UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2010

or

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

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.

(Exact name of Registrant as specified in its charter)

Delaware	85-0410612
(State of Incorporation)	(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400

Irvine, CA  92612

(949) 255-7100

(Address, zip code and telephone number of Registrant)

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

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

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

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

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

As of April 27, 2010, there were 43,592,519 shares of the Registrant’s $.01 par value Common Stock outstanding.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index

		Page Numbers
PART I.  FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets (unaudited)	3-4
	As of March 31, 2010
	As of December 31, 2009
	Consolidated Income Statements (unaudited)	5
	For the three months ended March 31, 2010 and 2009
	Consolidated Statements of Cash Flows (unaudited)	6
	For the three months ended March 31, 2010 and 2009
	Notes to Consolidated Financial Statements (unaudited)	7-22
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	23-35
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35
Item 4.	Controls and Procedures	36
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings	36
Item 1A.	Risk Factors	36
Item 6.	Exhibits	37
Signature		37

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

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information provided in this Quarterly Report on Form 10-Q (this “10-Q”) contains “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”).  Any statements that do not relate to historical or current facts or matters are forward-looking statements.  Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs, the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution investors that any forward-looking statements made by us herein are not guarantees of future performance and that investors should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this report.

Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements. You should also carefully consider the risks described in this 10-Q (see Part II, Item 1(A)) and in our 2009 Annual Report on Form 10-K (see Item 1A – “Risk Factors”).  There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.

_______________________

2

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS

(in thousands)

	March 31, 2010		December 31, 2009
			(Note 1)
Current assets:
Cash and cash equivalents	$	102,453	$	104,483
Restricted cash		25,186		24,034
Accounts receivable, net of allowance for doubtful accounts of $59,097
and $55,402 at March 31, 2010 and December 31, 2009, respectively		220,627		220,319
Prepaid expenses and other assets		17,679		21,757
Deferred tax assets		69,679		68,415
Total current assets		435,624		439,008
PrProperty and equipment, net		622,263		622,682
Intangible assets, net		52,432		53,931
Goodwill		338,364		338,296
Restricted cash, non-current		3,321		3,317
Deferred tax assets		102,799		108,999
Other assets		5,097		4,961
Total assets	$	1,559,900	$	1,571,194

See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY

(in thousands, except share data)

	March 31, 2010			December 31, 2009
				(Note 1)
Current liabilities:
Accounts payable	$	45,679		$	57,109
Accrued compensation and benefits		67,377			58,953
Accrued self-insurance obligations, current portion		45,703			45,661
Income taxes payable		628			-
Other accrued liabilities		58,995			55,265
Current portion of long-term debt and capital lease obligations		27,076			46,416
Total current liabilities		245,458			263,404
Accrued self-insurance obligations, net of current portion		123,943			121,948
Long-term debt and capital lease obligations, net of current portion		652,528			654,132
Unfavorable lease obligations, net		11,948			12,663
Other long-term liabilities		64,836			69,983
Total liabilities		1,098,713			1,122,130
Commitments and contingencies (Note 5)
Stockholders' equity:
Preferred stock of $.01 par value, authorized 10,000,000
shares, zero shares issued and outstanding as of
March 31, 2010 and December 31, 2009					-
Common stock of $.01 par value, authorized 125,000,000
shares, 43,769,054 and 43,764,240 shares issued and outstanding
as of March 31, 2010 and December 31, 2009, respectively		438			438
Additional paid-in capital		656,616			655,667
Accumulated deficit		(193,814	)		(204,012	)
Accumulated other comprehensive loss, net		(2,053	)		(3,029	)
Total stockholders' equity		461,187			449,064
Total liabilities and stockholders' equity	$	1,559,900		$	1,571,194

See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

	For the
	Three Months Ended
	March 31, 2010			March 31, 2009
Total net revenues	$	473,255		$	468,129
Costs and expenses:
Operating salaries and benefits		267,034			262,909
Self-insurance for workers’ compensation and general and
professional liability insurance		14,538			14,653
Operating administrative expenses		12,289			12,577
Other operating costs		97,480			95,779
Center rent expense		18,552			18,363
General and administrative expenses		15,266			16,750
Depreciation and amortization		12,446			10,723
Provision for losses on accounts receivable		5,878			3,988
Interest, net of interest income of $90 and $108, respectively		11,977			12,726
Total costs and expenses		455,460			448,468
Income before income taxes and discontinued operations		17,795			19,661
Income tax expense		7,296			8,059
Income from continuing operations		10,499			11,602
Discontinued operations:
Loss from discontinued operations, net of related taxes		(301	)		(1,051	)
Loss on disposal of discontinued operations, net of
related taxes		-			(308	)
Loss from discontinued operations, net		(301	)		(1,359	)
Net income	$	10,198		$	10,243
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.24		$	0.27
Loss from discontinued operations, net		(0.01	)		(0.04	)
Net income	$	0.23		$	0.23
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.24		$	0.26
Loss from discontinued operations, net		(0.01	)		(0.03	)
Net income	$	0.23		$	0.23
Weighted average number of common and common
equivalent shares outstanding:
Basic		44,033			43,643
Diluted		44,183			43,872

See accompanying notes.

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 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

	For the
	Three Months Ended
	March 31, 2010			March 31, 2009
Cash flows from operating activities:
Net income	$	10,198		$	10,243
Adjustments to reconcile net income to net cash provided by
operating activities, including discontinued operations:
Depreciation and amortization		12,446			10,723
Amortization of favorable and unfavorable lease intangibles		(474	)		(401	)
Provision for losses on accounts receivable		6,014			3,987
Loss on sale of assets, including discontinued
operations, net		-			523
Stock-based compensation expense		1,393			1,268
Deferred taxes		4,936			6,174
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		(6,322	)		(10,068	)
Restricted cash		(1,156	)		8,106
Prepaid expenses and other assets		4,283			154
Accounts payable		(5,859	)		(3,536	)
Accrued compensation and benefits		8,424			4,273
Accrued self-insurance obligations		2,037			907
Income taxes payable		628			-
Other accrued liabilities		2,470			4,743
Other long-term liabilities		(955	)		297
Net cash provided by operating activities		38,063			37,393
Cash flows from investing activities:
Capital expenditures		(17,058	)		(11,865	)
Proceeds from sale of assets held for sale		-			2,174
Net cash used for investing activities		(17,058	)		(9,691	)
Cash flows from financing activities:
Principal repayments of long-term debt and capital lease
obligations		(20,941	)		(19,612	)
Payment to non-controlling interest		(2,025	)		(311	)
Distribution to non-controlling interest		(69	)		-
Proceeds from issuance of common stock		-			13
Net cash used for financing activities		(23,035	)		(19,910	)
Net increase in cash and cash equivalents		(2,030	)		7,792
Cash and cash equivalents at beginning of period		104,483			92,153
Cash and cash equivalents at end of period	$	102,453		$	99,945

See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(1)  Nature of Business

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

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 205 healthcare centers in 25 states as of March 31, 2010.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at March 31, 2010, and our consolidated results of operations and cash flows for the three-month periods ended March 31, 2010 and 2009, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2009, which are included in our Annual Report on Form 10-K for the year ended December 31, 2009 (the “2009 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 significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals, and income taxes. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (the “FASB”) issued revised guidance for disclosures of fair value measurements.  The guidance requires additional disclosures regarding transfers between defined categories of  quality and reliability and prescribes a rollforward of activity in the lowest category (i.e. Level 3).  Disclosures regarding transfers are required beginning January 1, 2010 and the Level 3 rollforward is to be disclosed in reporting periods beginning after December 15, 2010.  Since we had no transfers between categories, the additional disclosures are not applicable to us for the periods presented.

