Form 8-K

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WdNjtUXL3zzV9/ujeu19rtHo5s/ak+asCB0Nf5IhmaCjbb/sms1alar68mTX7N3I 7Ysjmi+PL/+XIgtnVNDGdA== 0000904978-07-000088.txt : 20070711 0000904978-07-000088.hdr.sgml : 20070711 20070711170736 ACCESSION NUMBER: 0000904978-07-000088 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20070711 ITEM INFORMATION: Other Events ITEM INFORMATION: Financial Statements and Exhibits FILED AS OF DATE: 20070711 DATE AS OF CHANGE: 20070711 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SUN HEALTHCARE GROUP INC CENTRAL INDEX KEY: 0000904978 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-SKILLED NURSING CARE FACILITIES [8051] IRS NUMBER: 850410612 STATE OF INCORPORATION: DE FISCAL YEAR END: 1207 FILING VALUES: FORM TYPE: 8-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-12040 FILM NUMBER: 07974761 BUSINESS ADDRESS: STREET 1: 101 SUN AVENUE N E CITY: ALBUQUERQUE STATE: NM ZIP: 87109 BUSINESS PHONE: 5058213355 MAIL ADDRESS: STREET 1: 101 SUN LANE N E CITY: ALBUQERQUE STATE: NM ZIP: 87109 8-K 1 form8k.htm FORM 8-K Form 8-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 8-K

CURRENT REPORT

PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of Report (Date of earliest event reported): July 11, 2007

SUN HEALTHCARE GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware	0-49663	85-0410612
(State of Incorporation)	(Commission File Number)	(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400 Irvine, CA	92612
(Address of principal executive offices)	(Zip Code)

No Change

(Former name or former address, if changed since last report.)

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions:

o Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

o Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

o Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

o Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

Item 8.01. Other Events

Attached as Exhibit 99.1 is the unaudited financial information of Harborside Healthcare Corporation (“Harborside”) for the quarter ended March 31, 2007. Attached as Exhibit 99.2 is the unaudited pro forma financial information for the three months ended March 31, 2007 reflecting the acquisition of Harborside by Sun Healthcare Group, Inc. (“Sun”) and certain other transactions referenced therein.

In connection with the issuance by Sun of its 9 1/8% Senior Subordinated Notes due 2015, attached as Exhibit 99.3 is the unaudited financial information of Sun for the quarter ended March 31, 2007, as amended to include a new footnote to provide information regarding Sun’s subsidiaries that are guarantors and non-guarantors of the Senior Subordinated Notes.

Item 9.01 Financial Statements and Exhibits

99.1	Unaudited Consolidated Financial Information for Harborside Healthcare Corporation for the quarter ended March 31, 2007.

99.2	Unaudited Pro Forma Financial Information for the three months ended March 31, 2007 reflecting the acquisition of Harborside Healthcare Corporation by Sun Healthcare Group, Inc. and certain other transactions referenced therein.

99.3	Unaudited Consolidated Financial Information for Sun Healthcare Group, Inc. for the quarter ended March 31, 2007.

SIGNATURES

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

SUN HEALTHCARE GROUP, INC.

/s/ Jeffrey M. Kreger

Name: Jeffrey M. Kreger

Title: Vice President and Corporate Controller

Dated: July 11, 2007

EX-99.1 2 ex991.htm EXHIBIT 99.1 Exhibit 99.1

EXHIBIT 99.1

Harborside Healthcare Corporation and Subsidiaries

Consolidated Financial Statements

For the Quarterly Period Ended March 31, 2007

HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

AS OF

	December 31, 2006 (See Note B)		March 31, 2007 (unaudited)
Current assets:
Cash and cash equivalents	$	21,919	$	25,999
Accounts receivable, net of allowances for doubtful accounts of $12,474 and $18,806		74,141		71,319
Deferred income taxes		20,511		23,824
Prepaid expenses and other		28,015		20,958

Total current assets		144,586		142,100

Restricted cash		7,940		8,059
Property and equipment, net		289,483		289,562
Notes receivable		7,487		7,487
Goodwill		6,494		6,494
Deferred financing and other, net		8,465		8,303

Total assets	$	464,455	$	462,005

Current liabilities:
Long-term debt, current	$	5,881		$	6,708
Accounts payable		27,989			26,722
Employee compensation and benefits		21,415			18,483
Accrued vacation and earned time		6,828			7,458
Workers’ compensation claims reserve		12,872			13,186
Other accrued liabilities		13,599			13,419
Income taxes payable		223			435
Deferred income, current		147			134

Total current liabilities		88,954			86,545

Professional liability claims reserve		18,748			19,193
Deferred income, net		1,549			1,525
Long-term debt		235,063			234,150
Deferred income taxes		24,220			26,484
Preferred stock		60,239			62,197

Total liabilities		428,773			430,094

Minority interest		370			427

Stockholders' equity:
Common stock of $.01 par value, authorized
58,060,000 shares, 15,610,664 shares issued		156			156
Additional paid-in capital		181,506			181,506
Treasury stock		(183,746	)		(183,746	)
Retained earnings		37,396			33,568
Total stockholders' equity		35,312			31,484
Total liabilities and stockholders' equity	$	464,455		$	462,005

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

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HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(dollars in thousands)

FOR THE PERIODS ENDED MARCH 31,

		2006		2007

Total net revenues	$	136,886	$	165,350
Facility operating:
Salaries and wages		58,091		70,810
Benefits		19,136		22,456
Contract labor		1,181		1,673
Supplies		10,917		12,866
Purchased services		7,382		9,329
Insurance		1,641		1,932
Provision for losses on accounts receivable		1,854		7,940
Other		12,776		16,187
Total operating expense		112,978		143,193
Operating income		23,908		22,157

General and administrative		6,607		6,805
Depreciation and amortization		4,163		5,447
Management fee		125		275
Facility rent		7,061		7,308
Income from operations		5,952		2,322

Other:
Interest expense, net		2,930		4,763
Minority interest		62		57
Income before merger costs and taxes		2,960		(2,498	)

Merger and other non-recurring costs		-		192
Provision (benefit) for income taxes		133		(820	)

Net income (loss)	$	2,827	$	(1,870	)

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

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HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

FOR THE PERIODS ENDED MARCH 31,

		2006			2007

Operating activities:
Net income (loss)	$	2,827		$	(1,870	)
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation of property and equipment		3,622			4,789
Provision for losses on accounts receivable		1,854			7,940
Amortization of deferred financing and other intangibles		541			658
Amortization of deferred income		(37	)		(37	)
Amortization of loan costs
and fees (included in rental and interest expense)		3			3
Minority interest		62			57
Increase in deferred income taxes		-			(1,049	)

		8,872			10,491
Changes in operating assets and liabilities:
(Increase) in accounts receivable		(5,318	)		(5,118	)
Decrease in prepaid expenses and other		829			7,057
Increase (decrease) in accounts payable		3,354			(1,267	)
Increase (decrease) in employee compensation and benefits		1,251			(2,932	)
(Decrease) increase in accrued vacation and earned time		(22	)		630
(Decrease) increase in workers’ compensation claims reserve		(602	)		314
(Decrease) in accrued interest		(955	)		-
(Decrease) in other accrued liabilities		(1,506	)		(180	)
Increase in income taxes payable		19			212
Increase in claims reserve accrual		372			445
Net cash provided by operating activities		6,294			9,652

Investing activities:
Additions to property and equipment		(6,210	)		(4,868	)
Transfers to restricted cash, net		316			(119	)
Net cash used by investing activities		(5,894	)		(4,987	)

Financing activities:
Repayment of secured credit facility		(2,500	)		-
Additions to deferred financing costs		-			(499	)
Repayment of long-term debt		(93	)		(86	)
Net cash provided by financing activities		(2,593	)		(585	)

Net (decrease) increase in cash and cash equivalents		(2,193	)		4,080
Cash and cash equivalents, beginning of period		18,547			21,919
Cash and cash equivalents, end of period	$	16,354		$	25,999

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

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HARBORSIDE HEALTHCARE CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

A. NATURE OF BUSINESS AND MERGER

Subsidiaries of Harborside Healthcare Corporation (on a consolidated basis, the "Company" or "Harborside") operate long-term care facilities. As of March 31, 2007, the Company owned forty-four facilities and operated thirty-one additional facilities under various leases.

In October 2006, the Company entered into a merger agreement with Sun whereby Sun Healthcare Group, Inc. (“Sun”) would acquire all of our outstanding stock. On April 19, 2007, the companies completed the merger effective April 1, 2007. In connection with the merger, Sun entered into a $485,000,000 new senior secured credit facility with a syndicate of financial institutions led by Credit Suisse as the administrative agent and collateral agent (the “Credit Agreement”). The proceeds from the Credit Agreement, plus Sun’s cash on hand and the net proceeds from Sun’s issuance on April 12, 2007, of $200,000,000 aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015, were used to purchase all of our outstanding stock for $349,400,000 and refinance certain of our debt. Effective with the consummation of the merger, some but not all of the Company’s subsidiaries became guarantors of the Credit Agreement. Sun does not have any independent assets or operations and all guarantees are full and unconditional and joint and several. Any subsidiaries of the Company other than those guaranteeing the Credit Agreement are considered minor in accordance with Rule 3-10 of Regulation S-X.

B. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with the accounting principles generally accepted in the United States. The accompanying interim consolidated financial statements present fairly the Company’s financial position at March 31, 2007, and the consolidated results of operations and cash flows for the three-month periods ended March 31, 2007 and 2006, respectively. These statements are unaudited, and certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations. Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2006, which are included in Form 8-K as filed by Sun Healthcare Group, Inc. on March 12, 2007.

Accounts Receivable and Provision for Losses on Accounts Receivable

A provision for losses on accounts receivable totaling $5,860,000 was recorded during the first quarter of 2007 following the completion of a detailed cash collection study related to prior periods accounts receivable.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the period reported. Actual results could differ from those estimates. Significant estimates are used in determining the accounting for the collectibility of receivables, depreciation and amortization, health benefits, workers' compensation and general and professional liability claims, taxes and contingencies.

Reclassifications

Certain amounts from prior years have been reclassified to conform to current year presentation.

C. COMMITMENTS AND CONTINGENCIES

The Company self-insures for health benefits provided to a majority of its employees. The Company maintains stop-loss insurance such that the Company's liability for losses is limited. The Company recognizes an expense for estimated health benefit claims including claims incurred but not reported. As of December 31, 2006 and March 31, 2007, the Company maintained a reserve for self-insured employee health benefit claims in the amount of $3,202,000 and $3,592,000, respectively.

