Form 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended September 30, 2009.


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

For the transition period from to .

Commission file number: 001-33459

Skilled Healthcare Group, Inc.

(Exact name of registrant as specified in its charter)


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

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

(949) 282-5800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No 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 o 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer o	Accelerated filer þ	Non-accelerated filer o	Smaller reporting company o
	(do not check if 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 þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on October 30, 2009.

Class A common stock, $0.001 par value — 20,327,107 shares
Class B common stock, $0.001 par value — 17,000,668 shares

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

Skilled Healthcare Group, Inc.

Condensed Consolidated Balance Sheets
(In thousands, except per share data)


	September 30, 2009			December 31, 2008
	(Unaudited)
ASSETS

Current assets:
Cash and cash equivalents	$	3,235		$	2,047
Accounts receivable, less allowance for doubtful accounts of $25,283 and $26,593 at September 30, 2009 and December 31, 2008, respectively		101,528			102,954
Deferred income taxes		17,558			19,703
Prepaid expenses		11,952			9,226
Other current assets		6,828			7,483

Total current assets		141,101			141,413
Property and equipment, less accumulated depreciation of $54,416 and $40,118 at September 30, 2009 and December 31, 2008, respectively		362,910			346,466
Other assets:
Notes receivable		9,440			4,448
Deferred financing costs, net		14,847			10,184
Goodwill		449,962			449,962
Intangible assets, less accumulated amortization of $13,495 and $10,490 at September 30, 2009 and December 31, 2008, respectively		27,200			30,310
Other assets		25,326			23,797

Total other assets		526,775			518,701

Total assets	$	1,030,786		$	1,006,580

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable and accrued liabilities	$	45,068		$	55,478
Employee compensation and benefits		31,372			30,825
Current portion of long-term debt and capital leases		9,995			7,812

Total current liabilities		86,435			94,115
Long-term liabilities:
Insurance liability risks		29,898			30,654
Deferred income taxes		3,733			721
Other long-term liabilities		12,694			14,064
Long-term debt and capital leases, less current portion		462,518			462,449

Total liabilities		595,278			602,003
Stockholders’ equity:
Class A common stock, 175,000 shares authorized, $0.001 par value per share; 20,331 and 20,189 issued and outstanding at September 30, 2009 and December 31, 2008, respectively		20			20
Class B common stock, 30,000 shares authorized, $ 0.001 par value per share; 17,001 and 17,027 issued and outstanding at September 30, 2009 and December 31, 2008, respectively		17			17
Additional paid-in-capital		364,561			362,982
Retained earnings		71,533			43,400
Accumulated other comprehensive loss		(623	)		(1,842	)

Total stockholders’ equity		435,508			404,577

Total liabilities and stockholders’ equity	$	1,030,786		$	1,006,580

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

Skilled Healthcare Group, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)
(Unaudited)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(As Restated,						(As Restated,
				See Note 2)						See Note 2)
Revenue	$	188,365		$	182,474		$	570,755		$	543,549
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)		152,457			147,404			456,275			433,746
Rent cost of revenue		4,509			4,771			13,568			13,714
General and administrative		6,343			5,992			19,406			17,771
Depreciation and amortization		6,014			5,301			17,358			15,534

		169,323			163,468			506,607			480,765


Other income (expenses):
Interest expense		(8,417	)		(9,207	)		(24,748	)		(28,022	)
Interest income		285			169			896			506
Other income (expense)		59			(110	)		(1	)		199
Equity in earnings of joint venture		746			624			2,230			1,733

Total other expenses, net		(7,327	)		(8,524	)		(21,623	)		(25,584	)


Income from continuing operations before provision for income taxes		11,715			10,482			42,525			37,200

Provision for income taxes		2,420			1,909			14,000			12,439

Income from continuing operations		9,295			8,573			28,525			24,761
Loss from discontinued operations, net of tax		(243	)		—			(390	)		—

Net income	$	9,052		$	8,573		$	28,135		$	24,761


Earnings per share, basic:
Earnings per common share from continuing operations	$	0.25		$	0.23		$	0.77		$	0.68
Loss per common share from discontinued operations		(0.01	)		—			(0.01	)		—

Earnings per share	$	0.24		$	0.23		$	0.76		$	0.68

Earnings per share, diluted:
Earnings per common share from continuing operations	$	0.25		$	0.23		$	0.77		$	0.67
Loss per common share from discontinued operations		(0.01	)		—			(0.01	)		—

Earnings per share	$	0.24		$	0.23		$	0.76		$	0.67


Weighted-average common shares outstanding, basic		36,927			36,578			36,904			36,562

Weighted-average common shares outstanding, diluted		36,950			36,909			36,943			36,888

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

Skilled Healthcare Group, Inc.

Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)


	Nine Months Ended
	September 30,
	2009			2008
				(As Restated,
				See Note 2)
Cash Flows from Operating Activities
Net income from continuing operations	$	28,525		$	24,761
Net loss from discontinued operations		(390	)		—

Net income		28,135			24,761
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		17,358			15,534
Provision for doubtful accounts		8,332			10,503
Non-cash stock-based compensation		1,738			1,120
Excess tax benefits from stock-based payment arrangements		—			(23	)
Loss on disposal of asset		61			110
Amortization of deferred financing costs		3,289			2,275
Tax benefit from reversal of accrual for uncertain tax positions		(2,204	)		(1,463	)
Deferred income taxes		4,324			(2,254	)
Amortization of discount on senior subordinated notes		80			80
Changes in operating assets and liabilities:
Accounts receivable		(16,740	)		(10,768	)
Payments on notes receivable		3,412			3,919
Other current and non-current assets		5,788			474
Accounts payable and accrued liabilities		(7,102	)		(6,185	)
Employee compensation and benefits		253			2,447
Insurance liability risks		(2,151	)		1,852
Other long-term liabilities		834			4,210

Net cash provided by operating activities		45,407			46,592

Cash Flows from Investing Activities
Acquisition of healthcare facilities		(1,650	)		(23,052	)
Additions to property and equipment		(29,182	)		(34,470	)
Changes in other assets		—			(43	)

Net cash used in investing activities		(30,832	)		(57,565	)

Cash Flows from Financing Activities
Borrowings under line of credit, net		2,000			18,000
Repayments of long-term debt and capital leases		(7,825	)		(6,352	)
Additions to deferred financing costs		(7,952	)		(1,383	)
Excess tax benefits from stock-based payment arrangements		—			23

Net cash (used in) provided by financing activities		(13,777	)		10,288

Cash flows from discontinued operations		390			—

Increase (decrease) in cash and cash equivalents		1,188			(685	)
Cash and cash equivalents at beginning of period		2,047			5,012

Cash and cash equivalents at end of period	$	3,235		$	4,327

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

SKILLED HEALTHCARE GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Description of Business

Current Business

Skilled Healthcare Group, Inc. (“Skilled”) companies operate long-term care facilities and provide a wide range of post-acute care services, with a strategic emphasis on sub-acute specialty medical care. Skilled and its consolidated wholly owned companies are collectively referred to as the “Company.” As of September 30, 2009, the Company currently operates facilities in California, Iowa, Kansas, Missouri, Nevada, New Mexico and Texas, including 77 skilled nursing facilities (“SNFs”), which offer sub-acute care and rehabilitative and healthcare medical skilled nursing care, and 22 assisted living facilities (“ALFs”), which provide room and board and social services. In addition, the Company provides a variety of ancillary services such as physical, occupational and speech therapy in Company-operated facilities and unaffiliated facilities. Furthermore, the Company provides hospice care in the California and New Mexico markets. The Company also has an administrative service company that provides a full complement of administrative and consultative services that allows its facility operators and those unrelated facility operators, with whom the Company contracts, to better focus on delivery of healthcare services. The Company has four such agreements with unrelated facility operators. The Company is also a member in a joint venture located in Texas that provides institutional pharmacy services, which currently serves eight of the Company’s SNFs and other facilities unaffiliated with the Company.

Company History

Skilled was incorporated as SHG Holding Solutions, Inc. in Delaware in October 2005. The Company’s predecessor company acquired Summit Care, a publicly traded long-term care company with nursing facilities in California, Texas and Arizona in 1998. On October 2, 2001, the Company’s predecessor and 19 of its subsidiaries filed voluntary petitions for protection under Chapter 11 of the U.S. Bankruptcy Code and on November 28, 2001, the Company’s remaining three companies also filed voluntary petitions for protection under Chapter 11. In August 2003, the Company emerged from bankruptcy, paying or restructuring all debt holders in full, paying all accrued interest expenses and issuing 5.0% of the Company’s common stock to former bondholders. In connection with the Company’s emergence from bankruptcy, the Company engaged in a series of transactions, including the disposition in March 2005 of the Company’s California pharmacy business, selling two institutional pharmacies in southern California.

On June 30, 2009, the United States Bankruptcy Court for the Central District of California granted entry of a final decree closing the aforementioned Chapter 11 cases.

2. Restatement

On June 29, 2009, the Company restated its consolidated financial statements for the annual periods in fiscal years 2006 through 2008 and the quarterly periods in fiscal years 2007 and 2008 in its amended Annual Report on Form 10-K/A for the year ended December 31, 2008 and for the first quarter of 2009 in its amended Quarterly Report on Form 10-Q/A for the quarter ended March 31, 2009.

The restatement related to an understatement of accounts receivable allowance for doubtful accounts for the Company’s long-term care (“LTC”) operating segment, which was caused by improper dating of accounts receivable for that segment by a former senior officer of the LTC segment (the “former employee”). Management conducted a review of the Company’s accounts receivable allowance for doubtful accounts related to the LTC segment after the former employee left the Company’s employment following a disciplinary meeting on unrelated matters. Management determined that the former employee had acted in a manner inconsistent with the Company’s accounting and disclosure policies and practices. As a result of its review, management recommended to the Audit Committee that a restatement was required. The Audit Committee initiated and directed a special investigation regarding the accounting and reporting issues raised by the former employee’s improper dating of accounts receivable. Under the oversight of the Audit Committee, internal audit personnel with the assistance of outside legal counsel and other advisors, investigated the matter and reviewed our internal controls related to accounts receivable allowance for doubtful accounts related to the LTC segment. The Company’s investigation found no evidence that anyone else within the Company knew of or participated in the improper conduct.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The condensed consolidated financial statements and related financial information for the three and nine months ended September 30, 2008 included in this Form 10-Q should be read only in conjunction with the information contained in our Annual Report on Form 10-K/A for the year ended December 31, 2008, our Quarterly Report on Form 10-Q/A for the three months ended March 31, 2009, and the Company’s Quarterly Report on Form 10-Q for the three and six months ended June 30, 2009.

The following tables show the restatement adjustments and restated amounts for those accounts in the Statements of Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2008 and the Statement of Condensed Consolidated Cash Flows for the nine months ended September 30, 2008 affected by the restatements.

Three Months Ended September 30, 2008


	As		Restatement			As
Statements of Operations Line items	Reported		Adjustments			Restated
Cost of services	$	145,749	$	1,655		$	147,404
Income before provision for income taxes		12,137		(1,655	)		10,482
Provision for income taxes		2,561		(652	)		1,909
Net income		9,576		(1,003	)		8,573
Earnings per common share, basic	$	0.26	$	(0.03	)	$	0.23
Earnings per common share, diluted	$	0.26	$	(0.03	)	$	0.23

Nine Months Ended September 30, 2008


	As		Restatement			As
Statements of Operations Line items	Reported		Adjustments			Restated
Cost of services	$	430,145	$	3,601		$	433,746
Income before provision for income taxes		40,801		(3,601	)		37,200
Provision for income taxes		13,857		(1,418	)		12,439
Net income		26,944		(2,183	)		24,761
Earnings per common share, basic	$	0.74	$	(0.06	)	$	0.68
Earnings per common share, diluted	$	0.73	$	(0.06	)	$	0.67


	As			Restatement			As
Consolidated Statement of Cash Flows	Reported			Adjustments			Restated
Operating Activities
Net income	$	26,944		$	(2,183	)	$	24,761
Provision for doubtful accounts		6,902			3,601			10,503
Deferred income taxes		(836	)		(1,418	)		(2,254	)

3. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements as of September 30, 2009 and for the three and nine months ended September 30, 2009 and 2008 (collectively, the “Interim Financial Statements”), are unaudited. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company’s audited consolidated financial statements and notes thereto for the year ended December 31, 2008, which are included in the Company’s Annual Report on Form 10-K/A filed with the Securities and Exchange Commission (the “SEC”). Management believes that the Interim Financial Statements reflect all adjustments that are of a normal and recurring nature necessary to fairly present the Company’s financial position and results of operations and cash flows in all material respects. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The Company evaluated subsequent events through November 3, 2009, the date on which this Quarterly Report on Form 10-Q was filed with the SEC.

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

Estimates and Assumptions

The preparation of the Interim Financial Statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to consolidate subsidiary financial information and make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates in the Interim Financial Statements relate to revenue, allowance for doubtful accounts, the self-insured portion of general and professional liability and workers’ compensation claims, income taxes and impairment of goodwill and long-lived assets. Actual results could differ from those estimates.

Information regarding the Company’s significant accounting policies is contained in “Summary of Significant Accounting Policies” in Note 3 in the Company’s 2008 Annual Report on Form 10-K/A filed with the SEC.

Reclassifications

Certain prior year amounts have been reclassified to conform to current year presentation, including payments on notes receivable in the statement on cash flows and total assets by segment. Payments on notes receivable of $3.9 million for the nine months ending September 30, 2008 were reclassified from investing activity to operating activity in the statement of cash flows and other long term liabilities of $1.5 million for the nine months ending September 30, 2008 were reclassified to tax benefit from reversal of accrual for uncertain tax positions within operating activities in the statement of cash flows. Intangible assets of $15.0 million were reclassified from the long-term care segment to the ancillary segment.

Revenue and Accounts Receivable

Revenue and accounts receivable are recorded on an accrual basis as services are performed at their estimated net realizable value. The Company derives a significant amount of its revenue from funds under federal Medicare and state Medicaid health insurance programs, the continuation of which are dependent upon governmental policies, and are subject to audit risk and potential recoupment.

In the nine months ended September 30, 2009, the Company converted accounts receivable to notes receivable for certain of its Hallmark Rehabilitation business customers. As of September 30, 2009, notes receivable, net, was approximately $12.4 million, of which $3.0 million was reflected as current assets with the remaining balances reflected as long-term assets. Interest rates on these notes approximate market rates as of the date the notes were delivered.

As of September 30, 2009, three Hallmark Rehabilitation business customers had on these notes outstanding notes receivable of $11.6 million, or 94% of the notes receivable balance. These notes receivable as well as the trade receivables from the customers are guaranteed by the assets of the customers as well as personally guaranteed by the principal owners of the customers. As of September 30, 2009, these three customers represented 54% of the accounts receivable for the Company’s rehabilitation therapy services company. For the nine months ended September 30, 2009, these three customers represented approximately 52% of the rehabilitation therapy services company external revenue. The remaining notes receivable of $0.8 million, or 6% of the notes receivable balance, are primarily past due accounts converted from accounts receivable to notes receivable.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The notes receivable balance is stated net of an allowance for uncollectibility. This allowance at September 30, 2009 was approximately $0.4 million. There was no balance in the notes receivable allowance at December 31, 2008.

Hospice net patient service revenue is reported at the estimated net realizable amounts (exclusive of the provision for uncollectible accounts) from Medicare, Medicaid, commercial insurance and managed care payors, patients and others for services rendered to patients. To determine net patient service revenue, management adjusts gross patient service revenue for estimated contractual adjustments based on historical experience and estimated Medicare cap contractual adjustments. Net patient service revenue is recognized in the month in which services are delivered.