Reclassifications and Adjustments

Certain reclassifications have been made to the prior period financial statements to conform to the 2010 financial statement presentation.  Primarily, we have reclassified the results of operations of one divested center (see Note 4 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(2)  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, 2010			December 31, 2009
Revolving credit facility	$	-		$	-
Mortgage notes payable due at various dates through 2047, interest at
rates from 2.3% to 11.6%, collateralized by the carrying values of
various centers totaling approximately $200,000 (1)		169,475			170,608
Term loans		309,380			329,107
Senior subordinated notes		200,000			200,000
Capital leases		749			833
Total long-term obligations		679,604			700,548
Less amounts due within one year		(27,076	)		(46,416	)
Long-term obligations, net of current portion	$	652,528		$	654,132

(1) The mortgage notes payable balance includes fair value premiums of $0.7 million related to acquisitions.

The scheduled or expected maturities of long-term obligations, excluding premiums, as of March 31, 2010, were as follows (in thousands):

For the twelve months ending March 31:
2010	$	27,076
2011		41,668
2012		6,476
2013		36,693
2014		299,303
Thereafter		267,715
	$	678,931

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

We entered into interest rate swap agreements in July 2008 and July 2007 for interest rate risk management purposes.  The interest rate swap agreements effectively modify our exposure to interest rate risk by converting a portion of our floating rate debt to a fixed rate.  These agreements involve the receipt of floating rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The July 2008 agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.  The July 2007 agreement is based on a notional amount of $100.0 million and has a term of three years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 5.388%.

8

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The interest rate swap agreements qualify for hedge accounting treatment and have been designated as cash flow hedges.  Hedge effectiveness testing for the three months ended March 31, 2010 and 2009 indicates that the swaps are highly effective hedges, and as such, there is no amount related to hedging ineffectiveness to expense.  We do not anticipate our 2010 other comprehensive loss to be reclassified into earnings within the next year.

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

	Liability Derivatives
	March 31, 2010			December 31, 2009
	Balance Sheet			Balance Sheet
	Location		Fair Value	Location		Fair Value
Derivatives designated as
hedging instruments:
Interest rate swap	Other Long-Term			Other Long-Term
agreements	Liabilities	$	3,422	Liabilities	$	5,048

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended March 31 is as follows (in thousands):

							Gain/(Loss) Reclassified from
		Amount of Income/(Loss) in					Accumulated Other Comprehensive
		Other Comprehensive Income/(Loss)					Loss to Income (ineffective portion)
		2010		2009			2010		2009
Derivatives designated as cash
flow hedges:
Interest rate swap agreements	$	976	$	(69	)	$	-	$	-

(3)  Fair Value of Financial Instruments

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

		March 31, 2010				December 31, 2009
		Carrying				Carrying
		Amount		Fair Value		Amount		Fair Value
Cash and cash equivalents	$	102,453	$	102,453	$	104,483	$	104,483
Restricted cash	$	28,507	$	28,507	$	27,351	$	27,351
Long-term debt and capital lease obligations,
including current portion	$	679,604	$	553,252	$	700,548	$	574,770
Interest rate swap agreements	$	3,422	$	3,422	$	5,048	$	5,048

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At March 31, 2010 and December 31, 2009, the fair value of our long-term debt, including current maturities, and our interest rate swap agreements was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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

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

We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above pricing levels as of March 31, 2010 and December 31, 2009, respectively (in thousands):

		March 31, 2010
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(Level 2)
Cash equivalents – money market
funds/certificate of deposit	$	40,089	$	35,037	$	5,052
Restricted cash – money market funds	$	1,275	$	1,275	$	-
Interest rate swap agreements – liability	$	3,422	$	-	$	3,422

		December 31, 2009
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(Level 2)
Cash equivalents – money market
funds/certificate of deposit	$	36,480	$	31,429	$	5,051
Restricted cash – money market funds	$	1,275	$	1,275	$	-
Interest rate swap agreements – liability	$	5,048	$	-	$	5,048

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

(4) Discontinued Operations

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 income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

In October 2009, we transferred operations of a leased assisted living center in Utah to an outside party, whose results have been reclassified to discontinued operations for all periods presented.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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

		For the Three Months Ended
		March 31, 2010
		Inpatient
		Services			Other			Total
Net operating revenues	$	1		$	-		$	1
Loss from discontinued operations, net (1)	$	(289	)	$	(12	)	$	(301	)
Loss on disposal of discontinued operations, net (2)		-			-			-
Loss from discontinued operations, net	$	(289	)	$	(12	)	$	(301	)

(1)  Net of related tax benefit of $209

(2)  No related tax benefit

		For the Three Months Ended
		March 31, 2009
		Inpatient
		Services			Other			Total
Net operating revenues	$	210		$	-		$	210
Loss from discontinued operations, net (1)	$	(1,044	)	$	(7	)	$	(1,051	)
Loss on disposal of discontinued operations, net (2)		(279	)		(29	)		(308	)
Loss from discontinued operations, net	$	(1,323	)	$	(36	)	$	(1,359	)

(1)  Net of related tax benefit of $727

(2)  Net of related tax benefit of $214

(5)  Commitments and Contingencies

Insurance

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

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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

actually paid to date.  Expected loss methods are based upon an anticipated loss per unit of measure.  The Bornhuetter-Ferguson method is a combination of loss development methods and expected methods.

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

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

Activity in our insurance reserves as of and for the three months ended March 31, 2010 and 2009 is as follows (in thousands):

		Professional			Workers’
		Liability			Compensation			Total
Balance as of January 1, 2009	$	87,282		$	66,588		$	153,870
Current year provision, continuing operations		7,240			7,419			14,659
Current year provision, discontinued operations		306			155			461
Claims paid, continuing operations		(4,234	)		(5,217	)		(9,451	)
Claims paid, discontinued operations		(936	)		(835	)		(1,771	)
Amounts paid for administrative services and other		(1,362	)		(1,900	)		(3,262	)
Balance as of March 31, 2009	$	88,296		$	66,210		$	154,506
Balance as of January 1, 2010	$	94,930		$	67,506		$	162,436
Current year provision, continuing operations		7,384			7,154			14,538
Claims paid, continuing operations		(4,219	)		(4,609	)		(8,828	)
Claims paid, discontinued operations		(563	)		(579	)		(1,142	)
Amounts paid for administrative services and other		(850	)		(1,696	)		(2,546	)
Balance as of March 31, 2010	$	96,682		$	67,776		$	164,458

12

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 A summary of the assets and liabilities related to insurance risks at March 31, 2010 and December 31, 2009 is as indicated (in thousands):

		March 31, 2010							December 31, 2009
		Professional		Workers’			|		Professional		Workers’
		Liability		Compensation		Total	|		Liability		Compensation		Total
Assets (1):							|
Restricted cash							|
Current	$	3,378	$	12,350	$	15,728	|	$	3,406	$	12,013	$	15,419
Non-current		-		-		-	|		-		-		-
Total	$	3,378	$	12,350	$	15,728	|	$	3,406	$	12,013	$	15,419
							|
Liabilities (2)(3):							|
Self-insurance							|
liabilities							|
Current	$	20,679	$	19,836	$	40,515	|	$	20,369	$	20,119	$	40,488
Non-current		76,003		47,940		123,943	|		74,561		47,387		121,948
Total	$	96,682	$	67,776	$	164,458	|	$	94,930	$	67,506	$	162,436

(1)	Total restricted cash includes cash collateral deposits posted and other cash deposits held by third parties.  Total restricted cash above excludes $12,779 and $11,932 at March 31, 2010and December 31, 2009, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
(2)	Total self-insurance liabilities above exclude $5,188 and $5,173 at March 31, 2010 and December 31, 2009, respectively, related to our employee health insurance liabilities.
(3)	Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $60,291 for workers’ compensation, as of March 31, 2010, and $250 and $53,191for general and professional liability insurance and workers’ compensation, respectively, as of December 31, 2009.

(6)  Income Taxes

The provision for income taxes of $7.3 million for the three months ended March 31, 2010 results in an effective rate of approximately 41%.  This rate differs from the statutory tax rate of 35% primarily due to state taxes.  The provision for income taxes of $8.1 million for the three months ended March 31, 2009 also resulted in an effective tax rate of approximately 41%.

During the second quarter of 2009, the Internal Revenue Service commenced an examination of the tax returns for 2006 and the short-period ended April 19, 2007 of a business we acquired in 2007.  At this time, we are unable to determine what impact, if any, this examination will have on our financial statements.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  The remaining valuation allowance of $27.6 million at March 31, 2010 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

The Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $25.1 million, which includes approximately $14.6 million due to a significant acquisition in 2007. Accordingly, our net operating loss, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, there is approximately $107.6 million of NOLs which can be used to

13

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

offset U.S. taxable income in 2010.Considering annual IRC Section 382 limitations and built-in gains, we have a total of $226.1 million of utilizable NOL carryforwards to offset taxable income in 2010 and future years.

(7)  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 centers and 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.

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 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.

(b)  Other Inquiries

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

(8)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.  Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  More complete descriptions and accounting policies of the segments are described in Note 14 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2009 Form 10-K.

14

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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

As of and for the
Three Months Ended
March 31, 2010
			Rehabilitation		Medical
	Inpatient		Therapy		Staffing						Intersegment
	Services		Services		Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	420,528	$	29,362	$	23,357		$	8		$	-		$	473,255
Intersegment revenues		-		21,154		143			-			(21,297	)		-
Total revenues		420,528		50,516		23,500			8			(21,297	)		473,255
Operating salaries and benefits		208,171		41,699		17,164			-			-			267,034
Self-insurance for workers’
compensation and general and
professional liability insurance		13,741		429		307			61			-			14,538
Other operating costs		113,491		1,818		3,468			-			(21,297	)		97,480
General and administrative expenses		9,480		2,159		650			15,266			-			27,555
Provision for losses on accounts
receivable		5,579		259		40			-			-			5,878
Segment operating income (loss)	$	70,066	$	4,152	$	1,871		$	(15,319	)	$	-		$	60,770
Center rent expense		18,219		123		210			-			-			18,552
Depreciation and amortization		11,279		153		180			834			-			12,446
Interest, net		2,812		-		(1	)		9,166			-			11,977
Net segment income (loss)	$	37,756	$	3,876	$	1,482		$	(25,319	)	$	-		$	17,795
Identifiable segment assets	$	1,189,083	$	17,519	$	24,208		$	857,041		$	(528,438	)	$	1,559,413
Goodwill	$	333,756	$	75	$	4,533		$	-		$	-		$	338,364
Segment capital expenditures	$	16,136	$	119	$	113		$	690		$	-		$	17,058

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

15

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Three Months Ended
March 31, 2009
			Rehabilitation			Medical
	Inpatient		Therapy			Staffing					Intersegment
	Services		Services			Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	415,235	$	25,516		$	27,374	$	4		$	-		$	468,129
Intersegment revenues		-		18,216			560		-			(18,776	)		-
Total revenues		415,235		43,732			27,934		4			(18,776	)		468,129
Operating salaries and benefits		207,027		36,189			19,693		-			-			262,909
Self-insurance for workers’
compensation and general and
professional liability insurance		13,644		535			372		102			-			14,653
Other operating costs		108,309		1,790			4,456		-			(18,776	)		95,779
General and administrative expenses		9,864		1,916			797		16,750			-			29,327
Provision for losses on accounts
receivable		3,657		171			160		-			-			3,988
Segment operating income (loss)	$	72,734	$	3,131		$	2,456	$	(16,848	)	$	-		$	61,473
Center rent expense		18,004		115			244		-			-			18,363
Depreciation and amortization		9,728		128			190		677			-			10,723
Interest, net		3,209		(1	)		1		9,517			-			12,726
Net segment income (loss)	$	41,793	$	2,889		$	2,021	$	(27,042	)	$	-		$	19,661
Identifiable segment assets	$	1,152,042	$	15,020		$	27,359	$	874,452		$	(528,445	)	$	1,540,428
Goodwill	$	322,349	$	75		$	4,533	$	-		$	-		$	326,957
Segment capital expenditures	$	11,426	$	135		$	41	$	263		$	-		$	11,865

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

16

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Measurement of Segment Income

      We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items.  There were no items to reconcile net segment income to income before income taxes and discontinued operations for either period presented herein.

(9) Summarized Consolidating Information

In connection with the Company's offering of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”) in April 2007, certain 100% owned subsidiaries of the Company (the “Guarantors”) have, jointly and severally, unconditionally guaranteed the Notes. These guarantees are subordinated to all existing and future senior debt and senior 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 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 provided for the Company (the “Parent”), the Guarantors, and the Company's non-Guarantor subsidiaries with respect to the 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. 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:

17

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of March 31, 2010

(in thousands)

				Combined			Combined
	Parent			Guarantor		Non-Guarantor
	Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	87,049		$	13,197		$	2,207	$	-		$	102,453
Restricted cash		15,728			5,681			3,777		-			25,186
Accounts receivable, net		-			218,397			2,240		(10	)		220,627
Prepaid expenses and other assets		4,163			14,746			585		(1,815	)		17,679
Deferred tax assets		-			72,066			1,250		(3,637	)		69,679
Total current assets		106,940			324,087			10,059		(5,462	)		435,624
Property and equipment, net		9,052			546,955			66,256		-			622,263
Intangible assets, net		31,577			16,534			2,824		1,497			52,432
Goodwill		-			334,407			3,957		-			338,364
Restricted cash, non-current		2,974			347			-		-			3,321
Other assets		454			4,723			9		(89	)		5,097
Deferred tax assets		14,264			99,938			-		(11,403	)		102,799
Intercompany balances		273,547			-			5,085		(278,632	)		-
Investment in subsidiaries		666,103			-			-		(666,103	)		-
Total assets	$	1,104,911		$	1,326,991		$	88,190	$	(960,192	)	$	1,559,900
Current liabilities:
Accounts payable	$	12,702		$	32,396		$	591	$	(10	)	$	45,679
Accrued compensation and benefits		5,304			60,956			1,117		-			67,377
Accrued self-insurance obligations, current		4,037			41,666			-		-			45,703
Income taxes payable		628			-			-		-			628
Other accrued liabilities		15,330			39,640			4,025		-			58,995
Deferred tax liability		3,637			-			-		(3,637	)		-
Current portion of long-term debt		3,165			18,368			5,543		-			27,076
Total current liabilities		44,803			193,026			11,276		(3,647	)		245,458
Accrued self-insurance obligations, net of current		50,195			73,319			429		-			123,943
Deferred tax liability		-			-			11,403		(11,403	)		-
Long-term debt, net of current		506,743			87,247			58,538		-			652,528
Unfavorable lease obligations, net		-			13,445			-		(1,497	)		11,948
Intercompany balances		-			277,542			-		(277,542	)		-
Other long-term liabilities		41,983			22,853			-		-			64,836
Total liabilities		643,724			667,432			81,646		(294,089	)		1,098,713
Stockholders’ equity:
Common stock		438			-			-		-			438
Additional paid-in capital		656,616			-			-		-			656,616
Accumulated deficit		(193,814	)		659,559			6,544		(666,103	)		(193,814	)
Accumulated other comprehensive loss		(2,053	)		-			-		-			(2,053	)
Total stockholders' equity		461,187			659,559			6,544		(666,103	)		461,187
Total liabilities and stockholders' equity	$	1,104,911		$	1,326,991		$	88,190	$	(960,192	)	$	1,559,900

18

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2009

(in thousands)

				Combined			Combined
	Parent			Guarantor		Non-Guarantor
	Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	82,463		$	19,659		$	2,361	$	-		$	104,483
Restricted cash		15,419			5,288			3,327		-			24,034
Accounts receivable, net		-			217,805			2,542		(28	)		220,319
Prepaid expenses and other assets		9,493			13,383			608		(1,727	)		21,757
Deferred tax assets		-			85,766			1,266		(18,617	)		68,415
Total current assets		107,375			341,901			10,104		(20,372	)		439,008
Property and equipment, net		9,195			546,772			66,715		-			622,682
Intangible assets, net		32,702			16,897			2,336		1,996			53,931
Goodwill		-			334,338			3,958		-			338,296
Restricted cash, non-current		2,972			345			-		-			3,317
Other assets		280			4,741			9		(69	)		4,961
Deferred tax assets		15,393			123,963			-		(30,357	)		108,999
Intercompany balances		307,307			-			7,925		(315,232	)		-
Investment in subsidiaries		640,821			-			-		(640,821	)		-
Total assets	$	1,116,045		$	1,368,957		$	91,047	$	(1,004,855	)	$	1,571,194
Current liabilities:
Accounts payable	$	10,883		$	45,130		$	1,124	$	(28	)	$	57,109
Accrued compensation and benefits		9,546			48,617			790		-			58,953
Accrued self-insurance obligations, current		4,034			41,627			-		-			45,661
Other accrued liabilities		11,275			41,272			2,718		-			55,265
Deferred tax liability		9,843			-			-		(9,843	)		-
Current portion of long-term debt		22,244			18,592			5,580		-			46,416
Total current liabilities		67,825			195,238			10,212		(9,871	)		263,404
Accrued self-insurance obligations, net of current		48,200			73,319			429		-			121,948
Deferred tax liability		-			-			11,559		(11,559	)		-
Long-term debt, net of current		507,394			87,916			58,822		-			654,132
Unfavorable lease obligations, net		-			14,659			-		(1,996	)		12,663
Intercompany balances		-			340,608			-		(340,608	)		-
Other long-term liabilities		43,562			23,206			3,215		-			69,983
Total liabilities		666,981			734,946			84,237		(364,034	)		1,122,130
Stockholders’ equity:
Common stock		438			-			-		-			438
Additional paid-in capital		655,667			-			-		-			655,667
Accumulated deficit		(204,012	)		634,011			6,810		(640,821	)		(204,012	)
Accumulated other comprehensive loss		(3,029	)		-			-		-			(3,029	)
Total stockholders' equity		449,064			634,011			6,810		(640,821	)		449,064
Total liabilities and stockholders' equity	$	1,116,045		$	1,368,957		$	91,047	$	(1,004,855	)	$	1,571,194

19

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended March 31, 2010

(in thousands)

				Combined				Combined
	Parent			Guarantor			Non-Guarantor
	Company			Subsidiaries				Subsidiaries			Elimination			Consolidated
Total net revenues	$	9		$	486,738			$	7,805		$	(21,297	)	$	473,255
Costs and expenses:
Operating salaries and benefits		-			262,693				4,341			-			267,034
Self-insurance for workers’ compensation and
general and professional liability insurance		61			14,282				195			-			14,538
General and administrative expenses (1)		15,637			11,918				-			-			27,555
Other operating costs		-			117,090				1,687			(21,297	)		97,480
Center rent expense		-			18,345				207			-			18,552
Depreciation and amortization		834			11,009				603			-			12,446
Provision for losses on accounts receivable		-			5,791				87			-			5,878
Interest, net		9,044			1,842				1,091			-			11,977
Income from investment in subsidiaries		(25,282	)		-				-			25,282			-
Total costs and expenses		294			442,970				8,211			3,985			455,460
(Loss) income before income taxes and
discontinued operations		(285	)		43,768				(406	)		(25,282	)		17,795
Income tax (benefit) expense		(10,483	)		17,945				(166	)		-			7,296
Income (loss) from continuing operations		10,198			25,823				(240	)		(25,282	)		10,499
Discontinued operations:
Loss from discontinued operations, net		-			(275	)			(26	)		-			(301	)
(Loss) gain on disposal of discontinued
operations, net		-			-				-			-			-
Loss on discontinued operations, net		-			(275	)			(26	)		-			(301	)
Net income (loss)	$	10,198		$	25,548			$	(266	)	$	(25,282	)	$	10,198

(1) Includes operating administrative expenses

20

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended March 31, 2009

(in thousands)

				Combined				Combined
	Parent			Guarantor			Non-Guarantor
	Company			Subsidiaries				Subsidiaries			Elimination			Consolidated
Total net revenues	$	4		$	479,714			$	7,187		$	(18,776	)	$	468,129
Costs and expenses:
Operating salaries and benefits		-			258,898				4,011			-			262,909
Self-insurance for workers’ compensation and
general and professional liability insurance		102			14,392				159			-			14,653
General and administrative expenses (1)		17,121			12,206				-			-			29,327
Other operating costs		-			112,768				1,787			(18,776	)		95,779
Center rent expense		-			18,846				(483	)		-			18,363
Depreciation and amortization		676			9,469				578			-			10,723
Provision for losses on accounts receivable		-			3,880				108			-			3,988
Interest, net		9,377			2,231				1,118			-			12,726
Income from investment in subsidiaries		(26,333	)		-				-			26,333			-
Total costs and expenses		943			432,690				7,278			7,557			448,468
(Loss) income before income taxes and
discontinued operations		(939	)		47,024				(91	)		(26,333	)		19,661
Income tax (benefit) expense		(11,182	)		19,278				(37	)		-			8,059
Income from continuing operations		10,243			27,746				(54	)		(26,333	)		11,602
Discontinued operations:
(Loss) income from discontinued operations, net		-			(828	)			(223	)		-			(1,051	)
(Loss) gain on disposal of discontinued
operations, net		-			(522	)			214			-			(308	)
(Loss) income on discontinued operations, net		-			(1,350	)			(9	)		-			(1,359	)
Net income	$	10,243		$	26,396			$	(63	)	$	(26,333	)	$	10,243

(1)   Includes operating administrative expenses

21

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Three Months Ended March 31, 2010

(in thousands)

				Combined				Combined
	Parent			Guarantor			Non-Guarantor
	Company			Subsidiaries				Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	25,003		$	10,684			$	2,376		$	-	$	38,063
Cash flows from investing activities:
Capital expenditures		(690	)		(16,254	)			(114	)		-		(17,058	)
Net cash used for investing activities		(690	)		(16,254	)			(114	)		-		(17,058	)
Cash flows from financing activities:
Principal repayments of long-term debt and capital
lease obligations		(19,727	)		(892	)			(322	)		-		(20,941	)
Payment to non-controlling interest		-			-				(2,025	)		-		(2,025	)
Distribution to non-controlling interest		-			-				(69	)		-		(69	)
Net cash used for financing activities		(19,727	)		(892	)			(2,416	)		-		(23,035	)
Net increase (decrease) in cash and cash equivalents		4,586			(6,462	)			(154	)		-		(2,030	)
Cash and cash equivalents at beginning of period		82,463			19,659				2,361			-		104,483
Cash and cash equivalents at end of period	$	87,049		$	13,197			$	2,207		$	-	$	102,453

For the Three Months Ended March 31, 2009

(in thousands)

				Combined			Combined
	Parent			Guarantor		Non-Guarantor
	Company			Subsidiaries			Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	25,816		$	7,335		$	4,242		$	-	$	37,393
Cash flows from investing activities:
Capital expenditures		(260	)		(11,539	)		(66	)		-		(11,865	)
Proceeds from sale of assets held for sale		-			2,174			-			-		2,174
Net cash used for investing activities		(260	)		(9,365	)		(66	)		-		(9,691	)
Cash flows from financing activities:
Principal repayments of long-term debt and capital
lease obligations		(14,798	)		(955	)		(3,859	)		-		(19,612	)
Distribution to non-controlling interest		-			-			(311	)		-		(311	)
Proceeds from issuance of common stock		13			-			-			-		13
Net cash used for financing activities		(14,785	)		(955	)		(4,170	)		-		(19,910	)
Net increase (decrease) in cash and cash equivalents		10,771			(2,985	)		6			-		7,792
Cash and cash equivalents at beginning of period		72,529			17,952			1,672			-		92,153
Cash and cash equivalents at end of period	$	83,300		$	14,967		$	1,678		$	-	$	99,945

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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

Overview

Sun Healthcare Group, Inc.’s subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 183 skilled nursing centers, 14 assisted and independent living centers and eight mental health centers with 23,205 licensed beds located in 25 states as of March 31, 2010. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

Revenues from Medicare, Medicaid and Other Sources

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

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

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

	For the
	Three Months Ended
Sources of Revenues	March 31, 2010				March 31, 2009
Consolidated:
Medicaid	$	189,324	40.0	%	$	181,451	38.7	%
Medicare		142,181	30.0			141,876	30.3
Private pay and other		117,337	24.8			118,393	25.4
Managed care and commercial insurance		24,413	5.2			26,409	5.6
Total	$	473,255	100.0	%	$	468,129	100.0	%
Inpatient Only:
Medicaid	$	189,287	45.0	%	$	181,410	43.7	%
Medicare		137,722	32.7			137,864	33.2
Private pay and other		69,386	16.6			69,694	16.8
Managed care and commercial insurance		24,133	5.7			26,267	6.3
Total	$	420,528	100.0	%	$	415,235	100.0	%

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medicare

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

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequently refined in 1999, 2000 and 2005.  PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group (“RUG”) categories that are based upon each patient’s acuity level.

On July 31, 2008, the Centers for Medicare and Medicaid Services (“CMS”) issued a final rule to implement a 3.4% market basket increase for the 2009 federal fiscal year, which commenced on October 1, 2008.  The rule also contained an update of the wage indices. The net impact of these changes was approximately a 3.3% increase in our reimbursement rates, which resulted in increased revenues of approximately $3.8 million per quarter. 

On July 31, 2009, CMS issued its final rule for skilled nursing facilities for the 2010 federal fiscal year, which commenced on October 1, 2009.  This rule provides for a market basket increase of 2.2% in our reimbursement rates and a 3.3% reduction for a forecast error/parity adjustment.  We estimate that the net result of the two adjustments, based on our current acuity mix, will be a decrease of 0.85% in our reimbursement rates, which we estimate will decrease our net revenues by approximately $1.0 million per quarter.

In addition to the changes that affect the 2010 federal fiscal year, the rule also contains provisions for the 2011 federal fiscal year, which commences on October 1, 2010.  A portion of the published provisions for the 2011 federal fiscal year was changed as part of the recent healthcare reform.  We are not able to predict what changes will occur but are able to confirm that CMS has determined that the changes will be budget neutral.

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

	For the
	Three Months Ended
	March 31, 2010		March 31, 2009
$	465.96	$	450.41

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception to this limit is in place for patients residing in skilled nursing centers until December 31, 2010.   In addition, therapy rates are calculated using the Physicians Fee Schedule, for which rates are subject to a reduction of 21.3% based on a statutory formula.  Congress has repeatedly eliminated this exception in prior years and has eliminated it through May 31 in the current year. Legislation is currently pending in Congress to extend the elimination of the reduction.  If the exception is not extended, revenues from therapy services provided to our residents and residents of non-affiliated nursing and assisted living centers in which we provide therapy services will be adversely affected.

On July 31, 2009, CMS also issued its final rule for hospice services for the 2010 federal fiscal year.  The rule includes a market basket increase of 2.1% and a 0.7% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments will be an increase of 1.52% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.1 million per quarter.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medicaid

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

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

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

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

	For the
	Three Months Ended
	March 31, 2010		March 31, 2009
$	173.07	$	168.71

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

	For the
	Three Months Ended
	March 31, 2010		March 31, 2009
$	159.61	$	158.60

Managed Care and Insurance

During the three months ended March 31, 2010, we received 5.2% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

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

	For the
	Three Months Ended
	March 31, 2010		March 31, 2009
$	363.84	$	373.93

Private Payors, Veterans and Other

During the three months ended March 31, 2010, we received 24.8% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

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

	For the
	Three Months Ended
	March 31, 2010		March 31, 2009
$	189.66	$	178.93

Other Reimbursement Matters

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

Recent Accounting Pronouncements

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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following table sets forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):

	For the Three			For the Three			As a Percentage of Net Revenues
	Months Ended			Months Ended
	March 31, 2010			March 31, 2009			March 31, 2010			March 31, 2009
Total net revenues	$	473,255		$	468,129			100.0	%		100.0	%
Costs and expenses:
Operating salaries and benefits		267,034			262,909			56.4			56.1
Self-insurance for workers’ compensation and
general and professional liabilities		14,538			14,653			3.1			3.1
Other operating costs (1)		109,769			108,356			23.2			23.2
Center rent expense		18,552			18,363			3.9			3.9
General and administrative expenses		15,266			16,750			3.2			3.6
Depreciation and amortization		12,446			10,723			2.7			2.3
Provision for losses on accounts receivable		5,878			3,988			1.2			0.9
Interest, net		11,977			12,726			2.5			2.7
Income before income taxes and discontinued
operations		17,795			19,661			3.8			4.2
Income tax expense		7,296			8,059			1.5			1.7
Income from continuing operations		10,499			11,602			2.3			2.5
Loss from discontinued operations, net		(301	)		(1,359	)		(0.1	)		(0.3	)
Net income	$	10,198		$	10,243			2.2	%		2.2	%
Supplemental Financial Information:
EBITDA	$	42,218		$	43,110			8.9	%		9.2	%
EBITDAR	$	60,770		$	61,473			12.8	%		13.1	%

(1)   Operating administrative expenses are included in “other operating costs” above.

(2)  We define EBITDA as net income before loss (gain) on discontinued operations, interest expense (net of interest income), income tax expense (benefit), depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.

EBITDAR is EBITDA before center rent expense.  EBITDAR margin is EBITDAR as a percentage of revenue. We believe that the presentation of EBITDA and EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.

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

In addition to other financial measures, including net segment income, we use EBITDA and EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level.  EBITDA and EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes and depreciation and amortization

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

expense, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. These types of charges are dependent on factors unrelated to our underlying business. As a result, we believe that the use of EBITDA and EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.

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

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

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

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

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

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

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

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

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

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

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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 The following table provides a reconciliation of our net income, which is the most directly comparable financial measure presented in accordance with GAAP, to EBITDA and EBITDAR for the three months ended March 31 (in thousands):

	2010		2009
Net income	$	10,198	$	10,243
Plus:
Loss from discontinued operations		301		1,359
Interest expense, net		11,977		12,726
Income tax expense		7,296		8,059
Depreciation and amortization		12,446		10,723
EBITDA	$	42,218	$	43,110
Plus:
Center rent expense		18,552		18,363
EBITDAR	$	60,770	$	61,473

The following discussion of the “Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009” is based, in part, on the financial information presented in Note 8 – “Segment Information” in our interim consolidated financial statements.

Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009

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

Net revenues increased $5.2 million, or 1.1%, to $473.3 million for the three months ended March 31, 2010 from $468.1 million for the three months ended March 31, 2009. We reported net income for the three month periods ended March 31, 2010 and 2009 of $10.2 million each.

The increase in net revenues for the 2010 period included $5.3 million of additional revenue in our Inpatient Services segment primarily due to increases in rates from Medicare Part A and Medicaid, although the Medicaid rate increases were significantly offset by increased provider taxes.  Higher customer bases under our Medicaid,  managed care, commercial insurance and Medicare hospice programs, the October 2009 acquisition of a hospice company and a $6.8 million increase in revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes and billing rates, also contributed to the increase in net revenues.  This increase was partially offset by lower customer bases in our Medicare Part A and Part B, managed care and commercial insurance programs coupled with a $4.4 million decrease in revenue from our Medical Staffing segment, mainly due to a decrease in billable nursing hours.

Operating salaries and benefits increased $4.1 million, or 1.6%, to $267.0 million (56.4% of net revenues) for the three months ended March 31, 2010 from $262.9 million (56.1% of net revenues) for the three months ended March 31, 2009.  The increase resulted primarily from a $5.5 million increase in our Rehabilitation Therapy segment driven by increased service volume and wage rate increases and a $1.2 million increase in our Inpatient Services segment driven by health insurance costs and wage increases. These increases were offset by a $2.5 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the nurse staffing and pharmacy business.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $0.2 million, or 1.4%, to $14.5 million (3.1% of net revenues) for the three months ended March 31, 2010 from $14.7 million (3.1% of net revenues) for the three months ended March 31, 2009, primarily due to decreased exposures in our workers’ compensation programs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Other operating costs increased $1.4 million, or 1.3%, to $109.8 million (23.2% of net revenues) for the three months ended March 31, 2010 from $108.4 million (23.2% of net revenues) for the three months ended March 31, 2009.  The increase was primarily due to provider taxes and increased therapy costs in our Inpatient Services segment resulting from an increase in higher acuity patients requiring more rehabilitation therapy.

Center rent expense increased $0.2 million, or 1.1%, to $18.6 million (3.9% of net revenues) for the three months ended March 31, 2010 from $18.4 million (3.9% of net revenues) for the three months ended March 31, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

General and administrative expenses decreased $1.5 million, or 8.9%, to $15.3 million (3.2% of net revenues) for the three months ended March 31, 2010 from $16.8 million (3.6% of net revenues) for the three months ended March 31, 2009.  The decrease was primarily due to decreases in salaries and benefits resulting from restructuring efforts undertaken in 2009.

Depreciation and amortization increased $1.7 million, or 15.9%, to $12.4 million (2.7% of net revenues) for the three months ended March 31, 2010 from $10.7 million (2.3% of net revenues) for the three months ended March 31, 2009.  The increase was attributable to additional depreciation expense for property and equipment acquired during the period.

The provision for losses on accounts receivable increased $1.9 million, or 47.5%, to $5.9 million (1.2% of net revenues) for the three months ended March 31, 2010 from $4.0 million (0.9% of net revenues) for the three months ended March 31, 2009.  The increase resulted from increased credit risk associated with slower cash collections.

Net interest expense decreased $0.7 million, or 5.5%, to $12.0 million (2.5% of net revenues) for the three months ended March 31, 2010 from $12.7 million (2.7% of net revenues) for the three months ended March 31, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended March 31 (dollars in thousands):

	2010					2009
Inpatient Services	$	420,528		88.8	%	$	415,235		88.7	%
Rehabilitation Therapy Services		50,516		10.7			43,732		9.3
Medical Staffing Services		23,500		5.0			27,934		6.0
Corporate		8		-			4		-
Intersegment Eliminations		(21,297	)	(4.5	)		(18,776	)	(4.0	)
Total net revenues	$	473,255		100.0	%	$	468,129		100.0	%

Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended March 31 (in thousands):

	2010		2009
Rehabilitation Therapy Services	$	21,154	$	18,216
Medical Staffing Services		143		560
Total intersegment revenue	$	21,297	$	18,776

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 The following table sets forth the amount of net segment income for the three months ended March 31 (in thousands):

	2010			2009
Inpatient Services	$	37,756		$	41,793
Rehabilitation Therapy Services		3,876			2,889
Medical Staffing Services		1,482			2,021
Net segment income before Corporate		43,114			46,703
Corporate		(25,319	)		(27,042	)
Net segment income	$	17,795		$	19,661

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before income tax expense and discontinued operations. Net segment income for the three months ended March 31, 2010 for (1) our Inpatient Services segment decreased $4.0 million, or 9.7%, to $37.8 million, (2) our Rehabilitation Therapy Services segment increased $1.0 million, or 34.2%, to $3.9 million and (3) our Medical Staffing Services segment decreased $0.5 million, or 26.7%, to $1.5 million in comparison to the three months ended March 31, 2009, due to the factors discussed below for each segment.  We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment. 

Inpatient Services

Net revenues increased $5.3 million, or 1.3%, to $420.5 million for the three months ended March 31, 2010 from $415.2 million for the three months ended March 31, 2009.  The increase was primarily the result of:

-	an increase of $8.2 million in Medicaid revenues consisting of $4.6 million related to improved rates, which were significantly offset by increased provider tax expense (as discussed below), and $3.6 million from an increase in customer base; and
-	a $5.2 million increase in hospice revenues resulting from an October 2009 acquisition of a hospice company and a higher customer base;
	Offset in part by:
-	a decrease of $4.9 million in Medicare revenues as a result of a $8.4 million decrease in revenues due to a lower customer base and a $0.7 million decrease in Medicare Part B revenues, partially offset by a $4.2 million increase in revenues from higher Medicare Part A rates;
-	a $2.2 million decrease in managed care and commercial insurance revenues driven by lower customer base, which contributed $1.4 million of the decrease, and lower rates, which drove the remaining $0.8 million of the decrease; and
-	a $1.0 million decrease in private pay and other revenues, primarily resulting from lower customer base.

Operating salaries and benefits expenses increased $1.2 million, or 0.6%, to $208.2 million for the three months ended March 31, 2010 from $207.0 million for the three months ended March 31, 2009.  The increase was attributable to the following:

- an increase of $1.8 million in health insurance expense; and

- wage increases and related benefits and taxes of $1.0 million;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

	Offset in part by:
-	a decrease of $1.6 million in overtime pay.

Self-insurance for workers’ compensation and general and professional liability insurance increased $0.1 million, or 0.7%, to $13.7 million for the three months ended March 31, 2010 as compared to $13.6 million for the three months ended March 31, 2009, which was driven by increased exposures in our workers’ compensation programs.

Other operating costs increased $5.2 million, or 4.8%, to $113.5 million for the three months ended March 31, 2010 from $108.3 million for the three months ended March 31, 2009.  The increase was attributable to the following:

-	a $3.9 million increase in provider taxes;
-	a $1.1 million increase in contract labor driven by therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;
-	a $0.7 million increase in purchased services primarily related to housekeeping contracts; and
-	a $0.6 million increase in legal fees;
	Offset in part by:
-	a $0.4 million decrease in energy costs;
-	a $0.3 million additional cost savings due to vendor rebates;
-	a $0.2 million decrease in recruiting expenses;

- a $0.1 million decrease in equipment rentals; and

- a $0.1 million decrease in civil monetary penalties.

Operating administrative expenses decreased $0.4 million, or 4.0%, to $9.5 million for the three months ended March 31, 2010 from $9.9 million for the three months ended March 31, 2009, primarily due to lower aggregate salaries and benefits.

The provision for losses on accounts receivable increased $1.9 million, or 51.4%, to $5.6 million for the three months ended March 31, 2010 from $3.7 million for the three months ended March 31, 2009.  The increase resulted from increased credit risk associated with slower cash collections.

Center rent expense increased $0.2 million, or 1.1%, to $18.2 million for the three months ended March 31, 2010 from $18.0 million for the three months ended March 31, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

Depreciation and amortization increased $1.6 million, or 16.5%, to $11.3 million for the three months ended March 31, 2010 from $9.7 million for the three months ended March 31, 2009.  The increase was attributable to additional depreciation expense on property and equipment acquired during the period.

Net interest expense decreased $0.4 million, or 12.5%, to $2.8 million for the three months ended March 31, 2010 from $3.2 million for the three months ended March 31, 2009.  The decrease is a result of lower interest rates and lower aggregate borrowings.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $6.8 million, or 15.6%, to $50.5 million for the three months ended March 31, 2010 from $43.7 million for the three months ended March 31, 2009. The revenue increase was the result of:

- an increase of $5.2 million attributable to increased billable minutes, due in part to the  addition of 17 new contracts, net of lost contracts;

- an increase of $1.3 million attributable to a higher revenue per minute rate due to our renegotiation of certain customer contract rates and a shift in payor mix; and

- an increase of $0.3 million in other revenue, primarily related to contract management fees.

Operating salaries and benefits expenses increased $5.5 million, or 15.2%, to $41.7 million for the three months ended March 31, 2010 from $36.2 million for the three months ended March 31, 2009.  The increase was primarily driven by the increase in service volume mentioned above coupled with wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $4.4 million, or 15.8%, to $23.5 million for the three months ended March 31, 2010 from $27.9 million for the three months ended March 31, 2009.  The decrease was primarily the result of:

- a decrease of $1.1 million attributable to a decline in demand for our nurse staffing business;

- a decrease of $1.0 million due to a decline in hours for therapy and pharmacy;

- a decrease of $1.7 million related to closed offices; and

- a decrease of $0.6 million due to lower fees earned from the temporary placement of physicians.

 Operating salaries and benefits expenses decreased $2.5 million, or 12.7%, to $17.2 million for the three months ended March 31, 2010 as compared to $19.7 million for the three months ended March 31, 2009.  The decrease in operating salaries and benefits is a direct result of the decline in staffing levels for our nurse staffing, therapy staffing and pharmacy businesses.