The Company self-insures for most workers' compensation claims. The Company maintains stop-loss insurance such that the Company's liability for losses is limited. The Company accrues for estimated workers' compensation claims including claims incurred but not reported. As of December 31, 2006 and March 31, 2007, the Company maintained a reserve for self-insured workers’ compensation claims in the amount of $12,872,000 and $13,186,000, respectively.

The Company self-insures for general and professional liability claims. The Company's unaggregated self-insured retention was $10,000,000 per occurrence for locations outside of Florida for claims incurred after August 31, 2001. The Company accrues for estimated general and professional liability claims including claims incurred but not reported. As of December 31, 2006 and March 31, 2007, the Company maintained a reserve for estimated unpaid general and professional losses, including unreported claims, in the amounts of $18,748,000 and $19,193,000, respectively.

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Effective October 11, 2006, the Board of Directors of the Company approved a plan (the “Sales Bonus Plan”) to pay transaction bonuses to certain members of the Company’s senior management upon the consummation of the pending merger with Sun. These transaction bonuses were funded by the stockholders of the Company.

D. INCOME TAXES

The provision for income taxes was based upon our estimate of taxable income or loss for each respective accounting period. We recognized an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. We also recognized as deferred tax assets the future tax benefits from net operating loss ("NOL") and tax credit carryforwards.

The benefit for income taxes of $820,000 for the three months ended March 31, 2007 is based on a combined federal and state effective income tax rate of approximately 30%. This combined effective rate reflects the impact of permanent differences and minimum taxes. The provision for income taxes of $133,000 for the three months ended March 31, 2006 resulted from the operations of profitable subsidiaries in states that do not allow combined, consolidated or unitary tax return filings, as well as minimum taxes.

Internal Revenue Code Section 382 imposes a limitation on the use of a company's NOL carryforwards and other losses when the company has an ownership change. In general, an ownership change occurs when shareholders owning 5% or more of a "loss corporation" (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any 3-year testing period beginning on the first day following the change date for an earlier ownership change. The annual base Section 382 limitation is calculated by multiplying the loss corporation's value at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the IRS in the month of the ownership change or the two preceding months.

The merger with Sun Healthcare Group, Inc. on April 19, 2007 resulted in an ownership change under Section 382. The annual base Section 382 limitation as reflected on our tax returns to be applied to our tax attribute carryforwards due to this ownership change has not yet been determined. Our application of the rules under Section 382 will be subject to challenge upon IRS review. A successful challenge could significantly impact our ability to utilize deductions, losses and tax credits generated prior to the merger.

We have Federal NOL carryforwards of approximately $2,300,000 which begin to expire in 2021.

In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, and interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a recognition threshold and measurement parameters for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. As of March 31, 2007, we do not believe that the adoption of FIN 48 has a significant impact on our financial position or results of operations.

E. RECENT TRANSACTIONS AND SUBSEQUENT EVENTS

On April, 18, 2006, the Company exercised an option to purchase, at fair market value, four Massachusetts facilities currently leased from a real estate investment trust (the “REIT”). The aggregate annual rent for these four facilities is currently $2,180,000. In connection with the merger agreement described below, the Company, the landlord and Sun Healthcare Group, Inc. have agreed that the existing lease will be extended until December 31, 2007 and that the properties will then be acquired for an aggregate purchase price of $20,600,000.

Effective May 1, 2006, the Company acquired 75% of the equity interests of a home health company, Physicians Homecare, for $2,200,000. This home health company provides home health services through three branches located in Massachusetts. The Company recorded goodwill of approximately $3,800,000 as it assumed net liabilities in addition to the purchase price paid.

Effective August 1, 2006, the Company purchased two facilities (421 licensed beds and located in Connecticut) for a total purchase price of $18,925,000. The purchase was financed with additional debt entered into by the Company. In connection with this purchase, the Company also began managing a third facility (141 licensed beds and located in Connecticut) on August 1, 2006, which it then purchased on November 1, 2006 for $6,975,000. This purchase was also financed with additional debt entered into by the Company.

Effective October 1, 2006, the Company purchased eleven facilities in Kentucky with a total of 760 beds in eight rehabilitation and long-term care facilities, two Alzheimer's disease specialty facilities and one assisted living center. The total purchase price for these eleven facilities was $49,050,000 of which $340,000 was recorded as goodwill because the purchase price exceeded the total appraised value. The purchase was financed with additional debt entered into by the Company.

On October 18, 2006, the Company exercised options to purchase five Connecticut facilities, currently leased by the Company, for an aggregate gross purchase price of $69,250,000. The gross purchase price will be reduced by the collection of a $7,487,000 note receivable

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from the seller currently held by the Company. The aggregate annual rent for these five facilities is approximately $7,689,000. The Company funded this purchase through its Credit Agreement and the assumption of debt. On June 27, 2007, the Company completed the purchase of four of the five facilities. The fifth facility acquisition is expected to be completed in the third quarter of 2007.

On November 13, 2006, the Company received a notice from OHIMA, Inc. (“OHIMA”), the Lessor, in connection with the Master Lease between OHIMA and Massachusetts Holdings I, LLC, a subsidiary of the Company, as Lessee. The notice stated OHIMA's intent to exercise its right to cause the base rent payable under the Master Lease covering four Massachusetts facilities to reset in accordance with the terms of the lease. The notice served to trigger a thirty day negotiation period during which time OHIMA and the Company attempted to negotiate a revised base rent without resorting to the appraisal methodology described in the Master Lease. In February 2007, Harborside and OHIMA agreed to adjust the annual base rent from $2,122,000 to $2,950,000 effective March 1, 2007.

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EX-99.2 3 ex992.htm EXHIBIT 99.2 Exhibit 99.2

EXHIBIT 99.2

UNAUDITED PRO FORMA CONSOLIDATED

FINANCIAL INFORMATION

Introduction

The following tables present unaudited pro forma consolidated financial information of Sun Healthcare Group, Inc. (“Sun”) for the three months ended March 31, 2007. The tables and financial information contained herein are considered supplemental to our pro forma information included in our March 12, 2007 Form 8-K filing (the “March 12th 8-K”) with the Securities and Exchange Commission (the “SEC”). Please refer to the March 12th 8-K for further information.

The unaudited pro forma consolidated financial information relates to the following transactions:

1. the acquisition of Harborside Healthcare Corporation (“Harborside”);

2. entering into new credit facilities, the issuance of senior subordinated notes and the refinancing of outstanding indebtedness of Sun and of Harborside (collectively, the “Acquisition Financing Transactions”), all in connection with the acquisition of Harborside; and

3. acquisitions to be made by Harborside (collectively, the “Harborside Transactions”), consisting of (a) the acquisition of the real estate underlying five facilities in Connecticut (the “Moffie Portfolio”) that at March 31, 2007 were leased and operated by Harborside for a net purchase price of $61.7 million, pursuant to the exercise of a purchase option, which closed, as to four facilities, in the second quarter of 2007 (the purchase of the fifth facility is expected to be completed in the third quarter of 2007); and (b) the proposed acquisition of the real estate underlying four facilities in Massachusetts (the “NHP Portfolio”) that at March 31, 2007 were leased and operated by Harborside for a net purchase price of $20.6 million, pursuant to the exercise of a purchase option, which is expected to close in the fourth quarter of 2007.

The unaudited pro forma consolidated statement of operations for the three months ended March 31, 2007 gives effect to the Harborside acquisition, the Acquisition Financing Transactions and all the Harborside Transactions as if they had occurred on January 1, 2006.

Sun and Harborside have had no intercompany activity that would require elimination in preparing the unaudited pro forma consolidated financial information.

The pro forma adjustments and the resulting unaudited pro forma consolidated statement of operations were prepared based on available information and certain assumptions and estimates described in the notes to the unaudited pro forma consolidated financial information.

The unaudited pro forma consolidated statement of operations does not purport to represent what our results of operations would have been had the acquisition of Harborside, the Acquisition Financing Transactions and the Harborside Transactions occurred on the date indicated or to project our results of operations for any future period. Furthermore, the unaudited pro forma consolidated statement of operations does not reflect changes which may occur as a result of activities after the acquisition of Harborside. The unaudited pro forma consolidated statement of operations should be

read in conjunction with Harborside’s consolidated financial statements and related notes filed with the SEC in reports on Form 8-K on March 12, 2007 and on July 11, 2007, and our financial statements filed with the SEC in both our annual report on Form 10-K/A for the year ended December 31, 2006 and our quarterly report on Form 10-Q for the quarter ended March 31, 2007.

Unaudited Pro Forma Consolidated Statement of Operations

For the Three Months Ended March 31, 2007

(in thousands, except per share data)

														Pro Forma
						Moffie and								Combined
	As Reported		As Reported			NHP Purchase			Transaction					Sun and
	Sun		Harborside			Options			Adjustments					Harborside

Total net revenues	$	273,569	$	165,350		$	-		$	42		(2a	)	$	438,961
Costs and expenses:
Operating salaries and benefits		156,426		93,266			-			(1,465	)	(2a	)
										(1,000	)	(2b	)		247,227
Self-insurance for workers’ compensation
and general and professional liability
insurance		10,564		1,932			-			1,621		(2a	)		14,117
Operating administrative expenses		7,591		-			-			-					7,591
Other operating costs		56,612		40,055			-			(2,496	)	(2a	)		94,171
Facility rent expense		14,379		7,308			(2,475	)		(374	)	(2a	)		18,838
General and administrative expenses		12,832		6,805			-			358		(2a	)		19,995
Depreciation and amortization		3,920		5,447			846			(429	)	(2a	)		9,784
Provision for losses on accounts receivable		2,440		7,940			-			2,398		(2a	)		12,778
Interest, net		2,059		4,763			1,644			7,066		(3c	)
										429		(2a	)
										(534	)	(3b	)
										614		(3a	)		16,041
Management fee		-		275			-			(275	)	(2c	)		-
Diligence costs		-		192			-			(192	)	(2c	)		-
Minority interest		-		57			-			-					57
Loss on extinguishment of debt, net		19		-			-			-					19
Loss on sale of assets, net		7		-			-			-					7
Total costs and expenses		266,849		168,040			15			5,721					440,625

Income (loss) before income taxes and
discontinued operations		6,720		(2,690	)		(15	)		(5,679	)				(1,664	)
Income tax expense (benefit)		2,368		(820	)		-			(2,134	)	(2d	)		(586	)
Income (loss) from continuing operations	$	4,352	$	(1,870	)	$	(15	)	$	(3,545	)			$	(1,078	)

Earnings (loss) per common and common
equivalent share based on income from
continuing operations
Basic and Diluted	$	0.10												$	(0.03	)

Weighted average number of common and
Common equivalent shares outstanding:
Basic		42,908													42,908
Diluted		43,889													43,889

See Notes to Unaudited Pro Forma Consolidated Financial Information

Notes to Unaudited Pro Forma Consolidated Financial Information

1. Basis of Pro Forma Presentation

On October 19, 2006, Sun announced that it entered into a definitive agreement to acquire Harborside in a transaction in which Sun would pay approximately $349 million in cash for all of Harborside’s outstanding stock and to refinance or assume Harborside’s debt of approximately $241 million. The information contained herein is considered supplemental to our pro forma information included in the March 12th 8-K. Please refer to the March 12th 8-K for further information.