The Company is subject to two limitations on Medicare payments for hospice services. First, if inpatient days of care provided to patients at a hospice exceeds 20% of the total days of hospice care provided for an annual period beginning on November 1st, then payment for days in excess of this limit are paid for at the routine home care rate. None of the Company’s hospice programs exceeded the payment limits on inpatient services for the three and nine months ended September 30, 2009 and 2008.

Second, overall payments made by Medicare to the Company on a per hospice program basis are also subject to a cap amount calculated by the Medicare fiscal intermediary at the end of the hospice cap period. The Medicare revenue paid to a hospice program from November 1 to October 31 may not exceed the annual aggregate cap amount. This annual aggregate cap amount is calculated by multiplying the number of Medicare beneficiaries who received hospice care in a particular hospice during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year. If a hospice exceeds its aggregate cap, then the hospice must repay the excess back to Medicare. The Medicare cap amount is reduced proportionately for patients who transferred in and out of the Company’s hospice services. The Medicare cap amount is adjusted annually for inflation, but is not adjusted for geographic differences in wage levels, although hospice per diem payment rates are wage indexed.

The Company’s hospice programs exceed the Medicare cap in 2009. The Company accrued a Medicare cap contractual adjustment from continuing operations of $2.1 million for the three and nine month period ended September 30, 2009.

Goodwill and Intangible Assets

Goodwill is accounted for under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations,” and represents the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for as purchases. In accordance with FASB ASC Topic 350, “Intangibles — Goodwill and Other,” goodwill is subject to periodic testing for impairment. Goodwill of a reporting unit is tested for impairment on an annual basis, or, if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount, between annual testing. We did not record any impairment charges for the three and nine months ended September 30, 2009 and 2008.

Interests in joint ventures

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

Recent Accounting Pronouncements

In June 2009, the FASB issued guidance now codified as FASB ASC Topic 105, “Generally Accepted Accounting Principles,” as the single source of authoritative nongovernmental U.S. GAAP. FASB ASC Topic 105 does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all authoritative literature related to a particular topic in one place. All existing accounting standard documents were superseded and all other accounting literature not included in the FASB Codification (“the Codification”) is considered non-authoritative. These provisions of FASB ASC Topic 105 are effective for interim and annual periods ending after September 15, 2009 and, accordingly, are effective for the Company for the current quarterly and fiscal reporting period. The adoption of this pronouncement did not have an impact on the Company’s financial condition or results of operations, but did impact our financial reporting process by eliminating all references to pre-codification standards.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

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

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

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

The following table sets forth the computation of basic and diluted earnings per share of class A common stock and class B common stock for the three and nine months ended September 30, 2009 and 2008 (amounts in thousands, except per share data):


	Three Months Ended									Three Months Ended						Nine Months Ended									Nine Months Ended
	September 30, 2009									September 30, 2008						September 30, 2009									September 30, 2008
	Class A			Class B			Total			Class A		Class B		Total		Class A			Class B			Total			Class A		Class B		Total
										(As		(As		(As											(As		(As		(As
										Restated)		Restated)		Restated)											Restated)		Restated)		Restated)
Earnings per share, basic
Numerator:
Allocation of net income from continuing operations	$	5,015		$	4,280		$	9,295		$	4,550	$	4,023	$	8,573	$	15,374		$	13,151		$	28,525		$	13,052	$	11,709	$	24,761
Allocation of loss from discontinued operations		(131	)		(112	)		(243	)		—		—		—		(210	)		(180	)		(390	)		—		—		—

Allocation of net income	$	4,884		$	4,168		$	9,052		$	4,550	$	4,023	$	8,573	$	15,164		$	12,971		$	28,135		$	13,052	$	11,709	$	24,761


Earnings per share, diluted
Numerator:
Allocation of net income from continuing operations	$	5,018		$	4,277		$	9,295		$	4,522	$	4,051	$	8,573	$	15,386		$	13,139		$	28,525		$	12,962	$	11,799	$	24,761
Allocation of loss from discontinued operations		(131	)		(112	)		(243	)		—		—		—		(210	)		(180	)		(390	)		—		—		—

Allocation of net income	$	4,887		$	4,165		$	9,052		$	4,522	$	4,051	$	8,573	$	15,176		$	12,959		$	28,135		$	12,962	$	11,799	$	24,761


Denominator for basic and diluted earnings per share:
Weighted-average common shares outstanding, basic		19,923			17,004			36,927			19,414		17,164		36,578		19,890			17,014			36,904			19,273		17,289		36,562

Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable		23			—			23			55		276		331		37			2			39			38		288		326

Adjusted weighted-average common shares outstanding, diluted		19,946			17,004			36,950			19,469		17,440		36,909		19,927			17,016			36,943			19,311		17,577		36,888


Earnings per share, basic:
Earnings per common share from continuing operations	$	0.25		$	0.25		$	0.25		$	0.23	$	0.23	$	0.23	$	0.77		$	0.77		$	0.77		$	0.68	$	0.68	$	0.68
Loss per common share from discontinued operations		(0.01	)		(0.01	)		(0.01	)		—		—		—		(0.01	)		(0.01	)		(0.01	)		—		—		—

Earnings per share	$	0.24		$	0.24		$	0.24		$	0.23	$	0.23	$	0.23	$	0.76		$	0.76		$	0.76		$	0.68	$	0.68	$	0.68
Earnings per share, diluted:
Earnings per common share from continuing operations	$	0.25		$	0.25		$	0.25		$	0.23	$	0.23	$	0.23	$	0.77		$	0.77		$	0.77		$	0.67	$	0.67	$	0.67
Loss per common share from discontinued operations		(0.01	)		(0.01	)		(0.01	)		—		—		—		(0.01	)		(0.01	)		(0.01	)		—		—		—

Earnings per share	$	0.24		$	0.24		$	0.24		$	0.23	$	0.23	$	0.23	$	0.76		$	0.76		$	0.76		$	0.67	$	0.67	$	0.67

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

5. Business Segments

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

At September 30, 2009, LTC services are provided by 77 wholly owned SNF operating companies that offer post-acute, rehabilitative and specialty skilled nursing care, as well as 22 wholly owned ALF operating companies that provide room and board and social services. Ancillary services include rehabilitative services such as physical, occupational and speech therapy provided in the Company’s facilities and in unaffiliated facilities by its wholly owned operating company, Hallmark Rehabilitation GP, LLC. Also included in the ancillary services segment is the Company’s hospice business that began providing care to patients in October 2004.

The Company evaluates performance and allocates capital resources to each segment based on an operating model that is designed to maximize the quality of care provided and profitability. Accordingly, earnings from continuing operations before net interest, tax, depreciation and amortization (“EBITDA”) is used as the primary measure of each segment’s operating results because it does not include such costs as interest expense, income taxes, depreciation and amortization which may vary from segment to segment depending upon various factors, including the method used to finance the original purchase of a segment or the tax law of the states in which a segment operates. By excluding these items, the Company is better able to evaluate operating performance of the segment by focusing on more controllable measures. General and administrative expenses are not allocated to any segment for purposes of determining segment profit or loss, and are included in the “other” category in the selected segment financial data that follows. The accounting policies of the reporting segments are the same as those described in the accounting policies (see Note 3 above) included in the Company’s 2008 Annual Report on Form 10-K/A filed with the SEC. Intersegment sales and transfers are recorded at cost plus standard mark-up; intersegment transactions have been eliminated in consolidation.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

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


	Long-term		Ancillary
	Care Services		Services		Other			Elimination			Total
Three months ended September 30, 2009
Revenue from external customers	$	166,224	$	22,141	$	—		$	—		$	188,365
Intersegment revenue		793		16,590		—			(17,383	)		—

Total revenue	$	167,017	$	38,731	$	—		$	(17,383	)	$	188,365


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

Income before provision for income taxes											$	11,715

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


EBITDA(1)	$	27,803	$	3,794	$	(5,736	)	$	—		$	25,861


Three months ended September 30, 2008
Revenue from external customers	$	159,667	$	22,807	$	—		$	—		$	182,474
Intersegment revenue		1,216		16,211		—			(17,427	)		—

Total revenue	$	160,883	$	39,018	$	—		$	(17,427	)	$	182,474


Operating income, as restated	$	25,175	$	2,837	$	(9,006	)	$	—		$	19,006
Interest expense, net of interest income												(9,038	)
Other income												(110	)
Equity in earnings of joint venture												624

Income before provision for income taxes, as restated											$	10,482

Segment capital expenditures	$	12,400	$	433	$	395		$	—		$	13,228


EBITDA(1), as restated	$	27,252	$	3,004	$	(5,435	)	$	—		$	24,821

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


	Long-term		Ancillary
	Care Services		Services		Other			Elimination			Total
Nine months ended September 30, 2009
Revenue from external customers	$	499,368	$	71,387	$	—		$	—		$	570,755
Intersegment revenue		2,498		50,246		—			(52,744	)		—

Total revenue	$	501,866	$	121,633	$	—		$	(52,744	)	$	570,755


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

Income before provision for income taxes											$	42,525

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


EBITDA(1)	$	85,164	$	16,063	$	(17,492	)	$	—		$	83,735


Nine months ended September 30, 2008
Revenue from external customers	$	477,444	$	66,105	$	—		$	—		$	543,549
Intersegment revenue		3,014		49,335		—			(52,349	)		—

Total revenue	$	480,458	$	115,440	$	—		$	(52,349	)	$	543,549


Operating income, as restated	$	75,702	$	13,862	$	(26,780	)	$	—		$	62,784
Interest expense, net of interest income												(27,516	)
Other income												199
Equity in earnings of joint venture												1,733

Income before provision for income taxes, as restated											$	37,200

Segment capital expenditures	$	32,575	$	1,228	$	667		$	—		$	34,470


EBITDA(1), as restated	$	81,866	$	14,314	$	(15,930	)	$	—		$	80,250


(1)		EBITDA is defined as net income from continuing operations before depreciation, amortization and interest expense (net of interest income) and the provision for income taxes. See reconciliation of net income to EBITDA and a discussion of its uses and limitations on Item 2 — Results of Operations of this quarterly report.

The following table presents the segment assets as of September 30, 2009 compared to December 31, 2008 (dollars in thousands):


	Long-term		Ancillary
	Care Services		Services		Other		Total
September 30, 2009:
Segment total assets	$	874,993	$	96,438	$	59,355	$	1,030,786
Goodwill and intangibles included in total assets	$	426,039	$	51,123	$	—	$	477,162
December 31, 2008:
Segment total assets	$	865,744	$	90,226	$	50,610	$	1,006,580
Goodwill and intangibles included in total assets	$	429,149	$	51,123	$	—	$	480,272

6. Income Taxes

For the three months ended September 30, 2009 and 2008, the Company recognized income tax expense of $2.4 million and $1.9 million, respectively, which was primarily related to the Company’s effective tax rate applied to the Company’s income from continuing operations before provision for income taxes. The effective rates for the three months ended September 30, 2009 and 2008 were below our statutory rate primarily as a result of reductions of $1.9 million and $1.4 million, respectively, in our accrual for unrecognized tax benefits due to expirations of statutes of limitations.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

For the nine months ended September 30, 2009 and 2008, the Company recognized income tax expense of $14.0 million and $12.4 million, respectively, which was primarily related to the Company’s effective tax rate applied to the Company’s income from continuing operations before provision for income taxes. The effective rates for the nine months ended September 30, 2009 and 2008 were below our statutory rate primarily as a result of reductions of $2.2 million and $1.5 million, respectively, in our accrual for unrecognized tax benefits due to expirations of statutes of limitations.

For the nine months ended September 30, 2009, total unrecognized tax benefits, including penalties and interest, decreased by $2.2 million from $2.9 million to $0.7 million as a result of the expiration of the 2005 Internal Revenue Service and 2003 California income tax statutes of limitations. As of September 30, 2009, it is reasonably possible that unrecognized tax benefits could decrease by $0.7 million, all of which would affect the Company’s effective tax rate, due to additional statute expirations within the 12-month rolling period ending September 30, 2010.

The Company is subject to taxation in the United States and in various state jurisdictions. The Company’s tax years 2006 and forward are subject to examination by the United States Internal Revenue Service and from 2004 forward by the Company’s material state jurisdictions.

7. Other Current Assets and Other Assets

Other current assets consist of the following as of September 30, 2009 and December 31, 2008 (dollars in thousands):


	September 30, 2009		December 31, 2008
Current portion of notes receivable	$	2,973	$	1,523
Supplies inventory		2,716		2,684
Income tax refund receivable		1,020		2,739
Other current assets		119		537

	$	6,828	$	7,483

Other assets consist of the following at September 30, 2009 and December 31, 2008 (dollars in thousands):


	September 30, 2009		December 31, 2008
Equity investment in joint ventures	$	5,824	$	5,082
Restricted cash		14,840		13,969
Deposits and other assets		4,662		4,746

	$	25,326	$	23,797

8. Other Long-Term Liabilities

Other long-term liabilities consist of the following at September 30, 2009 and December 31, 2008 (dollars in thousands):


	September 30, 2009		December 31, 2008
Deferred rent	$	6,524	$	5,780
Other long-term tax liability		708		2,912
Asbestos abatement liability		5,462		5,372

	$	12,694	$	14,064

For more information regarding other long-term tax liability, see Note 6 — “Income Taxes” in the unaudited condensed consolidated financial statements under Part I, Item 1 of this report.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

9. Commitments and Contingencies

Litigation

On July 24, 2009, a purported class action complaint captioned Shepardson v. Skilled Healthcare Group, Inc., et al. was filed in the U.S. District Court for the Central District of California against us, our Chairman and Chief Executive Officer, our current Chief Financial Officer, our former Chief Financial Officer, and investment banks that underwrote the Company’s initial public offering, on behalf of two classes of purchasers of our securities. One purported class consists of all persons other than defendants who purchased our Class A common stock pursuant or traceable to our Initial Public Offering from May 14, 2007 through August 5, 2008. The second purported class consists of all persons other than defendants who purchased our Class A common stock from May 14, 2007, through June 9, 2009. The complaint, which seeks an unspecified amount of damages (including rescissory damages), asserts claims under the federal securities laws relating to our June 9, 2009 announcement that we would restate our financial statements for the period from January 1, 2006, to March 31, 2009, and that the restatement was likely to require cumulative charges against after-tax earnings in the aggregate amount of between $8 million and $9 million over the affected periods. The complaint also alleges that our registration statement and prospectus, financial statements, and public statements about our results of operations contained material false and misleading statements. None of the defendants have responded to the complaint at this time.

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

On May 4, 2006, three plaintiffs filed a complaint against the Company in the Superior Court of California, Humboldt County, entitled Bates v. Skilled Healthcare Group, Inc. and twenty-three of its companies. In the complaint, the plaintiffs allege, among other things, that certain California-based facilities operated by the Company’s wholly owned operating companies failed to provide an adequate number of qualified personnel to care for their residents and misrepresented the quality of care provided in their facilities. Plaintiffs allege these failures violated, among other things, the residents’ rights, the California Health and Safety Code, the California Business and Professions Code and the Consumer Legal Remedies Act. Plaintiffs seek, among other things, restitution of money paid for services allegedly promised to, but not received by, facility residents during the period from September 1, 2003 to the present. The complaint further sought class certification of in excess of 18,000 plaintiffs as well as injunctive relief, punitive damages and attorneys’ fees.

