10-Q 1 dvcr-20160930x10q.htm 10-Q 2016 Q3 Document


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________ 
FORM 10-Q
________________________________ 
CHECK ONE:
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: September 30, 2016
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             .

Commission file No.: 1-12996
________________________________ 
Diversicare Healthcare Services, Inc.
(exact name of registrant as specified in its charter)
 ________________________________
Delaware
 
62-1559667
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
1621 Galleria Boulevard, Brentwood, TN 37027
(Address of principal executive offices) (Zip Code)
(615) 771-7575
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and a “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
Accelerated filer
 
¨
 
 
 
 
Non-accelerated filer
 
¨
Smaller reporting Company
 
ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
6,360,495
(Outstanding shares of the issuer’s common stock as of October 31, 2016)
 



Part I. FINANCIAL INFORMATION
ITEM 1 – FINANCIAL STATEMENTS
DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
September 30,
2016
 
December 31,
2015
 
(Unaudited)
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
3,483

 
$
4,585

Receivables, less allowance for doubtful accounts of $10,196 and $8,180, respectively
39,978

 
43,819

Other receivables
1,352

 
1,407

Prepaid expenses and other current assets
3,853

 
2,223

Income tax refundable
378

 
347

Current assets of discontinued operations
44

 
36

Deferred income taxes
7,405

 
7,999

Total current assets
56,493

 
60,416

PROPERTY AND EQUIPMENT, at cost
125,356

 
114,383

Less accumulated depreciation and amortization
(67,245
)
 
(62,110
)
Property and equipment, net
58,111

 
52,273

OTHER ASSETS:
 
 
 
Deferred income taxes
14,853

 
11,762

Deferred lease and other costs, net
196

 
382

Investment in unconsolidated affiliate
989

 
798

Other noncurrent assets
2,477

 
3,994

Acquired leasehold interest, net
7,171

 
7,459

Total other assets
25,686

 
24,395

 
$
140,290

 
$
137,084

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

2


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(continued)
 
 
September 30,
2016
 
December 31,
2015
 
(Unaudited)
 
 
CURRENT LIABILITIES:
 
 
 
Current portion of long-term debt and capitalized lease obligations
$
6,888

 
$
6,603

Trade accounts payable
10,014

 
10,136

Current liabilities of discontinued operations
428

 
345

Accrued expenses:
 
 
 
Payroll and employee benefits
13,698

 
14,404

Self-insurance reserves, current portion
9,745

 
10,224

Other current liabilities
6,378

 
5,652

Total current liabilities
47,151

 
47,364

NONCURRENT LIABILITIES:
 
 
 
Long-term debt and capitalized lease obligations, less current portion and deferred financing costs
61,816

 
53,297

Self-insurance reserves, noncurrent portion
10,993

 
12,344

Other noncurrent liabilities
10,815

 
10,812

Total noncurrent liabilities
83,624

 
76,453

COMMITMENTS AND CONTINGENCIES

 

SHAREHOLDERS’ EQUITY:
 
 
 
Series A preferred stock, authorized 200,000 shares, $.10 par value, none issued and outstanding
—

 
—

Common stock, authorized 20,000,000 shares, $.01 par value, 6,592,000 and 6,513,000 shares issued, and 6,360,000 and 6,281,000 shares outstanding, respectively
66

 
65

Treasury stock at cost, 232,000 shares of common stock
(2,500
)
 
(2,500
)
Paid-in capital
21,667

 
21,142

Accumulated deficit
(9,348
)
 
(5,053
)
Accumulated other comprehensive loss
(370
)
 
(387
)
Total shareholders’ equity
9,515


13,267

 
$
140,290

 
$
137,084

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

3


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)
 
Three Months Ended September 30,
 
2016
 
2015
PATIENT REVENUES, net
$
97,313

 
$
98,105

EXPENSES:
 
 
 
Operating
79,441

 
78,501

Lease and rent expense
6,865

 
7,198

Professional liability
1,977

 
2,069

General and administrative
7,420

 
6,378

Depreciation and amortization
1,992

 
1,887

Total expenses
97,695

 
96,033

OPERATING INCOME (LOSS)
(382
)
 
2,072

OTHER EXPENSE:
 
 
 
Equity in net income of unconsolidated affiliate
130

 
97

Interest expense, net
(1,201
)
 
(998
)
Total other expense
(1,071
)
 
(901
)
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(1,453
)
 
1,171

BENEFIT (PROVISION) FOR INCOME TAXES
495

 
(502
)
INCOME (LOSS) FROM CONTINUING OPERATIONS
(958
)
 
669

LOSS FROM DISCONTINUED OPERATIONS:
 
 
 
Operating loss, net of tax benefit of $12 and $237, respectively
(17
)
 
(238
)
NET INCOME (LOSS)
(975
)
 
431

NET INCOME (LOSS) PER COMMON SHARE:
 
 
 
Per common share – basic
 
 
 
Continuing operations
$
(0.16
)
 
$
0.11

Discontinued operations
—

 
(0.04
)
 
$
(0.16
)
 
$
0.07

Per common share – diluted
 
 
 
Continuing operations
$
(0.16
)
 
$
0.11

Discontinued operations
—

 
(0.04
)
 
$
(0.16
)
 
$
0.07

COMMON STOCK DIVIDENDS DECLARED PER SHARE OF COMMON STOCK
$
0.055

 
$
0.055

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
 
 
 
Basic
6,212

 
6,121

Diluted
6,212

 
6,331

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

4


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands and unaudited)
 
 
Three Months Ended September 30,
 
2016
 
2015
NET INCOME (LOSS)
$
(975
)
 
$
431

OTHER COMPREHENSIVE INCOME:
 
 
 
Change in fair value of cash flow hedge, net of tax
364

 
151

Less: reclassification adjustment for amounts recognized in net income
(118
)
 
(109
)
Total other comprehensive income
246

 
42

COMPREHENSIVE INCOME (LOSS)
$
(729
)
 
$
473


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

5


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)
 
Nine Months Ended September 30,
 
2016
 
2015
PATIENT REVENUES, net
$
291,063

 
$
289,618

EXPENSES:
 
 
 
Operating
236,444

 
232,298

Lease and rent expense
20,971

 
21,529

Professional liability
5,977

 
6,150

General and administrative
21,035

 
18,770

Depreciation and amortization
6,055

 
5,629

Lease termination costs
2,008

 
—

Total expenses
292,490

 
284,376

OPERATING INCOME (LOSS)
(1,427
)
 
5,242

OTHER EXPENSE:
 
 
 
Equity in net income of unconsolidated affiliate
191

 
280

Interest expense, net
(3,429
)
 
(2,997
)
Debt retirement costs
(351
)
 
—

Total other expense
(3,589
)
 
(2,717
)
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(5,016
)
 
2,525

BENEFIT (PROVISION) FOR INCOME TAXES
1,834

 
(1,044
)
INCOME (LOSS) FROM CONTINUING OPERATIONS
(3,182
)
 
1,481

LOSS FROM DISCONTINUED OPERATIONS:
 
 
 
Operating loss, net of tax benefit of $33 and $628, respectively
(54
)
 
(800
)
NET INCOME (LOSS)
(3,236
)
 
681

NET INCOME (LOSS) PER COMMON SHARE:
 
 
 
Per common share – basic
 
 
 
Continuing operations
$
(0.51
)
 
$
0.24

Discontinued operations
(0.01
)
 
(0.13
)
 
$
(0.52
)
 
$
0.11

Per common share – diluted
 
 
 
Continuing operations
$
(0.51
)
 
$
0.24

Discontinued operations
(0.01
)
 
(0.13
)
 
$
(0.52
)
 
$
0.11

COMMON STOCK DIVIDENDS DECLARED PER SHARE OF COMMON STOCK
$
0.17

 
$
0.17

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
 
 
 
Basic
6,195

 
6,089

Diluted
6,195

 
6,310


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

6


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands and unaudited)
 
 
Nine Months Ended September 30,
 
2016
 
2015
NET INCOME (LOSS)
$
(3,236
)
 
$
681

OTHER COMPREHENSIVE INCOME:
 
 
 
Change in fair value of cash flow hedge, net of tax
398

 
382

Less: reclassification adjustment for amounts recognized in net income
(381
)
 
(345
)
Total other comprehensive income
17

 
37

COMPREHENSIVE INCOME (LOSS)
$
(3,219
)
 
$
718


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


7


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)
 
 
Nine Months Ended September 30,
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income (loss)
$
(3,236
)
 
$
681

Discontinued operations
(54
)
 
(800
)
Income (loss) from continuing operations
(3,182
)
 
1,481

Adjustments to reconcile income (loss) from continuing operations to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
6,055

 
5,629

Provision for doubtful accounts
5,785

 
5,425

Deferred income tax provision (benefit)
(2,329
)
 
204

Provision for self-insured professional liability, net of cash payments
1,853

 
2,063

Stock-based compensation
721

 
924

Equity in net income of unconsolidated affiliate, net of investment
(191
)
 
(281
)
Debt retirement costs
351

 
—

Provision for leases in excess of cash payments
(1,640
)
 
(1,203
)
Lease termination costs, net of cash payments
1,958

 
—

Other
463

 
116

Changes in assets and liabilities affecting operating activities:
 
 
 
Receivables, net
(2,071
)
 
(8,302
)
Prepaid expenses and other assets
(1,620
)
 
(507
)
Trade accounts payable and accrued expenses
(226
)
 
1,136

Net cash provided by continuing operations
5,927

 
6,685

Discontinued operations
(3,572
)
 
(4,896
)
Net cash provided by operating activities
2,355

 
1,789

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(11,596
)
 
(3,624
)
Acquisition of property and equipment through business combination
—

 
(7,000
)
Change in restricted cash
1,658

 
2,490

Deposits and other deferred balances
—

 
(9
)
Net cash used in continuing operations
(9,938
)
 
(8,143
)
Discontinued operations
—

 
—

Net cash used in investing activities
(9,938
)
 
(8,143
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Repayment of debt obligations
(70,883
)
 
(14,002
)
Proceeds from issuance of debt
80,855

 
21,941

Financing costs
(1,884
)
 
(192
)
Issuance and redemption of employee equity awards
(105
)
 
(31
)
Payment of common stock dividends
(1,025
)
 
(1,008
)
Payment for preferred stock restructuring
(477
)
 
(462
)
Net cash provided by financing activities
6,481

 
6,246

Discontinued operations
—

 
—

Net cash provided by financing activities
$
6,481

 
$
6,246


8


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)
(continued)
 
 
Nine Months Ended September 30,
 
2016
 
2015
NET DECREASE IN CASH AND CASH EQUIVALENTS
$
(1,102
)
 
$
(108
)
CASH AND CASH EQUIVALENTS, beginning of period
4,585

 
3,818

CASH AND CASH EQUIVALENTS, end of period
$
3,483

 
$
3,710

SUPPLEMENTAL INFORMATION:
 
 
 
Cash payments of interest
$
2,906

 
$
2,711

Cash payments of income taxes
$
521

 
$
216

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

9


DIVERSICARE HEALTHCARE SERVICES, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2016 AND 2015

1.
BUSINESS
Diversicare Healthcare Services, Inc. (together with its subsidiaries, “Diversicare Healthcare Services” or the “Company”) provides long-term care services to nursing center patients in nine states, primarily in the Southeast, Midwest, and Southwest. The Company’s centers provide a range of health care services to their patients and residents that include nursing, personal care, and social services. Additionally, the Company’s nursing centers also offer a variety of comprehensive rehabilitation services, as well as nutritional support services. The Company's continuing operations include centers in Alabama, Florida, Indiana, Kansas, Kentucky, Missouri, Ohio, Tennessee, and Texas.
As of September 30, 2016, the Company’s continuing operations consist of 54 nursing centers with 5,879 licensed nursing beds. The Company owns 17 and leases 37 of its nursing centers. Our nursing centers range in size from 48 to 320 licensed nursing beds. The licensed nursing bed count does not include 496 licensed assisted and residential living beds.