2. Transaction Adjustments

Pro forma transaction adjustments are necessary to reflect the impact of adjustments in the current period which pertain to prior periods and to reflect other transactions directly related to the proposed transaction.

The accompanying unaudited pro forma consolidated statement of operations reflects the following pro forma adjustments (in thousands):

(a)	To reclassify Harborside’s financial statement presentation to conform to Sun’s financial statement presentation:

(b)

To adjust operating salaries and benefits in the three months ended March 31, 2007 for estimated net decreases in operating expenses. Positions at Harborside’s corporate office and certain regional positions have been eliminated for an estimated net savings for the quarter of approximately $1,000. The annual estimated net savings from the elimination of positions at Harborside’s corporate and regional offices are estimated to be approximately $8,672. Sun may be unable to fully realize these estimated net cost savings.

(c)

To eliminate the management fee paid to Investcorp International Inc., (an affiliate of which was a major stockholder of Harborside prior to the acquisition by Sun) by Harborside of $275 in addition to the diligence costs incurred by Harborside of $192 in connection with the acquisition, both of which were recorded in the first quarter of 2007.

(d)	To reflect the tax provision at an effective rate of 35%, consistent with Sun’s current estimated effective tax rate.

3. Acquisition Financing Adjustments

Certain pro forma adjustments have been made to reflect financing transactions associated with the proposed transaction. Sun entered into the financing transactions to acquire Harborside and refinance the outstanding balance on Harborside's existing credit facility (in thousands):

(a)	To record the payments to be made from the proceeds of the new indebtedness:

Sources:

	Borrowings:
	Senior term loan			$	310,000
	Delayed draw senior term loan (1)				55,000
	Senior revolving loan				-
	Senior subordinated notes				200,000
					565,000
	Cash:
	Existing cash at Harborside				25,999
	Existing cash at Sun				80,143
					106,142

	Subtotal				671,142

Uses:
	Refinance existing debt - Sun (2)	$	10,000
	Refinance existing debt - Harborside		218,000
	Cash payment for Moffie equity, net		31,680
	Cash payment for NHP equity, net		20,600
	Financing fees (3)		17,520
	Subtotal		297,800		(297,800	)
					373,342
	Remaining funds available for Harborside merger:
	Cash payment for Harborside equity		349,400
	Estimated direct transaction costs		23,942		(373,342	)
		$	373,342	$	-

(1)	Includes borrowing of $31,680 (which is in addition to the $30,033 of indebtedness being assumed) to purchase Moffie Portfolio, $20,600 to purchase NHP Portfolio and the remaining of $2,720 to purchase Harborside.

(2)	Refinanced Sun debt includes $10,000 of current portion of long term debt.

(3)	Financing fees include $11,777 related to the revolving credit facility with a term of six years and the senior term loan with a term of 7 years, and $5,743 related to the senior subordinated notes with a term of 8 years. Such fees would be amortized and included as part of interest expense in the amount of $614 for the pro forma statement of operations for the three months ended March 31, 2007.

(b)	To reflect the non-cash write-off of deferred loan costs associated with the refinancing of existing indebtedness of both Sun and Harborside and to record the related reduction in interest expense of $534 for the amounts that had been amortized for the three months ended March 31, 2007.

(c)	To record pro forma interest expense based upon an assumed debt structure as follows:

						Three Months Ended
	Blended					March 31,
	Interest Rate			Debt		2007

Pro Forma Debt,
including
capital leases,
at closing	8.00	%	$	776,845	$	15,532
Sun historical interest costs						2,059
Harborside historical interest costs, including
adjustments for the Harborside Transactions						6,407
Adjustment to interest expense, net					$	7,066

The interest expense calculation presented above uses the LIBOR rate effective as of March 31, 2007, which was 5.35%, to determine the interest rate applied to the borrowings under the new senior credit facilities. The pro forma cash interest does not include the net impact of amortization of deferred financing costs of $614 for the three months ended March 31, 2007. Each 0.125% increase or decrease in interest rate on debt expected to be issued in connection with the transaction would result in an annual interest expense increase or decrease, respectively, of $769.

EX-99.3 4 ex993.htm EXHIBIT 99.3 Exhibit 99.3

EXHIBIT 99.3

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

(in thousands)

		March 31, 2007		December 31, 2006
		(unaudited)		(Note 1)
Current assets:
Cash and cash equivalents	$	99,670	$	131,935
Restricted cash		28,081		32,752
Accounts receivable, net of allowance for doubtful accounts of $24,880
and $24,866 at March 31, 2007 and December 31, 2006,
respectively		114,499		117,091
Inventories, net		4,728		4,808
Other receivables, net of allowance of $2,412 and $3,064 at
March 31, 2007 and December 31, 2006, respectively		1,736		2,211
Assets held for sale		4,500		7,172
Prepaid expenses		8,031		3,305

Total current assets		261,245		299,274

Property and equipment, net of accumulated depreciation of $52,028 and
$48,233 at March 31, 2007 and December 31, 2006, respectively		221,324		217,544
Intangible assets, net of
accumulated amortization of $7,216 and $6,799 at
March 31, 2007 and December 31, 2006, respectively		12,309		13,691
Goodwill		54,605		55,092
Restricted cash, non-current		33,033		29,083
Other assets, net		7,146		6,739

Total assets	$	589,662	$	621,423

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (CONTINUED)

LIABILITIES AND STOCKHOLDERS' EQUITY

(in thousands, except share data)

		March 31, 2007			December 31, 2006
		(unaudited)			(Note 1)
Current liabilities:
Accounts payable	$	39,090		$	43,400
Accrued compensation and benefits		40,663			42,723
Accrued self-insurance obligations, current portion		40,281			48,689
Income taxes payable		9,135			8,799
Liabilities held for sale		1,826			1,672
Other accrued liabilities		34,143			33,736
Current portion of long-term debt:
Company obligations		12,815			22,780
Clipper partnerships		786			736
Capital leases, current		618			494

Total current liabilities		179,357			203,029

Accrued self-insurance obligations, net of current portion		89,121			81,559
Long-term debt, net of current portion:
Company obligations		80,396			100,067
Clipper partnerships		49,181			49,392
Capital leases, net of current		776			696
Unfavorable lease obligations, net of accumulated amortization of $14,128
and $13,558 at March 31, 2007 and December 31, 2006, respectively		12,786			13,423
Other long-term liabilities		26,914			26,712
Deferred income taxes		2,412			2,412

Total liabilities		440,943			477,290

Commitments and contingencies

Stockholders' equity:
Preferred stock of $.01 par value, authorized
10,000,000 shares, no shares were issued or outstanding as of
March 31, 2007 and December 31, 2006		-			-
Common stock of $.01 par value, authorized
50,000,000 shares, 42,939,602 shares issued and 42,929,420 shares
outstanding as of March 31, 2007 and 42,889,918 shares issued
and 42,879,736 shares outstanding as of December 31, 2006		429			429
Additional paid-in capital		553,938			553,275
Accumulated deficit		(405,557	)		(409,480	)
		148,810			144,224
Less:
Common stock held in treasury, at cost, 10,182 shares
as of March 31, 2007 and December 31, 2006		(91	)		(91	)
Total stockholders' equity		148,719			144,133
Total liabilities and stockholders' equity	$	589,662		$	621,423

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

		For the
		Three Months Ended
		March 31, 2007			March 31, 2006
		(unaudited)			(unaudited)
					(Note 1)

Total net revenues	$	273,569		$	256,756
Costs and expenses:
Operating salaries and benefits		156,426			146,920
Self-insurance for workers' compensation and general and
professional liability insurance		10,564			12,672
Operating administrative expenses		7,591			7,874
Other operating costs		56,612			55,465
Facility rent expense		14,379			13,390
General and administrative expenses		12,832			11,645
Depreciation and amortization		3,920			2,867
Provision for losses on accounts receivable		2,440			1,448
Interest, net		2,059			4,367
Loss on extinguishment of debt, net		19			-
Loss on sale of assets, net		7			13
Total costs and expenses		266,849			256,661

Income before income taxes and discontinued operations		6,720			95
Income tax expense (benefit)		2,368			(727	)
Income from continuing operations		4,352			822

Discontinued operations:
(Loss) income from discontinued operations, net of related taxes		(79	)		383
Loss on disposal of discontinued operations, net of related taxes		(350	)		(66	)
(Loss) income from discontinued operations, net		(429	)		317

Net income	$	3,923		$	1,139

Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.10		$	0.03
(Loss) income from discontinued operations, net		(0.01	)		0.01
Net income	$	0.09		$	0.04

Diluted earnings per common and common equivalent share:
Loss from continuing operations	$	0.10		$	0.03
(Loss) income from discontinued operations, net		(0.01	)		0.01
Net income	$	0.09		$	0.04

Weighted average number of common and common
equivalent shares outstanding:
Basic		42,908			31,174
Diluted		44,029			31,228

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

		For the
		Three Months Ended
		March 31, 2007			March 31, 2006
		(unaudited)			(unaudited)
Cash flows from operating activities:
Net income	$	3,923		$	1,139
Adjustments to reconcile net income to net cash provided by
(used for) operating activities, including discontinued
operations:
Depreciation		2,434			1,613
Amortization		1,522			1,636
Amortization of favorable and unfavorable lease intangibles		(213	)		(379	)
Provision for losses on accounts receivable		2,523			1,948
Loss (gain) on disposal of discontinued operations, net		350			66
Loss on sale of assets		7			13
Restricted stock and stock option compensation		750			544
Other, net		2			25
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable, net		(2,050	)		(11,318	)
Inventories, net		-			(14	)
Other receivables, net		537			(3,186	)
Restricted cash		721			119
Prepaids and other assets		(6,558	)		(6,167	)
Accounts payable		(3,925	)		1,705
Accrued compensation and benefits		(1,666	)		67
Accrued self-insurance obligations		(846	)		3,404
Income taxes payable		2,426			1,856
Other accrued liabilities		1,230			(800	)
Other long-term liabilities		404			610
Net cash provided by (used for) operating activities		1,571			(7,119	)

Cash flows from investing activities:
Capital expenditures		(7,250	)		(3,333	)
Proceeds from sale of assets held for sale		3,238			-
Acquisitions, net		-			(236	)
Proceeds from sale/leaseback		-			838
Net cash used for investing activities		(4,012	)		(2,731	)

Cash flows from financing activities:
Net borrowings under Revolving Loan Agreement		6			17,720
Long-term debt repayments		(29,607	)		(7,694	)
Principal payments under capital lease obligations		(540	)		-
Net proceeds from exercise of employee stock options		573			-
Distribution of partnership equity		(256	)		(123	)
Net cash (used for) provided by financing activities		(29,824	)		9,903

Net (decrease) increase in cash and cash equivalents		(32,265	)		53
Cash and cash equivalents at beginning of period		131,935			16,641
Cash and cash equivalents at end of period	$	99,670		$	16,694

See accompanying notes.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) Nature of Business

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

Business

We are a provider, through our subsidiaries, of long-term, subacute and related specialty healthcare in the United States. We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services. Inpatient services represent the most significant portion of our business. We operated 141 long-term care facilities in 19 states as of March 31, 2007.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States for interim financial statements. In our opinion, the accompanying interim consolidated financial statements present fairly our financial position at March 31, 2007, and the consolidated results of our operations and cash flows for the three-month periods ended March 31, 2007 and 2006, respectively. We believe that all adjustments are of a normal and recurring nature with the exception of certain purchase accounting adjustments made in accordance with the provisions of Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS No. 141”) (see “Note 2 - Acquisitions”). These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations. Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2006, which are included in our Annual Report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”).

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals, and income taxes. Actual results could differ from those estimates.

Significant Accounting Policy - Income Taxes

In accordance with Statement of Financial Accounting Standard No. 109, Accounting for Income Taxes (“SFAS No. 109”), deferred tax assets and liabilities are recorded for tax carryforwards and the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes using enacted tax laws and rates. A valuation allowance is provided on our net deferred tax assets if it is determined that it is more likely than not that the net deferred tax assets will not be realized. FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”) prescribes a recognition threshold and measurement parameters for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

In accordance with SFAS No. 109, Accounting Principles Board Opinion No. 28, Interim Financial Reporting (“APB No. 28”), and FASB Interpretation No. 18, Accounting for Income Taxes in Interim Periods (“FIN 18”), as of each reporting period, we estimate an effective income tax rate that is expected to be applicable for the full fiscal year. The estimate of our effective income tax rate requires significant judgments regarding any utilization of deferred tax assets and the reduction in the related valuation allowance. Any reduction in the portion of the valuation allowance that was established in fresh-start accounting when we emerged from bankruptcy in February 2002 will first reduce any remaining intangible assets recorded in fresh-start accounting, with any excess being treated as an increase to capital in excess of par value. Any reduction in the

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

portion of the valuation allowance that was established after our emergence from bankruptcy will result in a reduction of our income tax expense.

Our effective tax rate is also influenced by the recognition and derecognition of tax positions pursuant to the more likely than not standard established by FIN 48 that such positions will be sustained by the taxing authority. In addition, other factors such as changes in tax laws, rulings by taxing authorities and court decisions, and significant changes in our operations through acquisitions or divestitures, can have a material impact on the effective tax rate. Differences between our estimated and actual effective income tax rates and related liabilities are recorded in the period they become known.

Reclassifications and Adjustments

Certain reclassifications of assets, liabilities, income and expense have been made to the prior period financial statements to conform to the 2007 financial statement presentation. Specifically, we have reclassified the results of operations of material divestitures subsequent to December 31, 2006 (see “Note 5 - Discontinued Operations and Assets and Liabilities Held for Sale”) for all periods presented to discontinued operations within the Statement of Operations, in accordance with accounting principles generally accepted in the United States.

As discussed in our 2006 Form 10-K, we recorded a $2.5 million non-cash charge to pre-tax earnings for the twelve months ended December 31, 2006, to account for certain lease rate escalation clauses pursuant to the adoption of the SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements (“SAB 108”). Consistent with the requirements of SAB 108, this adjustment has been allocated to the appropriate 2006 quarter in the accompanying consolidated financial statements.

(2) Acquisitions

Harborside

In October 2006, we entered into an agreement to acquire all of the outstanding stock of Harborside Healthcare Corporation (“Harborside”), a privately-held healthcare company based in Boston, Massachusetts that operates 73 skilled nursing facilities, one assisted living facility and one independent living facility with approximately 9,000 licensed beds in ten states. On April 19, 2007, we completed the acquisition of Harborside effective April 1, 2007. In connection with the acquisition of Harborside, we entered into a $485.0 million new senior secured credit facility with a syndicate of financial institutions led by Credit Suisse as the administrative agent and collateral agent (the “Credit Agreement”). The proceeds from the Credit Agreement, plus cash on hand and the net proceeds from our issuance on April 12, 2007, of $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015, were used to purchase all of the outstanding stock of Harborside for $349.4 million, refinance certain of the debt of Harborside and replace our prior revolving credit facility. The Credit Agreement, which provides for an initial interest rate of the London Interbank Offered Rate (“LIBOR”) plus 2%, also will provide funds for previously-exercised options related to the purchase of nine skilled nursing centers, as well as additional liquidity and a letter of credit facility. See “Note 3 - Loan Agreements.”

(3) Loan Agreements

In December 2005, we entered into an Amended and Restated Loan and Security Agreement (the “Revolving Loan Agreement”) with CapitalSource Finance LLC, as collateral agent, and certain lenders, which amended and restated an existing revolving credit facility. The Revolving Loan Agreement, among other things, provided for up to $100.0 million of borrowing availability and was scheduled to terminate on January 31, 2009. The interest rate on borrowings equals 2.75%, which percentage is subject to adjustment based on our fixed charge coverage ratio plus the greater of (i) 4.31% or (ii) (a) a floating rate equal to LIBOR for one month adjusted daily or (b), at our option, a rate that is fixed for a period of 30, 60 or 90 days equal to LIBOR two days prior to the commencement of such period. The Revolving Loan Agreement is secured by almost all of our assets.

Availability of amounts under the Revolving Loan Agreement was subject to compliance with financial covenants. Our borrowing availability under the Revolving Loan Agreement was generally limited to up to eighty-five percent (85%) of the value of our accounts receivable that are deemed eligible pursuant to the Revolving Loan Agreement but not to exceed $100.0 million. The defined borrowing base as of March 31, 2007 was $81.4 million, net of specified reserves of $6.4 million.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

As of March 31, 2007, we had $10.0 million in borrowings outstanding, $14.6 million in letters of credit and $56.8 million available to us for additional borrowing.

The Revolving Loan Agreement was terminated on April 19, 2007, when we entered into the Credit Agreement in connection with the acquisition of Harborside (see “Note 2 - Acquisitions”). The Credit Agreement, which is secured by substantially all of our assets, provides for $310.0 million in term loans, $55.0 million in delayed draw term loans, a $50.0 million revolving credit facility and a $70.0 million letter of credit facility. Availability of amounts under the revolving credit facility is subject to compliance with financial covenants including an interest coverage test, a total leverage covenant and a senior leverage covenant. The Credit Agreement contains customary events of default, such as our failure to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting, among other things, incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.

(4) Long-Term Debt and Capital Lease Obligations

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

		March 31, 2007			December 31, 2006

Revolving loan agreement	$	10,000		$	10,000
Mortgage notes payable due at various dates through 2037, interest at rates
from 5.5% to 10.8%, collateralized by various facilities (1)(2)		133,178			153,627
Capital leases (3)		1,394			1,190
Industrial revenue bonds		-			4,655
Other long-term debt		-			4,693
Total long-term obligations		144,572			174,165
Less amounts due within one year		(14,219	)		(24,010	)
Long-term obligations, net of current portion	$	130,353		$	150,155

(1)	Includes fair value premium of $0.3 million related to the acquisition of Peak Medical Corporation (“Peak”) in December 2005.
(2)	Includes $50.0 million and $50.1 million related to the consolidation of Clipper as of March 31, 2007 and December 31, 2006, respectively (see “Note 6 - Variable Interest Entities”).
(3)	Excludes $0.8 million reclassified to liabilities held for sale (See “Note 5 - Discontinued Operations and Assets and Liabilities Held for Sale”).

The scheduled or expected maturities of long-term debt, excluding premiums, as of March 31, 2007, were as follows (in thousands):


2008	$	14,219
2009		23,796
2010		3,551
2011		11,368
2012		32,141
Thereafter		59,200
	$	144,275

Included in the expected maturities of long-term debt are the following amounts related to the consolidation of Clipper, (in thousands): $786, $845, $902, $962, $1,020, and $45,451 for 2008, 2009, 2010, 2011, 2012 and thereafter, respectively (see “Note 6 - Variable Interest Entities”).

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(5) Discontinued Operations and Assets and Liabilities Held for Sale

(a) Discontinued Operations

In accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), the results of operations of assets to be disposed of, disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated statements of operations.

Inpatient Services: We sold a skilled nursing facility for $1.6 million in the fourth quarter of 2006. Although the sale of the facility was final, we continued to operate the facility in the first quarter of 2007 as the new owner was still in the process of obtaining licensure. The result of such operations was included in our discontinued operations for the first quarter of 2007. During the first quarter of 2007, we sold another skilled nursing facility for $4.9 million. The facility was reclassified as held for sale with a carrying amount of $3.7 million and we recorded a net loss of $0.5 million.

Home Health Services: In December 2006, we sold SunPlus Home Health Services (“SunPlus”), for a purchase price of $19.3 million.

(b) Assets and Liabilities Held for Sale

As of March 31, 2007, assets held for sale consisted of (i) SunAlliance, our remaining laboratory and radiology services operations, with a net carrying amount of $1.8 million, consisting of $3.6 million in assets, offset in part by $1.8 million in liabilities, and (ii) an undeveloped parcel of land valued at $0.9 million, which is classified in our Corporate segment in our consolidated financial statements. SunAlliance was sold on April 30, 2007, for $2.5 million plus a working capital adjustment yet to be determined.