In response to the complaint, the Company filed a demurrer. On November 28, 2006, the Humboldt Court denied the demurrer. On January 31, 2008, the Humboldt Court denied the Company’s motion for a protective order as to the names and addresses of residents within the facility and on April 7, 2008, the Humboldt Court granted plaintiffs’ motion to compel electronic discovery by the Company. On May 27, 2008, plaintiffs’ motion for class certification was heard, and the Humboldt Court entered its order granting plaintiffs’ motion for class certification on June 19, 2008. The Company subsequently petitioned the California Court of Appeal, First Appellate District, for a writ and reversal of the order granting class certification. The Court of Appeal denied the Company’s writ on November 6, 2008 and the Company accordingly filed a petition for review with the California Supreme Court. On January 21, 2009, the California Supreme Court denied the Company’s petition for review. The order granting class certification accordingly remains in place, and the action is proceeding as a class action. Primary professional liability insurance coverage has been exhausted for the policy year applicable to this case. The excess insurance carrier issuing the policy applicable to this case has issued its reservation of rights to preserve an assertion of non-coverage for this case due to the lack of any allegation of injury or harm to the plaintiffs. The Humboldt Court recently set the matter to begin trial on November 30, 2009. Given the uncertainty of the pleadings and facts at this juncture in the litigation, an assessment of potential exposure is uncertain at this time.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

As is typical in the healthcare industry, the Company experiences a significant number of litigation claims asserted against it. These matters are, in the opinion of management, immaterial both individually and in the aggregate with respect to the Company’s condensed consolidated financial position, results of operations and cash flows. While the Company believes that it provides quality care to its patients and is in substantial compliance with regulatory requirements, a legal judgment or adverse governmental investigation could have a material negative effect on the Company’s financial position, results of operations or cash flows.

Under U.S. GAAP, the Company establishes an accrual for an estimated loss contingency when it is both probable that an asset has been impaired or that a liability has been incurred and the amount of the loss can be reasonably estimated. Given the uncertain nature of litigation generally, and the uncertainties related to the incurrence, amount and range of loss on any pending litigation, investigation or claim, the Company is currently unable to predict the ultimate outcome of the aforementioned litigation, investigation or claim, determine whether a liability has been incurred or make a reasonable estimate of the liability that could result from an unfavorable outcome. While the Company believes that the liability, if any, resulting from the aggregate amount of uninsured damages for any outstanding litigation, investigation or claim will not have a material adverse effect on its condensed consolidated financial position, results of operations or cash flows, in view of the uncertainties discussed above, it could incur charges in excess of any currently established accruals and, to the extent available, excess liability insurance. In view of the unpredictable nature of such matters, the Company cannot provide any assurances regarding the outcome of any litigation, investigation or claim to which it is a party or the effect on the Company of an adverse ruling in such matters.

Insurance

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

Workers’ Compensation. The Company has maintained workers’ compensation insurance as statutorily required. Most of its commercial workers’ compensation insurance purchased is loss sensitive in nature. As a result, the Company is responsible for adverse loss development. Additionally, the Company self-insures the first unaggregated $1.0 million per workers’ compensation claim in California, Nevada and New Mexico.

The Company has elected not to carry workers’ compensation insurance in Texas and it may be liable for negligence claims that are asserted against it by its Texas-based employees.

The Company has purchased guaranteed cost policies for Kansas, Missouri and Iowa. There are no deductibles associated with these programs.

The Company recognizes a liability in its condensed consolidated financial statements for its estimated self-insured workers’ compensation risks. Historically, estimated liabilities have been sufficient to cover actual claims.

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

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The Company had a general and professional liability claims-made-based insurance policy with an individual claim limit of $2.0 million per loss and a $6.0 million annual aggregate limit for its California, Texas, New Mexico and Nevada facilities. Under this program, which expired on August 31, 2008, the Company retains an unaggregated $1.0 million self-insured general and professional liability retention per claim.

In September 2008, California-based skilled nursing facility companies purchased individual three-year general and professional liability insurance policies with a per occurrence and annual aggregate coverage limit of $1.0 million and $3.0 million, respectively, and an unaggregated $0.1 million per claim self-insured retention.

The Company has a three-year excess liability policy with applicable aggregate limits of $14.0 million for losses arising from claims in excess of $1.0 million for the California ALFs and the Texas, New Mexico, Nevada, Kansas and Missouri facilities. The Company retains an unaggregated self-insured retention of $1.0 million per claim for all Texas, New Mexico and Nevada facilities and its California ALFs. From September 2006 through August 2008, this excess coverage was modified to increase the coverage to $12.0 million for losses arising from claims in excess of $3.0 million, which are reported after the September 1, 2006 change. The Company’s ten New Mexico facilities were also covered under this policy after their acquisition in September 2007.

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

Employee Medical Insurance. Medical preferred provider option programs are offered as a component of our employee benefits. The Company retains a self-insured amount up to a contractual stop loss amount and we estimate our self-insured medical reserve on a quarterly basis, based upon actuarial analyses provided by external actuaries using the most recent trends of medical claims.

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


	As of September 30, 2009											As of December 31, 2008
	General and			Employee			Workers’					General and			Employee			Workers’
	Professional			Medical			Compensation			Total		Professional			Medical			Compensation			Total
Current	$	6,483	⁽¹⁾	$	1,692	⁽²⁾	$	4,059	⁽²⁾	$	12,234	$	8,172	⁽¹⁾	$	1,551	⁽²⁾	$	3,906	⁽²⁾	$	13,629

Non-current		19,074			—			10,824			29,898		20,871			—			9,783			30,654

	$	25,557		$	1,692		$	14,883		$	42,132	$	29,043		$	1,551		$	13,689		$	44,283


(1)		Included in accounts payable and accrued liabilities.

(2)		Included in employee compensation and benefits.

Financial Guarantees

Substantially all of the Company’s wholly owned companies guarantee the 11.0% senior subordinated notes maturing on January 15, 2014, the Company’s first lien senior secured term loan and the Company’s revolving credit facility. These guarantees are full and unconditional and joint and several. The Company has no independent assets or operations.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

10. Stockholders’ Equity

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) consists of two components, net income and other comprehensive income (loss). Other comprehensive income (loss) refers to revenue, expenses, gains, and losses that, under U.S. GAAP, are recorded as an element of stockholders’ equity but are excluded from net income. Currently, the Company’s other comprehensive income consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Other comprehensive income net of tax was $0.5 million and $0.1 million for the three months ended September 30, 2009, and 2008 respectively. Other comprehensive income (loss) net of tax was $1.2 million and $(0.1) million for the nine months ended September 30, 2009, and 2008, respectively.

2007 Stock Incentive Plan

The fair value of the stock option grants for the nine months ended September 30, 2009 and 2008 under FASB ASC Topic 718, “Compensation — Stock Compensation,” was estimated on the date of the grants using the Black-Scholes option pricing model with the following assumptions:


	2009			2008
Risk-free interest rate		2.62	%		3.23	%
Expected life	6.25 years			6.25 years
Dividend yield	0		%	0		%
Volatility		54.34	%		40.56	%
Weighted-average fair value	$	5.49		$	5.89

There were zero and 15,000 new stock options granted in the three months ended September 30, 2009 and 2008, respectively. There were 328,253 and 144,000 new stock options granted in the nine months ended September 30, 2009 and 2008, respectively.

There were no options exercised during the three and nine months ended September 30, 2009. As of September 30, 2009, there was $1.9 million of unrecognized compensation cost related to outstanding stock options, net of forecasted forfeitures. This amount is expected to be recognized over a weighted-average period of 3.0 years. To the extent the forfeiture rate is different than the Company has anticipated, stock-based compensation related to these awards will be different from the Company’s expectations.

The following table summarizes stock option activity during the nine months ended September 30, 2009 under the 2007 Stock Incentive Plan:


						Weighted-
						Average
				Weighted -		Remaining		Aggregate
				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(in years)		(in thousands)
Outstanding at January 1, 2009		309,000		$	14.35
Granted		328,253		$	10.11
Exercised		—		$	—
Forfeited or cancelled		(51,954	)	$	12.60

Outstanding at September 30, 2009		585,299		$	12.13		8.72	$	—

Exercisable at September 30, 2009		129,000		$	14.81		7.65	$	—

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

Equity related to stock option grants and stock awards included in cost of services in the Company’s condensed consolidated financial statement of operations was $0.2 million each in the three months ended September 30, 2009 and 2008, respectively. There was $0.7 million and $0.4 million included in cost of services in the nine months ended September 30, 2009 and 2008, respectively. The amount in general and administrative expenses was $0.3 million each in the three months ended September 30, 2009 and 2008, respectively. The amount included in general and administrative expenses was $1.0 million and $0.7 million in the nine months ended September 30, 2009 and 2008, respectively.

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

11. Fair Value Measurements

The following table summarizes the valuation of the Company’s interest rate swap as of September 30, 2009 by the FASB ASC Topic 820, “Fair Value Measurement and Disclosures,” fair value hierarchy (dollars in thousands):


	Level 1		Level 2			Level 3		Total
Interest rate swap	$	—	$	(1,015	)	$	—	$	(1,015	)

The Company uses its existing second amended and restated first lien credit agreement, as amended (the “Credit Agreement”), and 11.0% Senior Subordinated Notes due 2014 (the “2014 Notes”) to finance its operations. The Credit Agreement exposes the Company to variability in interest payments due to changes in interest rates. In November 2007, the Company entered into a $100.0 million interest rate swap agreement in order to manage fluctuations in cash flows resulting from interest rate risk. This interest rate swap changes a portion of the Company’s variable-rate cash flow exposure to fixed-rate cash flows at an interest rate of 6.4% until December 31, 2009. The Company continues to assess its exposure to interest rate risk on an ongoing basis.

The interest rate swap is required to be measured at fair value on a recurring basis. The fair value of the interest rate swap contract is determined by calculating the value of the discounted cash flows of the difference between the fixed interest rate of the interest rate swap and the counterparty’s forward LIBOR curve, which is the input used in the valuation. The forward LIBOR curve is readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized the interest rate swap as Level 2. The Company obtained the counterparty’s calculation of the valuation of the interest rate swap as well as a forward LIBOR curve from another investment bank and recalculated the valuation of the interest rate swap, which agreed with the counterparty’s calculation.

The fair value of interest rate swap agreements designated as hedging instruments against the variability of cash flows associated with floating-rate, long-term debt obligations are reported in accumulated other comprehensive income. These amounts subsequently are reclassified into interest expense as a yield adjustment in the same period in which the related interest on the floating-rate debt obligation affects earnings. As the interest rate swap matures on December 31, 2009, $1.0 million will be reclassified to earnings into interest expense as a yield adjustment over the remainder of 2009. The Company evaluates the effectiveness of the cash flow hedge, in accordance with FASB ASC Topic 815, “Derivatives and Hedging,” on a quarterly basis. The change in fair value is recorded as a component of other comprehensive income. Should the hedge become ineffective, the change in fair value would be recognized in the condensed consolidated statements of operations.

For the nine months ended September 30, 2009, the total net loss recognized from converting from floating rate (three-month LIBOR) to fixed rate for a portion of the interest payments under the Company’s long-term debt obligations was approximately $2.4 million. As of September 30, 2009, an unrealized loss of $0.6 million (net of income tax) is included in accumulated other comprehensive loss.

Below is a table listing the fair value of the interest rate swap as of September 30, 2009 and December 31, 2008 (dollars in thousands):

Derivatives designated as

September 30, 2009

December 31, 2008

hedging instruments

Fair Value

under ASC Topic 815

Balance Sheet Location

(Pre-tax)

Balance Sheet Location

(Pre-tax)

Interest rate swap

Accounts payable and accrued liabilities

(1,015

)

Accounts payable and
accrued liabilities

(3,007

)

Below is a table listing the amount of gain (loss) recognized before income tax in other comprehensive income (“OCI”) on the interest rate swap for the three and nine months ending September 30, 2009 and 2008 (dollars in thousands):


	Amount of Gain (Loss)
Derivatives in ASC Topic 815	Recognized in OCI on Derivative (Effective Portion)
Cash Flow Hedging	Three Months Ended September 30,				Nine Months Ended September 30,
Relationships	2009		2008		2009		2008
Interest rate swap	$	824	$	180	$	1,992	$	(220	)

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Below is a table listing the amount of gain (loss) reclassified from accumulated OCI into income (effective portion) for the three and nine months ending September 30, 2009 and 2008 (dollars in thousands):


Location of Gain (Loss)	Amount of Gain (Loss)
Reclassified from	Reclassified from Accumulated OCI into Income (Effective Portion)
Accumulated OCI into Income	Three Months Ended September 30,						Nine Months Ended September 30,
(Effective Portion)	2009			2008			2009			2008
Interest expense	$	(941	)	$	(397	)	$	(2,395	)	$	(886	)

12. Debt

On April 28, 2009, the Company entered into an amendment to extend the maturity of the revolving loan commitments under its second amended and restated first lien credit agreement from June 15, 2010 to June 15, 2012. The Company’s revolving line of credit has a capacity of $135.0 million through June 15, 2010, and will reduce to $124.0 million thereafter, until its maturity on June 15, 2012. The Company’s costs for the extension included upfront fees and expenses of approximately $8.0 million. The revolving loan will maintain current interest rates at the Company’s choice of LIBOR plus 2.75% or prime plus 1.75%.

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


	As of			As of
	September 30, 2009			December 31, 2008

Revolving Credit Facility, base interest rate, comprised of prime plus 1.75% (5.00% at September 30, 2009) collateralized by substantially all assets of the Company, due 2012	$	10,000		$	3,000

Revolving Credit Facility, interest rate based on LIBOR plus 2.75% (3.02% at September 30, 2009) collateralized by substantially all assets of the Company, due 2012		73,000			78,000

Term Loan, interest rate based on LIBOR plus 2.00% (2.28% at September 30, 2009) collateralized by substantially all assets of the Company, due 2012		148,950			150,900

Term Loan, interest rate swapped at 6.38% collateralized by substantially all assets of the Company, due 2012		100,000			100,000

2014 Notes, interest rate 11.0%, with an original issue discount of $465 and $545 at September 30, 2009 and December 31, 2008, respectively, interest payable semiannually, principal due 2014, unsecured		129,535			129,455

Notes payable, fixed interest rate 6.5%, payable in monthly installments, collateralized by a first priority deed of trust, due November 2014		1,576			1,669

Insurance premium financing		7,245			5,059

Present value of capital lease obligations at effective interest rates, collateralized by property and equipment		2,207			2,178


Total long-term debt and capital leases		472,513			470,261

Less amounts due within one year		(9,995	)		(7,812	)


Long-term debt and capital leases, net of current portion	$	462,518		$	462,449

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


13.		Discontinued Operations

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

In December 2008, the Company paid $0.2 million for a hospice business based in Ventura, California. During the three months ended September 30, 2009, the Company noted that this hospice business was not meeting expectations. The Company closed the operations during the three months ended September 30, 2009 and recorded a net loss of $0.4 million for the nine months ended September 30, 2009. Patients for the hospice business based in Ventura, California were transferred to other local hospice businesses. In addition, the Company wrote off the $0.2 million intangible asset associated with the hospice business based in Ventura, California in the three months ended September 30, 2009.

The Company continues to operate its hospice businesses in Foothill Ranch, California and New Mexico.

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


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2009			2008		2009			2008
Net operating revenues	$	174		$	—	$	635		$	—
Loss from discontinued operations before income tax		(396	)		—		(637	)		—
Tax benefit		(153	)		—		(247	)		—

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


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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not indicate future performance. Our forward-looking statements, which reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in our Annual Report on Form 10-K/A for the year ended December 31, 2008. As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our,” and “us” refer to Skilled Healthcare Group, Inc. and its wholly owned companies. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes included in this report.