Corporate

General and administrative expenses not directly attributed to segments decreased $1.5 million, or 8.9%, to $15.3 million for the three months ended March 31, 2010 from $16.8 million for the three months ended March 31, 2009.  The decrease was primarily due to decreases in salaries and benefits resulting from restructuring efforts taken in 2009.

Interest expense

Interest expense not directly attributed to operating segments decreased $0.3 million, or 3.2%, to $9.2 million for the three months ended March 31, 2010 from $9.5 million for the three months ended March 31, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since March 31, 2009.

Liquidity and Capital Resources

There have been no material changes to our liquidity and capital resources since December 31, 2009.  For the three months ended March 31, 2010, our net income was $10.2 million.  As of March 31, 2010, our working capital was $190.2 million and we had cash and cash equivalents of $102.5 million, $679.6 million in borrowings and $50.0 million available under our revolving credit facility.  As of March 31, 2010, we were in compliance with the covenants contained in the credit

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

agreement governing the revolving credit facility and our term loan indebtedness, and the indenture governing our 9-1/8% Senior Subordinated Notes due 2015.

Based on current levels of operations, we believe that our operating cash flows (which were $38.1 million for the three months ended March 31, 2010 and $37.4 million for the three months ended March 31, 2009), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed under “Capital Expenditures,” scheduled debt service payments and our other commitments described in our 2009 Form 10-K in the table under “Obligations and Commitments” at least through the next twelve months.  We believe our long term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness.  Although our credit agreement, which is described under “Loan Agreements”, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed.  However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

We have not drawn on our revolving credit facility since April 2007, and have since that time relied on our cash flows to provide for operational needs and capital expenditures.  However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions.  We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

Cash Flows

During the three months ended March 31, 2010, net cash provided by operating activities increased by $0.7 million as compared to the same period last year. This increase was the result of (i) our quarter-over-quarter increase in working capital changes of $2.9 million, driven by changes in accounts receivable, prepaid expenses and other assets, income taxes payable, accrued compensation and benefits and other accrued liabilities and (ii) a $2.2 million decrease in non-cash adjustments to net income, principally related to the provision for losses on accounts receivable.

Net cash used for investing activities of $17.1 million for the three months ended March 31, 2010 was for capital expenditures.

Net cash used for financing activities of $23.0 million for the three months ended March 31, 2010 is comprised of (i) $20.9 million used to repay long-term debt and capital lease obligations and (ii) $2.1 million paid to a non-controlling interest.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $17.1 million and $11.9 million for the three months ended March 31, 2010 and 2009, respectively.

Loan Agreements

In April 2007 we issued $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), which mature on April 15, 2015.  We are entitled to redeem some or all of the Notes at any time on or after April 15, 2011 at certain pre-specified redemption prices.  In addition, prior to April 15, 2011, we may redeem some or all of the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, if any, plus a “make whole” premium.  We are entitled to redeem up to 35% of the aggregate principal amount of the Notes until April 15, 2010 with the net proceeds from certain equity offerings at certain pre-specified redemption prices.  The Notes accrue interest at an annual rate of 9-1/8% and pay interest semi-annually on April 15th and October 15th of each year through the April 15, 2015 maturity date.  The Notes are unconditionally guaranteed on a senior subordinated basis by certain of our subsidiaries but are not secured by any of our assets or those of our subsidiaries.  (See Note 9 – “Summarized Consolidating Information.”)

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 In April 2007, we entered into a $485.0 million senior secured credit facility with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent (the “Credit Agreement”) in connection an acquisition.  The Credit Agreement provides for $365.0 million in term loans (of which $309.4 million was outstanding at March 31, 2010), a $50.0 million revolving credit facility (undrawn at March 31, 2010) and a $70.0 million letter of credit facility ($69.7 million outstanding at March 31, 2010).  The final maturity date of the term loans is April 19, 2014, and the revolving credit facility and letter of credit facility terminate on April 19, 2013. 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. We were in compliance with these covenants as of March 31, 2010.  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.  The Credit Agreement is collateralized by our assets and the assets of most of our subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of 0.25% of the aggregate principal amount of the term loans under the term loan facility outstanding as of January 15, 2008, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  The loans under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans is 1.0% for alternative base rate loans and 2.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 1.0% for alternative base rate revolving loans and up to 2.0% for LIBOR rate revolving loans based on our total leverage ratio.  Each year, commencing in 2009, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement.  Pursuant to this requirement, we paid $18.9 million and $8.5 million in the three months ended March 31, 2010 and 2009, respectively.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

																							Fair Value			Fair Value
		Expected Maturity Dates																				March 31,				December 31,
		2010			2011				2012			2013			2014			Thereafter			Total		2010 (1)			2009 (1)
							(Dollars in thousands)
Long-term debt:
Fixed rate debt (2)	$	24,920		$	15,504			$	4,762		$	35,408		$	146,349		$	267,715		$	494,658	$	373,468		$	375,801
Rate		9.8	%		7.8	%			7.3	%		6.9	%		6.8	%		8.4	%
Variable rate debt	$	2,156		$	26,164			$	1,714		$	1,285		$	152,954		$	-		$	184,273	$	179,784		$	198,969
Rate		2.6	%		3.2	%			2.4	%		2.4	%		2.4	%		-	%
Interest rate swaps:
Variable to fixed	$	150,000		$	-			$	-		$	-		$	-		$	-				$	(3,422	)	$	(5,048	)
Average pay rate		4.8	%		-				-			-			-			-
Average receive rate		0.2	%		-				-			-			-			-

(1)	The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.
(2)	Excludes fair value premiums of $0.7 million related to acquisitions.

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ITEM 4.  CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”), as amended, as controls and procedures that are designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated  and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding  required disclosure.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of management, including our Chief Executive Officer, Richard Matros, and our Chief Financial Officer, L. Bryan Shaul, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2010.

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

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

For a description of our legal proceedings, see Note 7(a) – “Other Events – Litigation” of our consolidated financial statements included in this 10-Q, which is incorporated by reference to this item.

ITEM 1A.  RISK FACTORS

Except for the addition of the risk factor below, there have been no material changes in our assessment of our risk factors from those set forth in our 2009 Form 10-K.

Healthcare reform may affect our revenues and increase our costs and otherwise adversely affect our business.

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

In addition, we expect to incur administrative costs in monitoring changes resulting from the healthcare reform legislation, determining the appropriate actions to be taken in response to those changes, and implementing the required actions to meet the new requirements and minimize the repercussions of the changes to our organization, reimbursement rates and costs.

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ITEM 6. EXHIBITS

31.1	Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
31.2	Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
32.1	Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
32.2	Section 906 Sarbanes-Oxley Certification by Chief Financial Officer

SIGNATURE

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

SUN HEALTHCARE GROUP, INC.

By:     /s/ L. Bryan Shaul                                       

L. Bryan Shaul

Executive Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

April 29, 2010

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