As of December 31, 2006, assets held for sale consisted of (i) SunAlliance with a net carrying amount of $0.9 million, consisting of $1.7 million in assets, offset in part by $0.8 million in liabilities, (ii) a skilled nursing facility with a carrying amount of $3.8 million, consisting of $4.6 million in assets, offset in part by $0.8 million in liabilities, and (iii) an undeveloped parcel of land valued at $0.9 million, which is classified in our Corporate segment in our consolidated financial statements.

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

		For the
		Three Months Ended
		March 31, 2007
		Inpatient			Pharmaceutical			Laboratory/		Home
		Services			Services			Radiology		Health		Other			Total

Net operating revenues	$	2,815		$	-		$	4,120	$	-	$	4,139		$	11,074

(Loss) income from discontinued
operations, net(1)	$	(425	)	$	16		$	236	$	5	$	89		$	(79	)
(Loss) gain on disposal of
discontinued operations, net(2)		(376	)		(14	)		-		41		(1	)		(350	)
(Loss) income on discontinued
operations, net	$	(801	)	$	2		$	236	$	46	$	88		$	(429	)

(1) Net of related tax benefit of $43

(2) Net of related tax benefit of $190

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

		For the
		Three Months Ended
		March 31, 2006
		Inpatient			Pharmaceutical			Laboratory/			Home
		Services			Services			Radiology			Health		Other			Total

Net operating revenues	$	5,344		$	-		$	3,689		$	15,467	$	5,758		$	30,258

(Loss) income from discontinued	$	(445	)	$	-		$	(179	)	$	4	$	1,003		$	383
operations, net(1)
Loss on disposal of
discontinued operations, net		(51	)		(8	)		(6	)		-		(1	)		(66	)
(Loss) income on discontinued
operations, net	$	(496	)	$	(8	)	$	(185	)	$	4	$	1,002		$	317

(1) Net of related tax expense of $215

(6) Variable Interest Entities

In December 2003, the FASB issued a revision to Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN No. 46R”), which was originally issued in January 2003. FIN No. 46R provides guidance on the consolidation of certain entities when control exists through means other than ownership of voting (or similar) interests and was effective for public entities that have interests in variable interest entities commonly referred to as special purpose entities for the first reporting period that ends after March 15, 2004. FIN No. 46R requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity (“VIE”).

As of March 31, 2007, we currently owned less than 16% of the voting interest in nine entities (collectively known as “Clipper”), each of which owns one facility that we operate in New Hampshire. Clipper's objective is to achieve rental income from the leasing of its facilities. In April 2004, we entered into an agreement with the owners of the remaining interests in those nine entities. That agreement granted us options, exercisable sequentially over a period of seven years, pursuant to which we can acquire 100% of the ownership of those nine entities for an aggregate amount of up to $10.3 million. We have paid an aggregate option purchase price for the first three option exercises of $0.9 million through March 31, 2007. The agreement also provides the owners the right to require us to purchase those ownership interests at the above described option prices. These put rights can be exercised for any options that have come due but which were not exercised up to that point in time, but no later than December 31, 2010.

We have concluded that Clipper, as identified above, meets the definition of a VIE because we have agreements with the majority owners granting to us the option to acquire, and to the owners, the right to put to us, 100% ownership of Clipper. We have recognized $9.3 million of the option value in other long-term liabilities in our consolidated balance sheets. The remaining $0.4 million is recorded as current in other accrued liabilities in our consolidated balance sheets. We have not recorded any minority interest associated with the 84% interest in which we do not own since the partnerships' net equity was a deficit and as the primary beneficiary, we would be responsible for all of their losses. Pursuant to FIN No. 46R, we have eliminated facility rent expense of $0.4 million and $0.9 million for each of the three months ended March 31, 2007 and 2006, respectively, and included $50.0 million and $50.1 million of mortgage debt of Clipper in our consolidated balance sheets as of March 31, 2007 and December 31, 2006, respectively, although we own less than 16% of the voting interest in the Clipper properties and are not directly obligated on the debt. The debt is collateralized by the fixed assets of the respective partnerships and limited liability companies that own the Clipper properties and none of our assets. Creditors do not have any general recourse against us for the mortgage debt.

The following provides a summary of the balance sheet impact of Clipper upon consolidation as of March 31, 2007 and December 31, 2006 (in thousands):

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

		March 31, 2007			December 31, 2006

Current assets:
Cash and cash equivalents	$	638		$	546
Other receivables		138			565
Restricted cash, current		996			767
Prepaids and other assets		57			126
Total current assets		1,829			2,004

Property and equipment, net:
Land		6,171			6,171
Land improvements		33			34
Buildings		34,803			35,034
Building improvements		2,971			2,830
Equipment		176			185
Construction-in-process		-			-
Total property and equipment, net		44,154			44,254

Favorable lease intangibles, net		8,594			9,122
Intercompany		4,836			4,836

Total assets	$	59,413		$	60,216
Current liabilities:
Mortgages, current	$	786		$	736
Other accrued liabilities		677			597
Total current liabilities		1,463			1,333

Mortgages, net of current		49,181			49,392
Other long-term liabilities		16,834			16,464
Total long-term liabilities		66,015			65,856

Total liabilities		67,478			67,189

Stockholders' deficit:
Accumulated deficit		(8,065	)		(6,973	)

Total liabilities and stockholders' deficit	$	59,413		$	60,216

For the three months ended March 31, 2007, the consolidation of Clipper resulted in the recording in our financial statements of a net loss of $0.5 million comprised of a $0.6 million charge to interest expense, and a $0.4 million charge to depreciation expense, partially offset by a $0.4 million credit to rent expense and a $0.1 million credit to taxes and other expense. For the three months ended March 31, 2006, the consolidation of Clipper included a net loss of $0.4 million comprised of a $1.0 million charge to interest expense, and a $0.3 million charge to depreciation expense, partially offset by a $0.9 million credit to rent expense.

(7) Commitments and Contingencies

(a) Insurance

We self-insure for certain insurable risks, including general and professional liability, workers' compensation liability and employee health insurance liability, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. These provisions are

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

based on actuarial analyses, internal evaluations of the merits of individual claims, and industry loss development factors or lag analyses. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any resulting adjustments are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

Prior to January 1, 2000, the maximum loss exposure with respect to the third-party insurance policies was $100,000 per claim for general and professional liability. Since January 2000, we have relied upon self-funded insurance programs for general and professional liability claims up to a base amount per claim and an aggregate per location, and have obtained excess insurance policies for claims above those amounts. The programs had the following self-insured retentions: (i) for events occurring from January 1, 2000 to December 31, 2002, $1.0 million per claim, and $3.0 million aggregate per location, (ii) for claims made in 2003, $10.0 million per claim with excess coverage above this level, and (iii) for claims made in 2004, 2005, 2006, and 2007, $5.0 million per claim with a $5.0 million excess layer that attaches at $5.0 million of liability and a $40.0 million excess layer that attaches at $10.0 million of liability. For locations, other than in the state of Oklahoma, acquired as part of our acquisition of Peak in December 2005, claims reported from 2003 until the acquisition date were covered by commercial insurance programs having limits of $1.0 million per occurrence/$3.0 million annual aggregate and featuring a $100,000 per occurrence deductible. Peak locations in Oklahoma had no insurance coverage in effect. Former Peak locations, including Oklahoma operations, were added to our general and professional liability programs effective December 9, 2005.

An independent actuarial analysis is prepared twice a year, in June and December, in order to determine the expected losses and reserves for estimated settlements for general and professional liability under the per claim retention level, including incurred but not reported losses. Claims paid for the three months ended March 31, 2007 and March 31, 2006 were $4.8 million and $5.7 million, respectively.

The majority of our workers' compensation risks are insured through high-retention insurance policies with third parties. Our reserves are estimated by independent actuaries beginning with the 1998 policy year and by company analysis using industry development factors for prior years. Effective with the policy period beginning January 1, 2002, we discount our workers' compensation reserves based on a 4% discount rate. Claims paid for the three months ended March 31, 2007 and March 31, 2006 were $3.5 million and $5.9 million, respectively.

The provision for insurance risks was as indicated (in thousands):

		For the
		Three Months Ended
		March 31, 2007		March 31, 2006

Professional Liability:
Continuing operations	$	6,432	$	7,433
Discontinued operations		108		346
	$	6,540	$	7,779

Workers' Compensation:
Continuing operations	$	4,132	$	5,239
Discontinued operations		162		677
	$	4,294	$	5,916

A summary of the assets and liabilities related to insurance risks at March 31, 2007 and December 31, 2006 is as indicated (in thousands):

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

		March 31, 2007							December 31, 2006
		Professional		Workers'			\|		Professional		Workers'
		Liability		Compensation		Total	\|		Liability		Compensation		Total
Assets (1):							\|
Restricted cash							\|
Current	$	3,363	$	17,807	$	21,170	\|	$	4,311	$	21,073	$	25,384
Non-current		-		29,923		29,923	\|		-		25,977		25,977
Total	$	3,363	$	47,730	$	51,093	\|	$	4,311	$	47,050	$	51,361
							\|
Liabilities (2)(3):							\|
Self-insurance							\|
liabilities							\|
Current	$	19,957	$	17,096	$	37,053	\|	$	23,967	$	21,073	$	45,040
Non-current		54,910		34,211		89,121	\|		51,111		30,448		81,559
Total	$	74,867	$	51,307	$	126,174	\|	$	75,078	$	51,521	$	126,599

(1)		Total restricted cash excluded $10,021 and $10,474 at March 31, 2007 and December 31, 2006, respectively, held for bank collateral, various mortgages, bond payments and reserves for capital expenditures required by HUD guaranteed mortgages.

(2)		Total self-insurance liabilities in the table excluded $3,228 and $3,649 at March 31, 2007 and December 31, 2006, respectively, related to our health insurance liabilities.

(3)		Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $750 and $11,322 for general and professional liability insurance and workers' compensation, respectively, as of March 31, 2007 and $750 and $10,694 for general and professional liability insurance and workers' compensation, respectively, as of December 31, 2006.