Business Overview

We are a provider of integrated long-term healthcare services through our skilled nursing companies and rehabilitation therapy business. We also provide other related healthcare services, including assisted living care and hospice care. We have an administrative service company that provides a full complement of administrative and consultative services that allows our facility operators and third-party facility operators with whom we contract to better focus on delivery of healthcare services. We have four such service agreements with unrelated facility operators. We focus on providing high-quality care to our patients and we have a strong commitment to treating patients who require a high level of skilled nursing care and extensive rehabilitation therapy, whom we refer to as high-acuity patients. As of September 30, 2009, we owned or leased 77 skilled nursing facilities and 22 assisted living facilities, together comprising approximately 10,800 licensed beds. Our facilities, approximately 73.7% of which we own, are located in California, Iowa, Texas, Kansas, Missouri, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. For the nine months ended September 30, 2009, we generated approximately 84.3% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, and hospice care.

Company History

Skilled Healthcare Group, Inc. was incorporated as SHG Holding Solutions, Inc. in Delaware in October 2005. Our predecessor company acquired Summit Care, a publicly traded long-term care company with nursing facilities in California, Texas and Arizona in 1998. On October 2, 2001, our predecessor and 19 of its subsidiaries filed voluntary petitions for protection under Chapter 11 of the U.S. Bankruptcy Code and on November 28, 2001, our remaining three companies also filed voluntary petitions for protection under Chapter 11. In August 2003, we emerged from bankruptcy, paying or restructuring all debt holders in full, paying all interest expense that had accrued on our debt and issuing 5.0% of our common stock to former bondholders. In connection with our emergence from bankruptcy, we engaged in a series of transactions, including the disposition in March 2005 of our California pharmacy business by selling two institutional pharmacies in southern California.

On June 30, 2009, the United States Bankruptcy Court for the Central District of California granted entry of a final decree closing the aforementioned Chapter 11 cases.

Restatement

On June 29, 2009, we restated our financial statements for the annual periods in fiscal years 2006 through 2008 and the quarterly periods in fiscal years 2007 and 2008 in our amended Annual Report on Form 10-K/A for the year ended December 31, 2008 and for the first quarter of 2009 in our amended Quarterly Report on Form 10-Q/A for the quarter ended March 31, 2009. For more information regarding the restatement adjustments and restated amounts for those line items in the condensed consolidated balance sheets and the condensed consolidated statements of operations and cash flows for the three and nine months ended September 30, 2008 affected by the restatement, see Note 2 - “Restatement” in Part I, Item 1 of this Quarterly Report.

The restatement related to an understatement of accounts receivable allowance for doubtful accounts for our long-term care (“LTC”) operating segment, which was caused by improper dating of accounts receivable for that segment by a former senior officer of the LTC segment (the “former employee”). Management conducted a review of the Company’s accounts receivable allowance for doubtful accounts related to the LTC segment after the former employee left the Company’s employment following a disciplinary meeting on unrelated matters. Management determined that the former employee had acted in a manner inconsistent with the Company’s accounting and disclosure policies and practices. As a result of its review, management recommended to the Audit Committee that a restatement was required. The Audit Committee initiated and directed a special investigation regarding the accounting and reporting issues raised by the former employee’s improper dating of accounts receivable. Under the oversight of the Audit Committee, internal audit personnel with the assistance of outside legal counsel and other advisors, investigated the matter and reviewed our internal controls related to accounts receivable allowance for doubtful accounts related to the LTC segment. The Company’s investigation found no evidence that anyone else within the Company knew of or participated in the improper conduct.

The condensed consolidated financial statements and related financial information for the three and nine months ended September 30, 2008 included in this Form 10-Q should be read only in conjunction with the information contained in our Annual Report on Form 10-K/A for the year ended December 31, 2008, our Quarterly Report on Form 10-Q/A for the three months ended March 31, 2009, and our Quarterly Report on Form 10-Q for the three and six months ended June 30, 2009.

Throughout the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, all referenced amounts for prior periods and prior period comparisons reflect the affected balances and amounts on a restated basis.

Revenue

Revenue by Service Offering

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

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

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


	Three Months Ended September 30,
	2009					2008
	Revenue		Revenue			Revenue		Revenue			Increase/(Decrease)
	Dollars		Percentage			Dollars		Percentage			Dollars			Percentage
Long-term care services:
Skilled nursing facilities	$	160,173		85.1	%	$	154,612		84.7	%	$	5,561			3.6	%
Assisted living facilities		6,051		3.2			5,055		2.8			996			19.7

Total long-term care services		166,224		88.3			159,667		87.5			6,557			4.1
Ancillary services:
Third-party rehabilitation therapy services		19,095		10.1			17,383		9.5			1,712			9.8
Hospice		3,046		1.6			5,424		3.0			(2,378	)		(43.8	)

Total ancillary services		22,141		11.7			22,807		12.5			(666	)		(2.9	)

Total	$	188,365		100.0	%	$	182,474		100.0	%	$	5,891			3.2	%


	Nine Months Ended September 30,
	2009					2008
	Revenue		Revenue			Revenue		Revenue			Increase/(Decrease)
	Dollars		Percentage			Dollars		Percentage			Dollars			Percentage
Long-term care services:
Skilled nursing facilities	$	481,242		84.3	%	$	463,124		85.2	%	$	18,118			3.9	%
Assisted living facilities		18,126		3.2			14,320		2.6			3,806			26.6

Total long-term care services		499,368		87.5			477,444		87.8			21,924			4.6
Ancillary services:
Third-party rehabilitation therapy services		57,154		10.0			51,683		9.5			5,471			10.6
Hospice		14,233		2.5			14,422		2.7			(189	)		(1.3	)

Total ancillary services		71,387		12.5			66,105		12.2			5,282			8.0

Total	$	570,755		100.0	%	$	543,549		100.0	%	$	27,206			5.0	%

Sources of Revenue

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


	Three Months Ended September 30,
	2009					2008
	Revenue		Percentage of			Revenue		Percentage of
	Dollars		Revenue			Dollars		Revenue
California	$	83,328		44.2	%	$	81,390		44.6	%
Texas		48,119		25.5			44,826		24.6
New Mexico		19,545		10.4			21,798		11.9
Kansas		14,573		7.7			13,223		7.2
Missouri		13,931		7.4			13,422		7.4
Nevada		7,835		4.2			7,721		4.2
Iowa		872		0.5			—		—
Other		162		0.1			94		0.1

Total	$	188,365		100.0	%	$	182,474		100.0	%


	Nine Months Ended September 30,
	2009					2008
	Revenue		Percentage of			Revenue		Percentage of
	Dollars		Revenue			Dollars		Revenue
California	$	253,956		44.5	%	$	243,517		44.8	%
Texas		143,887		25.2			138,219		25.4
New Mexico		62,923		11.0			60,409		11.1
Kansas		42,757		7.5			36,865		6.8
Missouri		41,648		7.3			41,806		7.7
Nevada		23,363		4.1			22,629		4.2
Iowa		1,748		0.3			—		—
Other		473		0.1			104		—

Total	$	570,755		100.0	%	$	543,549		100.0	%

Long-Term Care Services Segment

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

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


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Medicare		15.8	%		16.4	%		16.5	%		17.4	%
Managed care		6.6			6.6			7.0			7.0

Skilled mix		22.4			23.0			23.5			24.4
Private pay and other		18.0			18.8			18.0			17.7
Medicaid		59.6			58.2			58.5			57.9

Total		100.0	%		100.0	%		100.0	%		100.0	%

Our skilled mix was lower in the three and nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008 primarily due to a decrease in average length of stay for our skilled patients as well as a reduction in Medicare census from lower acute-care hospital admissions as a result of the challenging economic environment and competitive pressures in a handful of facilities.

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

Ancillary Service Segment

Rehabilitation Therapy. As of September 30, 2009, we provided rehabilitation therapy services to a total of 175 healthcare facilities, including 67 of our facilities, as compared to 185 facilities, including 65 of our facilities, as of September 30, 2008. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. Rehabilitation therapy revenue derived from servicing our own facilities is included in our revenue from skilled nursing facilities. Our rehabilitation therapy business receives payment for services from the third-party skilled nursing facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered.

Hospice. We provide hospice care in California and New Mexico. We derive substantially all of the revenue from our hospice business from Medicare and Medicaid reimbursement. In general, our program level margin increases as a program’s average daily patient census increases. Our objective is to increase the number of patients that each of our hospice programs serves, thus improving our site-level margins and leveraging our overhead. Our overall margins in 2009 were negatively impacted by the Medicare cap contractual allowance (see “— Regulatory and Other Governmental Actions Affecting Revenue”).

Manage our length-of-stay: We are continuing to take a broader view of managing the Medicare cap, (see “—Regulatory and Other Governmental Actions Affecting Revenue”) by actively managing our average length-of-stay on a market-by-market basis. A key component of this strategy is to analyze each hospice program’s mix of patients and referral sources to achieve an optimal balance of the types of patients and referral sources that we serve at each of our programs. We believe this strategy will increase our net patient service revenue by reducing our Medicare cap contractual adjustment. Developing new relationships and thereby adjusting patient mix takes time to implement and will continue to be an ongoing process.

Regulatory and Other Governmental Actions Affecting Revenue

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


	Three Months Ended September 30,
	2009					2008
	Revenue		Revenue			Revenue		Revenue
	Dollars		Percentage			Dollars		Percentage
Medicare	$	64,000		34.0	%	$	65,433		35.9	%
Medicaid		62,135		33.0			58,519		32.1

Subtotal Medicare and Medicaid		126,135		67.0			123,952		68.0
Managed Care		17,245		9.2			16,505		9.0
Private pay and other		44,985		23.8			42,017		23.0

Total	$	188,365		100.0	%	$	182,474		100.0	%


	Nine Months Ended September 30,
	2009					2008
	Revenue		Revenue			Revenue		Revenue
	Dollars		Percentage			Dollars		Percentage
Medicare	$	201,719		35.3	%	$	199,832		36.8	%
Medicaid		180,694		31.7			169,412		31.1

Subtotal Medicare and Medicaid		382,413		67.0			369,244		67.9
Managed Care		53,491		9.4			52,502		9.7
Private pay and other		134,851		23.6			121,803		22.4

Total	$	570,755		100.0	%	$	543,549		100.0	%

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

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

On July 31, 2008, CMS released its final rule on the fiscal year 2009 per diem payment rates for skilled nursing facilities. Under the final rule, CMS revised and rebased the skilled nursing facility market basket, resulting in a 3.4% market basket increase factor. Using this increase factor, the final rule increased aggregate payments to skilled nursing facilities nationwide by approximately $780.0 million. Additionally, in the final rule issued July 31, 2008, CMS decided to defer consideration of a possible reduction in payments to skilled nursing facilities related to a proposed readjustment to the refinement of nine new case mix groups (the so-called “parity adjustment”) until 2009, when the fiscal year 2010 per diem payment rates are set.

On August 11, 2009, the Centers for Medicare and Medicaid Services, or CMS, published its final rule on the fiscal year 2010 per diem payment rates for skilled nursing facilities. Under the final rule, CMS revised and rebased the skilled nursing facility market basket, resulting in a 2.2% market basket increase factor for fiscal year 2010. The fiscal year 2010 market basket adjustment will increase aggregate payments to skilled nursing facilities nationwide by approximately $690.0 million. Additionally, in the final rule, CMS recalibrated the parity adjustment to result in a reduction in payments to skilled nursing facilities by approximately 3.3%, or $1.05 billion. CMS noted that the negative $1.05 billion adjustment described in the final rule will be partially offset by the fiscal year 2010 market basket adjustment factor of 2.2%, or $690.0 million, with a net result of a reduction in payments to skilled nursing facilities of approximately $360.0 million. However, pending federal health reform legislative proposals may eliminate the market basket update provided in the final rule, which elimination could lead to a further reduction in payments to skilled nursing facilities. Given the substantial uncertainty surrounding federal health reform efforts, it is impossible to predict the likelihood of the elimination of the market basket update or any other proposed reductions in payments to skilled nursing facilities. Should federal health reform legislation or subsequent regulatory activities result in the reduction of payments to skilled nursing facilities, the loss of revenue associated with future changes in skilled nursing facility payments could, in the future, have an adverse impact on our financial condition or results of operations.

On August 6, 2009, CMS announced a final rule increasing Medicare payments to hospices in fiscal year 2010 by 1.4%, or approximately $170.0 million. CMS said the final rule reflects a 2.1% increase in the market basket, offset by a 0.7% decrease in payments to hospices due to a revised phase out of the wage index budget neutrality adjustment factor, starting with a 10% reduction in fiscal year 2010 and a 15% reduction each year from fiscal year 2011 through fiscal year 2016. The fiscal year 2010 hospice payment rates are effective for care and services furnished on or after October 1, 2009 through September 30, 2010.

On July 15, 2008, the Medicare Improvement for Patients and Providers Act of 2008 (H.R. 6331) became effective and extended certain therapy cap exceptions. These caps, effective January 1, 2006, imposed a limit to the annual amount that Medicare Part B (covering outpatient services) will pay for outpatient physical, speech language and occupational therapy services for each patient. These caps may result in decreased demand for rehabilitation therapy services that would be otherwise reimbursable under Part B, but for the caps. The Deficit Reduction Act of 2005, or DRA, established exceptions to the therapy caps for a variety of circumstances. These exceptions were scheduled to expire on June 30, 2008, but were extended by H.R. 6331 through December 31, 2009.

Medicare Part B also provides payment for certain professional services, including professional consultations, office visits and office psychiatry services, provided by a physician or practitioner located at a distant site. Such telehealth services previously were reimbursed only if the patient was located in the office of a physician or practitioner, a critical access hospital, a rural health clinic, a federally qualified health center or a hospital. H.R. 6331 now includes payment for such telehealth services if the patient is in a skilled nursing facility, and if the services provided are separately payable under the Medicare Physician Fee Schedule when furnished in a face-to-face encounter at a skilled nursing facility, effective January 1, 2009.

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

Historically, adjustments to reimbursement levels under Medicare have had a significant effect on our revenue. For a discussion of historic adjustments and recent changes to the Medicare program and related reimbursement rates see “Business — Sources of Reimbursement” in Part 1, Item 1 in our 2008 Annual Report on Form 10-K/A filed with the Securities and Exchange Commission and “Risk Factors — Reductions in Medicare reimbursement rates, including annual caps that limit the amounts that can be paid for outpatient therapy services rendered to any Medicare beneficiary, or changes in the rules governing the Medicare program could have a material adverse effect on our revenue, financial condition and results of operations” in Part 1, Item 1A of our 2008 Annual Report on Form 10-K/A filed with the Securities and Exchange Commission.

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

On February 8, 2006, the Deficit Reduction Act (DRA) of 2005 was signed into law (P.L. 109-171). With the passage of this legislation, specifically section 6034, Congress created the Medicaid Integrity Program (MIP) through section 1936 of the Social Security Act (the “Act”). Section 1936 of the Act requires the Secretary of Health and Human Services (HHS) to enter into contracts with eligible entities to perform four activities: (1) the review of Medicaid provider actions to detect fraud or potential fraud; (2) the auditing of Medicaid provider claims; (3) the identification of overpayments; and (4) the education of providers and others on payment integrity and quality of care issues. The contractors that perform these activities are known as Medicaid Integrity Contractors (MICs).