2.
CONSOLIDATION AND BASIS OF PRESENTATION OF FINANCIAL STATEMENTS
The interim consolidated financial statements include the operations and accounts of Diversicare Healthcare Services and its subsidiaries, all wholly-owned. All significant intercompany accounts and transactions have been eliminated in consolidation. The investment in an unconsolidated affiliate (a 50 percent-owned joint venture partnership) is accounted for using the equity method and is described in Note 8 to the interim consolidated financial statements.
The interim consolidated financial statements for the three and nine month periods ended September 30, 2016 and 2015, included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management of the Company, the accompanying interim consolidated financial statements reflect all normal, recurring adjustments necessary to present fairly the Company’s financial position at September 30, 2016, and the results of operations for the three and nine month periods ended September 30, 2016 and 2015, and cash flows for the nine month periods ended September 30, 2016 and 2015. The Company’s balance sheet information at December 31, 2015, was derived from its audited consolidated financial statements as of December 31, 2015.
The results of operations for the periods ended September 30, 2016 and 2015 are not necessarily indicative of the operating results that may be expected for a full year. These interim consolidated financial statements should be read in connection with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

3.
RECENT ACCOUNTING GUIDANCE
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers.  In March 2016, the FASB issued an update to ASU No. 2014-09 in the form of ASU No. 2016-08, which amended the principal-versus-agent implementation guidance and illustrations in the new revenue guidance. The update clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued another update to the new revenue standard in the form of ASU No. 2016-10, which amends the guidance on identifying performance obligations and the implementation guidance on licensing. In May 2016, ASU No. 2016-12 was issued, which amends the new revenue recognition guidance on transition, collectibility, noncash consideration and the presentation of taxes. The new revenue standard (including updates) will be effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted only as of annual reporting periods beginning after December 15, 2016. The Company will adopt the requirements of this standard effective January 1, 2018, and are currently evaluating the impact of the adoption on our financial condition and results of operations.
In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs (Topic 835), which amends and simplifies the presentation of debt issuance costs. The main provisions of the standard require that debt issuance costs related to a recognized liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, and amortization of the debt issuance costs must be reported as interest expense. The Company adopted ASU No. 2015-03 as of January 1, 2016. The new standard was applied on a retroactive basis and the Company has complied with the applicable disclosures for a change in accounting principle. The adoption of this guidance has not had a material impact on the Company's consolidated financial statements.

10


In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes, which changes how deferred taxes are classified on the Company's balance sheets and is effective for financial statements issued for annual periods beginning after December 15, 2016, with early adoption permitted. ASU 2015-17 requires all deferred tax assets and liabilities to be classified as non-current. Upon adoption, the Company anticipates reclassifying deferred income taxes of approximately $7,405,000 from current to non-current assets.
In February 2016, the FASB issued ASU No. 2016-02, Leases. The new standard requires that a lessee of operating leases recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. The lease liability will be equal to the present value of lease payments, with the right-of-use asset based upon the lease liability. The classification criteria for distinguishing between finance (or capital) leases and operating leases are substantially similar to the previous lease guidance. As such, operating leases will result in straight-line rent expense similar to current practice. For short-term leases (term of 12 months or less), a lessee is permitted to make an accounting election not to recognize lease assets and lease liabilities, which would generally result in lease expense being recognized on a straight-line basis over the lease term. The guidance is effective for annual and interim periods beginning after December 15, 2018, and will require application of the new guidance at the beginning of the earliest comparable period presented. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition. The adoption of this standard is expected to have a material impact on the Company’s financial position. The Company is currently assessing the impact of this new accounting pronouncement on the Company's results of operations, financial position, and cash flows.
In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The ASU was issued as part of the FASB Simplification Initiative and involves several aspects of accounting for shared-based payment transactions, including the income tax consequences and classification on the statement of cash flows. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company is currently assessing the impact of this new accounting pronouncement on the Company's results of operations, financial position, and cash flows.
In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230). The ASU provides clarification regarding how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The ASU is effective for annual and interim periods beginning after December 15, 2017, which will require the Company to adopt these provisions in the first quarter of fiscal 2018 using a retrospective approach. Early adoption is permitted. The Company does not expect the new accounting pronouncement to have a material impact on our consolidated financial statements.
 
4.
LONG-TERM DEBT AND INTEREST RATE SWAP
The Company has agreements with a syndicate of banks for a mortgage term loan ("Original Mortgage Loan") and the Company’s revolving credit agreement ("Original Revolver"). On February 26, 2016, the Company executed an Amended and Restated Credit Agreement (the "Credit Agreement") which modified the terms of the Original Mortgage Loan and the Original Revolver Agreements dated April 30, 2013. The Credit Agreement increases the Company's borrowing capacity to $100,000,000 allocated between a $72,500,000 Mortgage Loan ("Amended Mortgage Loan") and a $27,500,000 Revolver ("Amended Revolver"). The Amended Mortgage Loan consists of a $60,000,000 term loan facility and a $12,500,000 acquisition loan facility. Loan acquisition costs associated with the Amended Mortgage Loan and the Amended Revolver were capitalized in the amount of $1,812,000 and are being amortized over the five-year term of the agreements. Additionally, the Glasgow term loan balance was consolidated into the new Credit Agreement.
Under the terms of the amended agreements, the syndicate of banks provided the Amended Mortgage Loan with an original balance of $72,500,000 with a five-year maturity through February 26, 2021, and a $27,500,000 Amended Revolver through February 26, 2021. The Amended Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25-year amortization. Interest on the term and acquisition loan facilities are based on LIBOR plus 4.0% and 4.75%, respectively. A portion of the Amended Mortgage Loan is effectively fixed at 5.79% pursuant to an interest rate swap with an initial notional amount of $30,000,000. As of September 30, 2016, the interest rate related to the Amended Mortgage Loan was 4.52%. The Amended Mortgage Loan is secured by seventeen owned nursing centers, related equipment and a lien on the accounts receivable of these centers. The Amended Mortgage Loan and the Amended Revolver are cross-collateralized. The Company’s Amended Revolver has an interest rate of LIBOR plus 4.0% and is secured by accounts receivable and is subject to limits on the maximum amount of loans that can be outstanding under the revolver based on borrowing base restrictions. The Amended Mortgage Loan balance was $61,484,000 as of September 30, 2016, consisting of $59,195,000 on the term loan facility and $2,289,000 on the acquisition loan facility.
As of September 30, 2016, the Company had $9,000,000 borrowings outstanding under the Amended Revolver compared to $12,900,000 outstanding as of December 31, 2015. The outstanding borrowings on the revolver primarily compensate for accumulated Medicaid and Medicare receivables at recently acquired facilities as these facilities proceed through the change in ownership process with CMS. Annual fees for letters of credit issued under the Amended Revolver are 3.00% of the amount

11


outstanding. The Company has ten letters of credit with a total value of $7,868,000 outstanding as of September 30, 2016. Considering the balance of eligible accounts receivable, the letters of credit, the amounts outstanding under the revolving credit facility and the maximum loan amount of $27,500,000, the balance available for borrowing under the Amended Revolver was $6,981,000 at September 30, 2016.
The Company’s debt agreements contain various financial covenants, the most restrictive of which relates to debt service coverage ratios. As of September 30, 2016, the Company was compliant with the amended covenants as described in Note 10 to the interim consolidated financial statements.
Interest Rate Swap Transaction
As part of the debt agreements entered into in April 2013, the Company entered into an interest rate swap agreement with a member of the bank syndicate as the counterparty. The Company designated its interest rate swap as a cash flow hedge and the earnings component of the hedge, net of taxes, is reflected as a component of other comprehensive income. In conjunction with the Amendment to the Credit Agreement, the Company amended the terms of its interest rate swap on February 26, 2016. The interest rate swap agreement requires the Company to make fixed rate payments to the bank calculated on the initial notional amount of $30,000,000 at an annual fixed rate of 5.79% while the bank is obligated to make payments to the Company based on LIBOR on the same notional amount.
The Company assesses the effectiveness of its interest rate swap on a quarterly basis, and at September 30, 2016, the Company determined that the interest rate swap was effective. The interest rate swap valuation model indicated a net liability of $957,000 at September 30, 2016. The fair value of the interest rate swap is included in “other noncurrent liabilities” on the Company’s interim consolidated balance sheet. The liability related to the interest rate swap included in accumulated other comprehensive loss at September 30, 2016 is $593,000, net of the income tax benefit of $364,000. As the Company’s interest rate swap is not traded on a market exchange, the fair value is determined using a valuation based on a discounted cash flow analysis. This analysis reflects the contractual terms of the interest rate swap agreement and uses observable market-based inputs, including estimated future LIBOR interest rates. The interest rate swap valuation is classified in Level 2 of the fair value hierarchy, in accordance with the FASB guidance set forth in ASC 820, Fair Value Measurement.

5.
COMMITMENTS AND CONTINGENCIES
Professional Liability and Other Liability Insurance
The Company has professional liability insurance coverage for its nursing centers that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. Effective July 1, 2013, the Company established a wholly-owned, consolidated offshore limited purpose insurance subsidiary, SHC Risk Carriers, Inc. (“SHC”) which has issued a policy insuring claims made against all of the Company's nursing centers in Florida and Tennessee, as well as the Company’s formerly operated Arkansas and West Virginia facilities. Several of the Company’s nursing centers in Alabama, Kentucky, Ohio, and Texas are also covered under this policy. The SHC policy provides coverage limits of either $500,000 or $1,000,000 per medical incident with a sublimit per center of $1,000,000 and total annual aggregate policy limits of $5,000,000. The remaining nursing centers are covered by one of seven claims made professional liability insurance policies purchased from entities unaffiliated with the Company. These policies provide coverage limits of $1,000,000 per claim and have sublimits of $3,000,000 per center, with varying self-insured retention levels per claim and varying aggregate policy limits. 
Reserve for Estimated Self-Insured Professional Liability Claims
Because the Company’s actual liability for existing and anticipated professional liability and general liability claims will likely exceed the Company’s limited insurance coverage, the Company has recorded total liabilities for reported and estimated future claims of $19,878,000 as of September 30, 2016. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs related to these claims. All losses are projected on an undiscounted basis and are presented without regard to any potential insurance recoveries. Amounts are added to the accrual for estimates of anticipated liability for claims incurred during each period, and amounts are deducted from the accrual for settlements paid on existing claims during each period.
The Company evaluates the adequacy of this liability on a quarterly basis. Semi-annually, the Company retains a third-party actuarial firm to assist in the evaluation of this reserve. Since May 2012, Merlinos & Associates, Inc. (“Merlinos”) has assisted management in the preparation of the appropriate accrual for incurred but not reported general and professional liability claims based on data furnished as of May 31 and November 30 of each year. Merlinos primarily utilizes historical data regarding the frequency and cost of the Company's past claims over a multi-year period, industry data and information regarding the number of occupied beds to develop its estimates of the Company's ultimate professional liability cost for current periods.
On a quarterly basis, the Company obtains reports of asserted claims and lawsuits incurred. These reports, which are provided by the Company’s insurers and a third-party claims administrator, contain information relevant to the actual expense already incurred

12


with each claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by the Company quarterly and provided to the actuary semi-annually. Based on the Company’s evaluation of the actual claim information obtained, the semi-annual estimates received from the third-party actuary, the amounts paid and committed for settlements of claims and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular period may be revised upward or downward on a quarterly basis. Any increase in the accrual decreases results of operations in the period and any reduction in the accrual increases results of operations during the period.
As of September 30, 2016, the Company is engaged in 62 professional liability lawsuits. Ten lawsuits are currently scheduled for trial or arbitration during the next twelve months, and it is expected that additional cases will be set for trial or hearing. The Company’s cash expenditures for self-insured professional liability costs from continuing operations were $2,779,000 and $3,306,000 for the nine months ended September 30, 2016 and 2015, respectively.
Although the Company adjusts its accrual for professional and general liability claims on a quarterly basis and retains a third-party actuarial firm semi-annually to assist management in estimating the appropriate accrual, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. Professional liability cases have a long cycle from the date of an incident to the date a case is resolved, and final determination of the Company’s actual liability for claims incurred in any given period is a process that takes years. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given period. Each change in the amount of this accrual will directly affect the Company’s reported earnings and financial position for the period in which the change in accrual is made.
Civil Investigative Demand ("CID")
In July 2013, the Company learned that the United States Attorney for the Middle District of Tennessee ("DOJ") had commenced a civil investigation of potential violations of the False Claims Act ("FCA").
In October 2014, the Company learned that the investigation was started by the filing under seal of a false claims action against the two facilities that were the subject of the original CID. In connection with this matter, between July 2013 and early February 2016, the Company has received three civil investigative demands (a form of subpoena) for documents and information relating to our practices and policies for rehabilitation, and other services, our preadmission evaluation forms ("PAEs") required by TennCare and our Pre-Admission Screening and Resident Reviews ("PASRRs"). We have responded to those requests. The DOJ has also issued CID's for testimony from current and former employees of the Company. The DOJ’s civil investigation of the Company's practices and policies for rehabilitation now covers all of the Company’s facilities, but thus far only documents from six of our facilities have been requested.
In June 2016, the Company received an authorized investigative demand (a form of subpoena) for documents in connection with a criminal investigation by the DOJ related to our practices with respect to PAEs and PASRRs, and the Company has provided documents responsive to this subpoena. The Company cannot predict the outcome of these investigations or any possible related proceedings, and the outcome could have a materially adverse effect on the Company, including the imposition of damages, criminal charges, fines, penalties and/or a corporate integrity agreement. The Company is committed to provide caring and professional services to its patients and residents in compliance with applicable laws and regulations.
Other Insurance
With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. The Company is completely self-insured for workers’ compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. From June 30, 2003 until June 30, 2007, the Company’s workers’ compensation insurance programs provided coverage for claims incurred with premium adjustments depending on incurred losses. For the period from July 1, 2007 until June 30, 2008, the Company is completely self-insured for workers' compensation exposure. From July 1, 2008 through September 30, 2016, the Company is covered by a prefunded deductible policy. Under this policy, the Company is self-insured for the first $500,000 per claim, subject to an aggregate maximum of $3,000,000. The Company funds a loss fund account with the insurer to pay for claims below the deductible. The Company accounts for premium expense under this policy based on its estimate of the level of claims subject to the policy deductibles expected to be incurred. The liability for workers’ compensation claims is $193,000 at September 30, 2016. The Company has a non-current receivable for workers’ compensation policies covering previous years of $1,224,000 as of September 30, 2016. The non-current receivable is a function of payments paid to the Company’s insurance carrier in excess of the estimated level of claims expected to be incurred.
As of September 30, 2016, the Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $175,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims

13


is $666,000 at September 30, 2016. The differences between actual settlements and reserves are included in expense in the period finalized.

6.
STOCK-BASED COMPENSATION

Overview of Plans
In December 2005, the Compensation Committee of the Board of Directors adopted the 2005 Long-Term Incentive Plan (“2005 Plan”). The 2005 Plan allows the Company to issue stock options and other share and cash based awards. Under the 2005 Plan, 700,000 shares of the Company's common stock have been reserved for issuance upon exercise of equity awards granted thereunder. All grants under this plan expire 10 years from the date the grants were authorized by the Board of Directors.
In June 2008, the Company adopted the Advocat Inc. 2008 Stock Purchase Plan for Key Personnel (“Stock Purchase Plan”). The Stock Purchase Plan provides for the granting of rights to purchase shares of the Company's common stock to directors and officers and 150,000 shares of the Company's common stock has been reserved for issuance under the Stock Purchase Plan. The Stock Purchase Plan allows participants to elect to utilize a specified portion of base salary, annual cash bonus, or director compensation to purchase restricted shares or restricted share units (“RSU's”) at 85% of the quoted market price of a share of the Company's common stock on the date of purchase. The restriction period under the Stock Purchase Plan is generally two years from the date of purchase and during which the shares will have the rights to receive dividends, however, the restricted share certificates will not be delivered to the shareholder and the shares cannot be sold, assigned or disposed of during the restriction period. In June 2016, our shareholders approved an amendment to the Stock Purchase Plan to increase the number of shares of our common stock authorized under the Plan from 150,000 shares to 350,000 shares. No grants can be made under the Stock Purchase Plan after April 25, 2028.
In April 2010, the Compensation Committee of the Board of Directors adopted the 2010 Long-Term Incentive Plan (“2010 Plan”), followed by approval by the Company's shareholders in June 2010. The 2010 Plan allows the Company to issue stock appreciation rights, stock options and other share and cash based awards. Under the 2010 Plan, 380,000 shares of the Company's common stock have been reserved for issuance upon exercise of equity awards granted.

Equity Grants and Valuations
During the nine months ended September 30, 2016 and 2015, the Compensation Committee of the Board of Directors approved grants totaling approximately 83,000 and 74,000 shares of restricted common stock to certain employees and members of the Board of Directors, respectively. The fair value of restricted shares are determined as the quoted market price of the underlying common shares at the date of the grant. The restricted shares typically vest 33% on the first, second and third anniversaries of the grant date. Unvested shares may not be sold or transferred. During the vesting period, dividends accrue on the restricted shares, but are paid in additional shares of common stock upon vesting, subject to the vesting provisions of the underlying restricted shares. The restricted shares are entitled to the same voting rights as other common shares. Upon vesting, all restrictions are removed. Summarized activity of the equity compensation plans is presented below:
 
 
 
Weighted
 
Options/
 
Average
 
SOSARs
 
Exercise Price
Outstanding, December 31, 2015
232,000

 
$
6.97

Granted
—

 
—

Exercised
(1,000
)
 
3.91

Expired or cancelled
—

 
—

Outstanding, September 30, 2016
231,000

 
$
6.98

 
 
 
 
Exercisable, September 30, 2016
222,000

 
$
6.83



14


 
 
 
Weighted
 
 
 
Average
 
Restricted
 
Grant Date
 
Shares
 
Fair Value
Outstanding, December 31, 2015
141,000

 
$
9.07

Granted
83,000

 
8.87

Dividend Equivalents
3,000

 
8.87

Vested
(68,000
)
 
7.85

Cancelled
(7,000
)
 
9.80

Outstanding, September 30, 2016
152,000

 
$
9.47

Summarized activity of the Restricted Share Units for the Stock Purchase Plan is as follows:
 
 
 
Weighted
 
 
 
Average
 
Restricted
 
Grant Date
 
Share Units
 
Fair Value
Outstanding, December 31, 2015
62,000

 
$
9.58

Granted
17,000

 
8.87

Dividend Equivalents
1,000

 
8.86

Vested
(27,000
)
 
6.13

Cancelled
—

 
—

Outstanding, September 30, 2016
53,000

 
$
11.10


Prior to 2015, the Compensation Committee of the Board of Directors also approved grants of Stock Only Stock Appreciation Rights (“SOSARs”) and Stock Options at the market price of the Company's common stock on the grant date. The SOSARs and Options vest 33% on the first, second and third anniversaries of the grant date, and expire 10 years from the grant date. The SOSARs and Options were valued and recorded in the same manner, and will be settled with issuance of new stock for the difference between the market price on the date of exercise and the exercise price. The Company estimated the total recognized and unrecognized compensation related to SOSARs and stock options using the Black-Scholes-Merton equity grant valuation model.

In computing the fair value estimates using the Black-Scholes-Merton valuation model, the Company took into consideration the exercise price of the equity grants and the market price of the Company's stock on the date of grant. The Company used an expected volatility that equals the historical volatility over the most recent period equal to the expected life of the equity grants. The risk free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The Company used the expected dividend yield at the date of grant, reflecting the level of annual cash dividends currently being paid on its common stock.

While no SOSARs or Options were granted during 2016 and 2015, previously granted SOSARs and Options remain outstanding as of September 30, 2016. The following table summarizes information regarding stock options and SOSAR grants outstanding as of September 30, 2016:
 
 
Weighted
 
 
 
 
 
 
 
 
 
 
Average
 
 
 
Intrinsic
 
 
 
Intrinsic
Range of
 
Exercise
 
Grants
 
Value-Grants
 
Grants
 
Value-Grants
Exercise Prices
 
Prices
 
Outstanding
 
Outstanding
 
Exercisable
 
Exercisable
$10.21 to $11.59
 
$
10.88

 
61,000

 
$
—

 
52,000

 
$
—

$2.37 to $6.21
 
$
5.55

 
170,000

 
$
754,000

 
170,000

 
$
754,000

 
 
 
 
231,000

 
 
 
222,000

 
 
Stock-based compensation expense is non-cash and is included as a component of general and administrative expense or operating expense based upon the classification of cash compensation paid to the related employees. The Company recorded total stock-based compensation expense of $721,000 and $924,000 in the nine month periods ended September 30, 2016 and 2015, respectively.


15


7.
EARNINGS (LOSS) PER COMMON SHARE
Information with respect to basic and diluted net income (loss) per common share is presented below in thousands, except per share:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Net income (loss)
 
 
 
 
 
 
 
Income (loss) from continuing operations
$
(958
)
 
$
669

 
(3,182
)
 
1,481

Loss from discontinued operations, net of income taxes
(17
)
 
(238
)
 
(54
)
 
(800
)
Net income (loss)
$
(975
)
 
$
431

 
$
(3,236
)
 
$
681

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Net income (loss) per common share:
 
 
 
 
 
 
 
Per common share – basic
 
 
 
 
 
 
 
Income (loss) from continuing operations
$
(0.16
)
 
$
0.11

 
$
(0.51
)
 
$
0.24

Loss from discontinued operations
—

 
(0.04
)
 
(0.01
)
 
(0.13
)
Net income (loss) per common share – basic
$
(0.16
)
 
$
0.07

 
$
(0.52
)
 
$
0.11

Per common share – diluted
 
 
 
 
 
 
 
Income (loss) from continuing operations
$
(0.16
)
 
$
0.11

 
$
(0.51
)
 
$
0.24

Loss from discontinued operations
—

 
(0.04
)
 
(0.01
)
 
(0.13
)
Net income (loss) per common share – diluted
$
(0.16
)
 
$
0.07

 
$
(0.52
)
 
$
0.11

Weighted Average Common Shares Outstanding:
 
 
 
 
 
 
 
Basic
6,212

 
6,121

 
6,195

 
6,089

Diluted
6,212

 
6,331

 
6,195

 
6,310

The effects of 231,000 and 16,000 SOSARs and options outstanding were excluded from the computation of diluted earnings per common share in the nine months ended September 30, 2016 and 2015, respectively, because these securities would have been anti-dilutive.

8. EQUITY METHOD INVESTMENT
The investment in unconsolidated affiliate reflected on the interim consolidated balance sheet relates to a pharmacy joint venture partnership in which the Company owns 50%. This investment in unconsolidated affiliate is accounted for using the equity method as the Company exerts significant influence, but does not control or otherwise consolidate the entity. The investment in unconsolidated affiliate balance at September 30, 2016, was $989,000 as compared to $798,000 at December 31, 2015. Additionally, the Company's share of the net profits and losses of the unconsolidated affiliate are reported in equity in net earnings or losses of unconsolidated affiliate in our statement of operations. The Company's equity in the net income of unconsolidated affiliate for the quarter ended September 30, 2016, was $130,000 as compared to $97,000 for the quarter ended September 30, 2015. For the nine-month period ended September 30, 2016, the equity in the net income of unconsolidated affiliate was $191,000 compared to $280,000 for the nine-month period ended September 30, 2015.


16


9.
BUSINESS DEVELOPMENTS AND OTHER SIGNIFICANT TRANSACTIONS
2016 Acquisitions
On August 15, 2016, the Company entered into an Operation Transfer Agreement with Golden Living to assume the operations of 22 facilities in Alabama and Mississippi, which became effective in the fourth quarter of 2016. Refer to Note 10 of the interim consolidated financial statements for further discussion on the Company's acquisition of these facilities.

On February 26, 2016, the Company exercised its purchase options to acquire the real estate assets for Diversicare of Hutchinson in Hutchinson, Kansas and Clinton Place in Clinton, Kentucky for $4,250,000 and $3,300,000, respectively. The Company has operated these facilities since February 2015 and April 2012, respectively. Hutchinson is an 85-bed skilled nursing facility, and Clinton is an 88-bed skilled nursing facility. As a result of the consummation of the Agreements, the Company allocated the purchase price and acquisition costs between the assets acquired. The allocation of the purchase price was determined with the assistance of HealthTrust LLC, a third-party real estate valuation firm. The allocation for the assets acquired is as follows:
 

 
Hutchinson
Clinton Place
Purchase Price
$
4,250,000

$
3,300,000

Acquisition Costs
43,000

34,000

 
$
4,293,000

$
3,334,000

 
 
 
Allocation:
 
 
Buildings
3,443,000

2,898,000

Land
365,000

267,000

Furniture, Fixtures and Equipment
485,000

169,000

 
$
4,293,000

$
3,334,000


2015 Acquisitions
On February 1, 2015, the Company entered into an Asset Purchase Agreement (the “Purchase Agreement”) with Barren County Health Care Center, Inc. to acquire certain land, improvements, furniture, fixtures and equipment, personal property and intangible property, together comprising a 94-bed skilled nursing center in Glasgow, Kentucky, for an aggregate purchase price of $7,000,000.

As a result of this business combination transaction, the Company allocated the purchase price of $7,000,000 based on the fair value of the acquired net assets. The allocation of the purchase price was determined with the assistance of HealthTrust LLC, a third-party real estate valuation firm. The allocation for the net assets acquired is as follows:

 
February 1, 2015
Purchase Price
$
7,000,000

 
 
Land
672,000

Buildings
5,778,000

Furniture, Fixtures, and Equipment
550,000

 
$
7,000,000



17


On November 1, 2015, the Company entered into an Asset Purchase Agreement with Haws Fulton Investors, LLC to acquire certain land, improvements, furniture, fixtures and equipment, personal property and intangible property, together comprising a 60-bed skilled nursing center in Fulton, Kentucky, for an aggregate purchase price of $3,900,000.
As a result of this business combination transaction, the Company allocated the purchase price of $3,900,000 based on the fair value of the acquired net assets. The allocation for the net assets acquired is as follows:

 
November 1, 2015
Purchase Price
$
3,900,000

 
 
Land
300,000

Buildings
3,338,000

Furniture, Fixtures, and Equipment
262,000

 
$
3,900,000


2016 Lease Termination
On May 31, 2016, the Company entered into an Agreement with Avon Ohio, LLC to amend the original lease agreement, thus terminating the Company's right of possession of the facility. As a result, the Company incurred lease termination costs of $2,008,000 in the second quarter of 2016. Under the amended agreement, the Company is required to pay $300,000 per year through the term of the original lease agreement, July 31, 2024. For accounting purposes, this transaction was not reported as a discontinued operation, which is in accordance with the modified authoritative guidance for reporting discontinued operations, effective January 1, 2015. A disposal is now required to be reported in discontinued operations only if the disposal represents a strategic shift that has (or will have) a major effect on the Company's operations and financial results.


10.
SUBSEQUENT EVENTS

Golden Living
On October 1, 2016, the Company entered into a Master Lease Agreement (the "Lease") with Golden Living (the "Lessor") to directly lease eight facilities located in Mississippi from the Lessor, which resulted in the following business acquisitions: (i) a 152-bed skilled nursing facility known as Golden Living Center - Amory; (ii) a 130-bed skilled nursing facility known as Golden Living Center - Batesville; (iii) a 58-bed skilled nursing facility known as Golden Living Center - Brook Manor; (iv) a 119-bed skilled nursing facility known as Golden Living Center - Eupora; (v) a 140-bed skilled nursing facility known as Golden Living Center - Ripley; (vi) a 140-bed skilled nursing facility known as Golden Living Center - Southaven; (vii) a 120-bed skilled nursing facility known as Golden Living Center - Eason Blvd; (viii) a 60-bed skilled nursing facility known as Golden Living Center - Tylertown. The Lease has an initial term of ten years. The Company also assumed the individual leases of a 120-bed facility known as Broadmoor Nursing Home, with an initial lease term often years, and a 99-bed skilled nursing facility known as Leake County Nursing Home, with a lease term of two years.
On November, 1 2016, the Company amended and restated the Lease ("Amended Lease") with the Lessor to directly lease an additional twelve facilities located in Alabama from the Lessor, which resulted in the following business acquisitions: (i) a 87-bed skilled nursing facility known as Golden Living Center - Arab; (ii) a 180-bed skilled nursing facility known as Golden Living Center - Meadowood; (iii) a 132-bed skilled nursing facility known as Golden Living Center - Riverchase; (iv) a 100-bed skilled nursing facility known as Golden Living Center - Boaz; (v) a 154-bed skilled nursing facility known as Golden Living Center - Foley; (vi) a 50-bed skilled nursing facility known as Golden Living Center - Hueytown; (vii) a 85-bed skilled nursing facility known as Golden Living Center - Lanett; (viii) a 138-bed skilled nursing facility known as Golden Living Center - Montgomery; (ix) a 120-bed skilled nursing facility known as Golden Living Center - Oneonta; (x) a 173-bed skilled nursing facility known as Golden Living Center - Oxford; (xi) a 94-bed skilled nursing facility known as Golden Living Center - Pell City; (xii) a 123-bed skilled nursing facility known as Golden Living Center - Winfield. The Amended Lease has an initial term of ten years.
The completion of this acquisition brings the Company's operations to 76 nursing centers with 8,453 skilled nursings beds. They are expected to be accretive to earnings early in the Company's tenure as the operator of the Facilities.



18


Debt Modification
On October 3, 2016, the Company executed an Amendment to the Amended and Restated Revolving Loan and Security Agreement (the "Amended Revolver") with a syndicate of financial institutions and banks, including The PrivateBank and Trust Company, the administering agent, which modifies the terms of the Amended and Restated Revolving Loan and Security Agreement (the "Original Revolver"), dated February 26, 2016. The Amended Revolver increases the Company's maximum revolving facility to $52,250,000; provided that the maximum revolving facility be reduced to $42,250,000 on August 1, 2017.

The Amended Revolver amends certain provisions to our financial covenants including the following: the minimum Adjusted EBITDA shall not be less than $8,500,000 for the quarter ending September 30, 2016; $9,500,000 for the quarter ending December 31, 2016; $10,000,000 for the quarter ending March 31, 2017; $11,500,000 for the quarter ending June 30, 2017; and $13,000,000 for the quarter ending September 30, 2017 and for each quarter thereafter.


19



ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Diversicare Healthcare Services, Inc. (together with its subsidiaries, “Diversicare” or the “Company”) provides long-term care services to nursing center patients in nine states, primarily in the Southeast, Midwest, and Southwest. The Company’s centers provide a range of health care services to their patients and residents that include nursing, personal care, and social services. Additionally, the Company’s nursing centers also offer a variety of comprehensive rehabilitation services, as well as nutritional support services. The Company's continuing operations include centers in Alabama, Florida, Indiana, Kansas, Kentucky, Missouri, Ohio, Tennessee, and Texas.
As of September 30, 2016, the Company’s continuing operations consist of 54 nursing centers with 5,879 licensed nursing beds. The Company owns 17 and leases 37 of its nursing centers. Our nursing centers range in size from 48 to 320 licensed nursing beds. The licensed nursing bed count does not include 496 licensed assisted living and residential beds.
Strategic Operating Initiatives
During the third quarter of 2010, we identified several key strategic objectives to increase shareholder value through improved operations and business development. These strategic operating initiatives included: improving skilled mix in our nursing centers, improving our average Medicare rate, implementing Electronic Medical Records (“EMR”) to improve Medicaid capture, accelerating center renovations and completing strategic acquisitions. We have experienced success in these initiatives and expect to continue to build on these improvements. We describe each of these below as well as provide metrics for our most recent quarter versus the third quarter of 2010, the quarter before we embarked on our strategic operating initiatives.
Improving skilled mix and average Medicare rate:
Our strategic operating initiatives of improving our skilled mix and our average Medicare rate by accurately capturing the delivery of care required investing in nursing and clinical care to treat more acute patients along with nursing center based sales representatives to attract these patients. These initiatives developed referral and Managed Care relationships that have attracted and are expected to continue to attract patients whose stay in the centers is covered by Medicare and Managed Care. A comparison of our most recent quarter versus the third quarter of 2010, the quarter before we embarked on our strategic operating initiatives, reflects our success with these strategic operating initiatives: 
 
Three Months Ended
 
September 30, 2016
 
September 30,
2010
As a percent of total census:
 
 
 
Medicare census
11.4
%
 
12.3
%
Managed Care census
3.5
%
 
1.3
%
Total skilled mix census
14.9
%
 
13.6
%
As a percent of total revenues:
 
 
 
Medicare revenues
27.2
%
 
29.3
%
Managed Care revenues
6.9
%
 
2.8
%
Total skilled mix revenues
34.1
%
 
32.1
%
Medicare average rate per day:
$
455.69

 
$
394.23

The initiatives have developed positive results in growing our skilled patient population, increasing the Managed Care census to 3.5% of total census in the third quarter of 2016, as compared to 1.3% in the third quarter of 2010, and total skilled mix census to 14.9% from 13.6% over the same period.

20


Implementing Electronic Medical Records to improve Medicaid capture:
As another part of our strategic operating initiative, we implemented EMR to improve documentation of the delivery of care. We completed the implementation of EMR in all our nursing centers in December 2011, on time and under budget. A comparison of our most recent quarter versus the third quarter of 2010 reflects the increase in our average Medicaid rate per day:
 
Three Months Ended
 
September 30, 2016
 
September 30,
2010
Medicaid average rate per day:
$
169.51

 
$
147.93


Completing strategic acquisitions and dispositions:
Our strategic operating initiatives include a renewed focus on completing strategic acquisitions. We continue to pursue and investigate opportunities to acquire, lease or develop new centers, focusing primarily on opportunities within our existing geographic areas of operation.
On October 1, 2016 and November 1, 2016, we assumed the operations of ten centers in Mississippi and 12 centers in Alabama, respectively, which is further discussed in Note 10 to the interim consolidated financial statements. The completion of this acquisition brings the Company's operations to 76 nursing centers with 8,453 skilled nursings beds. These acquired facilities are expected to contribute in excess of $185 million in annual revenues.
As part of our strategic efforts, we also periodically perform thorough analyses on our existing centers in order to determine whether continuing operations within certain markets or regions is in line with the short-term and long-term strategy of the business. As a result, we disposed of an owned building in Arkansas in 2012, and reached an agreement to terminate our lease for eleven other facilities in Arkansas in 2013. In addition in 2014, the Company disposed of an owned building and two leased facilities in West Virginia. As a result of these transactions, we no longer operate within the states of Arkansas or West Virginia. In May 2016, we ceased operations at our Avon, Ohio, facility, thus terminating our lease with Avon Ohio, LLC. This transaction was not reported as a discontinued operation as described in Note 9 to the interim consolidated financial statements.
Basis of Financial Statements
Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, professional liability, depreciation and amortization expenses, incurred in the operation of the nursing centers we own and lease. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our interest, depreciation and amortization expenses include all such expenses across the range of our operations.

Critical Accounting Policies and Judgments
A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often involving estimates of the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income or loss to vary significantly from period to period. Our critical accounting policies are more fully described in our 2015 Annual Report on Form 10-K.


21


Revenue Sources
We classify our revenues from patients and residents into four major categories: Medicaid, Medicare, Managed Care, and Private Pay and other. Medicaid revenues are composed of the traditional Medicaid program established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. Managed Care revenues include payments for patients who are insured by a third-party entity, typically called a Health Maintenance Organization, often referred to as an HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a Managed Care replacement plan often referred to as Medicare replacement products. The Private Pay and other revenues are composed primarily of individuals or parties who directly pay for their services. Included in the Private Pay and other payors are patients who are hospice beneficiaries as well as the recipients of Veterans Administration benefits. Veterans Administration payments are made pursuant to renewable contracts negotiated with these payors.
The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the periods presented (dollar amounts in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Medicaid
$
49,083

 
50.4
%
 
$
48,958

 
49.9
%
 
$
144,628

 
49.7
%
 
$
140,008

 
48.3
%
Medicare
26,468

 
27.2

 
27,413

 
27.9

 
80,887

 
27.8

 
84,987

 
29.3

Managed Care
6,710

 
6.9

 
6,743

 
6.9

 
20,642

 
7.1

 
20,230

 
7.0

Private Pay and other
15,052

 
15.5

 
14,991

 
15.3

 
44,906

 
15.4

 
44,393

 
15.4

Total
$
97,313

 
100.0
%
 
$
98,105

 
100.0
%
 
$
291,063

 
100.0
%
 
$
289,618

 
100.0
%

The following table sets forth average daily skilled nursing census by payor source for our continuing operations for the periods presented: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
2015
 
2016
 
2015
Medicaid
3,129

 
68.1
%
 
3,143

 
67.6
%
 
3,073

 
68.2
%
 
3,088

 
66.9
%
Medicare
525

 
11.4

 
553

 
11.9

 
526

 
11.7

 
583

 
12.6

Managed Care
159

 
3.5

 
171

 
3.7

 
161

 
3.6

 
174

 
3.8

Private Pay and other
779

 
17.0

 
784

 
16.8

 
748

 
16.5

 
769

 
16.7

Total
4,592

 
100.0
%
 
4,651

 
100.0
%
 
4,508

 
100.0
%
 
4,614

 
100.0
%
Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, Managed Care, and Private Pay and other can significantly affect the profitability of the facility’s operations.

Health Care Industry
The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse laws and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. From time to time, the Company, like others in the healthcare industry, may be involved in regulatory actions of this type.
On April 16, 2015, the President signed into law the Medicare Access and CHIP Requthorization Act ("MACRA"). This bill includes a number of provisions, including the replacement of the Sustainable Growth Rate formula used by Medicare to pay physicians with new systems for establishing annual payment rate updates for physicians' services, an extension of the outpatient therapy cap exception process until December 31, 2017; and payment updates for post-acute providers. In addition, it increases premiums for Part B and Part D of Medicare for beneficiaries with income above certain levels and makes numerous other changes to Medicare and Medicaid. On October 30, 2015, CMS released a final rule addressing the implementation of certain provisions of MACRA, including the implementation of the new Merit-Based Incentive Payment System ("MIPS"). The current Value-Based Payment Modifier program is set to expire in 2018, with MIPS to begin in 2019. The October 30, 2015 final rule added measures where gaps exist in the current Physician Quality Reporting System, which is used by CMS to track the quality of care provided

22


to Medicare beneficiaries. The final rule also excludes services furnished in SNFs from the definition of primary care services for purposes of the Shared Savings Program. The final rule could impact our revenue in the future.
On February 20, 2015, CMS modified the Five Star Quality Rating System for nursing homes to include the use of antipsychotics in calculating the star ratings, modified calculations for staffing levels and reflect higher standards for nursing homes to achieve a high rating on the quality measure dimension. Since the standards for performance are more difficult to achieve, the number of our 4 and 5 star facilities could be reduced.
In March 2010, significant legislation concerning health care and health insurance was passed, including the “Patient Protection and Affordable Care Act,” (“Affordable Care Act”) along with the “Health Care and Education Reconciliation Act of 2010” (“Reconciliation Act”) collectively defined as the “Legislation.” We expect this Legislation to impact our Company, our employees and our patients in a variety of ways. Some aspects of these new laws have been implemented while others will be phased in over the next several years. This Legislation significantly changes the future responsibility of employers with respect to providing health care coverage to employees in the United States.
We also expect for this Legislation to continue to impact our Medicare and Medicaid reimbursement as well, though the exact timing and level of that impact is currently unknown. For example, the Legislation expands the role of home-based and community services, which may place downward pressure on our ability to maintain our population of Medicaid residents. Additional provisions under the Legislation for skilled nursing facilities participating in Medicare and/or Medicaid, including but not limited to, new transparency, reporting, and certification requirements, will likely lead to an increase in the Company's administrative and other costs.
The provisions of the Affordable Care Act discussed above are only examples of federal health reform provisions that we believe may have a material impact on the long-term care industry and on our business. We anticipate that many of the changes and reforms resulting from the Legislation, as well as other similar health care reforms, may be subject to further clarification and modification through promulgation of regulations, executive orders, and judicial review and could have a material adverse impact on our business, financial condition, and results of operations.
Medicare and Medicaid Reimbursement
A significant portion of our revenues are derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicare, Medicaid, Managed Care, Private Pay and other third party sources. We employ third-party specialists in reimbursement and also use these services to monitor regulatory developments and other changes to applicable coverage criteria to comply with reporting requirements and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.
Medicare
Effective October 1, 2011, Medicare rates were reduced by a nationwide average of 11.1%, the net effect of a reduction to restore overall payments to their intended levels on a prospective basis and the application of a 2.7% market basket increase and a negative 1.0% productivity adjustment required by the Affordable Care Act. The final Centers for Medicare and Medicaid Services (“CMS”) rule also adjusted the method by which group therapy is counted for reimbursement purposes and, for patients receiving therapy, changes the timing of reassessment for purposes of determining patient RUG categories. These October 2011 Medicare reimbursement changes decreased our Medicare revenue and our Medicare rate per patient day. The new regulations also resulted in an increase in costs to provide therapy services to our patients.
The Budget Control Act of 2011 (“BCA”), enacted on August 2, 2011, increased the United States debt ceiling and linked the debt ceiling increase to corresponding deficit reductions through 2021. The BCA also established a 12 member joint committee of Congress known as the Joint Select Committee on Deficit Reduction (“Super Committee”). The Super Committee’s objective was to create proposed legislation to reduce the United States federal budget deficit by $1.5 trillion for fiscal years 2012 through 2021. Part of the BCA required this legislation to be enacted by December 23, 2011, or approximately $1.2 trillion in spending reductions would automatically begin through sequestration on January 1, 2013, split between domestic and defense spending. As no legislation was passed that would achieve the targeted savings outlined in the BCA, payments to Medicare providers have been reduced by 2% from planned levels effective April 1, 2013. In April 2015, congressional committees began deliberations on proposed legislation that would extend sequestration and increase the amount cut by $700 million. If the bill were to become law, it would result in a net effect of increasing the sequester in 2024 beyond the 2% in the BCA.
In July 2016, CMS issued its final rule outlining fiscal year 2017 Medicare payment rates and quality programs for skilled nursing facilities. The policies in the proposed rule continue to shift Medicare payments from volume to value. CMS projects that aggregate payments to skilled nursing facilities will increase by a net 2.4% for fiscal year 2017. This estimate increase reflected a 2.7%

23


market basket increase, reduced by a 0.3% multi-factor productivity (MFP) adjustment required by the Patient Protection and Affordable Care Act (PPACA). This final rule also further defines the skilled nursing facilities Quality Reporting Program and clarifies the Value-Based Purchasing Program to establish performance standards, baseline and performance periods, performance scoring methodology and feedback reports. The Value-Based Purchasing Program final rule specifies the skilled nursing facility 30-day potentially preventable readmission measure, which assesses the facility-level risk standardized rate of unplanned, potentially preventable hospital readmissions for skilled nursing facility patients within 30 days of discharge from a prior admission to a hospital paid under the Inpatient Prospective Payment System, a critical access hospital, or a psychiatric hospital. There is also finalized additional policies related to the Value-Based Purchasing Program including: establishing performance standards; establishing baseline and performance periods; adopting a performance scoring methodology; and providing confidential feedback reports to the skilled nursing facilities.
Therapy Services. There are annual Medicare Part B reimbursement limits on therapy services that can be provided to an individual. The limits impose a $1,940 per patient annual ceiling on physical and speech therapy services, and a separate $1,940 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations and we provide services that are reimbursed under the exceptions process. The exceptions process has been extended several times, most recently in April 2015 by MACRA, which extended this exception process through December 31, 2017. This allows Part B providers to continue delivering therapy services above the current $1,940 threshold for therapy services, provided the services were medically necessary. In addition, the legislation replaced the mandatory medical manual review of therapy claims exceeding the cap with a review process targeting providers with high denial rates and outlier billing patterns, new providers and certain medical conditions within group practices.
Related to the exceptions process discussed above, for services provided with dates of service, providers are required to submit a request for an exception for therapy services above the threshold of $3,700 which will then be manually medically reviewed, consistent with the treatment of these services historically. Similar to the therapy cap exceptions process, the threshold process will have a $3,700 per patient threshold on physical and speech therapy services, and a separate $3,700 per patient threshold on occupational therapy services. The exception reviews were conducted by Medicare Administrative Contractors during this period.
On November 2, 2010, CMS released a final proposed rule as part of the Medicare Physician Fee Schedule (“MPFS”) that was effective January 1, 2011. The policy impacts the reimbursement we receive for Medicare Part B therapy services in our facilities. The policy provides that Medicare Part B pay the full rate for the therapy unit of service that has the highest Practice Expense ("PE") component for each patient on each day they receive multiple therapy treatments. Reimbursement for the second and subsequent therapy units for each patient each day they receive multiple therapy treatments is reimbursed at a rate equal to 75% of the applicable PE component through March 31, 2013. Effective April 1, 2013, the rate at which these services are reimbursed was reduced to 50% of the applicable PE component.
Medicare Part B therapy services in our centers are determined according to MPFS. Annually since 1997, the MPFS has been subject to a Sustainable Growth Rate Adjustment (“SGR”) intended to keep spending growth in line with allowable spending. Each year since the SGR was enacted, this adjustment produced a scheduled negative update to payment for physicians, therapists and other healthcare providers paid under the MPFS. In April 2015, as part of MACRA, Congress passed and the President signed into law the "permanent SGR fix" or "doc fix." Under this legislation, the Medicare formula for establishing physician payment rates was permanently replaced. The permanent fix is expected to remove a substantial annual risk of future payment reductions.
MACRA also extended several other elements of the Middle Class Tax Relief and Job Creation Act of 2012, including the reduction of bad debt treated as an allowable cost. Prior to this act, Medicare reimbursed providers for beneficiaries’ unpaid coinsurance and deductible amounts after reasonable collection efforts at a rate between 70 and 100% of beneficiary bad debt. This provision reduced bad debt reimbursement exposure for all providers to 65%. In addition to the provisions above, the legislation sets that for fiscal year 2018 (October 1, 2017 through September 30, 2018), all Medicare Part B providers will receive inflationary market basket increases no greater than 1%. This provision is expected to reduce Medicare payments to all post-acute providers by approximately $15.4 billion over the 2018-2025 period.
Medicaid
Several states in which we operate face budget shortfalls, which could result in reductions in Medicaid funding for nursing centers. The federal government made an effort to address the financial challenges state Medicaid programs are facing by increasing the amount of Medicaid funding available to states. Pressures on state budgets are expected to continue in the future and are expected to result in Medicaid rate reductions.
We receive the majority of our annual Medicaid rate increases during the third quarter of each year. The rate changes received in 2015, along with increased Medicaid acuity in our acuity based states, were the primary contributor to our 1.5% increase in average rate per day for Medicaid patients in 2016 compared to 2015. Based on the rate changes received during the third quarter of 2015,

24


we have experienced a favorable impact to our rate per day for Medicaid patients due to modest rate increases in many of the states within which we operate.
Effective February 1, 2015, the Company began participating in the Upper Payment Limit ("UPL") supplemental payment program in the state of Indiana that provides supplemental Medicaid payments for skilled nursing facilities that are licensed to non-state government entities such as county hospital districts. One skilled nursing facility previously operated by the Company entered into a transaction with one such hospital providing for the transfer of the license from the Company to the hospital district, and providing further for the Company's operating subsidiaries to retain the management of the facility on behalf of the hospital district, which is participating in the UPL program. The affected operating subsidiary therefore retains operations of its skilled nursing facility and the agreement between the hospital district and the Company is terminable by either party to fully restore the prior license status.
We are unable to predict what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the nine months ended September 30, 2016, we derived 27.2% and 50.4% of our total patient revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability.
We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so. However, private payors, including Managed Care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.
Licensure and Other Health Care Laws
All of our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing centers are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing centers or the addition of new licensed beds to existing centers. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, patient rights, and the physical condition of the center and the adequacy of the equipment used therein. Each center is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the center is subject to various sanctions, including, but not limited to, monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a center receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements.


25


Contractual Obligations and Commercial Commitments
We have certain contractual obligations of continuing operations as of September 30, 2016, summarized by the period in which payment is due, as follows (dollar amounts in thousands):
Contractual Obligations
Total
 
Less than
1  year
 
1 to 3
Years
 
3 to 5
Years
 
After
5 Years
Long-term debt obligations (1)
$
85,248

 
$
10,434

 
$
16,322

 
$
58,492

 
$
—

Settlement obligations (2)
2,286

 
2,286

 
—

 
—

 
—

Elimination of Preferred Stock Conversion feature (3)
1,374

 
687

 
687

 
—

 
—

Operating leases (4)
529,761

 
30,933

 
63,329

 
65,836

 
369,663

Required capital expenditures under operating leases (5)
1,692

 
186

 
372

 
372

 
762

Total
$
620,361

 
$
44,526

 
$
80,710

 
$
124,700

 
$
370,425

 
(1)
Long-term debt obligations include scheduled future payments of principal and interest of long-term debt and amounts outstanding on our capital lease obligations. Our long-term debt obligations increased $10.6 million between December 31, 2015 and September 30, 2016, which is related to our Amended and Restated Credit agreements. See Note 4, "Long-Term Debt and Interest Rate Swap," to the interim consolidated financial statements included in this report for additional information.
(2)
Settlement obligations relate to professional liability cases that are expected to be paid within the next twelve months. The professional liabilities are included in our current portion of self-insurance reserves.
(3)
Payments to Omega Health Investors ("Omega"), from which we lease 35 nursing centers, for the elimination of the preferred stock conversion feature in connection with restructuring the preferred stock and master lease agreements. Monthly payments of approximately $57,000 will be made through the end of the initial lease period that ends in September 2018.
(4)
Represents lease payments under our operating lease agreements. Assumes all renewal periods are enacted. Our operating lease obligations decreased $43.1 million between December 31, 2015 and September 30, 2016, which is related to our purchase of the Clinton and Hutchinson facilities, and termination of the lease for the Avon, Ohio facility.
(5)
Includes annual expenditure requirements under operating leases.
We have employment agreements with certain members of management that provide for the payment to these members of amounts up to two times their annual salary in the event of a termination without cause, a constructive discharge (as defined therein), or upon a change of control of the Company (as defined therein). The maximum contingent liability under these agreements is approximately $1,789,000 as of September 30, 2016. The terms of such agreements are for one year and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our common stock on September 30, 2016, the potential contingent liability for the repurchase of the equity grants is $421,000.


26


Results of Operations
The following tables present the unaudited interim statements of operations and related data for the three and nine month periods ended September 30, 2016 and 2015:
 
(in thousands)
Three Months Ended September 30,
 
2016
 
2015
 
Change
 
%
PATIENT REVENUES, net
$
97,313

 
$
98,105

 
$
(792
)
 
(0.8
)%
EXPENSES:
 
 
 
 
 
 
 
Operating
79,441

 
78,501

 
940

 
1.2
 %
Lease and rent expense
6,865

 
7,198

 
(333
)
 
(4.6
)%
Professional liability
1,977

 
2,069

 
(92
)
 
(4.4
)%
General and administrative
7,420

 
6,378

 
1,042

 
16.3
 %
Depreciation and amortization
1,992

 
1,887

 
105

 
5.6
 %
Total expenses
97,695

 
96,033

 
1,662

 
1.7
 %
OPERATING INCOME (LOSS)
(382
)
 
2,072

 
(2,454
)
 
(118.4
)%
OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Equity in net income of unconsolidated affiliate
130

 
97

 
33

 
34.0
 %
Interest expense, net
(1,201
)
 
(998
)
 
(203
)
 
(20.3
)%
 
(1,071
)
 
(901
)
 
(170
)
 
(18.9
)%
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(1,453
)
 
1,171

 
(2,624
)
 
(224.1
)%
BENEFIT (PROVISION) FOR INCOME TAXES
495

 
(502
)
 
997

 
198.6
 %
INCOME (LOSS) FROM CONTINUING OPERATIONS
$
(958
)
 
$
669

 
$
(1,627
)
 
(243.2
)%
 
(in thousands)
Nine Months Ended September 30,
 
2016
 
2015
 
Change
 
%
PATIENT REVENUES, net
$
291,063

 
$
289,618

 
$
1,445

 
0.5
 %
EXPENSES:
 
 
 
 
 
 

Operating
236,444

 
232,298

 
4,146

 
1.8
 %
Lease and rent expense
20,971

 
21,529

 
(558
)
 
(2.6
)%
Professional liability
5,977

 
6,150

 
(173
)
 
(2.8
)%
General and administrative
21,035

 
18,770

 
2,265

 
12.1
 %
Depreciation and amortization
6,055

 
5,629

 
426

 
7.6
 %
Lease termination costs
2,008

 
—

 
2,008

 
100.0
 %
Total expenses
292,490

 
284,376

 
8,114

 
2.9
 %
OPERATING INCOME (LOSS)
(1,427
)
 
5,242

 
(6,669
)
 
(127.2
)%
OTHER INCOME (EXPENSE):
 
 
 
 
 
 

Equity in net income of unconsolidated affiliate
191

 
280

 
(89
)
 
(31.8
)%
Interest expense, net
(3,429
)
 
(2,997
)
 
(432
)
 
(14.4
)%
Debt retirement costs
(351
)
 
—

 
(351
)
 
(100.0
)%
 
(3,589
)
 
(2,717
)
 
(872
)
 
(32.1
)%
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(5,016
)
 
2,525

 
(7,541
)
 
(298.7
)%
BENEFIT (PROVISION) FOR INCOME TAXES
1,834

 
(1,044
)
 
2,878

 
275.7
 %
INCOME (LOSS) FROM CONTINUING OPERATIONS
$
(3,182
)
 
$
1,481

 
$
(4,663
)
 
(314.9
)%

27


Percentage of Net Revenues
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
PATIENT REVENUES, net
100.0
 %
 
100.0
%
 
100.0
 %
 
100.0
 %
EXPENSES:
 
 
 
 
 
 
 
Operating
81.6

 
80.0

 
81.2

 
80.2

Lease and rent expense
7.1

 
7.3

 
7.2

 
7.4

Professional liability
2.0

 
2.1

 
2.1

 
2.1

General and administrative
7.6

 
6.5

 
7.2

 
6.5

Depreciation and amortization
2.0

 
1.9

 
2.1

 
1.9

Lease termination costs
—

 
—

 
0.7

 
—

Total expenses
100.3

 
97.8

 
100.5

 
98.1

OPERATING INCOME (LOSS)
(0.3
)
 
2.2

 
(0.5
)
 
1.9

OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Equity in net losses of unconsolidated affiliate
0.1

 
0.1

 
0.1

 
0.1

Interest expense, net
(1.2
)
 
(1.0
)
 
(1.2
)
 
(1.0
)
Debt retirement costs
—

 
—

 
(0.1
)
 
—

 
(1.1
)
 
(0.9
)
 
(1.2
)
 
(0.9
)
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
(1.4
)
 
1.3

 
(1.7
)
 
1.0

BENEFIT (PROVISION) FOR INCOME TAXES
0.5

 
(0.5
)
 
0.6

 
(0.4
)
INCOME (LOSS) FROM CONTINUING OPERATIONS
(0.9
)%
 
0.8
%
 
(1.1
)%
 
0.6
 %

28


Three Months Ended September 30, 2016 Compared With Three Months Ended September 30, 2015
Patient Revenues
Patient revenues were $97.3 million and $98.1 million for the three months ended September 30, 2016 and 2015, respectively, a decrease of $0.8 million. The following table summarizes the revenue fluctuations attributable to our portfolio growth (in thousands):
 
Three Months Ended September 30,
 
2016
 
2015
 
Change
Same-store revenue
$
93,041

 
$
95,307

 
$
(2,266
)
2015 acquisition revenue
4,272

 
2,798

 
1,474

Total revenue
$
97,313

 
$
98,105

 
$
(792
)
The overall decrease in revenues of $0.8 million is primarily driven by a decrease in our same-store centers. Declines in census related to Medicare, Medicaid and Managed Care payors resulted in decreased patient revenues by $1.7 million, $0.8 million and $0.5 million, respectively, or 7.6%, 1.8% and 8.0%, respectively. This was partially offset by an increase in Private and Medicaid payor rates, which generated additional revenues of $0.2 million and $0.3 million, respectively, or 2.6% and 0.7%, respectively.
The same-store revenue decrease was offset by incremental contributions from acquisition activity in 2015 of $1.5 million from our centers in Hutchinson, KS, Glasgow, KY, and Fulton, KY.
The following table summarizes key revenue and census statistics for continuing operations for each period:
 
 
Three Months Ended September 30,
 
 
 
2016
 
 
 
2015
 
 
Skilled nursing occupancy
78.1
%
 
 
 
77.5
%
 
 
As a percent of total census:
 
 
 
 
 
 
 
Medicare census
11.4
%
 
 
 
11.9
%
 
 
Medicaid census
68.1
%
 
 
 
67.6
%
 
 
Managed Care census
3.5
%
 
 
 
3.7
%
 
 
As a percent of total revenues:
 
 
 
 
 
 
 
Medicare revenues
27.2
%
 
 
 
27.9
%
 
 
Medicaid revenues
50.4
%
 
 
 
49.9
%
 
 
Managed Care revenues
6.9
%
 
 
 
6.9
%
 
 
Average rate per day:
 
 
 
 
 
 
 
Medicare
$
455.69

 
  
 
$
452.48

 
 
Medicaid
$
169.51

 
  
 
$
168.12

 
 
Managed Care
$
388.25

 
  
 
$
382.52

 
 

29


Operating Expense
Operating expense increased in the third quarter of 2016 to $79.4 million as compared to $78.5 million in the third quarter of 2015. The following table summarizes the expense increases attributable to our portfolio growth (in thousands):
 
Three Months Ended September 30,
 
2016
 
2015
 
Change
Same-store operating expense
$
76,067

 
$
76,081

 
$
(14
)
2015 acquisition expense
3,374

 
2,420

 
954

Total expense
$
79,441

 
$
78,501

 
$
940

Operating expense increased as a percentage of revenue at 81.6% for the third quarter of 2016 as compared to 80.0% for the third quarter of 2015. The increase is driven primarily by the $1.0 million increase in operating costs attributable to the nursing center operations acquired in 2015.
While the $0.9 million increase in operating expenses is attributable to the incremental operating expenses from the 2015 acquisitions, the same store nursing centers experienced a slight decrease in operating expenses during the third quarter of 2016 as compared to the third quarter of 2015. The health insurance premiums and wages increased for the same-store centers by $0.3 million and $0.4 million, respectively. Conversely, the same-store centers' nursing and ancillary costs decreased by $0.5 million and dietary costs decreased by $0.2 million in the third quarter of 2016 as compared to the third quarter of 2015.
Lease Expense
Lease expense decreased in the third quarter of 2016 to $6.9 million as compared to $7.2 million in the third quarter of 2015. The decrease in lease expense was primarily attributable to the purchase of Clinton and Hutchinson in February 2016, and termination of the Avon, Ohio lease in May 2016.
Professional Liability
Professional liability expense was $2.0 million and $2.1 million in the third quarters of 2016 and 2015, respectively. Our cash expenditures for professional liability costs of continuing operations were $1.2 million and $1.7 million for the third quarters of 2016 and 2015, respectively. Professional liability expense and cash expenditures fluctuate from year to year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims. See “Liquidity and Capital Resources” for further discussion of the accrual for professional liability.

General and Administrative Expense
General and administrative expense was $7.4 million in the third quarter of 2016 as compared to $6.4 million in the third quarter of 2015, an increase of $1.0 million, and increased as a percentage of revenue from 6.5% in 2015 to 7.6% in 2016. The increase in general and administrative expense is primarily attributable to an increase in legal and consulting fees by $0.7 million and $0.2 million, respectively, in the third quarter of 2016 compared to the third quarter of 2015, related to acquisition expenses.
Depreciation and Amortization
Depreciation and amortization expense was approximately $2.0 million in the third quarter of 2016 as compared to $1.9 million in 2015. The increase in depreciation expense relates to fixed assets at the newly leased and acquired centers.
Interest Expense, Net
Interest expense was $1.2 million in the third quarter of 2016 and $1.0 million in the third quarter of 2015, an increase of $0.2 million. The increase was primarily attributable to higher debt balances in 2016 as a result of higher outstanding borrowings on the revolving credit facility as a result of the purchase of Hutchinson and Clinton in the first quarter of 2016.
Income (loss) from Continuing Operations before Income Taxes; Income (loss) from Continuing Operations per Common Share
As a result of the above, continuing operations lost $1.5 million before income taxes for the third quarter of 2016 as compared to income of $1.2 million for the third quarter of 2015. The benefit for income taxes was $0.5 million for the third quarter of 2016, as compared to a provision of $0.5 million for the third quarter of 2015. The basic and diluted loss per common share from continuing operations were both $0.16 for the third quarter of 2016 as compared to both basic and diluted income per common share from continuing operations of $0.11 in the third quarter of 2015.

30


Nine Months Ended September 30, 2016 Compared With Nine Months Ended September 30, 2015
Patient Revenues
Patient revenues were $291.1 million and $289.6 million for the nine months ended September 30, 2016 and 2015, respectively, an increase of $1.5 million. The following table summarizes the revenue increases attributable to our portfolio growth (in thousands):
 
Nine Months Ended September 30,
 
2016
 
2015
 
Change
Same-store revenue
$
278,918

 
$
282,005

 
$
(3,087
)
2015 acquisition revenue
12,145

 
7,613

 
4,532

Total revenue
$
291,063

 
$
289,618

 
$
1,445

The overall increase in revenue of $1.5 million is attributable to increased revenue contributions from acquisition activity in 2015 of $4.5 million from our centers in Hutchinson, KS, Glasgow, KY, and Fulton, KY.
The same-store revenues decreased by $3.1 million in 2016 compared to the same period in 2015, primarily driven by a 8.7% and 4.6% decline in Medicare and Managed Care census, respectively, resulting in a decrease in revenue of $6.2 million and $0.8 million, respectively.
The decrease in same-store revenues was partially offset by an increase in the Medicaid and Private payor rates, resulting in an increase in revenue of $1.9 million and $0.7 million, respectively. Hospice census increased revenue by $0.9 million in 2016 compared to 2015, and the Company experienced an increase in Ancillary Services revenue by $0.5 million.
The following table summarizes key revenue and census statistics for continuing operations for each period:
 
 
Nine Months Ended September 30,
 
 
 
2016
 
 
 
2015
 
 
Skilled nursing occupancy
77.2
%
 
 
 
77.1
%
 
 
As a percent of total census:
 
 
 
 
 
 
 
Medicare census
11.7
%
 
 
 
12.6
%
 
 
Medicaid census
68.2
%
 
 
 
66.9
%
 
 
Managed Care census
3.6
%
 
 
 
3.8
%
 
 
As a percent of total revenues:
 
 
 
 
 
 
 
Medicare revenues
27.8
%
 
 
 
29.3
%
 
 
Medicaid revenues
49.7
%
 
 
 
48.3
%
 
 
Managed Care revenues
7.1
%
 
 
 
7.0
%
 
 
Average rate per day:
 
 
 
 
 
 
 
Medicare
$
455.33

 
  
 
$
454.59

 
 
Medicaid
$
168.42

 
  
 
$
165.97

 
 
Managed Care
$
390.71

 
  
 
$
386.63

 
 

31


Operating Expense
Operating expense increased in 2016 to $236.4 million as compared to $232.3 million in 2015. The following table summarizes the expense increases attributable to our portfolio growth (in thousands):
 
Nine Months Ended September 30,
 
2016
 
2015
 
Change
Same-store operating expense
$
226,782

 
$
225,939

 
$
843

2015 acquisition expense
9,662

 
6,359

 
3,303

Total expense
$
236,444

 
$
232,298

 
$
4,146

Operating expense increased as a percentage of revenue at 81.2% for 2016 as compared to 80.2% for 2015. The majority of the $4.1 million increase in operating expenses is attributable to the nursing center operations assumed in 2015, amounting to $3.3 million.
While the $3.3 million increase in operating expenses is attributable to the incremental operating expenses from the 2015 acquisitions, the same-store centers' health insurance premiums increased by $0.8 million. Bad debt and bad debt crossovers expense increased by $0.3 million and $0.3 million, respectively.
The increase in same-store operating expenses was partially offset by a $0.8 million decrease in nursing and ancillary costs in 2016 as compared to the same period in 2015.
Lease Expense
Lease expense decreased in 2016 to $21.0 million as compared to $21.5 million in 2015. The decrease in lease expense was primarily attributable to the purchase of Clinton and Hutchinson in February 2016, and termination of the Avon, Ohio lease in May 2016.
Professional Liability
Professional liability expense was $6.0 million in 2016 compared to $6.2 million in 2015, a decrease of $0.2 million. Our cash expenditures for professional liability costs of continuing operations were $2.8 million and $3.3 million for 2016 and 2015, respectively. Professional liability expense and cash expenditures fluctuate from year to year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims. See “Liquidity and Capital Resources” for further discussion of the accrual for professional liability.

General and Administrative Expense
General and administrative expense was $21.0 million in 2016 as compared to $18.8 million in 2015, an increase of $2.2 million, and increased as a percentage of revenue from 6.5% in 2015 to 7.2% in 2016. The increase in general and administrative expense is primarily attributable to an increase in legal and consulting fees of $1.0 million and $0.4 million, respectively, in 2016 compared to 2015, related to regulatory and acquisition expenses. Additionally, salaries increased by $0.5 million in 2016 compared to 2015.
Depreciation and Amortization
Depreciation and amortization expense was approximately $6.1 million in 2016 as compared to $5.6 million in 2015. The increase in depreciation expense relates to fixed assets at the newly leased and acquired centers.
Lease Termination Costs
Lease termination costs were $2.0 million in 2016 due to the termination of the Avon, Ohio operating lease in May 2016.
Interest Expense, Net
Interest expense was $3.4 million in 2016 and $3.0 million in 2015, an increase of $0.4 million. The increase was primarily attributable to higher debt balances in 2016 as a result of higher outstanding borrowings on the revolving credit facility from the purchase of Hutchinson and Clinton during the first quarter of 2016.

32


Debt retirement costs
Debt retirement costs were $0.4 million in 2016, which relates to the write off of our term loan deferred financing costs, as a result of our debt refinance that took place in February 2016.
Income (loss) from Continuing Operations before Income Taxes; Income (loss) from Continuing Operations per Common Share
As a result of the above, continuing operations lost $5.0 million before income taxes for 2016 as compared to income of $2.5 million in 2015. The benefit for income taxes was $1.8 million for the nine months ended September 30, 2016, as compared to a provision of $1.0 million for the nine months ended September 30, 2015. The basic and diluted loss per common share from continuing operations were both $0.51 for 2016 as compared to both basic and diluted income per common share from continuing operations of $0.24 in 2015.
Liquidity and Capital Resources
Liquidity
Our primary source of liquidity is the net cash flow provided by the operating activities of our centers. We believe that these internally generated cash flows will be adequate to service existing debt obligations, fund required capital expenditures as well as provide cash flows for investing opportunities. In determining priorities for our cash flow, we evaluate alternatives available to us and select the ones that we believe will most benefit us over the long-term. Options for our cash include, but are not limited to, capital improvements, dividends, purchase of additional shares of our common stock, acquisitions, payment of existing debt obligations, preferred stock redemptions as well as initiatives to improve nursing center performance. We review these potential uses and align them to our cash flows with a goal of achieving long-term success.
Net cash provided by operating activities of continuing operations totaled $5.9 million in the nine months ended September 30, 2016, compared to $6.7 million in the same period of 2015.
Our cash expenditures related to professional liability claims of continuing operations were $2.8 million and $3.3 million for nine months ended September 30, 2016 and 2015, respectively. Although we work diligently to limit the cash required to settle and defend professional liability claims, a significant judgment entered against us in one or more legal actions could have a material adverse impact on our cash flows and could result in our being unable to meet all of our cash needs as they become due.
Investing activities of continuing operations used cash of $9.9 million and $8.1 million in 2016 and 2015, respectively. The increase is primarily attributable to the asset purchases of Hutchinson and Clinton in February 2016.
Financing activities of continuing operations provided cash of $6.5 million in 2016 primarily due to draws on the Company's revolving credit facility and the new debt associated with the Company's refinance in February 2016. In 2015, financing activities of continuing operations provided cash of $6.2 million primarily due to draws to fund the acquisition of the Glasgow nursing center.

Dividends
On October 27, 2016, the Board of Directors declared a quarterly dividend of $0.055 per common share payable to shareholders of record as of December 31, 2016, to be paid on January 13, 2017. While the Board of Directors intends to pay quarterly dividends, the Board will make the determination of the amount of future cash dividends, if any, to be declared and paid based on, among other things, the Company’s financial condition, funds from operations, the level of its capital expenditures and its future business prospects and opportunities.
Professional Liability
The Company has professional liability insurance coverage for its nursing centers that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. Effective July 1, 2013, the Company established a wholly-owned, offshore limited purpose insurance subsidiary, SHC Risk Carriers, Inc. (“SHC”), to replace some of the expiring commercial policies. SHC covers losses up to specified limits per occurrence. On a per claim basis, coverage for losses in excess of those covered by SHC are maintained through unaffiliated commercial reinsurance carriers. All of the Company's nursing centers in Florida and Tennessee, as well as the Company’s formerly operated Arkansas and West Virginia facilities, are now covered under the captive insurance policies along with most of the nursing centers in Alabama, Kentucky, Ohio, and Texas. The insurance coverage provided for these centers under the SHC policy include coverage limits of $0.5 million or $1.0 million per medical incident with a sublimit per center of $1.0 million and total annual aggregate policy limits of $5.0 million. All other centers within the Company’s portfolio are covered through various commercial insurance policies which provide coverage limits of $1.0 million per claim and have sublimits of $3.0 million per center, with varying aggregate policy limits and deductibles. 

33


As of September 30, 2016, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred, but unreported claims of $19.9 million. Our calculation of this estimated liability is based on an assumption that the Company will not incur a severely adverse judgment with respect to any asserted claim; however, a significant judgment could be entered against us in one or more of these legal actions, and such a judgment could have a material adverse impact on our financial position and cash flows.
Capital Resources
As of September 30, 2016, we had $70.8 million of outstanding long-term debt and capital lease obligations. The $70.8 million total includes $0.3 million in capital lease obligations and $9.0 million currently outstanding on the revolving credit facility. The balance of the long-term debt is comprised of $61.5 million owed on our mortgage loan, which includes $59.2 million on the term loan facility and $2.3 million on the acquisition loan facility.
On February 26, 2016, the Company executed an Amended and Restated Credit Agreement (the "Credit Agreement") which modified the terms of the Original Mortgage Loan and the Original Revolver Agreements dated April 30, 2013. The Credit Agreement increases the Company's borrowing capacity to $100.0 million allocated between a $72.5 million Mortgage Loan ("Amended Mortgage Loan") and a $27.5 million Revolver ("Amended Revolver"). The Amended Mortgage Loan consists of a $60 million term loan facility and a $12.5 million acquisition loan facility. Loan acquisition costs associated with the Amended Mortgage Loan and the Amended Revolver were capitalized in the amount of $1.8 million and are being amortized over the five-year term of the agreements. Additionally, the Glasgow term loan balance was consolidated into the new Credit Agreement.
Under the terms of the amended agreements, the syndicate of banks provided the Amended Mortgage Loan with an original balance of $72.5 million with a five-year maturity through February 26, 2021, and a $27.5 million Amended Revolver through February 26, 2021. The Amended Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25-year amortization. Interest on the term and acquisition loan facilities are based on LIBOR plus 4.0% and 4.75%, respectively. A portion of the Amended Mortgage Loan is effectively fixed at 5.79% pursuant to an interest rate swap with an initial notional amount of $30.0 million. As of September 30, 2016, the interest rate related to the Amended Mortgage Loan was 4.52%. The Amended Mortgage Loan is secured by seventeen owned nursing centers, related equipment and a lien on the accounts receivable of these centers. The Amended Mortgage Loan and the Amended Revolver are cross-collateralized. The Company’s Amended Revolver has an interest rate of LIBOR plus 4.0% and is secured by accounts receivable and is subject to limits on the maximum amount of loans that can be outstanding under the revolver based on borrowing base restrictions.
As of September 30, 2016, the Company had $9.0 million borrowings outstanding under the Amended Revolver compared to $12.9 million outstanding as of December 31, 2015. The outstanding borrowings on the revolver primarily reflect the Company's approach to accumulated Medicaid and Medicare receivables at recently acquired facilities as these facilities proceed through the change in ownership process with CMS. Annual fees for letters of credit issued under the Amended Revolver are 3.00% of the amount outstanding. The Company has ten letters of credit with a total value of $7.9 million outstanding as of September 30, 2016. Considering the balance of eligible accounts receivable, the letters of credit, the amounts outstanding under the revolving credit facility and the maximum loan amount of $27.5 million, the balance available for borrowing under the Amended Revolver is $7.0 million at September 30, 2016.
On October 3, 2016, the Company executed an Amendment to the Amended and Restated Revolving Loan and Security Agreement, which modifies the terms of the Amended Revolver. The Amendment increases the Company's maximum revolving facility to $52,250,000; provided that the maximum revolving facility be reduced to $42,250,000 on August 1, 2017. The Amendment amends certain provisions to our financial covenants including the following: the minimum Adjusted EBITDA shall not be less than $8,500,000 for the quarter ending September 30, 2016; $9,500,000 for the quarter ending December 31, 2016; $10,000,000 for the quarter ending March 31, 2017; $11,500,000 for the quarter ending June 30, 2017; and $13,000,000 for the quarter ending September 30, 2017 and for each quarter thereafter. Refer to Note 10 to the interim consolidated financial statements for further discussion.
Our lending agreements contain various financial covenants, the most restrictive of which relates to debt service coverage ratios. We are in compliance with all such covenants at September 30, 2016.

34


Our calculated compliance with financial covenants is presented below:
 
 
Requirement
  
Level at
September 30, 2016
Minimum fixed charge coverage ratio
1.00:1.00
 
1.04:1.00
Minimum adjusted EBITDA
$8.5 million
 
$8.7 million
EBITDAR (mortgaged centers)
$10.0 million
 
$13.8 million
Current ratio (as defined in agreement)
1.00:1.00
 
1.34:1.00
As part of the debt agreements entered into in February 2016, we amended our interest rate swap agreement with a member of the bank syndicate as the counterparty. The interest rate swap agreement has the same effective date and maturity date as the Amended Mortgage Loan, and carries an initial notional amount of $30.0 million. The interest rate swap agreement requires us to make fixed rate payments to the bank calculated on the applicable notional amount at an annual fixed rate of 5.79% while the bank is obligated to make payments to us based on LIBOR on the same notional amounts. We entered into the interest rate swap agreement to mitigate the variable interest rate risk on our outstanding mortgage borrowings.
Receivables
Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid or other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.
Accounts receivable attributable to patient services of continuing operations totaled $50.2 million at September 30, 2016 compared to $52.0 million at December 31, 2015, representing approximately 47 days and 45 days revenue in accounts receivable, respectively. The decrease in accounts receivable is due to an increase in Medicaid collections from the centers undergoing the change in ownership process.
The allowance for bad debt was $10.2 million at September 30, 2016 as compared to $8.2 million at December 31, 2015. We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.
Off-Balance Sheet Arrangements
We have ten letters of credit outstanding with an aggregate value of approximately $7.9 million as of September 30, 2016, the first of which serves as a security deposit for our facility lease with Omega in the amount of $4.6 million. The second letter of credit serves our initial funding of insurance policies with a captive insurance company in the amount of $1.0 million. The balance of the outstanding letters of credit relate to deposits at various leased facilities where the Company opted to issue letters of credit as a deposit in lieu of cash. These letters of credit were issued under our revolving credit facility. Our accounts receivable serve as the collateral for this revolving credit facility.

Forward-Looking Statements
The foregoing discussion and analysis provides information deemed by management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those contemplated by the forward-looking statements made herein. Forward-looking statements are predictive in nature and are frequently identified by the use of terms such as "may," "will," "should," "expect," "believe," "estimate," "intend," and similar words indicating possible future expectations, events or actions. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors, many of which are beyond our ability to control or predict, could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not limited to, our ability to successfully integrate the operations of our new nursing centers in Alabama, Mississippi, Kansas and Kentucky, as well as successfully operate all of our centers, our ability to increase census at our renovated centers, changes in governmental reimbursement, including the impact of the CMS final rule that has resulted in a reduction in Medicare reimbursement and our ability to mitigate the impact of the revenue reduction, government regulation, the impact of the recently

35


adopted federal health care reform or any future health care reform, any increases in the cost of borrowing under our credit agreements, our ability to extend or replace our current credit facility, our ability to comply with covenants contained in those credit agreements, the outcome of professional liability lawsuits and claims, our ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of proceedings alleging violations of state or Federal False Claims Acts, laws and regulations governing quality of care or other laws and regulations applicable to our business including HIPAA and laws governing reimbursement from government payors, impacts associated with the implementation of our electronic medical records plan, the costs of investing in our business initiatives and development, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our centers, changing economic and competitive conditions, changes in anticipated revenue and cost growth, changes in the anticipated results of operations, the effect of changes in accounting policies as well as others. Investors also should refer to the risks identified in this “Management's Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part I. Item 1A. Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2015, for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them. These assumptions may not materialize to the extent assumed, and risks and uncertainties may cause actual results to be different from anticipated results. These risks and uncertainties also may result in changes to the Company’s business plans and prospects. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The chief market risk factor affecting our financial condition and operating results is interest rate risk. As of September 30, 2016, we had outstanding borrowings of approximately $70.5 million, $40.8 million of which was subject to variable interest rates. In connection with our February 2016 financing agreement, we entered into an interest rate swap with an initial notional amount of $30.0 million to mitigate the floating interest rate risk of a portion of such borrowing. In the event that interest rates were to change 1%, the impact on future pre-tax cash flows would be approximately $0.4 million annually, representing the impact of increased or decreased interest expense on variable rate debt.

ITEM 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended (the Exchange Act), our management, including our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of September 30, 2016. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act, such as this Quarterly Report on Form 10-Q, is properly recorded, processed, summarized and reported within the time periods required by the Securities and Exchange Commission’s rules and forms. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures that, by their nature, can provide only reasonable assurance regarding management’s control objectives. Management does not expect that its disclosure controls and procedures will prevent all errors and fraud. A control system, irrespective of how well it is designed and operated, can only provide reasonable assurance, and cannot guarantee that it will succeed in its stated objectives.
Based on an evaluation of the effectiveness of the design and operation of disclosure controls and procedures, our chief executive officer and chief financial officer concluded that, as of September 30, 2016, our disclosure controls and procedures were effective in reaching a reasonable level of assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission’s rules and forms.

PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to lawsuits alleging malpractice, negligence, violations of false claims acts, product liability, or related legal theories, many of which involve large claims and significant defense costs. Like many other companies engaged in the long-term care profession in the United States, we have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that we will continue to be subject to such suits as a result of the nature of our business. Further, as with all health care providers, we are periodically subject to regulatory actions seeking fines and penalties for alleged violations of health care laws and are potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws and with respect to the quality of care provided to residents of our facility. Like other health care providers, in the ordinary course of our business, we are also subject to claims made by employees and other disputes and litigation arising from the conduct of our business.
As of September 30, 2016, we are engaged in 62 professional liability lawsuits. Ten lawsuits are currently scheduled for trial or arbitration during the next twelve months, and it is expected that additional cases will be set for trial or hearing. The ultimate results of any of our professional liability claims and disputes cannot be predicted. We have limited, and sometimes no, professional liability insurance with regard to most of these claims. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.
In July 2013, the Company learned that the United States Attorney for the Middle District of Tennessee ("DOJ") had commenced a civil investigation of potential violations of the False Claims Act ("FCA").
In October 2014, the Company learned that the investigation was started by the filing under seal of a false claims action against the two facilities that were the subject of the original CID. In connection with this matter, between July 2013 and early February 2016, the Company has received three civil investigative demands (a form of subpoena) for documents and information relating to our practices and policies for rehabilitation, and other services, our preadmission evaluation forms ("PAEs") required by TennCare and our Pre-Admission Screening and Resident Reviews ("PASRRs"). We have responded to those requests. The DOJ has also

36


issued CID’s for testimony from current and former employees of the Company. The DOJ’s civil investigation of the Company’s practices and policies for rehabilitation now covers all of the Company’s facilities, but thus far only documents from six of our facilities have been requested.
In June 2016, the Company received an authorized investigative demand (a form of subpoena) for documents in connection with a criminal investigation by the DOJ related to our practices with respect to PAEs and PASRRs, and the Company has provided documents responsive to this subpoena. The Company cannot predict the outcome of these investigations or any possible related proceedings, and the outcome could have a materially adverse effect on the Company, including the imposition of damages, criminal charges, fines, penalties and/or a corporate integrity agreement. The Company is committed to provide caring and professional services to its patients and residents in compliance with applicable laws and regulations.
In January 2009, a purported class action complaint was filed in the Circuit Court of Garland County, Arkansas against the Company and certain of its subsidiaries and Garland Nursing & Rehabilitation Center (the “Facility”). The complaint alleges that the defendants breached their statutory and contractual obligations to the patients of the Facility over the five-year period prior to the filing of the complaints. On June 4, 2015, the Supreme Court of Arkansas issued a ruling in a lawsuit against another provider that may impact this action. In that case, the Court ruled that a lawsuit against several facilities formerly operated by Golden Living could proceed as a class action. The lawsuit against the Company remains in its early stages and has not yet been certified by the court as a class action. The Company intends to defend the lawsuit vigorously.
We cannot currently predict with certainty the ultimate impact of any of the above cases on our financial condition, cash flows or results of operations. Our reserve for professional liability expenses does not include any amounts for the pending DOJ investigation or the purported class action against the Arkansas facilities. An unfavorable outcome in any of these lawsuits or any of our professional liability actions, any regulatory action, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could subject us to fines, penalties and damages, including exclusion from the Medicare or Medicaid programs, and could have a material adverse impact on our financial condition, cash flows or results of operations.
ITEM 6. EXHIBITS
The exhibits filed as part of this report on Form 10-Q are listed in the Exhibit Index immediately following the signature page.

37


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
 
 
Diversicare Healthcare Services, Inc.
 
 
 
November 3, 2016
 
 
 
 
 
 
 
By:
 
/s/ Kelly J. Gill
 
 
 
Kelly J. Gill
 
 
 
President and Chief Executive Officer, Principal Executive Officer and
 
 
 
An Officer Duly Authorized to Sign on Behalf of the Registrant
 
 
 
 
By:
 
/s/ James R. McKnight, Jr.
 
 
 
James R. McKnight, Jr.
 
 
 
Executive Vice President and Chief Financial Officer and
 
 
 
An Officer Duly Authorized to Sign on Behalf of the Registrant

38


 
 
 
Exhibit
Number
  
Description of Exhibits
3.1

  
Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement No. 33-76150 on Form S-1).
 
 
3.2

  
Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.5 to the Company’s quarterly report on Form 10-Q for the quarter ended September 30, 2006).
 
 
3.3

  
Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement No. 33-76150 on Form S-1).
 
 
3.4

  
Bylaw Amendment adopted November 5, 2007 (incorporated by reference to Exhibit 3.4 to the Company’s annual report on Form 10-K for the year ended December 31, 2007).
 
 
3.5

  
Amendment to Certificate of Incorporation dated March 23, 1995 (incorporated by reference to Exhibit A of Exhibit 1 to the Company’s Form 8-A filed March 30, 1995).
 
 
3.6

  
Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.4 to the Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2001).
 
 
3.7

 
Certificate of Ownership and Merger of Diversicare Healthcare Services, Inc. with and into Advocat Inc. (incorporated by reference to Exhibit 3.1 to the Company's current report on Form 8-K filed March 14, 2013).
 
 
 
3.8

 
Amendment to Certificate of Incorporation dated June 9, 2016 (incorporated by reference to Exhibit 3.8 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2016).
 
 
 
4.1

 
Form of Common Stock Certificate (incorporated by reference to Exhibit 4 to the Company's Registration Statement No. 33-76150 on Form S-1).
 
 
 
10.1

 
First Amendment to Third Amended and Restated Revolving Loan and Security Agreement dated August 3, 2016 (incorporated by reference to Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2016).
 
 
 
10.2

 
First Amendment to Second Amended and Restated Term Loan and Security Agreement dated August 3, 2016 (incorporated by reference to Exhibit 10.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2016).
 
 
 
10.3

 
Second Amendment to Third Amended and Restated Revolving Loan and Security Agreement dated October 3, 2016.
 
 
 
31.1

  
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).
 
 
31.2

  
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).
 
 
32

  
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b).
 
 
101.INS

  
XBRL Instance Document
 
 
101.SCH

  
XBRL Taxonomy Extension Schema Document
 
 
101.CAL

  
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.LAB

  
XBRL Taxonomy Extension Labels Linkbase Document
 
 
101.PRE

  
XBRL Taxonomy Extension Presentation Linkbase Document


39