Advocat Inc.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

CHECK ONE:


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended: March 31, 2007


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission file No.: 1-12996

Advocat 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)

(Former name, former address and former fiscal year, if changed since last report.)

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

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

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

5,871,287

(Outstanding shares of the issuer’s common stock as of May 1, 2007)

TABLE OF CONTENTS


Part I. FINANCIAL INFORMATION
	ITEM 1 — FINANCIAL STATEMENTS
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 1A. RISK FACTORS
	ITEM 6. EXHIBITS
SIGNATURES
Ex-10.1 Fourth Amendment to Consolidated Amended and Restated Master Lease
Ex-31.1 Section 302 Certification
Ex-31.2 Section 302 Certification
Ex-32 Section 906 Certification

Part I. FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

ADVOCAT INC.

INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands)


	March 31,			December 31,
	2007			2006
	(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents	$	12,428		$	12,344
Restricted cash		25			25
Receivables, less allowance for doubtful accounts of $2,036 and $2,122, respectively		15,971			16,902
Current portion of note receivable		541			534
Prepaid expenses and other current assets		3,223			2,681
Insurance refunds receivable		2,121			3,519
Deferred income taxes		2,410			1,785

Total current assets		36,719			37,790


PROPERTY AND EQUIPMENT, at cost		61,644			59,954
Less accumulated depreciation		(33,618	)		(32,757	)
Discontinued operations, net		1,576			1,576

Property and equipment, net		29,602			28,773


OTHER ASSETS:
Deferred income taxes		20,874			21,849
Note receivable, net of current portion		4,880			4,758
Deferred financing and other costs, net		836			905
Cash restricted for capital expenditures		202			864
Other assets		2,080			1,962

Total other assets		28,872			30,338

	$	95,193		$	96,901

(Continued)

ADVOCAT INC.

INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(continued)


	March 31,			December 31,
	2007			2006
	(Unaudited)
CURRENT LIABILITIES:
Current portion of long-term debt	$	3,277		$	4,587
Current portion of settlement promissory notes		—			128
Short-term debt		2,534			2,534
Trade accounts payable		4,397			4,566
Accrued expenses:
Payroll and employee benefits		8,028			9,363
Current portion of self-insurance reserves		5,270			4,838
Other current liabilities		3,666			3,600

Total current liabilities		27,172			29,616


NONCURRENT LIABILITIES:
Long-term debt, less current portion		23,964			24,267
Self-insurance reserves, less current portion		21,330			22,159
Other noncurrent liabilities		6,655			5,733

Total noncurrent liabilities		51,949			52,159


COMMITMENTS AND CONTINGENCIES

SERIES C REDEEMABLE PREFERRED STOCK
$.10 par value, 5,000 shares authorized, issued and outstanding, including premium of $5,946 and $6,371 at March 31, 2007 and December 31, 2006, respectively.		10,864			11,289


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, 5,871,000 and 5,866,000 shares issued and outstanding, respectively		59			59
Paid-in capital		15,220			15,123
Accumulated deficit		(10,071	)		(11,345	)

Total shareholders’ equity		5,208			3,837

	$	95,193		$	96,901

The accompanying notes are an integral part of these interim consolidated balance sheets.

ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts, unaudited)


	Three Months Ended March 31,
	2007			2006
PATIENT REVENUES, net	$	54,592		$	52,647


EXPENSES:
Operating		41,740			40,090
Lease		4,596			3,825
Professional liability		423			(2,276	)
General and administrative		4,078			3,481
Stock-based compensation		69			—
Depreciation		909			935

Total expenses		51,815			46,055

OPERATING INCOME		2,777			6,592

OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)		47			(9	)
Other income		—			207
Interest income		251			183
Interest expense		(816	)		(999	)

		(518	)		(618	)


INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		2,259			5,974
PROVISION (BENEFIT) FOR INCOME TAXES		879			(729	)


NET INCOME FROM CONTINUING OPERATIONS		1,380			6,703


NET INCOME (LOSS) FROM DISCONTINUED OPERATIONS:
Operating income (loss), net of taxes of $11 and $0, respectively		16			(20	)
Gain (loss) on sale, net of taxes of $(23) and $0, respectively		(35	)		8

DISCONTINUED OPERATIONS		(19	)		(12	)

NET INCOME		1,361			6,691
PREFERRED STOCK DIVIDENDS		86			83


NET INCOME FOR COMMON STOCK	$	1,275		$	6,608


NET INCOME PER COMMON SHARE:
Per common share – basic
Continuing operations	$	0.22		$	1.15
Discontinued operations		0.00			0.00

	$	0.22		$	1.15


Per common share – diluted
Continuing operations	$	0.21		$	1.03
Discontinued operations		0.00			(0.01	)

	$	0.21		$	1.02


WEIGHTED AVERAGE COMMON SHARES:
Basic		5,870			5,740

Diluted		6,126			6,503

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

ADVOCAT INC.