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

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

Rapidly increasing Medicaid spending, combined with slow state revenue growth, has led many states to institute measures aimed at controlling spending growth. For example, California initially had extended its cost-based Medi-Cal long-term care reimbursement system enacted through Assembly Bill 1629 (A.B. 1629) through the 2009-2010 and 2010-2011 rate years with a growth rate of up to five percent for both years. However, due to California’s severe budget crisis, on July 24, 2009, the California Legislature passed a budget-balancing proposal that eliminated this five percent growth cap by amending current statute to provide that, for the 2009-2010 and 2010-2011 rate years, the weighted average Medi-Cal reimbursement rate paid to long-term care facilities shall not exceed the weighted average Medi-Cal reimbursement rate for the 2008-2009 rate year. In addition, the budget proposal increased the amounts that California nursing facilities will pay to Medi-Cal in quality assurance fees for the 2009-2010 and 2010-2011 rate years by including Medicare revenue in the calculation of the quality assurance fee that nursing facilities pay under A.B. 1629. California’s Governor signed the budget into law on July 28, 2009. Given that Medicaid outlays are a significant component of state budgets, we expect continuing cost containment pressures on Medicaid outlays for skilled nursing facilities in the states in which we operate. In addition, the DRA of 2005 limited the circumstances under which an individual may become financially eligible for Medicaid and nursing home services paid for by Medicaid.

Hospice Medicare Cap. Various provisions were included in Section 1814 of the Social Security Act, the legislation creating the Medicare hospice benefit, to manage the cost to the Medicare program for hospice. These measures include the patient’s waiver of curative care requirement, the six-month terminal prognosis requirement and the Medicare payment caps. The Medicare hospice benefit includes two fixed annual caps on payment, both of which are assessed on a hospice-specific basis. One cap is an absolute dollar amount; the other limits the number of days of inpatient care. None of our hospice programs exceeded the payment limits on general inpatient care services for the three and nine months ended September 30, 2009 and 2008. The caps are calculated from November 1 through October 31 of each year.

The Medicare revenue paid to a hospice program from November 1 to October 31 of the following year may not exceed an annual aggregate cap amount. This annual aggregate cap amount is calculated by multiplying the number of Medicare beneficiaries who received hospice care in a particular hospice 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. A hospice’s total reimbursement for the cap year cannot exceed the hospice aggregate cap. If its aggregate cap is exceeded, then the hospice must repay the excess back to Medicare. A particular hospice’s annual aggregate cap amount is reduced proportionately for patients who transferred in or out of that hospice’s services. The Medicare cap amount is annually adjusted for inflation, but is not adjusted for geographic differences in wage levels, although hospice per diem payment rates are wage indexed.

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

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

Critical Accounting Policies and Estimates Update

Disclosure of our critical accounting policies are more fully disclosed in our discussion and analysis of financial condition and results of operations in our 2008 Annual Report on Form 10-K/A filed with the Securities and Exchange Commission and as included below.

Goodwill and Intangible Assets

At September 30, 2009, goodwill in the amount of $450.0 million was recognized in our consolidated balance sheet, of which $416.0 million related to the long-term care reporting unit and $34.0 million related to the rehabilitation therapy unit. We account for goodwill in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 350, “Intangibles — Goodwill and Other.”

We assess the fair value of our reporting units for our goodwill impairment tests based upon a combination of the discounted cash flow (income approach) and guideline public company method (market approach). The income and market approaches were given equal weighting.

Goodwill is allocated to each reporting unit at the time of a business acquisition and is adjusted upon finalization of the purchase price of an acquisition.

The goodwill that resulted from the Onex Transaction as of December 27, 2005 was allocated to the long-term care services reporting unit and the rehabilitation therapy reporting unit based on the relative fair value of the assets on the date of the Onex Transaction. No goodwill was allocated to the hospice care reporting unit due to the start-up nature of the business and cumulative net losses before depreciation, amortization, interest expense (net) and provision for (benefit from) income taxes attributable to that segment. In addition, no synergies were expected to arise as a result of the Onex Transaction which might have provided a different basis for allocation of goodwill to reporting units.

Determination of Reporting Units

We consider the following businesses to be reporting units for the purpose of testing our goodwill for impairment under FASB ASC Topic 350:

	•		Long-term care services, which includes the operation of skilled nursing and assisted living facilities and is the most significant portion our business;

	•		Rehabilitation therapy, which provides physical, occupational and speech therapy in Company-owned facilities and unaffiliated facilities; and

	•		Hospice care, which was established in 2004 and provides hospice care in California and New Mexico.

We have not made any changes to our reporting units or to the allocation of goodwill by reporting unit during the last year.

Goodwill Impairment Testing

We test goodwill for impairment annually at the reporting unit level on October 1, or sooner if events or changes in circumstances indicate that the carrying amount of our reporting units, including goodwill, may exceed their fair values. Based upon the market conditions that existed in the third quarter of 2009, we performed an impairment analysis as of September 30, 2009. We have not made any material change in the accounting methodology used to evaluate goodwill impairment during the last year.

The discounted cash flow and market approach methodologies utilized by us in estimating the fair value of our reporting units for purposes of our goodwill impairment testing requires various judgmental assumptions about revenues, EBITDA and operating margins, growth rates, and working capital requirements. In determining those judgmental assumptions, we consider a variety of data, including—for each reporting unit—its annual budget for the upcoming year (which forms the basis of certain annual incentive targets for reporting unit management), its longer-term business plan, economic projections, anticipated future cash flows, market data, and historical cash flow growth rates. For the September 30, 2009 impairment analysis, an updated forecast was utilized as the budget for the upcoming year has not been prepared. Historically, our segments have experienced an average annual growth rate in revenue from 2006 to 2008 of 5.5%, 12.1%, and 105.9% for long-term care, therapy, and hospice reporting units, respectively. The year over year growth rates for the nine months ended September 30, 2009 and 2008 were 2.5%, 6.3%, and 3.4% for long-term care, therapy, and hospice reporting units, respectively.

Below are the key assumptions used to estimate the fair value of our reporting units at the time of our September 30, 2009 goodwill impairment test included for the discounted cash flow method:


	Long-term
	care			Therapy			Hospice
Forecasted organic growth		3.0	%		3.0	%		10.0	%
Long term revenue growth rate		2.5	%		2.5	%		3.0	%
Discount rate		9.5	%		13.0	%		15.5	%

Assumptions are also made for varying perpetual growth rates for periods beyond the longer-term business plan period. When estimating the fair value of its reporting units as of September 30, 2009, we assumed organic revenue growth rates of 3% for the long-term care reporting unit for the three years beyond the forecasted year and a 2.5% perpetual rate for the terminal year, based upon the growth rates implied by analysts covering us. The same growth rates were used for the therapy reporting unit. A revenue growth rate of 10% was utilized for the hospice reporting unit for the three years beyond the forecasted year and a 3% perpetual growth rate for the terminal year. A higher growth rate was used for the hospice reporting unit as this business is still essentially a start up business. A constant EBITDA margin was used.

The discount rate was developed using the capital asset pricing model through which a weighted average cost of capital was derived. The discount rate was estimated using the risk free rate, market risk premium, and cost of debt prevalent as of the valuation date. The Beta and capital structure were estimated based on an analysis of comparable guideline companies. In addition, a risk premium of 6.0% was included in order to account for the risks inherent in the cash flows and to reconcile the fair value indicated by the discounted cash flow model to our public market equity value at September 30, 2009.

As our net carrying value and the calculated fair value of equity exceeded our market capitalization as of September 30, 2009, we reviewed the implied control premium of our market capitalization to the fair value of equity of 56.3% and concluded that the implied control premium was reasonable based upon other market transactions as well as an analysis performed upon the fair value of our real estate holdings.

The fair value of long-term care and therapy exceeded its carrying amount as of September 30, 2009 by 2.7% and 6.5%, respectively. The long-term growth rate would have to be less than 2.4% in order to incur a goodwill impairment charge for the long-term care reporting unit and therapy reporting unit. There is no goodwill allocated to the hospice reporting unit.

Selected multiples used to estimate the fair value of our reporting units at the time of our September 30, 2009 goodwill impairment test included for the market approach: Earnings before interest expense (net of interest income) depreciation, amortization, and rent expense (“EBITDAR”) multiples ranging from 7.0x to 7.5x and EBITDA multiples ranging from 4.0x to 6.0x.

The key assumptions that changed from the prior annual impairment test include:

	•		reduction of 0.5% in the long-term revenue growth rate assumption for long-term care and therapy;

	•		increase of 0.5%, 2%, and 3.5%, respectively, in discount rates for long-term care, therapy, and hospice reporting;

	•		multiples in the market approach were reduced to reflect changes in guideline public company multiples; and

	•		overall weighting for the guideline transaction method within the weighting of the market approach was reduced from 10% to 0% given that there were few relevant transactions that closed in the twelve months before the September 30 test date.

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

We could be required to evaluate the recoverability of goodwill prior to the next annual assessment if we experience unexpected declines in operating results, including current projections of Medicare and Medicaid rate changes for the 2009-10 fiscal years, and the latest information on the effects of health care reform.

Results of Operations

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Occupancy statistics (skilled nursing facilities):
Available beds in service at end of period		9,094			9,042			9,094			9,042
Available patient days		839,244			833,812			2,478,427			2,476,453
Actual patient days		698,489			700,849			2,080,944			2,093,953
Occupancy percentage		83.2	%		84.1	%		84.0	%		84.6	%
Average daily number of patients		7,592			7,618			7,623			7,642
Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)
LTC only Medicare (Part A)	$	504		$	478		$	500		$	470
Medicare blended rate (Part A &B)		564			533			558			518
Managed care		372			357			369			358
Medicaid		147			140			145			137
Private and other		159			154			161			156
Weighted-average for all	$	230		$	222		$	232		$	222

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(As Restated)						(As Restated)
Revenue		100.0	%		100.0	%		100.0	%		100.0	%
Expenses:
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)		80.9			80.8			79.9			79.8
Rent cost of revenue		2.4			2.6			2.4			2.5
General and administrative		3.4			3.3			3.4			3.3
Depreciation and amortization		3.2			2.9			3.0			2.9

		89.9			89.6			88.7			88.5


Other income (expenses):
Interest expense		(4.5	)		(5.0	)		(4.3	)		(5.1	)
Interest income		0.2			0.1			0.2			0.1
Other income		—			(0.1	)		—			—
Equity in earnings of joint venture		0.4			0.3			0.4			0.3

Total other expenses, net		(3.9	)		(4.7	)		(3.7	)		(4.7	)

Income before provision for income taxes		6.2			5.7			7.6			6.8
Provision for income taxes		1.3			1.0			2.5			2.3

Income from continuing operations		4.9			4.7			5.1			4.5
Loss from discontinued operations, net of tax		(0.1	)		—			(0.1	)		—

Net income		4.8	%		4.7	%		5.0	%		4.5	%

EBITDA		13.7	%		13.6	%		14.7	%		14.8	%
Adjusted EBITDA		13.7	%		13.7	%		14.7	%		14.8	%

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
				(As Restated)						(As Restated)
Reconciliation of income from continuing operations to EBITDA and Adjusted EBITDA (in thousands):
Income from continuing operations	$	9,295		$	8,573		$	28,525		$	24,761
Interest expense, net of interest income		8,132			9,038			23,852			27,516
Provision for income taxes		2,420			1,909			14,000			12,439
Depreciation and amortization expense		6,014			5,301			17,358			15,534

EBITDA		25,861			24,821			83,735			80,250
Loss on disposal of asset		1			110			61			110

Adjusted EBITDA	$	25,862		$	24,931		$	83,796		$	80,360

We define EBITDA as net income from continuing operations before depreciation, amortization and interest expense (net of interest income) and the provision for income taxes. EBITDA margin is EBITDA as a percentage of revenue. We calculate Adjusted EBITDA by adjusting EBITDA (each to the extent applicable in the appropriate period) for:

•

the effect of a change in accounting principle, net of tax;

•

the change in fair value of an interest rate hedge that does not qualify for hedge accounting;

•

reversal of a charge related to the decertification of a facility;

•

gains or losses on sale of assets;

	•		provision for the impairment of long-lived assets; and

	•		the write-off of deferred financing costs of extinguished debt.

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

Specifically, we believe that a report of EBITDA and Adjusted EBITDA provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods. EBITDA and Adjusted EBITDA are two of the primary indicators management uses for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of accounting principles generally accepted in the United States of America, or U.S. GAAP, expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA and Adjusted EBITDA to prepare operating budgets, to measure our performance against those budgets on a consolidated segment and a facility-by-facility level, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.

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

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

Finally, we use Adjusted EBITDA to determine compliance with our debt covenants and assess our ability to borrow additional funds and to finance or expand operations. The credit agreement governing our first lien term loan uses a measure substantially similar to Adjusted EBITDA as the basis for determining compliance with our financial covenants, specifically our minimum interest coverage ratio and our maximum total leverage ratio, and for determining the interest rate of our first lien term loan. The indenture governing our 11% senior subordinated notes also uses a substantially similar measurement for determining the amount of additional debt we may incur. For example, both our credit facility and the indenture governing our 11% senior subordinated notes include adjustments for (i) gain or losses on disposal of assets, (ii) the write-off of deferred financing costs of extinguished debt; (iii) reorganization expenses; and (iv) fees and expenses related to our transaction with Onex Corporation affiliates in December 2005. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our credit facility. In addition, if we cannot satisfy certain financial covenants under the indenture for our 11% senior subordinated notes, we cannot engage in certain specified activities, such as incurring additional indebtedness or making certain payments.

Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA and Adjusted EBITDA are non- U.S. GAAP financial measures that have no standardized meaning defined by U.S. GAAP. Therefore, our EBITDA and Adjusted EBITDA measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under U.S. GAAP. Some of these limitations are:

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

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

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

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

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

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

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

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

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

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

Revenue. Revenue increased $5.9 million, or 3.2%, to $188.4 million in the three months ended September 30, 2009, from $182.5 million in the three months ended September 30, 2008.

Revenue in our long-term care services segment increased $6.6 million, or 4.1%, to $166.2 million in the three months ended September 30, 2009, from $159.7 million in the three months ended September 30, 2008. The increase in long-term care services segment revenue resulted primarily from a $5.6 million, or 3.6%, increase in our skilled nursing facilities revenue and a $1.0 million, or 19.7%, increase in our assisted living facilities revenue. The increase in skilled nursing facilities revenue resulted from a $2.6 million increase due to the opening of the Dallas Center of Rehabilitation and acquisition of the Rehabilitation Center of Des Moines and a $7.8 million increase due to higher rates from Medicare, Medicaid and managed care pay sources offset by a $5.4 million decrease due to a decline in occupancy rates and skilled mix. Our average daily number of skilled nursing patients decreased by 26, or 0.3%, to 7,592 in the three months ended September 30, 2009, from 7,618 in the three months ended September 30, 2008. Our average daily Part A Medicare rate increased 5.4% to $504 in the three months ended September 30, 2009, from $478 in the three months ended September 30, 2008 as a result of market basket increases provided under the Medicare program, as well as a higher patient acuity mix from the expansion of our Express Recovery™ Unit services. Our average daily Medicaid rate increased 5.0% to $147 in the three months ended September 30, 2009, from $140 per day in the three months ended September 30, 2008, primarily due to increased Medicaid rates in Texas, California and Missouri. The $1.0 million increase in assisted living facilities revenue is primarily attributed to the acquisition of the Kansas assisted living facilities in September 2008. Our skilled mix declined to 22.4% in the three months ended September 30, 2009, from 23.0% in the three months ended September 30, 2008 primarily due to a decrease in average length of stay for our skilled patients as well as a reduction in Medicare census from lower acute-care hospital admissions as a result of the challenging economic environment and competitive pressures in a handful of facilities.

Revenue in our ancillary services segment, excluding intersegment revenue, decreased $0.7 million, or 2.9%, to $22.1 million in the three months ended September 30, 2009, from $22.8 million in the three months ended September 30, 2008. This decrease in our ancillary services segment revenue resulted from a $1.7 million, or 9.8%, increase in rehabilitation therapy services, which was offset by a $2.4 million, or 43.8%, decrease in revenue from our hospice business. The increase in rehabilitation therapy services revenue resulted primarily from a $1.7 million, or 12.4%, increase in therapy services under existing third-party facility contracts due to higher rates, increased census and improved Medicare Part A RUG distribution. The margins on the cancelled contracts are significantly below the overall margin of the therapy business. Hospice revenue decreased as a result of accruing a Medicare cap contractual adjustment of $2.1 million in the three months ended September 30, 2009.