(8) Capital Stock

(a) Common Stock

As of March 31, 2007, we had issued 42,939,602 shares, inclusive of 10,182 treasury shares. The shares issued included (i) 9,972,777 shares issued in connection with the extinguishment of liabilities subject to compromise pursuant to our Plan of Reorganization implemented in connection with our emergence from Chapter 11 bankruptcy proceedings in 2002 (“Plan of Reorganization”), (ii) 4,425,232 shares issued in a private placement of our common stock in February 2004, (iii) 760,000 shares issued in payment of deferred rent as part of our restructuring plan initiated in 2003, (iv) 8,871,890 shares issued in connection with the acquisition of Peak, (v) 6,900,000 shares issued in a public offering in December 2005, (vi) 11,500,000 shares issued in a public offering in December 2006, and (vii) 509,703 shares issued pursuant to stock options and stock awards to our employees and directors.

(b) Warrants

In February 2004, in conjunction with our private equity offering, we issued warrants to purchase 2,017,897 shares of our common stock, of which 1,707,924 shares have a strike price of $12.65, 62,160 shares have a strike price of $12.82, and 247,813 shares have a strike price of $15.87. The warrants expire in February 2009.

Our 2004 Equity Incentive Plan (the “2004 Plan”), as amended, allows for the issuance of up to 5.6 million shares of our common stock. Restricted stock awards are outright stock grants. Option awards are granted with an exercise price equal to the market price of our stock at the date of grant; those option awards generally vest based on four years of continuous service and have seven-year contractual terms. Share awards generally vest over four years and no dividends are paid on unexercised options or unvested share awards. Pursuant to the 2004 Plan, certain option and share awards provide for accelerated vesting if there is a change in control (as defined in the 2004 Plan).

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Pursuant to the 2004 Plan, as of March 31, 2007, our employees and directors held options to purchase 1,783,515 shares of common stock, 10,398 shares of unvested restricted common stock, and 945,043 unvested restricted stock units. As of March 31, 2007, 31,193 shares of restricted common stock valued at $11.25 per share were held by our executive officers and key employees. During the three months ended March 31, 2007, we issued 86,809 shares of common stock upon the vesting of restricted stock shares, restricted stock units and the exercise of stock options.

As of March 31, 2007, our directors held options to purchase 20,000 shares under our 2002 Non-employee Director Equity Incentive Plan (the “Director Plan”). Upon the adoption of the 2004 Plan, the grant of further awards under the Director Plan was suspended so that no additional awards could be made under the Director Plan.

Upon our acquisition of Peak, we assumed the Peak 1998 Stock Incentive Plan (the “Peak Plan”). As of March 31, 2007, our employees held options to purchase 15,369 shares of common stock under the Peak Plan, and 85,468 shares had been issued upon the exercise of stock options. No additional awards will be made under the Peak Plan.

All share-based payments to employees, including grants of employee stock options, are recognized in the statement of operations based on their fair values. Pursuant to Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123(R)”), cash flows resulting from the tax benefits in excess of the compensation cost recognized for employee stock options (excess tax benefits) are to be classified as financing cash flows; however, since we have a net operating loss carryforward that is increased by any excess tax benefit, the tax benefit will not be recognized until the deduction actually reduces current taxes payable. As of March 31, 2007, total unrecognized compensation cost related to stock option awards was $4.4 million and the related weighted-average period over which it is expected to be recognized is approximately 2.7 years. Recognition of share based payments at fair value reduced income before income taxes and discontinued operations, and net income, for the three months ended March 31, 2007 and March 31, 2006 by $.4 million and $.2 million, respectively. Basic and diluted earnings per share were $0.09 and $0.04 for the three months ended March 31, 2007 and March 31, 2006, respectively.

A summary of option activity under the 2004 Plan, the Director Plan, and the Peak Plan during the three months ended March 31, 2007 is presented below:

					Weighted
					Average		Aggregate
				Weighted	Remaining		Intrinsic
	Shares			Average	Contractual		Value
Options	(in thousands)			Exercise Price	Term		(in thousands)
Outstanding at January 1, 2007	1,492		$	7.52	-		-
Granted	418			12.36	-		-
Exercised	(70	)		7.48	-		-
Forfeited or expired	(21	)		7.52	-		-
Outstanding at March 31, 2007	1,819		$	8.62	5 years	$	6,785

Exercisable at March 31, 2007	650		$	7.42	5 years	$	3,206

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table. Expected volatility is based on the historical volatility of our stock. The expected term of options granted is derived using a temporary “shortcut approach” for our “plain vanilla” employee stock options. Under this approach, the expected term is presumed to be the mid-point between the vesting date and the end of the contractual term. The risk-free rate for the period within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The weighted-average grant-date fair value of stock options granted during the three months ended March 31, 2007 and 2006 was $6.31 and $3.44, respectively.

Expected volatility	55.47% - 80.62%
Weighted-average volatility	65.36%
Expected term (in years)	4.75
Risk-free rate	3.02% - 4.66%

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Compensation cost associated with the restricted stock awards granted to employees is recognized over the requisite service period with an offsetting credit to equity; the full fair value of the share-based payment is not recognized until the instrument is vested. A summary of restricted stock activity during the three months ended March 31, 2007 is as follows:

				Weighted-
				Average
	Shares			Grant-Date
Nonvested Shares	(in thousands)			Fair Value

Nonvested at January 1, 2007	587		$	7.92
Granted	418		$	12.36
Vested	(16	)	$	10.24
Forfeited	(33	)	$	7.91
Nonvested at March 31, 2007	956		$	9.82

The total fair value of restricted shares vested during the three months ended March 31, 2007 was $0.3 million, and $0.3 million for the three months ended March 31, 2006.

(9) Net Income per Share

Basic net income per share is based upon the weighted average number of common shares outstanding during the period. The weighted average number of common shares for the three months ended March 31, 2007 and 2006, include all the common shares that are presently outstanding, common shares to be issued pursuant to our Plan of Reorganization, and the common shares issued as common stock awards. See “Note 8 - Capital Stock.”

The diluted calculation of income per common share includes the dilutive effect of warrants, stock options and non-vested restricted stock using the treasury stock method.

(10) Income Taxes

The provision for income taxes of $2.4 million for the three months ended March 31, 2007 is based on a combined federal and state effective income tax rate of approximately 35%. This combined effective rate reflects the impact of both permanent differences and the reversal of our valuation allowance on our net deferred tax assets that were generated after our emergence from bankruptcy in February 2002. This rate is subject to change if assumptions relating to the allocation of tax attributes between pre- and post-emergence periods change or if our ability to use our deferred tax assets were to change. The current benefit for income taxes of $0.7 million for the three months ended March 31, 2006 consisted of $1.2 million of IRS refunds received due to NOL carrybacks and $0.5 million of provision for federal and state income taxes based on operations for that period.

In connection with the fresh-start accounting adopted in 2002, our assets and liabilities were recorded at their respective fair values. Deferred tax assets and liabilities were then recognized for the tax effects of the differences between fair values and tax bases. In addition, deferred tax assets were recognized for future tax benefits of NOL, capital loss and tax credit carryforwards, and a valuation allowance was recorded for the overall net increase in deferred tax assets recognized in connection with fresh-start accounting.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

To the extent management believes the pre-emergence net deferred tax assets will more likely than not be realized, a reduction in the valuation allowance established in fresh-start accounting will be recorded. The reduction in this valuation allowance will first reduce any remaining intangible assets recorded in fresh-start accounting, with any excess being treated as an increase to capital in excess of par value. During the three months ended March 31, 2007, the fresh-start valuation allowance was reduced by $1.9 million, and remaining intangible assets recorded in fresh-start accounting were reduced accordingly.

The issuance of our common stock in connection with the acquisition of Peak in 2005 resulted in an ownership change under Section 382. The annual base Section 382 limitation to be applied to our tax attribute carryforwards as a result of this ownership change is approximately $10.0 million. Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes. Our application of the rules under Section 382 is subject to challenge upon IRS review. A successful challenge could significantly impact our ability to utilize deductions, losses and tax credits generated prior to the date of the Peak acquisition.

After considering the reduction in tax attributes resulting from the preliminary calculation of the Section 382 limitation, we have Federal NOL carryforwards of approximately $152.5 million with expiration dates from 2007 through 2026. Various subsidiaries have state NOL carryforwards totaling approximately $75.4 million with expiration dates through the year 2026.

We adopted FIN 48 effective January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. The adoption of FIN 48 did not have a material effect on our consolidated financial position or results of operations.

In addition to the full valuation allowance offsetting our net deferred tax assets, we had unrecognized tax benefits of $18.0 million as of January 1, 2007, the adoption date. If recognized, $9.6 million of these unrecognized tax benefits would impact the effective tax rate. Unrecognized tax benefits are not expected to change significantly over the next twelve months except for a possible increase resulting from our acquisition of Harborside (see “Note 2 - Acquisitions”).

We recognized potential accrued interest related to unrecognized tax benefits in income tax expense. Penalties, if incurred, would also be recognized as a component of income tax expense. The amount of accrued interest expense related to unrecognized benefits was $3.2 million as of the adoption date.

We file numerous consolidated and separate state and local income tax returns in addition to our consolidated U.S. federal income tax return. With few exceptions, we are no longer subject to U.S. federal, state or local income tax examinations for years before 2003. These jurisdictions can, however, adjust NOL carryforwards from earlier years.

(11) Other Events

(a) Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our facilities, claims relating to employment and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition and cash flows. In certain states in which we have or have had operations, insurance coverage

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions. There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

In December 2006, Harborside was notified by the United States Department of Justice (“DOJ”) that one of its subsidiaries is one of a significant number of unrelated defendants in a qui tam lawsuit filed under the Federal False Claims Act. In response to a request by the DOJ, Harborside has cooperated with the DOJ’s investigation and has supplied information relating to the matter, which relates to Harborside’s Medicare billings for durable medical equipment. Although the complaint remains under seal pending completion of the DOJ’s investigation, it is our understanding that neither we nor any of our other subsidiaries is a defendant in this litigation. We have met with a representative of the DOJ to discuss the litigation and intend to continue to cooperate with the investigation and respond to the litigation in a timely fashion. Based on our understanding of the allegations as described by the DOJ, we do not believe that the litigation will have a material impact on our operations or financial condition.

(b) Other Inquiries

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

(c) Legislation, Regulations and Market Conditions

We are subject to extensive federal, state and local government regulation relating to licensure, conduct of operations, ownership of facilities, expansion of facilities and services and reimbursement for services. As such, in the ordinary course of business, our operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. We believe that we are in substantial compliance with the applicable laws and regulations. However, if we are ever found to have engaged in improper practices, we could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, which may have a material adverse impact on our financial position, results of operations and cash flows.