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


	Three Months Ended March 31,
	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	1,361		$	6,691
Discontinued operations		(19	)		(12	)

Net income from continuing operations		1,380			6,703
Adjustments to reconcile net income from continuing operations to net cash provided by operating activities:
Depreciation		909			935
Provision for doubtful accounts		110			339
Deferred income tax provision (benefit)		350			(778	)
Provision for (benefit from) self-insured professional liability, net of cash payments		(472	)		(2,975	)
Stock based compensation		69			—
Amortization of deferred balances		69			51
Provision for leases in excess of cash payments		583			8
Gain on sale of bed license		—			(207	)
Foreign currency transaction gain (loss)		(47	)		9
Non-cash interest expense		—			43
Non-cash interest income		(30	)		(108	)

Net cash provided by operating activities before changes in other assets and liabilities		2,921			4,020
Changes in other assets and liabilities affecting operating activities:
Receivables, net		755			323
Prepaid expenses and other assets		737			(213	)
Trade accounts payable and accrued expenses		(1,532	)		(1,880	)

Net cash provided by continuing operations		2,881			2,250
Discontinued operations		40			176

Net cash provided by operating activities		2,921			2,426


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(1,737	)		(563	)
Proceeds from sale of discontinued operations and bed license		—			268
Decrease in restricted cash deposits		—			275
Decrease in cash restricted for capital expenditures		662			—
Deposits and other deferred balances		—			(29	)

Net cash used by continuing operations		(1,075	)		(49	)
Discontinued operations		—			(10	)

Net cash used by investing activities		(1,075	)		(59	)


CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of debt obligations		(1,617	)		(1,529	)
Proceeds from exercise of stock options		27			4
Payment of preferred stock dividends		(86	)		—
Payment for preferred stock restructuring		(86	)		—
Financing costs		—			(17	)

Net cash used by financing activities		(1,762	)		(1,542	)

(Continued)

ADVOCAT INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2007 AND 2006

1. BUSINESS

Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing center patients in eight states, primarily in the Southeast. The Company’s centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, the Company offers a variety of comprehensive rehabilitation services as well as nutritional support services.

As of March 31, 2007, the Company’s continuing operations consist of 42 nursing centers with 4,405 licensed nursing beds and 66 assisted living units. The Company’s continuing operations include nine owned nursing centers and 33 leased nursing centers. The Company’s continuing operations include centers in Alabama, Arkansas, Florida, Kentucky, Ohio, Tennessee, Texas and West Virginia.

2. BASIS OF PRESENTATION OF FINANCIAL STATEMENTS

The interim consolidated financial statements for the three month periods ended March 31, 2007 and 2006, 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 generally accepted accounting principles 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 March 31, 2007 and the results of operations and cash flows for the three month periods ended March 31, 2007 and 2006. The Company’s consolidated balance sheet at December 31, 2006 was derived from the Company’s audited consolidated financial statements as of December 31, 2006.

The results of operations for the three month periods ended March 31, 2007 and 2006 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 consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

3. INSURANCE MATTERS

Professional Liability and Other Liability Insurance-

Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, the Company has purchased professional liability insurance coverage for its facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.

The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, the Company maintains insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.

Reserve for Estimated Self-Insured Professional Liability Claims-

Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for professional liability and other claims of $25.3 million as of March 31, 2007. 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.

The Company records its estimated liability for these professional liability claims based on the results of a third-party actuarial analysis. Each quarter, amounts are added to the accrual for estimates of anticipated liability for claims incurred during that period. These estimates are assessed and adjusted quarterly as claims are actually reported, as lawsuits are filed, and as those actions are actually resolved. As indicated by the chart of reserves by policy year set forth below, final determination of the Company’s actual liability for claims incurred in any given period is a process that takes years. At each quarter end, the Company records any revisions in estimates and differences between actual settlements and reserves, with changes in estimated losses being recorded in the consolidated statements of income in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period.

Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. 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 quarter. 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.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. A significant judgment entered against the Company in one or more legal actions could have a material adverse impact on the Company’s financial position and cash flows.

The following summarizes the Company’s accrual for professional liability and other claims for each policy year as of the end of the period:


	March 31,		December 31,
	2007		2006
Policy Year End March 9,
2008	$	515,000	$	—
2007		7,780,000		6,992,000
2006		7,555,000		7,629,000
2005		5,212,000		6,042,000
2004		2,660,000		3,228,000
2003 and earlier		1,535,000		1,826,000

	$	25,257,000	$	25,717,000

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. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $0.4 million as of March 31, 2007.

Effective June 30, 2003, the Company entered into workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. The Company accounts for premium expense under these policies based on its estimate of the level of claims expected to be incurred. As of March 31, 2007, the Company has recorded estimated premium refunds due under these programs totaling approximately $2.1 million included in “insurance refunds receivable” in the accompanying balance sheet. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.

The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 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 is $0.9 million at March 31, 2007. The differences between actual settlements and reserves are included in expense in the period finalized.

4. STOCK-BASED COMPENSATION

In March 2007 the Compensation Committee of the Board of Directors approved the grant of 107,700 Stock only Stock Appreciation Rights (“SOSARs”) at an exercise price of $11.59, the market price of the Company’s common stock on the date the SOSARs were granted. The SOSARs will vest one-third on the first, second, and third anniversaries of the grant date.

As a result of the SOSARs granted the Company recorded an additional $45,000 in stock-based compensation expense for the three months ended March 31, 2007. As of March 31, 2007, there was approximately $1,054,000 of remaining compensation costs related to the SOSARs granted to be recognized over the remaining vesting period. The Company estimated the total recognized and unrecognized compensation using the Black-Scholes-Merton (“BSM”) option valuation model.

The table below shows the weighted average assumptions the Company used to develop the fair value estimates for the SOSAR grants.


Expected volatility (range)		133% - 143%
Risk free interest rate (range)		4.45% - 4.46%
Expected dividends		—
Weighted average expected term (years)		6.0

In computing the fair value estimates the exercise price of the SOSARs and the market price of the Company’s stock were both $11.59. The Company used an expected volatility that equals the historical volatility over the most recent period equal to the expected life of the options. The risk free interest rate is based on the U.S. treasury yield curve in effect at the time of grant. The Company used an expected dividend yield of zero since it has not paid cash dividends on its common stock and estimated the options expected term based on the average of the vesting term and the original

contractual terms of the grants, consistent with the interpretive guidance in SAB 107. Once the SOSARs were valued the Company applied an estimated forfeiture rate for awards granted which are not expected to vest.