Cost of Services Expenses. Our cost of services expenses increased $5.1 million, or 3.5%, to $152.5 million, or 80.9% of revenue, in the three months ended September 30, 2009, from $147.4 million, or 80.8% of revenue, in the three months ended September 30, 2008.

Cost of services expenses in our long-term care services segment, prior to intersegment eliminations, increased $5.8 million, or 4.5%, to $134.6 million, or 81.0%, of our long-term care services segment revenue in the three months ended September 30, 2009, from $128.8 million, or 80.7%, of our long-term care services segment revenue in the three months ended September 30, 2008.

The increase in long-term care services segment cost of services expenses resulted primarily from a $3.5 million, or 2.9%, increase in cost of services expenses at our skilled nursing facilities and a $0.9 million, or 27.3%, increase in cost of services expenses at our assisted living facilities.

Cost of services expenses at our skilled nursing facilities increased $2.5 million due to the opening of our newly constructed building in Texas and acquisition of The Rehabilitation Center of Des Moines, and $1.0 million resulted from operating costs increasing at facilities acquired or developed prior to June 1, 2008 by $5 per patient day, or 2.9%, to $178 per patient day in the three months ended September 30, 2009, from $173 per patient day in the three months ended September 30, 2008. The $1.0 million increase in operating costs resulted from a $3.1 million increase in labor costs primarily due to increased benefits costs, offset by $1.5 million decrease in bad debt expense and a $0.6 million decrease in other expenses such as food, therapy, and other purchased services, due to the decreased census. Cost of services expenses at our assisted living facilities increased $1.0 million due to the acquisition of seven assisted living facilities in September 2008 and the opening of Tonganoxie in April 2009, offset by $0.1 million decrease in operating costs at facilities acquired or developed prior to June 1, 2008.

Cost of services expenses in our ancillary services segment, prior to intersegment eliminations, decreased $0.8 million, or 2.2%, to $35.0 million in the three months ended September 30, 2009, from $35.8 million in the three months ended September 30, 2008. Cost of services expenses were 90.4% of total ancillary services segment revenue of $38.7 million in the three months ended September 30, 2009, as compared to 91.8% of total ancillary services segment revenue of $39.0 million in the three months ended September 30, 2008. The decrease in our ancillary services segment cost of services expenses resulted from a $0.5 million, or 1.6%, decrease in operating expenses related to our rehabilitation therapy services to $30.0 million in the three months ended September 30, 2009, from $30.5 million in the three months ended September 30, 2008, and a $0.3 million, or 5.7%, decrease in operating expenses related to our hospice business. Prior to intersegment eliminations, cost of services expenses related to our rehabilitation therapy services were 84.0% of total rehabilitation therapy revenue of $35.7 million in the three months ended September 30, 2009, as compared to 90.8%, of total rehabilitation therapy revenue of $33.6 million in the three months ended September 30, 2008. The increase in rehabilitation therapy margin was due primarily to a decrease in bad debt expense. Cost of services expenses related to our hospice services were 98.0% of total hospice revenue before including the 2009 cap overage of $2.1 million, resulting in revenue of $5.1 million in the three months ended September 30, 2009, as compared to 98.1% of total hospice revenue of $5.4 million in the three months ended September 30, 2008. Cost of services expense in our hospice business was challenged by labor inefficiencies in our California operations.

Rent Cost of Revenue. Rent cost of revenue decreased by $0.3 million, or 6.3% to $4.5 million, or 2.4% of revenue, in the three months ended September 30, 2009, from $4.8 million, or 2.6% of revenue, in the three months ended September 30, 2008.

General and Administrative Services Expenses. Our general and administrative services expenses increased $0.3 million, or 5.0%, to $6.3 million, or 3.4% of revenue, in the three months ended September 30, 2009 from $6.0 million, or 3.3% of revenue, in the three months ended September 30, 2008. The increase in our general and administrative expenses was primarily the result of increased headcount for certain administrative functions.

Depreciation and Amortization. Depreciation and amortization increased by $0.7 million, or 13.2%, to $6.0 million, or 3.2% of revenue, in the three months ended September 30, 2009, from $5.3 million, or 2.9% of revenue, in the three months ended September 30, 2008. This increase primarily resulted from increased depreciation and amortization related to the opening of the Dallas Center of Rehabilitation skilled nursing facility as well as new assets placed in service during 2008 and 2009. We expect that depreciation costs will continue to increase as we place additional Express Recovery™ Units in service over the remainder of 2009.

Interest Expense. Interest expense decreased by $0.8 million, or 8.7%, to $8.4 million in the three months ended September 30, 2009, from $9.2 million in the three months ended September 30, 2008. The decrease in our interest expense was primarily due to a decrease in the average interest rate on our debt from 7.1% for the three months ended September 30, 2008, to 5.8% for the three months ended September 30, 2009, which resulted in a $1.6 million savings. Average debt outstanding decreased by $4.5 million, from $474.9 million for the three months ended September 30, 2008 to $470.4 million for the three months ended September 30, 2009, which resulted in a decrease in interest expense of $0.1 million. The remainder of the variance in interest expense was primarily due to a $0.2 million decrease in capitalized interest expense and an increase of $0.6 million in deferred financing fee amortization as a result of fees paid to extend the maturity date of our revolving credit facility in April 2009.

Interest Income. Interest income increased by $0.1 million, or 50.0%, to $0.3 million in the three months ended September 30, 2009 from $0.2 million in the three months ended September 30, 2008 due to an increase in outstanding notes receivable.

Equity in Earnings of Joint Venture. Equity earnings of joint venture increased by $0.1 million, or 16.7%, to $0.7 million, or 0.4% of revenue, in the three months ended September 30, 2009, from $0.6 million, or 0.3% of revenue, in the three months ended September 30, 2008. The increase was due to the increased profitability of our pharmacy joint venture.

Provision for Income Taxes. Our provision for income taxes for the three months ended September 30, 2009 was $2.4 million, or 20.7% of pre-tax earnings from continuing operations, as compared to $1.9 million and 18.2% of pre-tax earnings from continuing operations for the three months ended September 30, 2008. The increase in tax expense during the three months ended September 30, 2009 was due primarily to a $1.2 million increase in pre-tax earnings from continuing operations as compared to the prior period. The effective rates for the three months ended September 30, 2009 and 2008 were below our statutory rate primarily as a result of reductions of $1.9 million and $1.4 million, respectively, in our accrual for unrecognized tax benefits due to expirations of statutes of limitations.

EBITDA. EBITDA increased by $1.1 million, or 4.4%, to $25.9 million in the three months ended September 30, 2009, from $24.8 million in the three months ended September 30, 2008. The $1.1 million increase was primarily related to the $5.9 million increase in revenue for the period and $0.3 million decrease in rent cost of revenue offset by the $5.1 million increase in cost of services expenses, and $0.3 million increase in general and administrative service expenses, all discussed above.

Net Income from Continuing Operations. Net income from continuing operations increased by $0.7 million, or 8.1%, to $9.3 million in the three months ended September 30, 2009, from $8.6 million in the three months ended September 30, 2008. The $0.7 million increase was related primarily to the $1.1 million increase in EBITDA, the $0.1 million increase in interest income, and the $0.8 million decrease in interest expense, offset by the $0.5 million increase in income tax expense, and the $0.7 million increase in depreciation and amortization, all discussed above.

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

Revenue. Revenue increased $27.2 million, or 5.0%, to $570.8 million in the nine months ended September 30, 2009, from $543.5 million in the nine months ended September 30, 2008.

Revenue in our long-term care services segment increased $21.9 million, or 4.6%, to $499.4 million in the nine months ended September 30, 2009, from $477.4 million in the nine months ended September 30, 2008. The increase in long-term care services segment revenue resulted primarily from an $18.1 million, or 3.9%, increase in our skilled nursing facilities revenue and a $3.8 million, or 26.6%, increase in our assisted living facilities revenue. The increase in skilled nursing facilities revenue resulted from a $6.3 million increase due to our April 2008 acquisition of a skilled nursing facility in Kansas, opening of the Dallas Center of Rehabilitation in April 2009, and acquisition of The Rehabilitation Center of Des Moines and a $28.9 million increase due to higher rates from Medicare, Medicaid and managed care pay sources offset by a $18.5 million decrease due to a decline in occupancy rates and skilled mix. Our average daily number of skilled nursing patients decreased by 19, or 0.2%, to 7,623 in the nine months ended September 30, 2009, from 7,642 in the nine months ended September 30, 2008. Our average daily Part A Medicare rate increased 6.4% to $500 in the nine months ended September 30, 2009, from $470 in the nine months ended September 30, 2008 as a result of market basket increases provided under the Medicare program, as well as a higher patient acuity mix from the expansion of our Express Recovery™ Unit services. Our average daily Medicaid rate increased 5.8% to $145 in the nine months ended September 30, 2009, from $137 per day in the nine months ended September 30, 2008, primarily due to increased Medicaid rates in Texas, California and Missouri. The $3.8 million increase in assisted living facilities revenue is primarily attributed to the acquisition of the Kansas assisted living facilities in September 2008 as well as the opening of our facility in Tonganoxie, Kansas earlier this year. Our skilled mix declined to 23.5% in the nine months ended September 30, 2009, from 24.4% in the nine months ended September 30, 2008 primarily due to a decrease in average length of stay for our skilled patients as well as a reduction in Medicare census from lower acute-care hospital admissions as a result of the challenging economic environment and competitive pressures in a handful of facilities.

Revenue in our ancillary services segment, excluding intersegment revenue, increased $5.3 million, or 8.0%, to $71.4 million in the nine months ended September 30, 2009, from $66.1 million in the nine months ended September 30, 2008. This increase in our ancillary services segment revenue resulted from a $5.5 million, or 10.6%, increase in rehabilitation therapy services, offset by a $0.2 million, or 1.3%, decrease in revenue from our hospice business. The increase in rehabilitation therapy revenue resulted primarily from a $5.1 million, or 13.5%, increase in therapy services under existing third-party facility contracts due to higher rates, increased census and improved Medicare Part A RUG distribution. The margins on the cancelled contracts are significantly below the overall margin of the therapy business. Hospice revenue decreased as a result of accruing a Medicare cap contractual adjustment of $2.1 million in the three months ended September 30, 2009.

Cost of Services Expenses. Our cost of services expenses increased $22.6 million, or 5.2%, to $456.3 million, or 79.9% of revenue, in the nine months ended September 30, 2009, from $433.7 million, or 79.8% of revenue, in the nine months ended September 30, 2008.

Cost of services expenses in our long-term care services segment, prior to intersegment eliminations, increased $18.2 million, or 4.7%, to $403.0 million, or 80.7%, of our long-term care services segment revenue in the nine months ended September 30, 2009, from $384.8 million, or 80.6%, of our long-term care services segment revenue in the nine months ended September 30, 2008. The cost of services expenses recorded in the nine months ended September 30, 2009 and September 30, 2008, were each 81.0% of revenue, excluding the respective $1.7 million decrease and $2.0 million decrease in calculated self-insured general and professional liability and workers’ compensation insurance reserves.

The increase in long-term care services segment cost of services expenses resulted primarily from a $10.6 million, or 2.9%, increase in cost of services expenses at our skilled nursing facilities and a $3.3 million, or 34.7%, increase in cost of services expenses at our assisted living facilities.

Cost of services expenses at our skilled nursing facilities increased $6.6 million due to the acquisition of a Kansas facility in April 2008, the opening of the Dallas Center of Rehabilitation and acquisition of the Rehabilitation Center of Des Moines, and $3.9 million resulted from operating costs increasing at facilities acquired or developed prior to January 1, 2008 by $5 per patient day, or 2.9%, to $179 per patient day in the nine months ended September 30, 2009, from $174 per patient day in the nine months ended September 30, 2008. The $3.9 million increase in operating costs resulted from a $7.6 million increase in labor costs, or 5.9%, on a per patient day basis, as the fixed labor costs increased as a percent of total labor costs due to the decline in census and also due to slight labor rate increases. These labor cost increases were offset by a $2.5 million decrease in ancillary costs, and a $1.2 million decrease in other expenses such as food, therapy, and other purchased services, due to the decreased census. Cost of services expenses at our assisted living facilities increased $3.3 million due to the acquisition of seven assisted living facilities in September 2008 and the opening of our Tonganoxie facility in April 2009.

Cost of services expenses in our ancillary services segment, prior to intersegment eliminations, increased $4.7 million, or 4.7%, to $105.6 million in the nine months ended September 30, 2009, from $100.9 million in the nine months ended September 30, 2008. Cost of services expenses were 86.8% of total ancillary services segment revenue of $121.6 million in the nine months ended September 30, 2009, as compared to 87.4% of total ancillary services segment revenue of $115.4 million in the nine months ended September 30, 2008. The increase in our ancillary services segment cost of services expenses resulted from a $2.9 million, or 3.3%, increase in operating expenses related to our rehabilitation therapy services to $90.4 million in the nine months ended September 30, 2009, from $87.5 million in the nine months ended September 30, 2008, and a $1.8 million, or 13.4%, increase in operating expenses related to our hospice business. Prior to intersegment eliminations, cost of services expenses related to our rehabilitation therapy services were 84.2% of total rehabilitation therapy revenue of $107.4 million in the nine months ended September 30, 2009, as compared to 86.6% of total rehabilitation therapy revenue of $101.0 million in the nine months ended September 30, 2008. The increase in rehabilitation therapy margin was primarily due to increased labor productivity as well as lower bad debt expense. Cost of services expenses related to our hospice services were 93.3% of total hospice revenue before including the 2009 cap overage of $2.1 million, resulting in revenue of $16.3 million in the nine months ended September 30, 2009, as compared to 93.1% of total hospice revenue of $14.4 million in the nine months ended September 30, 2008. Cost of services expense in our hospice business was challenged by labor inefficiencies in our California operations.

Rent Cost of Revenue. Rent cost of revenue decreased by $0.1 million, or 0.7%, to $13.6 million, or 2.4% of revenue, in the nine months ended September 30, 2009, from $13.7 million, or 2.5% of revenue, in the nine months ended September 30, 2008.

General and Administrative Services Expenses. Our general and administrative services expenses increased $1.6 million, or 9.0%, to $19.4 million, or 3.4% of revenue, in the nine months ended September 30, 2009 from $17.8 million, or 3.3% of revenue, in the nine months ended September 30, 2008. The increase in our general and administrative expenses was primarily the result of $0.9 million of expense incurred related to the restatement of our financial results and increased headcount for certain administrative functions.

Depreciation and Amortization. Depreciation and amortization increased by $1.9 million, or 12.3%, to $17.4 million, or 3.0% of revenue, in the nine months ended September 30, 2009, from $15.5 million, or 2.9% of revenue, in the nine months ended September 30, 2008. This increase primarily resulted from increased depreciation and amortization related to the opening of the Dallas Center of Rehabilitation skilled nursing facility as well as new assets placed in service during 2008 and 2009. We expect that depreciation costs will continue to increase as we place additional Express Recovery™ Units in service over the remainder of 2009.