We entered into a Corporate Integrity Agreement (the “CIA”) with the HHS/OIG in July 2001. It became effective on February 28, 2002 and terminated February 28, 2007. Notwithstanding the termination of the CIA, certain obligations under the CIA will continue until HHS/OIG completes its review of our final report under the CIA, which we expect to submit in May 2007.

(12) Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

In December 2006, we sold SunPlus, our home health services operations, for a purchase price of $19.3 million (see “Note 5 - Discontinued Operations and Assets and Liabilities Held for Sale”). The home health services and the laboratory

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

and radiology services operations have been reclassified to assets and liabilities held for sale, and pursuant to SFAS No. 144, their net revenues and net operating income have been reclassified to discontinued operations for all periods presented and is no longer considered a reportable segment.

The following summarizes the services provided by our reportable and other segments:

Inpatient Services: This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these facilities by registered nurses, licensed practical nurses and certified nursing aids. At March 31, 2007, we operated 141 long-term care facilities (consisting of 118 skilled nursing facilities, 13 assisted living and independent living facilities, seven mental health facilities, and three specialty acute care hospitals) with 15,447 licensed beds as compared with 148 long-term care facilities (consisting of 124 skilled nursing facilities, 14 assisted living and independent living facilities, seven mental health facilities, and three specialty acute care hospitals) with 15,923 licensed beds at March 31, 2006.

Rehabilitation Therapy Services: This segment provides primarily physical, occupational and speech services to affiliated and nonaffiliated skilled nursing facilities. At March 31, 2007, this segment provided services to 390 facilities, of which 303 were nonaffiliated and 87 were affiliated, as compared to 439 facilities, of which 346 were nonaffiliated and 93 were affiliated at March 31, 2006.

Medical Staffing Services: As of March 31, 2007, this segment derived 59.4% of its revenues from hospitals and other providers, 21.5% from skilled nursing facilities, 12.7% from schools and 6.4% from prisons. We provide (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians, and (v) related medical personnel. As of March 31, 2007, this segment had 30 division offices, which provided temporary therapy, nursing and physician staffing services in major metropolitan areas and two division offices, which specialize in the placement of temporary traveling therapists and one division office specializing in permanent placement of healthcare professionals.

Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable, property and equipment and unallocated intangible assets. Although corporate assets include unallocated intangible assets, the amortization, if applicable, is reflected in the results of operations of the associated segment.

The accounting policies of the segments are the same as those described in the “Note 3 - Summary of Significant Accounting Policies" of our 2006 Form 10-K. We primarily evaluate segment performance based on profit or loss from operations after allocated expenses and before reorganization and restructuring items, income taxes and extraordinary items. Gains or losses on sales of assets and certain items including impairment of assets recorded in connection with SFAS No. 144 and Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), and restructuring costs are not considered in the evaluation of segment performance. Allocated expenses include intersegment charges assessed to segments for management services and asset use based on segment operating results and average asset balances, respectively. We account for intersegment sales and provision of services at estimated market prices.

Our reportable segments are strategic business units that provide different products and services. They are managed separately, among other reasons, because each business has different marketing strategies due to differences in types of customers, different distribution channels and different capital resource needs.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

The following tables summarize, for the periods indicated, operating results and other financial information, by business segment:

As of and for the
Three Months Ended
March 31, 2007		Segment Information (in thousands):

				Rehabilitation			Medical
		Inpatient		Therapy			Staffing					Intersegment					Discontinued
		Services		Services			Services		Corporate			Eliminations			Consolidated		Operations

Revenues from external customers	$	229,135	$	20,680		$	23,747	$	7		$	-		$	273,569	$	11,073

Intersegment revenues		-		10,262			187		-			(10,449	)		-		-

Total revenues		229,135		30,942			23,934		7			(10,449	)		273,569		11,073

Operating salaries and benefits		111,478		26,048			18,900		-			-			156,426		4,635

Self insurance for workers'
compensation and general and
professional liability insurance		9,786		397			294		87			-			10,564		271

Other operating costs		63,539		1,717			1,806		18			(10,449	)		56,631		5,956

General and administrative expenses		5,306		1,257			1,026		12,834			-			20,423		55

Provision for losses on accounts
receivable		2,408		(80	)		112		-			-			2,440		83

Segment operating income (loss)	$	36,618	$	1,603		$	1,796	$	(12,932	)	$	-		$	27,085	$	73

Facility rent expense		14,130		50			199		-			-			14,379		119

Depreciation and amortization		3,199		116			169		436			-			3,920		35

Interest, net		2,480		10			15		(446	)		-			2,059		41

Net segment income (loss)	$	16,809	$	1,427		$	1,413	$	(12,922	)	$	-		$	6,727	$	(122	)

Identifiable segment assets	$	381,153	$	13,211		$	34,632	$	675,884		$	(521,053	)	$	583,827	$	5,835

Segment capital expenditures	$	5,857	$	794		$	97	$	397		$	-		$	7,145	$	105

______________________________________

General and administrative expenses include operating administrative expenses.

The term "segment operating income (loss)" is defined as earnings before facility rent expense, depreciation and amortization, interest, restructuring costs, net, loss on contract termination, gain on sale of assets, net, income taxes and discontinued operations.

The term "net segment income (loss)" is defined as earnings before restructuring costs, net, loss on contract termination, gain on sale of assets, net, income taxes and discontinued operations.

Other operating costs include loss on extinguishment of debt.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

As of and for the
Three Months Ended
March 31, 2006		Segment Information (in thousands):

				Rehabilitation			Medical
		Inpatient		Therapy			Staffing					Intersegment					Discontinued
		Services		Services			Services		Corporate			Eliminations			Consolidated		Operations

Revenues from external customers	$	215,435	$	20,000		$	21,318	$	3		$	-		$	256,756	$	30,258

Intersegment revenues		-		9,384			129		-			(9,513	)		-		-

Total revenues		215,435		29,384			21,447		3			(9,513	)		256,756		30,258

Operating salaries and benefits		103,497		25,898			17,525		-			-			146,920		18,004

Self insurance for workers'
compensation and general and
professional liability insurance		11,824		459			294		95			-			12,672		1,023

Other operating costs		61,949		1,853			1,176		-			(9,513	)		55,465		8,671

General and administrative expenses		4,309		2,667			895		11,648			-			19,519		304

Provision for losses on accounts
Receivable		1,384		(84	)		148		-			-			1,448		499

Segment operating income (loss)	$	32,472	$	(1,409	)	$	1,409	$	(11,740	)	$	-		$	20,732	$	1,757

Facility rent expense		13,118		58			214		-			-			13,390		726

Depreciation and amortization		2,189		89			187		402			-			2,867		382

Interest, net		3,433		(6	)		36		904			-			4,367		51

Net segment income (loss)	$	13,732	$	(1,550	)	$	972	$	(13,046	)	$	-		$	108	$	598

Identifiable segment assets	$	374,931	$	12,608		$	35,257	$	598,143		$	(520,989	)	$	499,950	$	31,183

Segment capital expenditures	$	2,460	$	61		$	127	$	351		$	-		$	2,999	$	334

______________________________________

General and administrative expenses include operating administrative expenses.

The term "net segment income (loss)" is defined as earnings before restructuring costs, net, loss on contract termination, gain on sale of assets, net, income taxes and discontinued operations.

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Measurement of Segment Income

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

		For the
		Three Months Ended
		March 31, 2007		March 31, 2006

Net segment income	$	6,727		108
Loss on sale of assets, net		(7	)	(13	)
Consolidated income before income taxes and
discontinued operations	$	6,720		95

(13) Summarized Consolidating Information

In connection with the Company's offering of the 9¹/₈% Senior Subordinated Notes in April 2007, certain subsidiaries of the Company and substantially all of Harborside Healthcare Corporation and its subsidiaries (the "Guarantors") have, jointly and severally, unconditionally guaranteed the 9¹/₈% Notes. These guarantees are subordinated to all existing and future senior debt and guarantees of the Guarantors and are unsecured.

The Company conducts all of its business through and derives virtually all of its income from its subsidiaries. Therefore, the Company's ability to make required payments with respect to its indebtedness (including the 9¹/₈% Notes) and other obligations depends on the financial results and condition of its subsidiaries and its ability to receive funds from its subsidiaries.

Pursuant to Rule 3-10 of Regulation S-X, the following summarized consolidating information is for the Company (the "Parent"), the wholly-owned Guarantors, and the Company's non-Guarantor subsidiaries with respect to the 9¹/₈% Notes. This summarized financial information has been prepared from the books and records maintained by the Company, the Guarantors and the non-Guarantor subsidiaries. The summarized financial information may not necessarily be indicative of the results of operations or financial position had the Guarantors or non-Guarantor subsidiaries operated as independent entities. The separate financial statements of the Guarantors are not presented because management has determined they would not be material to investors. Current and deferred taxes are provided for by the Parent. In addition, intercompany activities between subsidiaries and the Parent are presented within operating activities on the condensed consolidating statement of cash flows.

Condensed consolidating financial statements for the Company and its subsidiaries, including the Parent only, the combined Guarantor Subsidiaries and the combined Non-Guarantor Subsidiaries are as follows:

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEET

As of March 31, 2007

(in thousands)

				Combined			Combined
	Parent			Guarantor			Non-Guarantor
	Company			Subsidiaries			Subsidiaries			Elimination			Consolidated

Current assets:
Cash and cash equivalents	$	88,965		$	9,409		$	1,296		$	-		$	99,670
Restricted cash		23,151			3,573			1,357			-			28,081
Accounts receivable, net		-			115,831			(1,319	)		(13	)		114,499
Inventories, net		-			4,728			-			-			4,728
Other receivables, net		395			777			564			-			1,736
Assets held for sale		896			-			3,604			-			4,500
Prepaid expenses		6,165			1,858			8			-			8,031
Total current assets		119,572			136,176			5,510			(13	)		261,245
Property and equipment, net		6,469			161,265			53,590			-			221,324
Intangible assets, net		1,646			9,384			1,279			-			12,309
Goodwill, net		(3,834	)		58,439			-			-			54,605
Restricted cash, non-current		29,923			3,110			-			-			33,033
Other assets, net		2,708			(8,766	)		(7,711	)		20,915			7,146
Investment in subsidiaries		117,385			-			-			(117,385	)		-
Total assets	$	273,869		$	359,608		$	52,668		$	(96,483	)	$	589,662