5. RECLASSIFICATIONS

As discussed in Note 6, the consolidated financial statements of the Company have been reclassified to reflect as discontinued operations certain divestitures and lease terminations.

6. DISCONTINUED OPERATIONS

Effective March 31, 2007 the Company terminated operations at its leased facility in Eureka Springs, Arkansas. The owner of the property, a subsidiary of Omega Healthcare Investors, Inc., sold the property and the Company cooperated in an orderly transition to the new owner.

The facility had low occupancy and operated at a loss. The facility had been leased subject to a master lease covering 29 nursing centers. Under the terms of that lease, the master lease rental payment will not be reduced. This facility accounted for revenues of approximately $586,000 and $540,000 in the three month periods ended March 31, 2007 and 2006, respectively. In 2003, the Company recorded an impairment charge of $178,000 to reduce the book value of this property to its estimated realizable value. The $26,000 net loss on lease termination primarily relates to legal and other costs to facilitate the transaction as well as the transfer of working capital.

In May 2006, the Company completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. In 2005, the Company recorded an impairment charge of $4,397,000 to reduce the net book value of these properties to their estimated realizable value, and no material gain or loss was recognized upon the completion of the sale in 2006. The Company closed its only remaining North Carolina assisted living facility in April 2006 and is continuing its efforts to sell this facility and land.

Each of these facilities and businesses constitute components under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and, accordingly, the Company has reclassified the operations and disposed property of each of these components as discontinued operations for all periods presented in the Company’s consolidated financial statements.

7. EARNINGS PER COMMON SHARE

Information with respect to basic and diluted net income per common share is presented below:


	Three Months Ended
	March 31,
	2007			2006
Net income per common share:
Per common share – basic
Income from continuing operations	$	0.22		$	1.15
Income (loss) from discontinued operations
Operating income, net of taxes		0.01			—
Loss on sale, net of taxes		(0.01	)		—

Discontinued operations, net of taxes		—			—

Net income	$	0.22		$	1.15


	Three Months Ended
	March 31,
	2007			2006
Per common share – diluted
Income from continuing operations	$	0.21		$	1.03
Income (loss) from discontinued operations
Operating income (loss), net of taxes		0.01			(0.01	)
Loss on sale, net of taxes		(0.01	)		—

Discontinued operations, net of taxes		—			(0.01	)

Net income	$	0.21		$	1.02

The impact of the weighted average SOSARs outstanding were not included in the computation of diluted earnings per common share because these securities would have been anti-dilutive due to the effects of stock based compensation charges that will be recognized in future periods. In addition, diluted earnings per common share in 2006 included the impact of 636,000 dilutive shares resulting from the assumed conversion of the Series B Convertible Preferred Stock. In 2006, the Series B Convertible Preferred Stock was exchanged for Series C Preferred Stock, which is not convertible into common shares and, therefore, no convertible preferred stock was outstanding during 2007.

8. LONG-TERM DEBT

As part of the comprehensive refinancing in 2006 with its commercial mortgage lender, Capmark Finance Inc. (“Capmark”), the Company received proceeds of $1.1 million to fund a renovation of a nursing center that is part of the collateral for the mortgage loans. At of March 31, 2007, the remaining loan proceeds restricted for the nursing center renovation, $202,000, are held in an account controlled by the lender and are classified in non-current assets as “cash restricted for capital expenditures” in the accompanying balance sheets. The renovation was completed during 2007 and the remaining restricted proceeds will be applied to the final renovation bills during the second quarter of 2007.

The Term Note is secured by an assignment of a Note Receivable taken in the sale of the Company’s Canadian subsidiary, an assignment of the proceeds from certain workers compensation insurance premium refunds, by certain real estate held for sale, by two owned nursing centers, and by a second mortgage on the seven nursing centers securing the Mortgage Loan. The Term Note requires that any proceeds received upon disposition of any assets securing the Term Note must be paid to Capmark to reduce the balance of the Term Note. During the three months ending March 31, 2007, additional principal payments of $1.5 million were made from such proceeds.

The Company’s debt agreements contain various financial covenants the most restrictive of which relate to cash flow, debt service coverage ratios, liquidity and limits on the payment of dividends to shareholders. The Company is in compliance with such covenants at March 31, 2007.

9. SALE OF BED LICENSE

In January 2006, the Company sold 10 licensed beds which it owned in Kentucky but had not placed in service. The sales price was $260,000, and the Company recognized a gain of $207,000 on the sale, which is included in “other income” in the interim consolidated statements of income for the three months ended March 31, 2006.

10. INCOME TAXES

Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN 48” or “the interpretation”). This interpretation provides guidance on financial statement recognition and measurement of tax positions taken, or

expected to be taken, in tax returns. The initial adoption of the interpretation had no impact on the Company’s financial statements.

In connection with the Canadian Customs and Revenue Agency (“CCRA”) audit of the Canadian 2003 and 2002 federal tax returns of Diversicare Canada Management Services Co., Inc. (“DCMS”), the Company’s Canadian subsidiary sold in 2004, CCRA has proposed certain adjustments to the Company’s tax returns. Under the terms of the sale of DCMS, the Company is liable for any liability that arises from these adjustments.