Interest Expense. Interest expense decreased by $3.3 million, or 11.8%, to $24.7 million in the nine months ended September 30, 2009, from $28.0 million in the nine months ended September 30, 2008. The decrease in our interest expense was primarily due to a decrease in the average interest rate on our debt from 7.2% for the nine months ended September 30, 2008, to 5.9% for the nine months ended September 30, 2009, which resulted in a $4.7 million savings. Average debt outstanding increased by $7.3 million, from $471.7 million for the nine months ended September 30, 2008 to $479.0 million for the nine months ended September 30, 2009, which resulted in additional interest expense of $0.4 million. The remainder of the variance in interest expense was due to a $0.1 million decrease in capitalized interest expense related to the development of long-term care facilities and a $1.1 million increase in deferred financing fee amortization as a result of fees paid to extend the maturity date of our revolving credit facility in April 2009.

Interest Income. Interest income increased by $0.4 million, or 80.0%, to $0.9 million in the nine months ended September 30, 2009 from $0.5 million in the nine months ended September 30, 2008 due to an increase in outstanding notes receivable.

Equity in Earnings of Joint Venture. Equity earnings of joint venture increased by $0.5 million, or 29.4% to $2.2 million, or 0.4% of revenue, in the nine months ended September 30, 2009, from $1.7 million, or 0.3% of revenue, in the nine months ended September 30, 2008. The increase was due to increased profitability in our pharmacy joint venture.

Provision for Income Taxes. Our provision for income taxes for the nine months ended September 30, 2009 was $14.0 million, or 32.9% of pre-tax earnings from continuing operations, as compared to $12.4 million and 33.4% of pre-tax earnings from continuing operations for the nine months ended September 30, 2008. The increase in tax expense during the nine months ended September 30, 2009 was due to a $5.3 million increase in pre-tax earnings from continuing operations as compared to the prior period. The effective rates for the nine months ended September 30, 2009 and 2008 were below our statutory rate primarily as a result of reductions of $2.2 million and $1.5 million, respectively, in our accrual for unrecognized tax benefits due to expirations of statutes of limitations.

EBITDA. EBITDA increased by $3.4 million, or 4.2%, to $83.7 million in the nine months ended September 30, 2009, from $80.3 million in the nine months ended September 30, 2008. The $3.4 million increase was primarily related to the $27.2 million increase in revenue and $0.1 million decrease in rent cost of revenue for the period offset by the $22.6 million increase in cost of services expenses, and $1.6 million increase in general and administrative service expenses, all discussed above.

Net Income from Continuing Operations. Net income from continuing operations increased by $3.7 million, or 14.9%, to $28.5 million in the nine months ended September 30, 2009, from $24.8 million in the nine months ended September 30, 2008. The $3.7 million increase was related primarily to the $3.4 million increase in EBITDA, the $0.4 million increase in interest income, and the $3.3 million decrease in interest expense offset by the increase in income tax expense of $1.6 million, and the increase in depreciation and amortization of $1.9 million, all discussed above.

Liquidity and Capital Resources

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


	Nine Months Ended
	September 30,
	2009			2008
Cash Flows from Continuing Operations
Net cash provided by operating activities	$	45,407		$	46,592
Net cash used in investing activities		(30,832	)		(57,565	)
Net cash (used in) provided by financing activities		(13,777	)		10,288
Cash flows from discontinued operations		390			—

Net increase (decrease) in cash and equivalents		1,188			(685	)
Cash and equivalents at beginning of period		2,047			5,012

Cash and equivalents at end of period	$	3,235		$	4,327

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

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

At September 30, 2009, we had cash of $3.2 million. Our available cash is held in accounts at third-party financial institutions. We have periodically invested in AAA money market funds. To date, we have experienced no loss or lack of access to our invested cash or cash equivalents; however, we can provide no assurances that access to our invested cash or cash equivalents will not be impacted by adverse conditions in the financial markets.

Net cash provided by operating activities from continuing operations primarily consists of net income adjusted for certain non-cash items including depreciation and amortization, stock-based compensation, as well as the effect of changes in working capital and other activities. Cash provided by operating activities from continuing operations for the nine months ended September 30, 2009 was $45.4 million and consisted of net income of $28.1 million, and adjustments for non-cash items of $33.0 million, offset by $15.7 million used for working capital and other activities. Working capital and other activities primarily consisted of an increase in accounts receivable of $16.7 million, a $2.2 million decrease in insurance liability risks, and a $7.1 million decrease in accounts payable and accrued liabilities, offset by a $3.4 million payment in notes receivable, a $5.8 million decrease in other current and non-current assets, a $0.8 million increase in other long-term liabilities and a $0.3 million increase in employee compensation benefits. The increase in accounts receivable offset by collections was due primarily to an increase in revenue for the nine months ended September 30, 2009, as compared to the year ago comparable period. Days sales outstanding for continuing operations decreased slightly from 49.9 for the three months ended December 31, 2008 to 49.6 for the three months ended September 30, 2009. The decrease in accounts payable and accrued liabilities was primarily due to the timing of interest payments on our senior subordinated debt.

Net cash provided by operating activities in the nine months ended September 30, 2008 was $46.6 million and consisted of net income of $24.8 million and adjustments for non-cash items of $25.9 million, offset by $4.1 million used for working capital and other activities. Working capital and other activities primarily consisted of an increase in accounts receivable of $10.8 million, a $6.2 million decrease in accounts payable and accrued liabilities, offset by a decrease of $3.9 million in payments on notes receivable, a $0.5 million decrease in other current and non-current assets, a $1.9 million increase in insurance liability risks, a $2.4 million increase in employee compensation benefits and a $4.2 million increase in other long-term liabilities

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

Net cash used in investing activities for the nine months ended September 30, 2008 of $57.6 million was primarily attributable to capital expenditures of $34.5 million, $11.7 million of which related to the development of a skilled nursing facility in Texas, $8.9 million of which related to Express Recovery™ Units being put in place at our existing skilled nursing facilities, and $13.9 million of which related to routine capital expenditures. The balance of the cash used in investing activities consisted primarily of $23.1 million used to acquire healthcare facilities, $8.9 million of which was used to acquire seven assisted living facilities located in Kansas in September 2008, and $13.2 million of which was used to acquire the real property and assets of a 152-bed skilled nursing facility and an adjacent 34-unit assisted living facility located in Wichita, Kansas.

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

Net cash provided by financing activities for the nine months ended September 30, 2008 of $10.3 million primarily reflects net borrowings under our line of credit of $18.0 million, offset by scheduled debt repayments of $6.4 million and a $1.4 million increase in deferred financing fees.

Principal Debt Obligations and Capital Expenditures

We are significantly leveraged. As of September 30, 2009, we had $472.5 million in aggregate indebtedness outstanding, consisting of $129.5 million principal amount of our 11.0% senior subordinated notes (net of the unamortized portion of the original issue discount of $0.5 million), a $249.0 million first lien senior secured term loan that matures on June 15, 2012, $83.0 million principal amount outstanding under our $135.0 million revolving credit facility, and capital leases and other debt of approximately $11.0 million. Furthermore, we had $4.6 million in outstanding letters of credit against our $135.0 million revolving credit facility, leaving approximately $47.4 million of additional borrowing capacity under our amended senior secured credit facility as of September 30, 2009.

On April 28, 2009, we extended the maturity of the revolving loan commitments under our second amended and restated first lien credit agreement to June 15, 2012. The revolving line of credit has a capacity of $135.0 million through June 15, 2010, and will reduce to $124.0 million thereafter, until its maturity on June 15, 2012. Our costs for the extension include up-front fees and expenses of approximately $8.0 million. The revolving loan will continue to charge interest at our choice of LIBOR plus 2.75% or prime plus 1.75%. The revolving credit facility was previously scheduled to mature on June 15, 2010.

Under the terms of our amended senior secured credit facility, we must maintain compliance with specified financial covenants measured on a quarterly basis, including a minimum interest coverage minimum ratio as well as a maximum leverage ratio. The covenants also include annual and lifetime limitations, including the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Furthermore, in addition to a $2.6 million annual permanent reduction requirement, we must permanently reduce the principal amount of debt outstanding by applying the proceeds from any asset sale, insurance or condemnation payments, issuance of additional indebtedness or equity, and 25% to 50% of excess cash flows from operations based on the leverage ratio then in effect. We believe that we were in compliance with our debt covenants as of September 30, 2009.

Substantially all of our companies guarantee our 11.0% senior subordinated notes, the first lien senior secured term loan and our revolving credit facility. We have no independent assets or operations and the guarantees provided by our companies are both full and unconditional and joint and several.

We intend to invest in the maintenance and general upkeep of our facilities on an ongoing basis. We also expect to perform renovations of our existing facilities every five to ten years to remain competitive. Combined, we expect that these activities will amount to approximately $1,550 per bed, or approximately $16.0 million in capital expenditures in 2009 on our existing facilities. In addition, we are continuing with the expansion of our Express Recovery™ Units. These units cost, on average, between $0.4 million and $0.6 million each. We completed seven Express Recovery™ Units as of September 30, 2009. We are in the process of developing an additional two Express Recovery™ Units that are scheduled to be completed by December 31, 2009.

Our relationship with Baylor Healthcare System offers us the ability to build long-term care facilities selectively on Baylor acute campuses. In the first quarter of 2009, we completed a 136-bed skilled nursing facility in downtown Dallas. We currently have two facilities we are planning and/or developing at or near Baylor Hospitals in Texas; one to be located in downtown Fort Worth, on which we broke ground in the first quarter of 2009, and another in Garland, Texas, a northern suburb of Dallas, where we recently acquired the land adjacent to the Baylor Garland Hospital that is in the design and site preparation phase.

As of September 30, 2009, we had outstanding purchase commitments of $10.3 million related to our skilled nursing facility currently under development in Fort Worth, Texas, which we expect to complete by the end of 2010. Finally, we may also invest in expansions of our existing facilities and the acquisition or development of new facilities. We currently anticipate that we will incur total capital expenditures in 2009 of approximately $36.0 million to $38.0 million. Due to the proposed slowdown in the growth of Medicare and Medicaid spending, we will continue to assess our capital spending plans going forward. For more detailed information regarding the slowdown in growth of Medicare and Medicaid spending, see “Sources of Revenue—Medicare” in Part I, Item 2 and “Risk Factors” in Part II, Item 1A of this Quarterly Report.

Based upon our current level of operations, we believe that cash generated from operations, cash on hand and borrowings available to us will be adequate to meet our anticipated debt service requirements, capital expenditures and working capital needs for at least the next 12 months. We cannot assure you, however, that our business will generate sufficient cash flow from operations or that future borrowings will be available under our senior secured credit facilities, or otherwise, to enable us to grow our business, service our indebtedness, including our amended senior secured credit agreement and our 11.0% senior subordinated notes, or make anticipated capital expenditures. One element of our business strategy is to selectively pursue acquisitions and strategic alliances. Any acquisitions or strategic alliances may result in the incurrence of, or assumption by us, of additional indebtedness. We continually assess our capital needs and may seek additional financing through a variety of methods including through an extension of our revolving credit facility or by accessing available debt and equity markets, as considered necessary to fund capital expenditures and potential acquisitions or for other purposes. Our future operating performance, ability to service or refinance our 11.0% senior subordinated notes and ability to service and extend or refinance our senior secured credit facilities and our 11.0% senior subordinated notes will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control. For additional discussion, see “Other Factors Affecting Liquidity and Capital Resources—Global Market and Economic Conditions” below in Part 1, Item 2 of this Quarterly Report.

In November 2007, we entered into an interest rate swap agreement in the notional amount of $100.0 million, maturing on December 31, 2009. Under the terms of the swap agreement, we will be required to pay a fixed interest rate of 4.4%, plus a 2.0% margin, or 6.4% in total. In exchange for the payment of the fixed rate amounts, we will receive floating rate amounts equal to the three-month LIBOR rate in effect on the effective date of the swap agreement and the subsequent reset dates, which are the quarterly anniversaries of the effective date. The effect of the swap agreement is to convert $100.0 million of variable rate debt into fixed rate debt, with an effective interest rate of 6.4%.

Other Factors Affecting Liquidity and Capital Resources

Medical and Professional Malpractice and Workers’ Compensation Insurance. Skilled nursing facilities, like physicians, hospitals and other healthcare providers, are subject to a significant number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain professional liability and general liability as well as workers’ compensation insurance in amounts and with deductibles that we believe to be sufficient for our operations. Historically, unfavorable pricing and availability trends emerged in the professional liability and workers’ compensation insurance market and the insurance market in general that caused the cost of these liability coverages to generally increase dramatically. Many insurance underwriters became more selective in the insurance limits and types of coverage they would provide as a result of rising settlement costs and the significant failures of some nationally known insurance underwriters. As a result, we experienced substantial changes in our professional insurance program beginning in 2001. Specifically, we were required to assume substantial self-insured retentions for our professional liability claims. A self-insured retention is a minimum amount of damages and expenses (including legal fees) that we must pay for each claim. We use actuarial methods to estimate the value of the losses that may occur within this self-insured retention level and we are required under our workers’ compensation insurance agreements to post a letter of credit or set aside cash in trust funds to securitize the estimated losses that we may incur. Because of the high retention levels, we cannot predict with absolute certainty the actual amount of the losses we will assume and pay.

We estimate our general and professional liability reserves on a quarterly basis and our workers’ compensation reserve on a semiannual basis, based upon actuarial analyses using the most recent trends of claims, settlements and other relevant data from our own and our industry’s loss history. Based upon these analyses, at September 30, 2009, we had reserved $25.6 million for known or unknown or potential uninsured general and professional liability claims and $14.9 million for workers’ compensation claims. We have estimated that we may incur approximately $6.5 million for general and professional liability claims and $4.1 million for workers’ compensation claims for a total of $10.6 million to be payable within 12 months; however, there are no set payment schedules and we cannot assure you that the payment amount in 2009 will not be significantly larger or smaller. To the extent that subsequent claims information varies from loss estimates, the liabilities will be adjusted to reflect current loss data. There can be no assurance that in the future general and professional liability or workers’ compensation insurance will be available at a reasonable price or that we will not have to further increase our levels of self-insurance. For a detailed discussion of our general and professional liability and workers’ compensation reserve, see “Business — Insurance” in Part 1, Item 1 in our 2008 Annual Report on Form 10-K/A filed with the Securities and Exchange Commission.

Inflation. We derive a substantial portion of our revenue from the Medicare program. We also derive revenue from state Medicaid and similar reimbursement programs. Payments under these programs generally provide for reimbursement levels that are adjusted for inflation annually based upon the state’s fiscal year for the Medicaid programs and in each October for the Medicare program. However, we cannot assure you that these adjustments will continue in the future and, if received, will reflect the actual increase in our costs for providing healthcare services.

Labor and supply expenses make up a substantial portion of our operating expenses. Those expenses can be subject to increase in periods of rising inflation and when labor shortages occur in the marketplace. To date, we have generally been able to implement cost control measures or obtain increases in reimbursement sufficient to offset increases in these expenses. We cannot assure you that we will be successful in offsetting future cost increases.

Global Market and Economic Conditions. Recent global market and economic conditions have been unprecedented and challenging with tight credit conditions and recession in most major economies expected to continue throughout the remainder of 2009 and possibly longer.

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

Medicare and Medicaid Reimbursement Climate. Recently proposed slowdowns in the growth of Medicare and Medicaid spending may result in an increase in our costs for providing healthcare services and have an adverse impact on our financial condition, including results of operations. For more detailed information regarding the slowdown in growth of Medicare and Medicaid spending, see “Sources of Revenue—Medicare” in Part I, Item 2 and “Risk Factors” in Part II, Item 1A of this Quarterly Report.

Recent Accounting Standards

See Item 2 of Part I, “Financial Statements — Note 3 — Summary of Significant Accounting Policies — Recent Accounting Pronouncements.”

Off-Balance Sheet Arrangements

We have outstanding letters of credit of $4.6 million under our $135.0 million revolving credit facility as of September 30, 2009.