Current liabilities:
Accounts payable	$	10,622		$	27,814		$	667		$	(13	)	$	39,090
Accrued compensation and benefits		4,851			35,443			369			-			40,663
Accrued self-insurance obligations, current portion		(11,828	)		47,121			4,988			-			40,281
Income taxes payable		9,184			(1	)		(48	)		-			9,135
Liabilities held for sale		-			-			1,826			-			1,826
Other accrued liabilities		8,977			20,189			4,977			-			34,143
Current portion of long-term debt		10,154			2,442			1,005			-			13,601
Capital leases, current		194			424			-			-			618
Total current liabilities		32,154			133,432			13,784			(13	)		179,357
Accrued self-insurance obligations, net of current portion		42,703			45,989			429			-			89,121
Long-term debt, net of current portion		7,077			68,421			54,079			-			129,577
Capital leases, net of current		228			548			-			-			776
Unfavorable lease obligations, net		-			20,273			(7,487	)		-			12,786
Intercompany balances		40,284			(42,911	)		(18,288	)		20,915			-
Other long-term liabilities		292			17,323			9,299			-			26,914
Deferred income taxes		2,412			-			-			-			2,412
Total liabilities		125,150			243,075			51,816			20,902			440,943

Stockholders’ equity:
Common stock		429			-			-			-			429
Additional paid-in capital		553,938			-			-			-			553,938
Accumulated deficit		(405,557	)		116,533			852			(117,385	)		(405,557	)
Less: common stock held in treasury, at cost		(91	)		-			-			-			(91	)
Total stockholders' equity (deficit)		148,719			116,533			852			(117,385	)		148,719
Total liabilities and stockholders' equity (deficit)	$	273,869		$	359,608		$	52,668		$	(96,483	)	$	589,662

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEET

As of December 31, 2006

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated

Current assets:
Cash and cash equivalents	$	119,810		$	11,337		$	788		$	-		$	131,935
Restricted cash		27,335			4,571			846			-			32,752
Accounts receivable, net		-			116,710			381			-			117,091
Inventories, net		-			4,808			-			-			4,808
Other receivables, net		261			835			1,115			-			2,211
Assets held for sale		897			4,614			1,661			-			7,172
Prepaid expenses		1,856			1,374			75			-			3,305
Total current assets		150,159			144,249			4,866			-			299,274
Property and equipment, net		6,508			157,310			53,726			-			217,544
Intangible assets, net		1,876			10,509			1,306			-			13,691
Goodwill, net		(3,834	)		58,926			-			-			55,092
Restricted cash, non-current		25,977			3,106			-			-			29,083
Other assets, net		2,329			(9,165	)		(7,340	)		20,915			6,739
Investment in subsidiaries		98,180			-			-			(98,180	)		-
Total assets	$	281,195		$	364,935		$	52,558		$	(77,265	)	$	621,423

Current liabilities:
Accounts payable	$	12,350		$	29,854		$	1,196		$	-		$	43,400
Accrued compensation and benefits		8,561			33,025			1,137			-			42,723
Accrued self-insurance obligations, current portion		(3,345	)		45,225			6,809			-			48,689
Income taxes payable		8,848			(1	)		(48	)		-			8,799
Liabilities held for sale		-			825			847			-			1,672
Other accrued liabilities		4,356			23,438			5,942			-			33,736
Current portion of long-term debt		3,696			18,861			959			-			23,516
Capital leases, current		189			305			-			-			494
Total current liabilities		34,655			151,532			16,842			-			203,029
Accrued self-insurance obligations, net of current portion		35,141			45,989			429			-			81,559
Long-term debt, net of current portion		16,707			78,308			54,444			-			149,459
Capital leases, net of current		278			418			-			-			696
Unfavorable lease obligations, net		-			21,409			(7,986	)		-			13,423
Intercompany balances		47,559			(47,060	)		(21,414	)		20,915			-
Other long-term liabilities		310			17,110			9,292			-			26,712
Deferred income taxes		2,412			-			-			-			2,412
Total liabilities		137,062			267,706			51,607			20,915			477,290

Stockholders’ equity:
Common stock		429			-			-			-			429
Additional paid-in capital		553,275			-			-			-			553,275
Accumulated deficit		(409,480	)		97,229			951			(98,180	)		(409,480	)
Less: common stock held in treasury, at cost		(91	)		-			-			-			(91	)
Total stockholders' equity (deficit)		144,133			97,229			951			(98,180	)		144,133
Total liabilities and stockholders' equity (deficit)	$	281,195		$	364,935		$	52,558		$	(77,265	)	$	621,423

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

For the Three Months Ended March 31, 2007

(in thousands)

	Parent Company		Combined Guarantor Subsidiaries		Combined Non-Guarantor Subsidiaries		Elimination		Consolidated

Total net revenues	$ 7		$ 281,936		$ 2,075		$ (10,449	)	$ 273,569
Costs and expenses:
Operating salaries and benefits	-		155,310		1,116		-		156,426
Self insurance for workers’ compensation and general and professional liability insurance	87		10,381		96		-		10,564
Other operating costs	16		66,664		381		(10,449	)	56,612
Facility rent expense	-		14,804		(425	)	-		14,379
General and administrative expenses(1)	12,829		7,589		5		-		20,423
Depreciation and amortization	435		3,032		453		-		3,920
Provision for losses on accounts receivable	-		2,436		4		-		2,440
Interest, net	(446	)	1,732		773		-		2,059
Loss on extinguishment of debt, net	-		19		-		-		19
Loss on sale of assets, net	-		7		-		-		7
Income from investment in subsidiaries	(19,205	)	-		-		19,205		-
Total costs and expenses	(6,284	)	261,974		2,403		8,756		266,849

Income (loss) before income taxes and discontinued operations	6,291		19,962		(328	)	(19,205	)	6,720
Income tax expense	2,368		-		-		-		2,368
Income (loss) from continuing operations	3,923		19,962		(328	)	(19,205	)	4,352

Discontinued operations:
(Loss) income from discontinued operations, net	-		(102	)	23		-		(79	)
(Loss) gain on disposal of discontinued operations, net	-		(556	)	206		-		(350	)
(Loss) income on discontinued operations, net	-		(658	)	229		-		(429	)

Net income (loss)	$ 3,923		$ 19,304		$ (99	)	$ (19,205	)	$ 3,923

(1) Includes operating administrative expenses

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

For the Three Months Ended March 31, 2006

(in thousands)

	Parent Company		Combined Guarantor Subsidiaries	Combined Non-Guarantor Subsidiaries		Elimination		Consolidated

Total net revenues	$ 3		$ 264,204	$ 2,062		$ (9,513	)	$ 256,756
Costs and expenses:
Operating salaries and benefits	-		145,925	995		-		146,920
Self insurance for workers’ compensation and general and professional liability insurance	93		12,475	104		-		12,672
Other operating costs	-		64,495	483		(9,513	)	55,465
Facility rent expense	-		14,266	(876	)	-		13,390
General and administrative expenses(1)	11,488		8,023	8		-		19,519
Depreciation and amortization	402		2,074	391		-		2,867
Provision for losses on accounts receivable	-		1,438	10		-		1,448
Interest, net	904		2,360	1,103		-		4,367
Loss on sale of assets, net	7		6	-		-		13
Income from investment in subsidiaries	(13,314	)	-	-		13,314		-
Total costs and expenses	(420	)	251,062	2,218		3,801		256,661

Income (loss) before income taxes and discontinued operations	423		13,142	(156	)	(13,314	)	95
Income tax benefit	(727	)	-	-		-		(727	)
Income (loss) from continuing operations	1,150		13,142	(156	)	(13,314	)	822

Discontinued operations:
(Loss) income from discontinued operations, net	(2	)	484	(99	)	-		383
(Loss) gain on disposal of discontinued operations, net	(9	)	5	(62	)	-		(66	)
(Loss) income on discontinued operations, net	(11	)	489	(161	)	-		317

Net income (loss)	$ 1,139		$ 13,631	$ (317	)	$ (13,314	)	$ 1,139

(1) Includes operating administrative expenses

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Three Months Ended March 31, 2007

(in thousands)

		Parent Company			Combined Guarantor Subsidiaries			Combined Non-Guarantor Subsidiaries			Elimination		Consolidated

Net cash provided by (used for) operating activities	$	(27,802	)	$	27,880		$	1,493		$	-	$	1,571

Cash flows from investing activities:
Capital expenditures		(399	)		(6,473	)		(378	)		-		(7,250	)
Proceeds from sale of assets held for sale		-			3,238			-			-		3,238
Net cash used for investing activities		(399	)		(3,235	)		(378	)		-		(4,012	)

Cash flows from financing activities:
Net borrowings under Revolving Loan Agreement		6			-			-			-		6
Long-term debt repayments		(3,177	)		(26,111	)		(319	)		-		(29,607	)
Principal payments under capital lease obligation		(46	)		(462	)		(32	)		-		(540	)
Net proceeds from exercise of employee stock options		573			-			-			-		573
Distribution of partnership equity		-			-			(256	)		-		(256	)
Net cash used for financing activities		(2,644	)		(26,573	)		(607	)		-		(29,824	)
Net (decrease) increase in cash and cash equivalents		(30,845	)		(1,928	)		508			-		(32,265	)
Cash and cash equivalents at beginning of period		119,810			11,337			788			-		131,935
Cash and cash equivalents at end of period	$	88,965		$	9,409		$	1,296		$	-	$	99,670

For the Three Months Ended March 31, 2006

(in thousands)

		Parent Company			Combined Guarantor Subsidiaries			Combined Non-Guarantor Subsidiaries			Elimination		Consolidated

Net cash (used for) provided by operating activities	$	(13,625	)	$	5,945		$	561		$	-	$	(7,119	)

Cash flows from investing activities:
Capital expenditures, net		(352	)		(2,532	)		(449	)		-		(3,333	)
Acquisitions, net		-			(236	)		-			-		(236	)
Proceeds from sale/leaseback		-			838			-			-		838
Net cash used for investing activities		(352	)		(1,930	)		(449	)		-		(2,731	)

Cash flows from financing activities:
Net borrowings under Revolving Loan Agreement		17,720			-			-			-		17,720
Long-term debt repayments		(3,157	)		(4,163	)		(374	)		-		(7,694	)
Distribution of partnership equity		-			-			(123	)		-		(123	)
Net cash provided by (used for) financing activities		14,563			(4,163	)		(497	)		-		9,903
Net increase (decrease) in cash and cash equivalents		586			(148	)		(385	)		-		53
Cash and cash equivalents at beginning of period		5,352			10,486			803			-		16,641
Cash and cash equivalents at end of period	$	5,938		$	10,338		$	418		$	-	$	16,694

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