As of January 1, 2007, the amount of unrecognized tax benefits was $648,000, including $102,000 of related accrued interest and $0 penalties. The unrecognized tax benefits are accrued in “other current liabilities” as we anticipate settling the matter during 2007.

The Company has chosen to classify interest and penalties as a component separate from income tax expense on the income statements.

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

Overview

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.

As of March 31, 2007, our continuing operations consist of 42 nursing centers with 4,405 licensed nursing beds and 66 assisted living units. As of March 31, 2007, our continuing operations included nine owned nursing centers and 33 leased nursing centers.

Divestitures. We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. Effective March 31, 2007, we terminated our operations at a leased facility in Arkansas. The owner of the facility sold the property and we cooperated in an orderly transition to the new owner. In May 2006, we completed the sale of certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. We closed one remaining North Carolina assisted living facility in April 2006, and are continuing our efforts to sell this facility and land.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.

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, 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 depreciation and interest 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 requiring estimates about the effect of matters that are inherently uncertain. Our accounting policies that fit this definition include the following:

Revenues

Patient Revenues

The fees we charge patients in our nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Rates under federal and state-funded programs are determined prospectively for each facility and may be based on the acuity of the care and services provided. These rates may be based on facility’s actual costs subject to program ceilings and other limitations or on established rates based on acuity and services provided as determined by the federal and state-funded programs. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the

third-party payors which may result in retroactive adjustments. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Retroactive adjustments, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.

Allowance for Doubtful Accounts

Our allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. We monitor these factors and determine the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of income in the period identified.

Professional Liability and Other Self-Insurance Reserves

Self-insurance reserves primarily represent the accrual for self-insured risks associated with general and professional liability claims, employee health insurance and workers compensation. Our health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. Our workers compensation reserve relates primarily to periods of self insurance prior to May 1997 and consists of an estimate of the future costs to be incurred for the known claims. Expected insurance coverages are reflected as a reduction of the reserves. All of our self-insurance reserves are assessed and adjusted on a quarterly basis.

Accrual for Professional and General Liability Claims-

Because our actual liability for existing and anticipated professional liability and general liability claims will exceed our limited insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $25.3 million as of March 31, 2007. 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 related legal costs incurred and expected to be incurred. All losses are projected on an undiscounted basis.

We retain a third-party actuarial firm to estimate the appropriate accrual for incurred general and professional liability claims. For current periods, the actuary primarily uses historical data regarding the frequency and cost of our past claims over a multi-year period and information regarding our number of occupied beds to develop its estimates of our ultimate professional liability cost for current periods. The actuary estimates our professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period.

On a quarterly basis, we obtain reports of claims and lawsuits that we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by us and provided to the actuary. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular prior period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years. For

information regarding the amount of accrual by period, see Note 3, “Insurance Matters,” in the Notes to the Interim Consolidated Financial Statements.

Although we retain a third-party actuarial firm to assist us, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, our 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 quarter. Many factors could result in differences between amounts estimated and the ultimate amount of our loss for any period. One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. This assumption may not prove accurate, as changes in legislation such as tort reform, changes in our financial condition, changes in our risk management practices and other factors may affect the severity and frequency of claims incurred in future periods as compared to historical claims. Another key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on our historical data. While most of our claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, we have not experienced an uninsured loss in excess of this limit. In the event that we believe we have incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.

We believe that the use of actuarial methods described above provides a valid and reasonable method to estimate our liability for professional and general liability claims and that the expertise of a third- party actuary is required to estimate liabilities using this methodology.

Each quarter, we record in our consolidated statement of operations for that period the estimated accrual for anticipated liability claims incurred in that period as well as any revisions in estimates and differences between actual settlements and accruals for prior periods. While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect our cash position because the accrual for these liabilities is not funded. 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.

Professional liability costs are material to our financial position, and differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. The liability recorded at March 31, 2007, was $25.3 million, compared to current assets of $36.7 million and total assets of $95.2 million. For the three months ended March 31, 2007 and 2006, our professional liability expense was $0.4 million and negative $2.3 million, respectively, with the negative amount representing net benefits resulting from downward revisions in previous estimates. These amounts are material in relation to our reported net income from continuing operations for the related periods of $1.4 million and $6.7 million, respectively.

Accrual for Other Self-Insured Claims-

With respect to workers’ compensation insurance, substantially all of our employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. We are completely self-insured for workers compensation exposures prior to May 1997. We have been and remain a non-subscriber to the Texas workers’ compensation system and are, therefore, completely self-insured for employee injuries with respect to our Texas operations. We have provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability we recorded for the self-insured obligations under these plans is $0.4 million as of March 31, 2007.

Effective June 30, 2003, we entered into workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred. As of March 31, 2007, we have recorded estimated premium refunds due under these programs totaling approximately $2.1 million, included in “insurance refunds receivable” in the accompanying balance sheet. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.

We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. We provide 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 is $0.9 million at March 31, 2007. The differences between actual settlements and reserves are included in expense in the period finalized.

Asset Impairment

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the recoverability of the carrying values of our properties on a property by property basis. On a quarterly basis, we review our properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.

Stock-Based Compensation

We account for our stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment,” using the modified prospective method, in which we recognize compensation cost for all share-based payments granted after the effective date, January 1, 2006. We record stock-based compensation expense by amortizing our unrecognized stock-based compensation on a straight-line basis over the remaining vesting period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton option valuation method, which requires us to use certain key assumptions to develop the fair value estimates. These key assumptions include expected volatility, risk-free interest rate, expected dividends and expected term.

Income Taxes

We follow SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. We assess the need for a valuation allowance to reduce the deferred tax assets by the amount we believe is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations.