Item 3.		*Quantitative and Qualitative Disclosures About Market Risk*

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

Interest Rate Exposure — Interest Rate Risk Management

We use our senior secured credit facility and 11.0% senior subordinated notes to finance our operations. Our first lien credit agreement exposes us to variability in interest payments due to changes in interest rates. In November 2007, we entered into a $100.0 million interest rate swap agreement in order to manage fluctuations in cash flows resulting from interest rate risk. This interest rate swap changes a portion of our variable-rate cash flow exposure to fixed-rate cash flows at an interest rate of 6.4% until December 31, 2009. We continue to assess our exposure to interest rate risk on an ongoing basis.

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


	Twelve Months Ending September 30,
	2010			2011			2012			2013			2014			Thereafter			Total		Fair Value
Fixed-rate debt ⁽¹⁾	$	7,376		$	140		$	148		$	157		$	130,167		$	833		$	138,821	$	143,371
Average interest rate		3.5	%		6.0	%		6.0	%		6.0	%		11.0	%		6.0	%

Variable-rate debt	$	2,600		$	2,600		$	326,750		$	—		$	—		$	—		$	331,950	$	314,524
Average interest rate⁽²⁾		2.6	%		3.9	%		5.2	%		—			—			—


(1)		Excludes unamortized original issue discount of $0.5 million on our 11.0% senior subordinated notes.

(2)		Based on implied forward three-month LIBOR rates in the yield curve as of September 30, 2009.

For the nine months ended September 30, 2009, the loss recognized from converting from floating rate (three-month LIBOR) to fixed rate for a portion of the interest payments under our long-term debt obligations was approximately $2.4 million. At September 30, 2009, an unrealized loss of $0.6 million (net of income tax) is included in accumulated other comprehensive loss. Below is a table listing the interest expense exposure detail and the fair value of the interest rate swap agreement as of September 30, 2009 (dollars in thousands):

Notional

Trade

Effective

Nine Months Ended

Fair Value

Loan

Amount

Date

Maturity

September 30, 2009

(Pre-tax)

First Lien

100,000

10/24/07

10/31/07

12/31/09

1,219

(1,015

)

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


Item 4.		*Controls and Procedures*

Disclosure Controls and Procedures

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

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

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

Changes in Internal Control Over Financial Reporting

As disclosed in our Form 10-Q/A for the quarter ended March 31, 2009, management identified a material weakness in internal control over financial reporting for the quarter ended March 31, 2009.

In May 2009, a former employee left the employment of the Company after a disciplinary meeting on unrelated matters. During a review of the former employee’s work, we discovered that there had been understatements of the LTC segment accounts receivable allowance for doubtful accounts for the quarterly periods ended March 31, 2006 through March 31, 2009. The former employee performed functions that should have been assigned to other employees, and thereafter reviewed by him and other senior personnel. The former employee improperly manipulated consolidated LTC accounts receivable aging reports used in the allowance for doubtful accounts calculation by transferring balances from delinquent aging categories to more current categories. For the quarters ended March 31, 2006 to June 30, 2007, this was accomplished through worksheets that the former employee prepared by modifying system generated data. For the quarters ended September 30, 2007 to March 31, 2009, the former employee altered the accounts receivable aging by posting transactions to fictitious patient accounts in a test facility which had been a part of the production environment. Our policy is to apply a higher reserve percentage to the more delinquent accounts. Thus, the Company understated the LTC segment accounts receivable allowance for doubtful accounts because we relied on the aging reports produced by the former employee, which made the accounts receivable appear more current.

To remediate the material weakness described above and enhance our internal control over financial reporting, management has implemented the changes listed below in addition to the changes reported in our Quarterly Report on Form 10-Q for the three and six months ended June 30, 2009:

•

We have tightened the access and user rights on each of the applications that have a direct impact on financial reporting. We continue to monitor on a routine basis access and user rights to our reporting systems in an ongoing effort to improve the security of our financial reporting systems.

•

We segregated testing and training environments from the production environment in all key applications.

•

We implemented regularly scheduled segregation of duties reviews for conflicts identified by management, to be performed on each of the applications which have a direct impact on financial reporting, and completed initial reviews for each such application.

Other than as described above, during the three months ended September 30, 2009, there was no change in our internal control over financial reporting (as defined in Rules 12a-15(f) and 15d-15(f) of the Exchange Act) that has materially affected, or is reasonably likely to affect, our internal control over financial reporting.

PART II — OTHER INFORMATION


Item 1.		*Legal Proceedings*

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


Item 1A.		*Risk Factors*

For a detailed discussion of the risk factors that should be understood by any investor contemplating investment in our stock, please refer to Part II, Item 1A, Risk Factors, in our Form 10-K/A for the year ended December 31, 2008 filed with the Securities and Exchange Commission. Other than the changes noted below, there has been no material change in our risk factors from those set therein.

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

In the nine months ended September 30, 2009, we received approximately 44.5% and 25.2% of our revenue from operations in California and Texas, respectively, and in the nine months ended September 30, 2008, we received approximately 44.8% and 25.4% of our revenue from operations in California and Texas, respectively. Accordingly, isolated economic conditions and changes in state healthcare spending prevailing in either of these markets could affect the ability of our patients and third-party payors to reimburse us for our services, either through a reduction of the tax base used to generate state funding of Medicaid programs, an increase in the number of indigent patients eligible for Medicaid benefits, changes in state funding levels or healthcare programs or other factors. An economic downturn or changes in the laws affecting our business in these markets could have a material adverse effect on our financial position, results of operations and cash flows.

We expect the federal and state governments to continue their efforts to contain growth in Medicaid expenditures, which could adversely affect our revenue and profitability.

We receive a significant portion of our revenue from Medicaid, which accounted for 31.7% and 31.1% of our total revenue for the nine months ended September 30, 2009 and 2008, respectively. In addition, many private payors for our third-party rehabilitation therapy services are reimbursed under the Medicaid program for services that we provided to patients. Accordingly, if Medicaid reimbursement rates are reduced or fail to increase as quickly as our costs, or if there are changes in the rules governing the Medicaid program that are disadvantageous to our business or industry, our business and results of operations could be adversely affected.

Medicaid is a state-administered program financed by both state funds and matching federal funds. Medicaid spending has increased rapidly in recent years, becoming a significant component of state budgets. This, combined with slower state revenue growth, has led both the federal government and many states to institute measures aimed at controlling the growth of Medicaid spending. For example, the DRA included several measures that are expected to reduce Medicare and Medicaid payments to skilled nursing facilities by $100.0 million over five years (2006-2010). These included limiting the circumstances under which an individual may become financially eligible for nursing home services under Medicaid, which could result in fewer patients being able to afford our services. Moreover, the federal Medicaid Integrity Contractor (MIC) program is increasing the scrutiny placed on Medicaid payments, and could result in recoupments of alleged overpayments in an effort to rein in Medicaid spending; the Mid-Session Review of the presidential budget submitted for federal fiscal year 2010 included, through federal fiscal year 2014, $490.0 million in savings from improving “Medicare and Medicaid program integrity,” and another $175.0 million in Medicaid savings through implementation of coding edits to ensure “appropriate Medicaid payments.” It is uncertain what proportion of these estimated cost savings will come from recoupments against long-term care facilities. However, despite the savings projected from effectively reducing payments to Medicaid providers, we note that the Mid-Session Review of the presidential budget submitted for federal fiscal year 2010 also included an outlay of $1.479 billion for Medicaid spending through federal fiscal year 2014, with a net increase in Medicaid outlays of $48.0 billion during the same time period. In fiscal year 2010, for example, the Federal share of current law Medicaid outlays is expected to be $284.0 billion, a

$26.0 billion (10.1%) increase over projected fiscal year 2009 spending. Some of the projected increases in Medicaid outlays are pursuant to the American Recovery and Reinvestment Act, passed in February 2009, which contained several temporary measures expected to increase Medicaid expenditures. In order to qualify for increases in Medicaid matching funds from the federal government, states cannot implement eligibility standards, methodologies or procedures that are more restrictive than those in effect as of July 1, 2008 and, in addition, must comply with prompt pay requirements when making Medicaid payments. We can provide no assurances regarding the temporary measures’ actual effect on Medicaid claims payment in any particular state, whether these temporary measures will eventually be made permanent, or what effect, if any, they will have on our business. Despite these temporary measures and the general projected increase in overall Medicaid expenditures over the next five years, we expect continued efforts to contain Medicaid expenditures generally.

On February 19, 2009, the California legislature approved a new budget to help relieve a $42 billion budget deficit. Signed the following day, the budget package came after months of negotiation, during which time California’s governor, Arnold Schwarzenegger, declared a fiscal state of emergency in California. The new budget implements spending cuts in several areas, including spending on Medi-Cal, California’s Medicaid program. Some of the spending cuts are triggered only if an inadequate amount of federal funding is received from the American Recovery and Reinvestment Act of 2009 described above. Further, California initially had extended its cost-based Medi-Cal long-term care reimbursement system enacted through Assembly Bill 1629 (A.B. 1629) through the 2009-2010 and 2010-2011 rate years with a growth rate of up to five percent for both years. However, due to California’s severe budget crisis, on July 24, 2009, the California Legislature passed a budget-balancing proposal that eliminated this five percent growth cap by amending current statute to provide that, for the 2009-2010 and 2010-2011 rate years, the weighted average Medi-Cal reimbursement rate paid to long-term care facilities shall not exceed the weighted average Medi-Cal reimbursement rate for the 2008-2009 rate year. In addition, the budget proposal increased the amounts that California nursing facilities will pay to Medi-Cal in quality assurance fees for the 2009-2010 and 2010-2011 rate years by including Medicare revenue in the calculation of the quality assurance fee that nursing facilities pay under A.B. 1629. California’s Governor signed the budget into law on July 28, 2009. Any decrease in California’s Medi-Cal spending for skilled nursing facilities could adversely affect our financial condition and results of operation. We expect continuing cost containment pressures on Medicaid outlays for skilled nursing facilities both in the states in which we operate and by the federal government. These may take the form of both direct decreases in reimbursement rates or in rule changes that limit the beneficiaries, services or providers eligible to receive Medicaid benefits. For a description of other currently proposed reductions in Medicaid expenditures and a description of the implementation of the Medicaid program in the states in which we operate, see Part I, Item 2 of this report, “Revenue— Regulatory and Other Governmental Actions Affecting Revenue.”

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

In recent years, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for, the availability of, and reimbursement for, healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including to provide comprehensive healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs. The ultimate content or timing of any future healthcare reform legislation, and its impact on us, is impossible to predict. If significant reforms are made to the U.S. healthcare system, those reforms may have an adverse effect on our financial condition and results of operations.

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

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

Overall payments made by Medicare to us are subject to a cap amount calculated by the Medicare fiscal intermediary at the end of each hospice cap period. The hospice cap period runs from November 1 through October 31. Total Medicare payments received by each of our Medicare-certified program during this period are compared to the cap amount for this period. Payments in excess of the cap amount must be returned by us to Medicare. The cap amount is calculated by multiplying the number of beneficiaries electing hospice care during the period by a statutory Medicare cap amount that is indexed for inflation. The Medicare cap amount is reduced proportionately for Medicare patients who transferred into or out of our hospice programs and either received or will receive hospice services from another hospice provider. The hospice cap amount is computed on a hospice-specific basis.

Our net patient service revenue for the three months ended September 30, 2009 was reduced by approximately $2.1 million as a result of our hospice programs exceeding the Medicare cap. Our ability to comply with this limitation depends on a number of factors relating to a given hospice program, including number of admissions, average length of stay, mix in level of care and Medicare patients that transfer into and out of our hospice programs. Our revenue and profitability may be materially reduced if we are unable to comply with this and other Medicare payment limitations. We cannot assure you that additional hospice programs will not exceed the cap amount in the future or that our estimate of the Medicare cap contractual adjustment will not differ materially from the actual Medicare cap amount.

The accuracy of our estimates of the Medicare cap contractual adjustment is affected by many factors, including:

•

the actual number of Medicare beneficiary patient admissions and discharges and the dates of occurrence of each;

•

changes in the average length of stay at our hospice programs;

•

fluctuations in admissions and discharges at our hospice programs;

•

possible enrollment of beneficiaries in our hospice programs who may have previously elected Medicare hospice coverage through another hospice program and whose Medicare cap amount is prorated for the days of service for the previous hospice admission;

•

fiscal intermediary disallowances of certain beneficiaries and changes in calculation methodology;

•

uncertainty surrounding length of patient stay in various patient groups, particularly with respect to non-cancer patients; and

•

the fact that we are not advised of the Medicare cap amount that will be used by Medicare to calculate our Medicare cap contractual adjustment until the latter part of the Medicare cap year, requiring us to use an estimate of that amount throughout the year.

As a result of exceeding the hospice cap for the period from November 1, 2008 through October 31, 2009, we will be required to repay a portion of payments previously received from Medicare. We actively monitor the Medicare cap amount and seek to implement corrective measures as necessary. We maintain what we believe are adequate allowances in the event that we exceed the Medicare cap in any give fiscal year; however, because of the many variables involved in estimating the Medicare cap contractual adjustment that are beyond our control, we cannot assure you that we will not increase or decrease our estimated contractual allowance in the future.


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

None.


Item 3.		*Defaults Upon Senior Securities*

None.


Item 4.		*Submission of Matters to a Vote of Security Holders*

None.


Item 5.		*Other Information*

None.


	Page
	Number
Part I. Financial Information		3

Item 1. Financial Statements		3

Condensed Consolidated Balance Sheets — September 30, 2009 (unaudited) and December 31, 2008		3

Condensed Consolidated Statements of Operations — Three and nine months ended September 30, 2009 (unaudited) and September 30, 2008 (unaudited and restated)		4

Condensed Consolidated Statements of Cash Flows — Three and nine months ended September 30, 2009 (unaudited) and September 30, 2008 (unaudited and restated)		5

Notes to Unaudited Condensed Consolidated Financial Statements		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23

Item 3. Quantitative and Qualitative Disclosures About Market Risk		46

Item 4. Controls and Procedures		47

Part II. Other Information		49

Item 1. Legal Proceedings		49

Item 1A. Risk Factors		49

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		51

Item 3. Defaults Upon Senior Securities		51

Item 4. Submission of Matters to a Vote of Security Holders		51

Item 5. Other Information		51

Item 6. Exhibits		52

Signatures		53

Exhibit 31.1
Exhibit 31.2
Exhibit 32


	Nine Months Ended
	September 30,
	2009		2008
Supplemental cash flow information
Cash paid for:
Interest expense, net of capitalized interest	$	26,188	$	29,992
Income taxes, net	$	13,258	$	18,092
Non-cash activities:
Conversion of accounts receivable into notes receivable, net	$	10,257	$	3,289
Insurance premium financed	$	7,970	$	8,141


Number		Description

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

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

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


	SKILLED HEALTHCARE GROUP, INC.

Date: November 3, 2009	/s/ Devasis Ghose
	Devasis Ghose
	Executive Vice President, Treasurer and Chief Financial Officer (Principal Financial Officer and Authorized Signatory)

	/s/ Christopher N. Felfe
	Christopher N. Felfe
	Senior Vice President, Finance and Chief Accounting Officer (Principal Accounting Officer and Authorized Signatory)


Number		Description

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

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

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

(1)		I have reviewed this quarterly report on Form 10-Q of Skilled Healthcare Group, Inc.;

(2)		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

(3)		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

(4)		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

	a.		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b.		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c.		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	d.		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	a.		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	b.		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.


	/s/ Boyd Hendrickson
	Boyd Hendrickson
	Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer)


Dated: November 3, 2009	/s/ Boyd Hendrickson
	Boyd Hendrickson
	Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer)