule announcement constituted a triggering event for evaluating whether the recoverability of goodwill, intangible assets and other long-lived assets in the operating segments of our Inpatient Services reportable segment affected by the CMS Final Rule was impaired.

During the three months ended September 30, 2011, we recognized $317.1 million of non-cash loss on asset impairment for the healthcare facilities operating segments in our Inpatient Services reportable segment.  The non-cash charges consisted of $314.7 million of goodwill impairment and $2.4 million of asset impairment for intangible assets for favorable lease obligations.  See Note 2 – “Asset Impairment” to our consolidated financial statements included in this Form 10-Q for additional information.

2011 Restructuring

The CMS Final Rule prospective net decrease in Medicare reimbursement rates is 11.1%, after the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  As a result of the expected negative impact of the CMS Final Rule on our business, we commenced a broad-based mitigation initiative, which includes infrastructure cost reductions without affecting the quality of our patient care.  During our third quarter ended September 30, 2011, we incurred $2.4 million of restructuring costs in connection with our mitigation initiative, which consisted primarily of severance benefits resulting from reductions of staff.  We will continue to focus on reducing costs to further mitigate the impact on our business of the reduced Medicare reimbursement rates.

 
26

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
2010 Restructuring

In November 2010, our former parent, Sun Healthcare Group, Inc. (“Old Sun”) completed a restructuring of its business by separating its real estate assets and its operating assets into two separate publicly traded companies.  The restructuring consisted of certain key transactions including a reorganization, through a series of internal corporate restructurings, such that (i) substantially all of Old Sun’s owned real property and related mortgage indebtedness owed to third parties were transferred to or assumed by Sabra Health Care REIT, Inc. (“Sabra”), a Maryland corporation and a wholly-owned subsidiary of Old Sun, or one or more subsidiaries of Sabra, and (ii) all of Old Sun’s operations and other assets and liabilities were transferred to or assumed by SHG Services, Inc., a Delaware corporation and a wholly-owned subsidiary of Old Sun (“New Sun”), or one or more subsidiaries of New Sun.

In November 2010, Old Sun distributed to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”), together with a pro rata cash distribution to Old Sun’s stockholders aggregating approximately $10 million.  Old Sun then merged with and into Sabra, with Sabra surviving the merger and Old Sun’s stockholders receiving shares of Sabra common stock in exchange for their shares of Old Sun’s common stock (the “REIT Conversion Merger”).  Immediately following the Separation and REIT Conversion Merger, New Sun changed its name to Sun Healthcare Group, Inc.  Pursuant to master lease agreements that were entered into between subsidiaries of Sabra and of New Sun in connection with the Separation, subsidiaries of Sabra lease to subsidiaries of New Sun the properties that Sabra’s subsidiaries own following the REIT Conversion Merger.

The Separation was accounted for as a reverse spinoff where New Sun was designated as the “accounting” spinnor and Sabra was designated as the “accounting” spinnee.  Accordingly, the assets and liabilities distributed were recorded based on their historical carrying values.

For accounting purposes, the historical consolidated financial statements of Old Sun became the historical consolidated financial statements of New Sun after the distribution on November 15, 2010. In this Form 10-Q, we discuss financial and other data of both Old Sun and of New Sun because New Sun has continued the business of Old Sun and is the successor issuer to Old Sun for purposes of the Securities Exchange of 1934, as amended (the “Exchange Act”).   References to ‘we’, ‘us’ ‘our’ and the ‘Company’ refer to Old Sun and New Sun and their businesses.

Revenues from Medicare, Medicaid and Other Sources

We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and healthcare centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on federal and state budgets resulting from the current economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes specialty services provided by us, such as skilled therapy services, to third parties. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

In addition, we have experienced, and may continue to experience, due to current economic conditions, reduced demand for the specialty services that we provide to third parties.  We are unable to predict the future impact or extent of such reduced demand.

 
27

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The following table sets forth the total nonaffiliated revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (data is in thousands and includes revenues for acquired centers following the date of acquisition only):

   
For the
   
For the
 
   
Three Months Ended
   
Nine Months Ended
 
Sources of Revenues
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
                                                 
Consolidated:
                                               
Medicaid
  $ 191,821       39.5 %   $ 193,013       40.8 %   $ 562,981       38.6 %   $ 569,222       40.2 %
Medicare
    154,953       31.9       137,606       29.1       472,652       32.4       419,846       29.7  
Private pay and other
    114,689       23.6       118,650       25.0       348,026       23.9       354,190       25.0  
Managed care and
                                                               
  commercial insurance
  24,387       5.0       24,142       5.1       73,762       5.1       72,476       5.1  
Total
  $ 485,850       100.0 %   $ 473,411       100.0 %   $ 1,457,421       100.0 %   $ 1,415,734       100.0 %
                                                                 
Inpatient Only:
                                                               
Medicaid
  $ 191,799       44.1 %   $ 192,980       45.8 %   $ 562,889       43.2 %   $ 569,125       45.2 %
Medicare
    150,016       34.5       132,831       31.5       458,589       35.2       405,896       32.3  
Private pay and other
    69,320       15.9       71,889       17.0       207,998       16.0       211,619       16.8  
Managed care and
                                                               
  commercial insurance
  24,136       5.5       23,873       5.7       72,955       5.6       71,631       5.7  
Total
  $ 435,271       100.0 %   $ 421,573       100.0 %   $ 1,302,431       100.0 %   $ 1,258,271       100.0 %

Medicare

Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation’s elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or those having end-stage renal disease. Medicare is comprised of four related health insurance programs.  Medicare Part A provides for inpatient services including hospital, skilled long-term care, hospice and home healthcare. Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies.  Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B.  Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequent revisions, the most recent of which was effective October 1, 2010. PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group  (“RUGs”) categories prior to October 1, 2010 (these 53 RUGs categories are referred to collectively as “RUGs III”) and 66 RUGs categories after October 1, 2010 (these 66 RUGs categories are referred to collectively as “RUGs IV”).  Each RUGs level represents the level of services required to treat the patient’s condition or level of acuity.

Under the RUGs III system, CMS considered some services that were delivered in the hospital when determining the payment category, referred to as the “lookback.”  Under the RUGs IV system, CMS eliminated this consideration. The RUGs III system also reimbursed for therapy service delivered concurrently, in a group or individually at the same rate.  The RUGs IV system changes maintain the same reimbursement methodology for group and individual therapy, but will only consider concurrent therapy if it is delivered to two patients and divides the services between the two patients that receive the services.

Changes were also made in the qualifications required to qualify for each RUGs level and additional levels were added to provider further refinement.

 
28

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
$
519.12
 
$
463.45
 
$
519.70
 
$
464.51
 

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception was in place for patients residing in skilled nursing centers.  That exception will continue through December 31, 2011.

Effective January 1, 2011, changes were made in the payment methodology for Medicare Part B services received by patients in a skilled nursing facility setting. As part of the Physician Fee Schedule, CMS applied a Multiple Procedure Payment Reduction (“MPPR”).  CMS previously applied an MPPR to diagnostic services and has now expanded it to include other Part B services.  A portion of the payment for Part B services is related to activities that CMS contends are only delivered one time when multiple units of the same or related services are delivered on the same day.  CMS reduced the portion of the rate that contains these services by 25%, which equates to a 7.2% reduction in the reimbursement rate for Part B therapy services provided by us.  The change reduces the amount we are able to charge to internal and external customers.  We estimate the impact to be a $6.5 million annual reduction in consolidated revenues.

In July 2010, CMS issued its final rule for skilled nursing facilities for the 2011 federal fiscal year, which commenced on October 1, 2010.  This rule provided for a market basket increase of 2.3%, which was reduced by a prior period market basket adjustment of 0.6%, generating a net market basket increase of 1.7%.

On July 29, 2011, CMS released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which commences on October 1, 2011.  In the final rule, CMS adjusted Medicare payment rates to correct what it perceives is a lack of parity between RUGs III and RUGs IV.   CMS created the RUGs IV system to be budget neutral, but its analysis of billing data from the first eight months of implementation, October 1, 2010 to May 31, 2011, indicated that the RUGs IV system reimburses at a higher level overall than the RUGs III system.  CMS calculated that the aggregate increase in payments was 12.6%.  After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates is 11.1%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  We estimate that the net impact of both the parity and therapy provisions of the CMS Final Rule on our operations, after putting into place plans to mitigate a portion of that impact without affecting the quality of our patient care, will be a reduction of income before income taxes of between $22 million and $23 million for the fourth quarter of 2011 and between $45 million and $50 million for 2012.
 
We receive Medicare reimbursements for hospice care at daily or hourly rates based on the level of care furnished to the patient.  Our ability to receive Medicare reimbursement for our hospice services is subject to two limitations:
 
 
·
If inpatient days of care provided to all patients at a hospice exceed 20% of the total days of hospice care provided by that hospice for an annual period, then payment for days in excess of this limit are paid for at the lower routine home care rate.  None of our hospice programs exceeded the payment limits on inpatient services for 2010 or 2009.
 
 
·
Overall payments made by Medicare on a per hospice program basis are subject to a cap amount at the end of an annual period.  The cap amount is calculated by multiplying the number of first time Medicare hospice beneficiaries during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year.  If a hospice program exceeds its aggregate cap, then the hospice must repay the excess.

 
29

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 

In July 2011, CMS issued its final rule for hospice services for the 2012 federal fiscal year.  The rule includes a market basket increase of 3.0% and a 0.6% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments and updated wage index data will be an increase of 2.2% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.3 million per quarter.

The proposed rule also includes a change in the methodology used to apply the aggregate hospice cap.  This change is optional and we do not anticipate any impact on our hospice revenues.

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing and rehabilitation centers has its own unique Medicaid reimbursement system.

Medicaid outlays are a significant component of state budgets, and there have been cost containment pressures on Medicaid outlays for skilled nursing centers.  The current economic downturn has caused many states to institute freezes on or reductions in Medicaid spending to address state budget concerns.

Twenty-one of the states in which we operate impose a provider tax on skilled nursing centers as a method of increasing federal matching funds paid to those states for Medicaid.  Those states that have imposed the provider tax have used some or all of the matching funds to fund Medicaid reimbursement to skilled nursing centers.

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
$
174.89
 
$
173.11
 
$
173.73
 
$
172.91
 

For comparison purposes, the following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (including the impact from individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
$
159.64
 
$
159.20
 
$
158.81
 
$
159.30
 

The State of California intends to implement a holdback of 10% on Medicaid payments to skilled nursing facility providers.  The reimbursement rates remain unchanged, but 10% of payment for dates of service from June 1, 2011 to July 31, 2012 will be retained by the state.  Legislation requires that the funds be repaid no later than December 31, 2012.  CMS approved California’s State Plan Amendment in October 2011, allowing California to proceed with the holdback.  Presently, no withholding has been initiated and it is unclear when California will take action to implement the 10% payment reduction.  However, it is likely that payment withholdings will occur during the first half of 2012.


 
30

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Managed Care and Insurance

During the three months ended September 30, 2011, we received 5.0% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
$
382.31
 
$
375.78
 
$
375.49
 
$
368.92
 

Private Payors, Veterans and Other

During the three months ended September 30, 2011, we received 23.6% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
$
188.20
 
$
186.17
 
$
191.40
 
$
188.16
 

Other Reimbursement Matters

Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may either delay or disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.

Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 1 – “Nature of Business” to our consolidated financial statements included in this Form 10-Q.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Results of Operations

The following tables set forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):
 
 
   
For the Three
   
For the Three
   
As a Percentage of Net Revenues
 
   
Months Ended
   
Months Ended
             
   
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
Total net revenues
  $ 485,850     $ 473,411       100.0 %     100.0 %
Costs and expenses:
                               
Operating salaries and benefits
    273,223       268,501       56.2       56.7  
Self-insurance for workers’ compensation and
                           
general and professional liabilities
    15,250       14,531       3.1       3.1  
Other operating costs (1)
    113,793       110,676       23.4       23.4  
Center rent expense
    37,184       18,954       7.7       4.0  
General and administrative expenses
    14,825       14,146       3.1       3.0  
Depreciation and amortization
    8,295       12,639       1.7       2.7  
Provision for losses on accounts receivable
    4,916       5,098       1.0       1.1  
Interest, net
    4,835       10,527       1.0       2.2  
Other (2)
    320,326       4,747       65.9       1.0  
(Loss) income before income taxes and
        discontinued operations
    (306,797 )     13,592       (63.1 )     2.9  
Income tax expense
    1,569       5,559       0.3       1.2  
(Loss) income from continuing operations
    (308,366 )     8,033       (63.5 )     1.7  
Loss from discontinued operations, net
    (1,040 )     (477 )     (0.2 )     (0.1 )
Net (loss) income
  $ (309,406 )   $ 7,556       (63.7 )%     1.6 %
                                 
Supplemental Financial Information (3):
                               
EBITDA
  $ (293,667 )   $ 36,758       (60.4 )%     7.8 %
Adjusted EBITDA
  $ 26,659     $ 36,758       5.5 %     7.8 %
Adjusted EBITDAR
  $ 63,843     $ 55,712       13.1 %     11.8 %
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


 
   
For the Nine
   
For the Nine
   
As a Percentage of Net Revenues
 
   
Months Ended
   
Months Ended
             
   
September 30, 2011
   
September 30, 2010
   
September 30, 2011
   
September 30, 2010
 
                         
Total net revenues
  $ 1,457,421     $ 1,415,734       100.0 %     100.0 %
Costs and expenses:
                               
Operating salaries and benefits
    818,248       799,603       56.1       56.5  
Self-insurance for workers’ compensation and
                           
general and professional liabilities
    45,779       43,433       3.1       3.1  
Other operating costs (1)
    338,126       328,011       23.2       23.1  
Center rent expense
    111,110       56,306       7.6       4.0  
General and administrative expenses
    45,156       44,570       3.1       3.1  
Depreciation and amortization
    23,636       37,449       1.6       2.6  
Provision for losses on accounts receivable
    14,960       15,811       1.0       1.1  
Interest, net
    14,689       34,105       1.0       2.4  
Other (2)
    320,628       6,995       22.0       0.5  
(Loss) income before income taxes and
        discontinued operations
    (274,911 )     49,451       (18.9 )     3.5  
Income tax expense
    14,642       19,990       1.0       1.4  
(Loss) income from continuing operations
    (289,553 )     29,461       (19.9 )     2.1  
Loss from discontinued operations, net
    (1,794 )     (1,734 )     (0.1 )     (0.1 )
Net (loss) income
  $ (291,347 )   $ 27,727       (20.0 )%     2.0 %
                                 
Supplemental Financial Information (3):
                               
EBITDA
  $ (236,586 )   $ 121,005       (16.2 )%     8.5 %
Adjusted EBITDA
  $ 84,042     $ 121,005       5.8 %     8.5 %
Adjusted EBITDAR
  $ 195,152     $ 177,311       13.4 %     12.5 %
 
(1) Operating administrative expenses are included in “other operating costs” above.
 
(2) Other expenses include loss on sale of assets, transaction costs, restructuring costs and loss on asset impairment.
 
(3) We define EBITDA as net income before loss from discontinued operations, interest expense (net of interest income), income tax expense, depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.  Adjusted EBITDA is EBITDA adjusted for loss on sale of assets, restructuring costs and loss on asset impairment.  Adjusted EBITDA margin is Adjusted EBITDA as a percentage of revenue.  Adjusted EBITDAR is Adjusted EBITDA before center rent expense.  Adjusted EBITDAR margin is Adjusted EBITDAR as a percentage of revenue.

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

Specifically, we believe that a presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are three of the primary indicators we use for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of GAAP expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.

In addition to other financial measures, including net segment income, we use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes and depreciation and amortization expense, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business
 
33

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
unit operates. These types of charges are dependent on factors unrelated to our underlying business. The additional items we exclude from Adjusted EBITDA and Adjusted EBITDAR are also charges that we believe are unrelated to the operation of our underlying business.  As a result, we believe that the use of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.

We also make capital allocations to each of our centers based on the centers’ lease terms and their expected Adjusted EBITDA returns.  We establish compensation and bonus programs for our center-level employees that are based upon the achievement of pre-established Adjusted EBITDA targets.

Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP.  As the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDAR are significant components in understanding and assessing our financial performance, EBITDA, Adjusted EBITDA and Adjusted EBITDAR should not be considered in isolation or as alternatives to net income, cash flows generated by or used in operating, investing or financing activities or other financial statement data presented in the consolidated financial statements included in this Form 10-Q as indicators of financial performance or liquidity.  Therefore, our EBITDA, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP.  Some of these limitations are:

 
·
they do not reflect our cash expenditures, or future requirements for capital expenditures, or contractual commitments;
 
·
they do not reflect changes in, or cash requirements for, our working capital needs;
 
·
they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;
 
·
they do not reflect any income tax payments we may be required to make;
 
·
although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future in order to remain competitive in the market, and EBITDA, Adjusted EBITDA and Adjusted EBITDAR do not reflect any cash requirements for such replacements;
 
·
they are not adjusted for all non-cash income or expense items that are reflected in our consolidated statements of cash flows; and
 
·
other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.

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

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The following table provides a reconciliation of our net (loss) income, which is the most directly comparable financial measure presented in accordance with GAAP, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR for the periods indicated (in thousands):

   
For the Three Months Ended
   
For the Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Net (loss) income
  $ (309,406 )   $ 7,556     $ (291,347 )   $ 27,727  
                                 
Plus:
                               
Loss from discontinued operations, net
    1,040       477       1,794       1,734  
Income tax expense
    1,569       5,559       14,642       19,990  
Interest expense, net
    4,835       10,527       14,689       34,105  
Depreciation and amortization
    8,295       12,639       23,636       37,449  
EBITDA
  $ (293,667 )   $ 36,758     $ (236,586 )   $ 121,005  
                                 
Plus:
                               
Loss on sale of assets, net
    809       -       809       -  
Restructuring costs
    2,426       -       2,728       -  
Loss on asset impairment
    317,091       -       317,091       -  
Adjusted EBITDA
  $ 26,659     $ 36,758     $ 84,042     $ 121,005  
                                 
Plus:
                               
Center rent expense
    37,184       18,954       111,110       56,306  
Adjusted EBITDAR
  $ 63,843     $ 55,712     $ 195,152     $ 177,311  


The following discussion of the “Three Months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010” is based, in part, on the financial information presented in Note 8 – “Segment Information” in our consolidated financial statements included in this Form 10-Q.

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

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $12.5 million, or 2.6%, to $485.9 million for the three months ended September 30, 2011 from $473.4 million for the three months ended September 30, 2010.  We reported a net loss for the three months ended September 30, 2011 of $309.4 million and net income of $7.5 million for the three months ended September 20, 2010.

The increase in net revenues for the 2011 period included $13.7 million of additional revenue in our Inpatient Services segment, which were partially offset by a $0.7 million decrease in nonaffiliated revenues from our Rehabilitation Therapy Services segment and a $0.5 million decrease in nonaffiliated revenue from our Medical Staffing segment.

Operating salaries and benefits increased $4.7 million, or 1.8%, to $273.2 million (56.2% of net revenues) for the three months ended September 30, 2011 from $268.5 million (56.7% of net revenues) for the three months ended September 30, 2010.  The increase resulted primarily from increased wage rates and benefits.

Self-insurance for workers’ compensation and general and professional liability insurance expense increased $0.8 million, or 5.5%, to $15.3 million (3.1% of net revenues) for the three months ended September 30, 2011 from $14.5 million (3.1% of net revenues) for the three months ended September 30, 2010, primarily due to increased claims related activity in our general and professional liability self-insurance.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 

Other operating costs increased $3.1 million, or 2.8%, to $113.8 million (23.4% of net revenues) for the three months ended September 30, 2011 from $110.7 million (23.4% of net revenues) for the three months ended September 30, 2010.  The increase was primarily due to increases in purchased services, supplies and provider taxes.

Center rent expense increased $18.2 million, or 95.8%, to $37.2 million (7.7% of net revenues) for the three months ended September 30, 2011 from $19.0 million (4.0% of net revenues) for the three months ended September 30, 2010.  The increase is primarily attributable to the new lease agreements entered into with Sabra in conjunction with the Separation.

General and administrative expenses increased $0.7 million, or 5.0%, to $14.8 million (3.1% of net revenues) for the three months ended September 30, 2011 from $14.1 million (3.0% of net revenues) for the three months ended September 30, 2010.  The increase was primarily due to increased purchased services.

Depreciation and amortization decreased $4.3 million, or 34.1%, to $8.3 million (1.7% of net revenues) for the three months ended September 30, 2011 from $12.6 million (2.7% of net revenues) for the three months ended September 30, 2010.  The decrease was attributable to the transfer of assets to Sabra in conjunction with the Separation.

The provision for losses on accounts receivable decreased $0.2 million, or 3.9%, to $4.9 million (1.0% of net revenues) for the three months ended September 30, 2011 from $5.1 million (1.1% of net revenues) for the three months ended September 30, 2010.  The decrease resulted from improving cash collections trends, which improved our accounts receivable aging, leading to a reduction in our provision for losses on accounts receivable for the three months ended September 30, 2011 when compared to the three months ended September 30, 2010.

Net interest expense decreased $5.7 million, or 54.3%, to $4.8 million (1.0% of net revenues) for the three months ended September 30, 2011 from $10.5 million (2.2% of net revenues) for the three months ended September 30, 2010 due to lower aggregate indebtedness resulting from the Separation.

Other expenses for the three months ended September 30, 2011 consisted of a $317.1 million loss on asset impairment, $2.4 million of restructuring costs and a $0.8 million loss on sale of assets.  The $317.1 million loss on asset impairment is discuss in more detail in “Asset Impairment” above and in Note 2 – “Asset Impairment” of our consolidated financial statements included in this Form 10-Q.  The $2.4 million of restructuring costs is discussed in more detail in “2011 Restructuring” above and in the Restructuring Costs portion Note 1 – “Nature of Business” of our consolidated financial statements included in this Form 10-Q.  The $0.8 million loss on sale of assets resulted from the disposal of two hospice operations during the quarter and is discussed in Note 5 – “Discontinued Operations” of our consolidated financial statements included in this Form 10-Q.  Other expenses for the three months ended September 30, 2010 consisted of $4.7 million of REIT transaction costs associated with the Separation.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended September 30 (dollars in thousands):

   
2011
   
2010
 
                         
Inpatient Services
  $ 435,271       89.6 %   $ 421,573       89.1 %
Rehabilitation Therapy Services
    62,359       12.8       51,740       10.9  
Medical Staffing Services
    21,753       4.5       22,205       4.7  
Corporate
    15       -       14       -  
Intersegment Eliminations
    (33,548 )     (6.9 )     (22,121 )     (4.7 )
                                 
Total net revenues
  $ 485,850       100.0 %   $ 473,411       100.0 %


 
36

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended September 30 (in thousands):

   
2011
   
2010
 
             
Rehabilitation Therapy Services
  $ 32,791     $ 21,397  
Medical Staffing Services
    757       724  
Total intersegment revenue
  $ 33,548     $ 22,121  

The following table sets forth the amount of net segment income for the three months ended September 30 (in thousands):

   
2011
   
2010
 
             
Inpatient Services
  $ 30,726     $ 36,168  
Rehabilitation Therapy Services
    2,296       3,961  
Medical Staffing Services
    1,221       1,195  
Net segment income before Corporate
    34,243       41,324  
Corporate
    (20,714 )     (27,732 )
Net segment income
  $ 13,529     $ 13,592  

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the strengths and performance of each segment based on operations and financial measures, including net segment income.  Net segment income is defined as earnings before income tax expense, transaction costs, restructuring costs, loss on sale of assets, loss on asset impairment and discontinued operations.  Net segment income for the three months ended September 30, 2011 for (1) our Inpatient Services segment decreased $5.4 million, or 15.0%, to $30.7 million, (2) our Rehabilitation Therapy Services segment decreased $1.7 million, or 42.0%, to $2.3 million and (3) our Medical Staffing Services segment remained unchanged at $1.2 million in comparison to the three months ended September 30, 2010, due to the factors discussed below for each segment.  We use net segment income among other things to help identify opportunities for improvement and assist in allocating resources to each segment. 

Inpatient Services

Net revenues increased $13.7 million, or 3.2%, to $435.3 million for the three months ended September 30, 2011 from $421.6 million for the three months ended September 30, 2010.  The increase was primarily the result of:

-
a $14.4 million increase in Medicare revenues as a result of a $13.3 million increase in revenues related to Medicare Part A rates, a $0.8 million increase due to an increased customer base, and a $0.3 million increase in Medicare Part B revenues;
   
-
a $3.6 million increase in hospice revenues due to internal growth and an acquisition of a hospice company in December 2010;
   
-
a $0.4 million increase in managed care and commercial insurance revenues driven primarily by improved rates;
   
-
a $0.2 million increase in other revenue including from veterans’ coverage and other various inpatient services; and
   
-
a $0.1 million increase in Medicaid revenues consisting of a $1.5 million increase related to higher rates, offset in part by a $1.4 million from a decrease in customer base;
   
 
Offset in part by:
 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
-
a $2.7 million decrease due to closure of operations in 2010 and 2011; and
   
-
a $2.3 million decrease in private revenues primarily due to a lower customer base.

Operating salaries and benefits expenses decreased $6.7 million, or 3.2%, to $202.7 million for the three months ended September 30, 2011 from $209.4 million for the three months ended September 30, 2010.  The decrease was attributable to the following:

-
a decrease of $7.9 million in salaries, wages and benefits due primarily to the transfer of therapists from our Inpatient Services segment to our Rehabilitation Services segment, as well as the outsourcing of housekeeping services;
   
 
Offset in part by:
   
-
increases in compensation and related benefits of $1.2 million due to merit and cost of living adjustments.
 
Self-insurance for workers’ compensation and general and professional liability insurance expense increased $0.5 million, or 3.6%, to $14.2 million for the three months ended September 30, 2011 as compared to $13.7 million for the three months ended September 30, 2010, which was driven by increased claims related activity in our general and professional liability self-insurance.

Other operating costs increased $14.5 million, or 12.7%, to $128.8 million for the three months ended September 30, 2011 from $114.3 million for the three months ended September 30, 2010.  The increase was attributable to the following:

-
a $10.5 million increase in contract labor resulting from use of therapists in our Rehabilitation Therapy Services segment who were formerly employed by our Inpatient Services segment;
   
-
a $1.3 million increase in purchased services primarily related to outsourced housekeeping contracts;
   
-
a $1.2 million increase in other supplies, principally food and oxygen;
   
-
a $1.2 million increase in provider taxes due to increased provider tax rates from a number of states in which we operate;
   
-
a $0.5 million increase in equipment rental costs; and
   
-
a $0.4 million increase in utility costs;
   
 
Offset in part by:
   
-
a $0.6 million decrease in administrative costs to manage the therapists that transferred to our Rehabilitation Therapy Services segment.

Operating administrative expenses decreased $0.5 million, or 4.6%, to $10.3 million for the three months ended September 30, 2011 compared to $10.8 million for the three months ended September 30, 2010, primarily due to lower salaries and benefits expense.

Center rent expense increased $18.3 million, or 98.4%, to $36.9 million for the three months ended September 30, 2011 from $18.6 million for the three months ended September 30, 2010.  The increase is attributable to the new lease agreements entered into with Sabra in conjunction with the Separation and other negotiated rent increases.

Depreciation and amortization decreased $4.6 million, or 40.0%, to $6.9 million for the three months ended September 30, 2011 from $11.5 million for the three months ended September 30, 2010.  The decrease was attributable to the transfer of assets to Sabra in conjunction with the Separation.
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The provision for losses on accounts receivable increased $0.2 million, or 4.3%, to $4.8 million for the three months ended September 30, 2011 from $4.6 million for the three months ended September 30, 2010.  The increased expense is due to slower cash collections.

Net interest expense decreased $2.5 million, or 100.0%, for the three months ended September 30, 2011 from $2.5 million for the three months ended September 30, 2010.  The decrease is primarily the result of the transfer of mortgages for previously owned centers to Sabra in conjunction with the Separation.  Our remaining owned centers have no debt.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $10.7 million, or 20.7%, to $62.4 million for the three months ended September 30, 2011 from $51.7 million for the three months ended September 30, 2010. The revenue increase was the result of:

-
an increase of $11.6 million attributable to increased billable minutes, primarily due to the addition of 48 new affiliated contracts resulting from the transfer of therapy employees from our Inpatient Services segment to our Rehabilitation Therapy Services segment;
   
 
Offset in part by:
   
-
a decrease of $0.7 million due to a lower revenue per minute.  This rate decrease was due to the negative impacts of the MPPR rule, which reduced Medicare Part B rates, that was put in place January 2011 in the amount of $1.6 million. The effects were partially offset by nonaffiliated and affiliated rate increases as well as other Part B rate increases; and
   
-
a decrease in other revenue of $0.2 million primarily due to a one-time legal settlement received in 2010.

Operating salaries and benefits expenses increased $11.4 million, or 26.7%, to $54.3 million for the three months ended September 30, 2011 from $42.9 million for the three months ended September 30, 2010.  The increase was driven primarily by the transfer of therapists from our Inpatient Services segment to our Rehabilitation Therapy services segment associated with the transfer of 48 affiliated contracts and wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $0.4 million, or 1.8%, to $21.8 million for the three months ended September 30, 2011 from $22.2 million for the three months ended September 30, 2010.  The decrease was primarily the result of:

-
a decrease of $0.2 million due to a decline in therapy and pharmacy staffing lines of business;
   
-
a decrease of $0.1 million due to a decrease in nursing hours; and
   
-
a decrease of $0.1 million due to lower fees earned from temporary placement of physicians.

Corporate

General and administrative expenses not directly attributed to segments increased $0.7 million, or 5.0%, to $14.8 million for the three months ended September 30, 2011 from $14.1 million for the three months ended September 30, 2010.  The increase was primarily due to increased purchased services.

Interest expense not directly attributed to operating segments decreased $3.1 million, or 38.8%, to $4.9 million for the three months ended September 30, 2011 from $8.0 million for the three months ended September 30, 2010 due to lower aggregate indebtedness resulting from the Separation.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $41.7 million, or 2.9%, to $1,457.4 million for the nine months ended September 30, 2011 from $1,415.7 million for the nine months ended September 30, 2010.  We reported net (loss) income for the nine month periods ended September 30, 2011 and 2010 of $(291.3) million and $27.7 million, respectively.

The increase in net revenues for the 2011 period included $44.2 million of additional revenue in our Inpatient Services segment, which were partially offset by a $0.1 million decrease in nonaffiliated revenues from our Rehabilitation Therapy Services segment and a $2.4 million decrease in nonaffiliated revenue from our Medical Staffing segment.

Operating salaries and benefits increased $18.6 million, or 2.3%, to $818.2 million (56.1% of net revenues) for the nine months ended September 30, 2011 from $799.6 million (56.5% of net revenues) for the nine months ended September 30, 2010.

Self-insurance for workers’ compensation and general and professional liability insurance expense increased $2.4 million, or 5.5%, to $45.8 million (3.1% of net revenues) for the nine months ended September 30, 2011 from $43.4 million (3.1% of net revenues) for the nine months ended September 30, 2010, primarily due to increased claims related activity in our general and professional liability self-insurance.

Other operating costs increased $10.1 million, or 3.1%, to $338.1 million (23.2% of net revenues) for the nine months ended September 30, 2011 from $328.0 million (23.1% of net revenues) for the nine months ended September 30, 2010.  The increase was primarily due to increases in purchased services, supplies and provider taxes.

Center rent expense increased $54.8 million, or 97.3%, to $111.1 million (7.6% of net revenues) for the nine months ended September 30, 2011 from $56.3 million (4.0% of net revenues) for the nine months ended September 30, 2010.  The increase is primarily attributable to the new lease agreements entered into with Sabra in conjunction with the Separation.

General and administrative expenses increased $0.6 million, or 1.3%, to $45.2 million (3.1% of net revenues) for the nine months ended September 30, 2011 from $44.6 million (3.1% of net revenues) for the nine months ended September 30, 2010.  The increase was primarily due to increased purchased services.

Depreciation and amortization decreased $13.8 million, or 36.9%, to $23.6 million (1.6% of net revenues) for the nine months ended September 30, 2011 from $37.4 million (2.6% of net revenues) for the nine months ended September 30, 2010.  The decrease was attributable to the transfer of assets to Sabra in conjunction with the Separation.

The provision for losses on accounts receivable decreased $0.8 million, or 5.1%, to $15.0 million (1.0% of net revenues) for the nine months ended September 30, 2011 from $15.8 million (1.1% of net revenues) for the nine months ended September 30, 2010.  The decrease resulted from improving cash collections trends, which improved our accounts receivable aging, leading to a reduction in our provision for losses on accounts receivable for the nine months ended September 30, 2011 when compared to the nine months ended September 30, 2010.

Net interest expense decreased $19.4 million, or 56.9%, to $14.7 million (1.0% of net revenues) for the nine months ended September 30, 2011 from $34.1 million (2.4% of net revenues) for the nine months ended September 30, 2010 due to lower aggregate indebtedness resulting from the Separation.

Other expenses for the nine months ended September 30, 2011 consisted of a $317.1 million loss on asset impairment, $2.7 million of restructuring costs and a $0.8 million loss on sale of assets.  The $317.1 million loss on asset impairment is discuss in more detail in “Asset Impairment” above and in Note 2 – “Asset Impairment” of our consolidated financial statements included in this Form 10-Q.  Of the $2.7 million of restructuring costs, $2.4 million is discussed in more detail in “2011 Restructuring” above and in the Restructuring Costs portion Note 1 – “Nature of Business” of our consolidated financial statements included in this Form 10-Q.  The remaining $0.3 million relations to costs related to the integration of a
 
40

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
December 2010 hospice acquisition.  The $0.8 million loss on sale of assets resulted from the disposal of two hospice operations during the quarter and is discussed in Note 5 – “Discontinued Operations” of our consolidated financial statements included in this Form 10-Q.  Other expenses for the three months ended September 30, 2010 consisted of $7.0 million of REIT transaction costs associated with the Separation.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the nine months ended September 30 (dollars in thousands):

   
2011
   
2010
 
                         
Inpatient Services
  $ 1,302,431       89.4 %   $ 1,258,271       88.9 %
Rehabilitation Therapy Services
    188,355       12.9       153,307       10.8  
Medical Staffing Services
    67,388       4.6       69,076       4.9  
Corporate
    36       -       28       -  
Intersegment Eliminations
    (100,789 )     (6.9 )     (64,948 )     (4.6 )
Total net revenues
  $ 1,457,421       100.0 %   $ 1,415,734       100.0 %

Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the nine months ended September 30 (in thousands):

   
2011
   
2010
 
             
Rehabilitation Therapy Services
  $ 98,710     $ 63,584  
Medical Staffing Services
    2,079       1,364  
Total intersegment revenue
  $ 100,789     $ 64,948  

The following table sets forth the amount of net segment income for the nine months ended September 30 (in thousands):

   
2011
   
2010
 
             
Inpatient Services
  $ 95,880     $ 113,601  
Rehabilitation Therapy Services
    8,495       11,757  
Medical Staffing Services
    4,082       4,479  
Net segment income before Corporate
    108,457       129,837  
Corporate
    (62,740 )     (80,386 )
Net segment income
  $ 45,717     $ 49,451  

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the strengths and performance of each segment based on operational and financial measures, including net segment income.  Net segment income is defined as earnings before income tax expense, transaction costs, restructuring costs, loss on sale of assets, loss on asset impairment and discontinued operations.  Net segment income for the nine months ended September 30, 2011 for (1) our Inpatient Services segment decreased $17.7 million, or 15.6%, to $95.9 million, (2) our Rehabilitation Therapy Services segment decreased $3.3 million, or 27.7%, to $8.5 million and (3) our Medical Staffing Services segment decreased $0.4 million, or 8.9%, to $4.1 million in comparison to the nine months ended September 30, 2010, due to the factors discussed below for each segment.  We use net segment income among other things to help identify opportunities for improvement and assist in allocating resources to each segment. 


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

Net revenues increased $44.1 million, or 3.5%, to $1,302.4 million for the nine months ended September 30, 2011 from $1,258.3 million for the nine months ended September 30, 2010.  The increase was primarily the result of:

-
an increase of $45.9 million in Medicare revenues as a result of a $40.5 million increase in revenues related to Medicare Part A rates, a $5.1 million increase due to an increased customer base, and a $0.3 million increase in Medicare Part B revenues;
   
-
a $10.0 million increase in hospice revenues due to internal growth and an acquisition of a hospice company in December 2010;
   
-
a $1.9 million increase in other revenue including from veterans’ coverage and other various inpatient services; and
   
-
a $1.7 million increase in managed care and commercial insurance revenues driven primarily by improved rates;
   
 
Offset in part by:
   
-
an $8.1 million decrease due to closure of operations in 2010 and 2011;
   
-
a decrease of $4.5 million in private revenues primarily due to a lower customer base; and
   
-
a $2.8 million decrease in Medicaid revenues consisting of a $1.3 million increase related to higher rates, offset by a $4.1 million from a decrease in customer base.
   
Operating salaries and benefits expenses decreased $17.0 million, or 2.7%, to $605.5 million for the nine months ended September 30, 2011 from $622.5 million for the nine months ended September 30, 2010.  The decrease was attributable to the following:

-
a decrease of $23.7 million in salaries, wages and benefits due primarily to the transfer of therapists from our Inpatient Services segment to our Rehabilitation Services segment, as well as the outsourcing of housekeeping services;
   
 
Offset in part by:
   
-
an increase in salaries and related benefits of $3.9 million related to an acquisition of a hospice company in December 2010; and
   
-
increases in compensation and related benefits of $2.8 million due to merit and cost of living adjustments.

Self-insurance for workers’ compensation and general and professional liability insurance expense increased $1.6 million, or 3.9%, to $42.6 million for the nine months ended September 30, 2011 as compared to $41.0 million for the nine months ended September 30, 2010, which was driven by increased claims related activity in our general and professional liability self-insurance.

Other operating costs increased $45.2 million, or 13.4%, to $383.4 million for the nine months ended September 30, 2011 from $338.2 million for the nine months ended September 30, 2010.  The increase was attributable to the following:

-
a $34.0 million increase in contract labor resulting from use of therapists in with our Rehabilitation Therapy Services segment who were formerly employed by our Inpatient Services segment;
   
-
a $4.6 million increase in purchased services primarily related to outsourced housekeeping contracts;
   
-
a $4.4 million increase in other supplies, principally food and oxygen;
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
-
a $3.5 million increase in provider taxes due to increased provider tax rates from a number of states in which we operate;
   
-
a $1.5 million increase in utility costs; and
   
-
a $0.7 million increase in equipment rentals costs;
   
 
Offset in part by:
   
-
a $2.0 million decrease in administrative costs to manage the therapists that transferred to our Rehabilitation Therapy Services segment;
   
-
a $0.9 million decrease in education and training costs; and
   
-
a $0.6 million decrease in real estate tax expense.

Operating administrative expenses increased $0.1 million, or 0.3%, to $31.0 million for the nine months ended September 30, 2011 compared to $30.9 million for the nine months ended September 30, 2010, primarily due to higher salaries and benefits expense.

Center rent expense increased $54.9 million, or 99.3%, to $110.2 million for the nine months ended September 30, 2011 from $55.3 million for the nine months ended September 30, 2010.  The increase is attributable to the new lease agreements entered into with Sabra in conjunction with the Separation and other negotiated rent increases.

Depreciation and amortization decreased $14.3 million, or 42.1%, to $19.7 million for the nine months ended September 30, 2011 from $34.0 million for the nine months ended September 30, 2010.  The decrease was attributable to the transfer of assets to Sabra in conjunction with the Separation.

The provision for losses on accounts receivable decreased $0.7 million, or 4.7%, to $14.2 million for the nine months ended September 30, 2011 from $14.9 million for the nine months ended September 30, 2010.  The decreased expense is due to improving cash collections trends.

Net interest expense decreased $7.9 million, or 101.3%, for the nine months ended September 30, 2011 from $7.8 million for the nine months ended September 30, 2010.  The decrease is the result of the transfer of mortgages for previously owned centers to Sabra in conjunction with the Separation.  Our remaining owned centers have no debt.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $35.1 million, or 22.9%, to $188.4 million for the nine months ended September 30, 2011 from $153.3 million for the nine months ended September 30, 2010. The revenue increase was the result of:

-
an increase of $35.6 million attributable to increased billable minutes, primarily due to the addition of 48 new affiliated contracts resulting from the transfer of therapy employees from our Inpatient Services segment to our Rehabilitation Therapy Services segment; and
   
 
Offset in part by:
   
-
a decrease of $0.5 million attributable to a lower revenue per minute.  This rate decrease was due to the negative impacts of the MPPR rule, which reduced Medicare Part B rates, that was put in place January 2011 in the amount of $4.6 million, mostly offset by nonaffiliated and affiliated rate increases as well as other Part B rate increases and adjustments.

Operating salaries and benefits expenses increased $35.2 million, or 27.8%, to $161.9 million for the nine months ended September 30, 2011 from $126.7 million for the nine months ended September 30, 2010.  The increase was driven by the
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

transfer of therapists from our Inpatient Services segment to our Rehabilitation Therapy services segment associated with the transfer of 48 affiliated contracts and wage increases.
 
Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $1.7 million, or 2.5%, to $67.4 million for the nine months ended September 30, 2011 from $69.1 million for the nine months ended September 30, 2010.  The decrease was primarily the result of:

-
a decrease of $1.4 million due to a decline in therapy and pharmacy staffing hours; and
   
-
a decrease of $1.0 million due to lower fees earned from the temporary placement of physicians;
   
 
Offset in part by:
   
-
an increase of $0.7 million due to an increase in billable hours for nurse staffing.

Operating salaries and benefits expenses increased $0.4 million, or 0.8%, to $50.8 million for the nine months ended September 30, 2011 as compared to $50.4 million for the nine months ended September 30, 2010.  The decrease is due to the decline in staffing hours referenced above.

Corporate

General and administrative expenses not directly attributed to segments increased $0.6 million, or 1.3%, to $45.2 million for the nine months ended September 30, 2011 from $44.6 million for the nine months ended September 30, 2010.  The increase was primarily due to increased purchased services.

Interest expense not directly attributed to operating segments decreased $11.5 million, or 43.7%, to $14.8 million for the nine months ended September 30, 2011 from $26.3 million for the nine months ended September 30, 2010 due to lower aggregate indebtedness resulting from the Separation.


Liquidity and Capital Resources

For the three months and nine months ended September 30, 2011, our net loss was $309.4 million and $291.3 million, respectively, which included a non-cash pre-tax loss on asset impairment of $317.1 million.  As of September 30, 2011, our working capital was $191.3 million and we had cash and cash equivalents of $91.2 million, $142.6 million in borrowings and $59.6 million available under our revolving credit facility. As of September 30, 2011, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility and our term loan indebtedness as described under “Loan Agreements” below.

While we are continuing to evaluate the impact of the CMS Final Rule, we estimate that the prospective net impact of the CMS Final Rule on our operations, after giving effect to our mitigation initiative, will be a reduction of income before income taxes of between $22 million and $23 million for the fourth quarter of 2011 and between $45 million and $50 million for 2012.  The substantial reduction in profitability will result in a reduced cash flow and liquidity.

Based on our current analysis, we anticipate that we will be in compliance with the covenants in our credit agreement, and be able to utilize the revolving credit facility, at least through 2012.

Based on current levels of operations and the mitigation initiative described above, we believe that our operating cash flows (which were $17.9 million for the three months ended September 30, 2011 and $49.3 million for the nine months ended September 30, 2011), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary), scheduled debt service payments and our other commitments described in our 2010 Form 10-K in the table under “Obligations and Commitments” at least through the next twelve months, notwithstanding the negative impact of the multi-year economic
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
downturn on our ability to collect certain of our accounts receivable and the loss of revenue resulting from the CMS final rule.  We believe our long term liquidity needs will be satisfied by these same sources.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.  Although our credit agreement, which is described under “Loan Agreements”, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to incur additional indebtedness, if needed. However, there can be no assurance that we will be able to incur additional indebtedness or access additional sources of capital, such as issuing debt or equity securities, on terms that are acceptable to us or at all.
 
The State of California intends to implement a holdback of 10% on Medicaid payments to skilled nursing facility providers.  The reimbursement rates remain unchanged, but 10% of payment for dates of service from June 1, 2011 to July 31, 2012 will be retained by the state.  Legislation requires that the funds be repaid no later than December 31, 2012.  CMS approved California’s State Plan Amendment in October 2011, allowing California to proceed with the holdback.  Presently, no withholding has been initiated and it is unclear when California will take action to implement the 10% payment reduction.  However, it is likely that payment withholdings will occur during the first half of 2012.

Cash Flows

During the nine months ended September 30, 2011, net cash provided by operating activities decreased by $55.0 million as compared to the same period last year.  In addition to decreased net income of $319.1 million, the decrease in cash flows from operating activities was the result of (i) our period-over-period decrease in working capital changes of $35.5 million, driven principally by temporary cash usage from the impact of timing differences on scheduled payroll and accounts payable disbursement cycles, plus increased payments of claims accrued in our self-insurance obligations in an effort to settle claims and the related funding of cash restricted for future settlements and (ii) a period-over-period increase of $299.6 million in non-cash adjustments to net income, principally related to loss on asset impairment.  Increased center rent expense of $54.8 million and reduced interest expense of $19.4 million, which also resulted primarily from the Separation, contributed to the decrease in net cash provided by operating activities.  All of these factors are discussed in “Results of Operations” above.

Net cash used for investing activities of $30.9 million for the nine months ended September 30, 2011 were for capital expenditures and payments related to a December 2010 hospice acquisition, offset in part by cash received for sale of assets.

Net cash used for financing activities was $8.4 million for the nine months ended September 30, 2011, which was attributable to repayments of long-term debt and capital lease obligations.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $14.2 million and $13.8 million for the three months ended September 30, 2011 and 2010, respectively.

Loan Agreements

In October 2010, we entered into a $285.0 million senior secured credit facility (the “Credit Agreement”) with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent.  The Credit Agreement provides for $150.0 million in term loans ($139.9 million outstanding at September 30, 2011), a $60.0 million revolving credit facility ($30.0 million of which may be utilized for letters of credit) and a $75.0 million funded letter of credit facility funded by proceeds of additional term loans, which was fully utilized at September 30, 2011.  The revolving credit facility is undrawn as of September 30, 2011 but was utilized for $0.4 million of letters of credit.  In the event we require additional letters of credit in the future, we will need to utilize availability under the revolving credit facility. The final maturity date of the term loans and the letter of credit facility is October 18, 2016 and the revolving credit facility terminates on October 18, 2015.

Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test and a leverage covenant.  The Credit Agreement contains customary events of default, such as a failure by us to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting certain actions, including incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
dispositions, mergers and investments.  Our obligations under the Credit Agreement are guaranteed by most of our subsidiaries and are collateralized by our assets and the assets of most of our subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of $2.5 million, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  Borrowings under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) the greater of 1.75% or LIBOR, adjusted for statutory reserves or (b) an alternative base rate determined by reference to the highest of (i) the prime rate announced by Credit Suisse, (ii) the federal funds rate plus one-half of 1.0%, and (iii) the greater of 1.75% or one-month LIBOR adjusted for statutory reserves plus 1%.  The applicable percentage for term loans and revolving loans is 4.75% for alternative base rate loans and 5.75% for LIBOR loans.  Each year, commencing in 2012, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement. In addition to paying interest on outstanding loans under the Credit Agreement, we are required to pay a facility fee of 0.50% per annum to the lenders under the revolving credit facility in respect of the unused revolving commitments.
 
The Credit Agreement requires that 50% of our term loans be subject to at least a three-year hedging arrangement.  To satisfy this requirement, we executed two hedging instruments on January 18, 2011; a two-year interest rate cap and a two-year “forward starting” interest rate swap.  The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 7.5% for two years.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935% for this portion of the term loans.  There was no fee for this swap agreement.  Both arrangements qualify for hedge accounting treatment.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk because we have issued debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates of interest on our debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

                                             
Fair Value
   
Fair Value
 
   
Expected Maturity Dates
    September 30,   December 31,
   
2012
   
2013
   
2014
   
2015
   
2016
   
Thereafter
   
Total
   
2011 (1)
   
2010 (1)
 
   
(Dollars in thousands)
             
Long-term debt:
                                                     
Fixed rate debt
  $ 1,033     $ 947     $ 679     $ -     $ -     $ -     $ 2,659     $ 2,532     $ 8,584  
Rate
    8.7 %     8.6 %     8.5 %     - %     - %     - %                        
                                                                         
Variable rate debt
  $ 10,000     $ 10,000     $ 10,000     $ 10,000     $ 10,000     $ 89,922     $ 139,922     $ 108,440     $ 147,500  
Rate
    11.5 %     7.5 %     7.5 %     7.5 %     7.5 %     7.5 %                        
                                                                         
Interest rate hedges:
                                                          $ 1,922     $ -  
Cap
  $ 82,500     $ 82,500     $ -     $ -     $ -     $ -                          
  Maximum rate
1.75 %     1.75 %     -       -       -       -                          
Variable to fixed
  $ -     $ -     $ 82,500     $ 82,500     $ -     $ -                          
  Average pay rate
-       -       3.185 %     3.185 %     -       -                          
  Average receive rate
-       -       1.75 %     1.75 %     -       -                          
 
    (1)
    The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 4.  CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Exchange Act as controls and procedures that are designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated  and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding  required disclosure.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of management, including our Chief Executive Officer, William A. Mathies, and our Chief Financial Officer, L. Bryan Shaul, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2011.

There were no changes in our internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

ITEM 5.  OTHER INFORMATION

On July 29, 2011, CMS released the CMS Final Rule for skilled nursing facilities for the 2012 federal fiscal year, which became effective on October 1, 2011.  After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates under the CMS Final Rule is 11.1%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  As a result of this decrease, during the third quarter ended September 30, 2011, we commenced a broad-based mitigation initiative, which includes infrastructure cost reductions, to reduce the impact of the CMS Final Rule on our business and results of operations.  During the third quarter ended September 30, 2011, we incurred $2.4 million of restructuring costs for this initiative, which consisted primarily of severance benefits resulting from reductions of staff.

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

For a description of our legal proceedings, see Note 6(b) – “Commitments and Contingencies – Litigation” of our consolidated financial statements included in this Form 10-Q, which is incorporated by reference to this item.

ITEM 1A.  RISK FACTORS

We have set forth below a risk factor not previously disclosed in Part I, Item 1A. of our Annual Report on Form 10-K for the year ended December 31, 2010, which was filed with the Securities and Exchange Commission on March 3, 2011. No other material changes from the risk factors previously disclosed in the Annual Report on Form 10-K for the year ended December 31, 2010 have been made.

The decrease in Medicare revenues as a result of the final rule issued by the Centers for Medicare and Medicaid Services, or from future legislative or regulatory action, could have adverse effects on our financial condition and require us to seek waivers from our lenders and landlords.

Our revenues are heavily dependent on payments administered under the Medicare and Medicaid programs. The final rule issued on July 29, 2011 by CMS for Medicare reimbursement rates for skilled nursing facilities for the 2012 federal fiscal year, which began October 1, 2011, provides for an 11.1% prospective net reduction from Medicare reimbursement rates, after the application of the market basket increase of 2.7% less the productivity adjustment of 1.0%, prevailing in the
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
2011 federal fiscal year and makes changes in therapy reimbursement that will further reduce our revenues from the Medicare program or increase our costs of providing such services.  There are additional regulatory or legislative initiatives pending that could further reduce Medicare payments for our healthcare services.  In addition, the failure of the "Supercommittee" to agree upon a plan to reduce the federal deficit would lead to automatic expense reduction, which includes an across-the-board 2% cut to Medicare payments, including those for skilled nursing facilities.  The adverse effects resulting from the reduction in our Medicare revenues could include, but are not limited to, reduced liquidity and cash flows, which could result in our need to seek waivers from our lenders and landlords and/or attempt to renegotiate our Credit Agreement and affected lease agreements. If we are required to seek such waivers and/or renegotiate the terms of such agreements, there is no assurance that we will be successful in obtaining the waivers or amending any such agreement on terms that are acceptable to us, or at all, which could have an adverse effect on our financial position, results of operations and cash flows.


ITEM 6. EXHIBITS

31.1
Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
   
31.2
Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
   
32.1
Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
   
32.2
Section 906 Sarbanes-Oxley Certification by Chief Financial Officer
   
101.INS
XBRL Instance Document
   
101.SCH
XBRL Taxonomy Extension Schema Document
   
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
   
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
   
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document


SIGNATURE

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.

SUN HEALTHCARE GROUP, INC.
 
 
 
By:  /s/ L. Bryan Shaul                                       
L. Bryan Shaul
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)

November 3, 2011
 
 
 
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