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 statutes 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. We are involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact us.

Medicare and Medicaid Reimbursement-

A significant portion of our revenues is derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, 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.

The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment system for nursing centers and contained numerous Medicare and Medicaid cost-saving measures. As initially implemented, the BBA negatively impacted the entire long-term care industry. During 1999 and 2000, certain amendments to the BBA were enacted, which helped restore some of the Medicare funding originally eliminated under the BBA. However, certain provisions in the amendments expired on September 30, 2002 and December 31, 2005.

In 2005, the Centers for Medicare and Medicaid Services (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment designed to increase reimbursement for the effects of inflation. The actual amount of the market basket adjustments is adjusted based on various factors. The market basket adjustment that became effective October 1, 2006 resulted in an estimated average increase of approximately 2.1% for our facilities as a group, and increased our revenue by approximately $0.1 million per month.

Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations, and the majority of services provided by us are reimbursed under the exceptions. On December 9, 2006, Congress passed the Tax Relief and Health Care Act of 2006 (TRHCA), which includes an extension of the existing exceptions process through December 31, 2007. If the exception process is discontinued after 2007, it is expected that the reimbursement

limitations will reduce therapy revenues, and negatively impact our operating results and cash flows.

The Federal Deficit Reduction Act of 2005 mandates reducing by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on the Company.

The TRHCA passed by Congress on December 9, 2006 reduces the maximum federal matching under Medicare provider assessments to 5.5% of aggregate Medicaid outlays. This reduction in funding will become effective for fiscal years beginning after January 1, 2008. The Congressional action eliminated a regulatory effort proposed by the President’s proposed fiscal year 2007 federal budget to reduce the allowable federal matching share from 6% to 3%. The new law is expected to have an adverse effect in those states where the tax percentage exceeds 5.5%. The budget proposed by President Bush for the government’s 2007 fiscal year includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to eliminate certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which the Company operates. In the event the Federal government reduces the amount of state funding eligible for the Federal matching program, there will be pressure on the states to reduce current reimbursement levels. If the states reduce the Medicaid reimbursement in response to any Federal action, it is expected that the reduction in revenues would have a material effect on the Company’s operating results. The Company is unable to quantify the impact that these possible reimbursement cuts would have on it.

Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the three months ended March 31, 2007, we derived 32.3% and 55.6% of our total patient and resident 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 are unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on our operations.

We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. 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 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 homes are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. 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, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility 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 facility 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 facility 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.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of March 31, 2007, summarized by the period in which payment is due, as follows (dollar amounts in thousands):


			Less than		2 to 3		4 to 5		After
Contractual Obligations	Total		1 year		Years		Years		5 Years
Long-term and short-term debt obligations ⁽¹⁾	$	39,204	$	8,356	$	6,604	$	24,244	$	—
Other settlement obligations	$	523	$	523	$	—	$	—	$	—
Series C Preferred Stock ⁽²⁾	$	6,123	$	344	$	689	$	5,090	$	—
Elimination of Preferred Stock Conversion feature ⁽³⁾	$	7,898	$	687	$	1,374	$	1,374	$	4,463
Operating leases	$	497,340	$	16,378	$	34,451	$	33,243	$	413,268
Required capital expenditures under mortgage loans ⁽⁴⁾	$	1,276	$	400	$	549	$	327	$	—
Required capital expenditures under operating leases ⁽⁵⁾	$	20,997	$	775	$	1,543	$	1,377	$	17,302

Total	$	573,361	$	27,463	$	45,210	$	65,655	$	435,033


⁽¹⁾		Long-term and short-term debt obligations include scheduled future payments of principal and interest of long-term and short-term debt.

⁽²⁾		Series C Preferred Stock includes quarterly dividend payments and redemption value at preferred shareholder’s earliest redemption date.

⁽³⁾		Payments for the elimination of preferred stock conversion feature.

⁽⁴⁾		Includes expenditure requirements for capital maintenance under mortgage loan covenants as well as $0.2 million for planned facility renovation in accordance with loan agreement.

⁽⁵⁾		Includes capital 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 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.8 million. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, these 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 exercise price. Based on the closing price of our stock on March 31, 2007, the maximum contingent liability for the repurchase of the currently vested options is approximately $2.1 million. No amounts have been accrued for this contingent liability.

Results of Operations

The following tables present the unaudited interim statements of income and related data for the three month periods ended March 31, 2007 and 2006:


	Three Months Ended March 31,
(in thousands)	2007			2006			Change			%
PATIENT REVENUES, net	$	54,592		$	52,647		$	1,945			3.7

EXPENSES:
Operating		41,740			40,090			1,650			4.1
Lease		4,596			3,825			771			20.2
Professional liability		423			(2,276	)		2,699			(118.6	)
General and administrative		4,078			3,481			597			17.2
Stock-based compensation		69			—			69			N/A
Depreciation		909			935			(26	)		(2.8	)

Total expenses		51,815			46,055			5,760			12.5

OPERATING INCOME		2,777			6,592			(3,815	)		(57.9	)

OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)		47			(9	)		56			(622.2	)
Other income		—			207			(207	)		(100.0	)
Interest income		251			183			68			37.2
Interest expense		(816	)		(999	)		183			(18.3	)

		(518	)		(618	)		100			(16.2	)

INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		2,259			5,974			(3,715	)		(62.2	)
PROVISION (BENEFIT) FOR INCOME TAXES		879			(729	)		1,608			(220.6	)

NET INCOME FROM CONTINUING OPERATIONS	$	1,380		$	6,703		$	(5,323	)		(79.4	)


	Three Months Ended
	March 31,
*Percentage of Net Revenues*	2007			2006
PATIENT REVENUES, net		100.0	%		100.0	%

EXPENSES:
Operating		76.4			76.1
Lease		8.4			7.3
Professional liability		0.8			(4.3	)
General and administrative		7.5			6.6
Stock-based compensation		0.1			—
Depreciation		1.7			1.8

Total expenses		94.9			87.5

OPERATING INCOME		5.1			12.5

OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)		0.1			—
Other income		—			0.4
Interest income		0.4			0.3
Interest expense		(1.5	)		(1.9	)

		(1.0	)		(1.2	)

INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		4.1			11.3
PROVISION (BENEFIT) FOR INCOME TAXES		1.6			(1.4	)

NET INCOME FROM CONTINUING OPERATIONS		2.5	%		12.7	%

Three Months Ended March 31, 2007 Compared With Three Months Ended March 31, 2006

As noted in the overview, we have entered into several divestiture transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.

Patient Revenues. Patient revenues increased to $54.6 million in 2007 from $52.6 million in 2006, an increase of $2.0 million, or 3.7%. The increase in patient revenues is due to increased Medicare utilization, increased Medicaid rates in certain states and Medicare rate increases. The average rate of occupancy at the Company’s nursing centers was 78.3% in 2007 compared to 78.4% in 2006. As a percentage of total census, Medicare days increased to 14.8% in 2007 from 14.5% in 2006. Medicare revenues were 32.3% of patient revenue in 2007 and 31.3% in 2006, while Medicaid and similar programs were 55.6% in 2007 compared to 55.4% in 2006.

The Company’s average rate per day for Medicare Part A patients increased to $339.21 in 2007 from $321.53 in 2006, an increase of 5.5%. This increase was the result of annual inflation adjustments and the acuity levels of Medicare patients in our nursing centers, which were higher in the first quarter of 2007 than in 2006. Our average rate per day for Medicaid patients increased to $137.21 in 2007 from $132.37 in 2006, an increase of 3.7%.

Operating expense. Operating expense increased to $41.7 million in 2007 from $40.1 million in 2006, an increase of $1.6 million, or 4.1%. As a percentage of patient revenues, operating expense was approximately 76.4% of revenue in 2007, compared to 76.1% of revenue in 2006. The increase in operating expense is primarily attributable to cost increases related to wages and benefits.

The largest component of operating expenses is wages, which increased to $24.8 million in 2007 from $23.4 million in 2006, an increase of $1.4 million, or 5.8%. This increase is primarily attributable to an increase in wages as a result of increased costs of nursing care associated with the higher Medicare census and competitive labor markets in most of the areas in which we operate, and regular merit and inflationary raises for personnel. Wage rate increases averaged approximately 3.7% for the period, increasing wages approximately $0.9 million.

These costs were partially offset by reductions in workers compensation costs and bad debt expense. Costs of workers compensation insurance were approximately $0.2 million lower in 2007 compared to 2006. We have had better than expected claims experience, allowing us to reduce the cost of workers compensation insurance. Bad debt expense was $0.2 million lower in 2007 compared to 2006.

The remaining increases in operating expense are primarily due to the effects of increases in Medicare census.

Lease expense. Lease expense increased to $4.6 million in 2007 from $3.8 million in 2006. Effective October 1, 2006, we renewed a master lease covering 29 nursing centers. This resulted in an increase in lease expense of $0.6 million during 2007 for the effects of recording scheduled rent increases on a straight-line basis over the term of the renewal period. This increase has no effect on cash rent payments at the start of the lease term, and will only result in additional cash outlay as the 3 percent annual increases take effect each year. In addition, there was an increase in lease expense of $0.1 million resulting from rent increases for lessor funded property renovations.

Professional liability. Professional liability expense in 2007 resulted in a net expense of $0.4 million, compared to a benefit of $2.3 million in 2006, an increase in expense of $2.7 million. Our cash expenditures for professional liability costs were $0.7 million and $0.5 million for the three month periods ended March 31, 2007 and 2006, respectively. During 2007, our total recorded

liabilities for self-insured professional liability risks declined to $25.3 million, down from $25.7 million at December 31, 2006.

General and administrative expense. General and administrative expense increased to $4.1 million in 2007 from $3.5 million in 2006, an increase of $0.6 million or 17.2%. The increase is primarily attributable to increased compensation costs of $0.4 million and costs of compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 of $0.1 million. The majority of our costs of Sarbanes-Oxley compliance were incurred in the third and fourth quarters of 2006.

As a percentage of total net revenues, general and administrative expense was approximately 7.5% in 2007 and 6.6% and 2006.

Stock-based compensation. During 2007, we recorded stock-based compensation expense of $69,000. There was no stock-based compensation in the first quarter of 2006.

Depreciation. Depreciation expense was approximately $0.9 million in both 2007 and 2006.

Foreign currency transaction gain (loss). A foreign currency transaction gain of $47,000 was recorded in 2007, compared to a loss of $9,000 in 2006. These gains and losses result from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004.

Interest expense. Interest expense decreased to $0.8 million in 2007 from $1.0 million in 2006, a decrease of $0.2 million or 18.3%. Interest expense decreased as a result of payments of debt from proceeds of the sale of discontinued operations, principal payments made in connection with a refinancing transaction in August 2006, and other principal payments. These decreases were partially offset by interest rate increases on our variable rate debt.

Income from continuing operations before income taxes; income from continuing operations per common share. As a result of the above, continuing operations reported income before income taxes of $2.3 million in 2007 compared to income before income taxes of $6.0 million in 2006. The provision for income taxes was $0.9 million in 2007, compared to a benefit for income taxes of $0.7 million in 2006. Our effective tax rate differs materially from the statutory rate in 2006 mainly due to changes in our valuation allowance for net deferred tax assets. For the year ended December 31, 2006, we recorded a deferred tax benefit of approximately $9.7 million to reduce deferred tax asset valuation allowances, based on improvements in our financial position and our updated forecast of income available to support the turnaround of existing net operating loss carryforward credits. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. The basic and diluted income per common share from continuing operations were $0.22 and $0.21, respectively, in 2007, as compared to a basic and diluted income per common share from continuing operations of $1.15 and $1.03, respectively, in 2006.

Income from discontinued operations. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed several divestitures, and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. Operating income of discontinued operations, net of taxes, was approximately $16,000 in 2007, compared to a loss from discontinued operations of $20,000 in 2006. The disposition of discontinued operations and completions of lease terminations resulted in a loss of $35,000, net of taxes, in the first quarter of 2007, compared to a gain of $8,000 recorded in the first quarter of 2006.

Liquidity and Capital Resources

As of March 31, 2007, we had $29.8 million of outstanding borrowings, including $2.5 in short-term debt and current scheduled payments of long-term debt of $3.3 million. The majority of the current scheduled payments of long-term debt consist of payments required by our loan agreements from

anticipated proceeds from the liquidation of collateral securing debt. During the three months ending March 31, 2007, additional principal payments of $1.5 million were made from such proceeds.

On August 7, 2006, we entered into an agreement with our commercial mortgage lender, Capmark Finance Inc. (“Capmark”), for a comprehensive refinancing of our long term debt. Under the terms of the new agreement, Capmark provided mortgage debt of approximately $22.5 million with a five year maturity and a term note of approximately $8.1 million with a four year maturity to refinance our remaining mortgage and bank term debt. At March 31, 2007, the outstanding balance under the mortgage debt was $22.4 million and the interest rate on the mortgage debt was 9.07% as of March 31, 2007. At March 31, 2007, the outstanding balance under the term note was $4.9 million and the interest rate was 11.57%.

As of March 31, 2007, we had no borrowings under our working capital line of credit. The maximum outstanding balance of the working capital line of credit is $2.3 million. There are certain limitations based on borrowing base restrictions. The working capital line of credit matures in January 2008 with interest at either LIBOR plus 2.5% or the bank’s prime rate plus 0.50% (up to a maximum of 9.5%).

We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. Due to our past claim experience and increasing cost of claims throughout the long-term care industry, the premiums paid by us for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, we are effectively self-insured and expect to remain so for the foreseeable future.

We have essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2007. For claims made during the period from March 10, 2007 through March 9, 2008, we maintain insurance coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.

As of March 31, 2007, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $25.3 million. 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. Future committed settlements total $0.5 million, and are payable in the second quarter of 2007. Settlements of currently pending claims will require additional cash expenditures.

Net cash provided by operating activities of continuing operations before changes in other assets and liabilities totaled $2.9 million and $4.0 million in the three month periods ended March 31, 2007 and 2006, respectively. These amounts primarily represent the cash flows from net operations. The effects of working capital changes were to use $40,000 and $1.7 million of cash, respectively, in the three month periods ended March 31, 2007 and 2006, resulting in net cash provided by continuing operations of $2.9 million and $2.3 million in the three month periods ended March 31, 2007 and 2006, respectively. Discontinued operations provided cash of $40,000 and $176,000 in the three month periods ended March 2007 and 2006, respectively.

Investing activities of continuing operations used cash of $1.1 million and $49,000 in the three month periods ended March 31, 2007 and 2006, respectively. These amounts primarily represent

cash used for purchases of property, plant and equipment. We have used between $3.0 million and $4.1 million for capital expenditures of continuing operations in each of the three calendar years ending December 31, 2006. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2007, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will be higher as we complete facility renovations at certain owned facilities. Investing activities of discontinued operations used no cash in the first quarter of 2007 and $10,000 in cash in the first quarter of 2006.

Financing activities of continuing operations used cash of $1.8 million and $1.5 million in the three month periods ended March 31, 2007 and 2006, respectively. The use of funds primarily represents payments to retire existing debt. There were no cash flows from financing activities of discontinued operations in 2007 or 2006. No interest costs or debt were allocated to discontinued operations.

Facility Renovations

After a strategic review, we determined that renovating certain facilities offered the opportunity to improve occupancy, quality of care and profitability. We developed a plan to identify those facilities with the greatest potential for benefit, and began the renovation program during 2005. Renovation projects on four facilities were completed during 2006. We completed two additional projects in the first quarter of 2007, and management is currently developing plans to begin additional facility renovations.

A total of $7.3 million has been spent on these renovation programs to date, with $5.6 million spent on facilities leased from Omega and $1.7 million spent on owned facilities. The amounts spent on the facilities leased from Omega are financed through increased rent, and are not reflected as capital expenditures.

For the four facilities with renovations completed before the beginning of the first quarter 2007, first quarter occupancy improved from 64.5% in 2006 to 71.1% in 2007, and Medicare census as a percent of total increased from 14.2% in 2006 to 17.2% in 2007. No assurance can be given that these facilities will continue to show such occupancy or revenue mix improvement or that the other renovated facilities will experience similar improvements.

West Virginia Facility Option Agreement

We have entered into an option agreement to purchase certain assets of a skilled nursing facility in West Virginia. We recently made an application to state regulatory authorities to allow us to operate the facility, and construct a new 90 bed replacement facility. In the event our application is approved, we will seek to arrange financing and begin construction of the replacement facility.

Receivables

Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid and 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 $17.6 million at March 31, 2007, compared to $18.5 million at December 31, 2006, representing approximately 29 and 31 days in accounts receivable at each period end, respectively.

The allowance for bad debt was $2.0 million at March 31, 2007, compared to $2.1 million at December 31, 2006. 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.

Inflation

We do not believe that our operations have been materially affected by inflation. We expect salary and wage increases for our skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157; “Fair Value Measurements” (“SFAS No. 157”). This new standard provides guidance for using fair value to measure assets and liabilities and establishes a fair value hierarchy that prioritizes the information used to develop the measurements. Statement 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The provisions of Statement 157 are effective for entities as of the beginning of a fiscal year that begins after November 15, 2007. Earlier application is permitted, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any financial statements for an interim period within that fiscal year. We do not expect the adoption of this new standard to have a material impact on our financial position.

In February 2007, the FASB issued SFAS No. 159; “The Fair Value Option for Financial Assets and Financial Liabilities – including an Amendment of FASB Statement No. 115”(“SFAS No. 159”). This new standard permits entities to choose to measure many financial instruments and certain other items at fair value. Most provisions of SFAS No. 159 will only impact those entities that elect the fair value option or have investments accounted for under FASB Statement No. 115. The provisions of Statement 159 are effective for entities as of the beginning of a fiscal year that begins after November 15, 2007. Earlier application is permitted, provided that the reporting entity also elects to apply the provisions of SFAS No. 157. We do not expect the adoption of this new standard to have a material impact on our financial position.

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 Annual Report on Form 10-K for the year ended December 31, 2006. 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. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not limited to, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under our credit agreements, 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 regulatory proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities, changing economic conditions 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 our Form 10-K for the year ended December 31, 2006 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 March 31, 2007, we had outstanding borrowings of approximately $29.8 million, including $2.5 million in fixed-rate borrowings and $27.3 million in variable-rate borrowings. In the event that interest rates were to change 1%, the impact on future cash flows would be approximately $0.3 million annually, representing the impact of increased or decreased interest expense on variable rate debt.

We have a note receivable denominated in Canadian dollars related to the sale of our Canadian operations. This note is currently recorded on our balance sheet at $5.4 million US based on the outstanding balance of the note and the exchange rate as of March 31, 2007. The carrying value of the note in our financial statements will be increased or decreased each period based on fluctuations in the exchange rate between US and Canadian currencies, and the effect of such changes will be included as income or loss in our statement of operations in the period of change. In the three month periods ended March 31, 2007 and 2006, we reported transaction gains (losses) of $47,000 and $(9,000), respectively, as a result of the effect of changes in the currency exchange rates on this note. A further change of 1% in the exchange rate between US and Canadian currencies would result in a corresponding increase or decrease to earnings of approximately $54,000.

ITEM 4. CONTROLS AND PROCEDURES

Advocat, with the participation of our principal executive and financial officers has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of March 31, 2007. Based on this evaluation, the principal executive and financial officers have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal control over financial reporting that has occurred during our fiscal quarter ended March 31, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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 an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and we are no exception in this regard. 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.

As of March 31, 2007, we are engaged in 15 professional liability lawsuits. One of these matters is currently scheduled for trial within the next year. 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.

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. An unfavorable outcome in any of the lawsuits, 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 have a material adverse impact on our financial condition, cash flows or results of operations and could also subject us to fines, penalties and damages. Moreover, we could be excluded from the Medicare, Medicaid or other state or federally-funded health care programs, which would also have a material adverse impact on our financial condition, cash flows or results of operations.

ITEM 1A. RISK FACTORS

Information regarding risk factors appears in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Forward-Looking Statements,” in Part I — Item 2 of this Form 10-Q and in “Risk Factors” in Part I — Item 1A of our Report on Form 10-K for the fiscal year ended December 31, 2006. There have been no material changes from the risk factors previously disclosed in our Report on Form 10-K.

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.


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		Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement No. 33-76150 on Form S-1)
3.3		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)
3.4		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)
3.5		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).
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)
4.2		Amended and Restated Rights Agreement dated as of December 7, 1998 (incorporated by reference to Exhibit 1 to Form 8-A/A filed December 7, 1998)
10.1		Fourth Amendment to Consolidated Amended and Restated Master Lease executed and delivered as of April 1, 2007 by and between Sterling Acquisition Corp., a Kentucky corporation, and Diversicare Leasing Corp., a Tennessee corporation.
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).


	Three Months Ended March 31,
	2007		2006
NET INCREASE IN CASH AND CASH EQUIVALENTS	$	84	$	825

CASH AND CASH EQUIVALENTS, beginning of period		12,344		7,070


CASH AND CASH EQUIVALENTS, end of period	$	12,428	$	7,895


SUPPLEMENTAL INFORMATION:
Cash payments of interest	$	707	$	913


Cash payments of income taxes	$	176	$	140


		ADVOCAT INC.
May 9, 2007
	By:	/s/ William R. Council, III William R. Council, III
		President and Chief Executive Officer, Principal Executive
		Officer and
		An Officer Duly Authorized to Sign on Behalf of the Registrant

	By:	/s/ L. Glynn Riddle, Jr. L. Glynn Riddle, Jr.
		Executive Vice President and Chief Financial Officer, Secretary,
		Principal Accounting Officer and
		An Officer Duly Authorized to Sign on Behalf of the Registrant

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