Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2006

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 number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   61-1323993

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

680 South Fourth Street  
Louisville, KY   40202-2412
(Address of principal executive offices)   (Zip Code)

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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.

 

Large accelerated filer  þ   Accelerated filer  ¨   Non-accelerated filer  ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class of Common Stock

 

Outstanding at October 31, 2006

Common stock, $0.25 par value   39,874,429 shares

 


 

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Table of Contents

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX

 

          Page

PART I.

   FINANCIAL INFORMATION   
Item 1.   

Financial Statements:

  
  

Condensed Consolidated Statement of Operations — for the three months ended
September 30, 2006 and 2005 and for the nine months ended September 30, 2006
and 2005

   3
  

Condensed Consolidated Balance Sheet — September 30, 2006 and December 31, 2005

   4
  

Condensed Consolidated Statement of Cash Flows — for the three months ended
September 30, 2006 and 2005 and for the nine months ended September 30, 2006
and 2005

   5
  

Notes to Condensed Consolidated Financial Statements

   6
Item 2.   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   24
Item 3.   

Quantitative and Qualitative Disclosures About Market Risk

   42
Item 4.   

Controls and Procedures

   43

PART II.

   OTHER INFORMATION   
Item 1.   

Legal Proceedings

   44
Item 6.   

Exhibits

   45

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Revenues

   $ 1,058,892     $ 951,265     $ 3,163,616     $ 2,881,499  
                                

Salaries, wages and benefits

     589,753       520,875       1,734,568       1,544,846  

Supplies

     170,815       144,914       502,007       415,519  

Rent

     81,252       66,457       225,466       197,553  

Other operating expenses

     176,546       159,417       524,245       475,238  

Depreciation and amortization

     32,046       25,916       89,720       73,852  

Interest expense

     4,667       1,931       10,850       6,370  

Investment income

     (3,530 )     (2,471 )     (10,665 )     (7,849 )
                                
     1,051,549       917,039       3,076,191       2,705,529  
                                

Income from continuing operations before reorganization items and income taxes

     7,343       34,226       87,425       175,970  

Reorganization items

                       (1,371 )
                                

Income from continuing operations before income taxes

     7,343       34,226       87,425       177,341  

Provision for income taxes

     3,774       13,809       37,680       71,389  
                                

Income from continuing operations

     3,569       20,417       49,745       105,952  

Discontinued operations, net of income taxes:

        

Income (loss) from operations

     (757 )     (916 )     6,850       13,859  

Gain (loss) on divestiture of operations

     126       (3,147 )     (25 )     (500 )
                                

Net income

   $ 2,938     $ 16,354     $ 56,570     $ 119,311  
                                

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 0.09     $ 0.54     $ 1.27     $ 2.84  

Discontinued operations:

        

Income (loss) from operations

     (0.02 )     (0.03 )     0.18       0.37  

Gain (loss) on divestiture of operations

           (0.08 )           (0.01 )
                                

Net income

   $ 0.07     $ 0.43     $ 1.45     $ 3.20  
                                

Diluted:

        

Income from continuing operations

   $ 0.09     $ 0.45     $ 1.20     $ 2.32  

Discontinued operations:

        

Income (loss) from operations

     (0.02 )     (0.02 )     0.17       0.30  

Gain (loss) on divestiture of operations

           (0.07 )           (0.01 )
                                

Net income

   $ 0.07     $ 0.36     $ 1.37     $ 2.61  
                                

Shares used in computing earnings per common share:

        

Basic

     39,014       38,013       39,104       37,279  

Diluted

     39,769       46,033       41,300       45,648  

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)

 

     September 30,
2006
    December 31,
2005
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 13,354     $ 83,420  

Cash – restricted

     5,874       5,135  

Insurance subsidiary investments

     228,675       231,134  

Accounts receivable less allowance for loss of $66,904 – September 30, 2006 and $62,078 – December 31, 2005

     635,307       479,605  

Inventories

     50,477       43,731  

Deferred tax assets

     69,061       61,078  

Assets held for sale

     12,130       12,056  

Other

     29,906       28,805  
                
     1,044,784       944,964  

Property and equipment

     979,038       891,009  

Accumulated depreciation

     (446,324 )     (369,393 )
                
     532,714       521,616  

Goodwill

     108,129       69,879  

Intangible assets less accumulated amortization of $5,445 – September 30, 2006 and $1,763 – December 31, 2005

     118,825       34,317  

Insurance subsidiary investments

     45,640       48,796  

Deferred tax assets

     89,917       73,750  

Other

     83,549       67,239  
                
   $ 2,023,558     $ 1,760,561  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 129,957     $ 134,547  

Salaries, wages and other compensation

     280,065       244,851  

Due to third party payors

     28,417       26,642  

Professional liability risks

     65,521       70,090  

Other accrued liabilities

     90,441       79,704  

Income taxes

     78,621       58,572  

Long-term debt due within one year

     71       6,221  
                
     673,093       620,627  

Long-term debt

     174,208       26,323  

Professional liability risks

     191,096       182,113  

Deferred credits and other liabilities

     103,034       60,962  

Commitments and contingencies

    

Stockholders’ equity:

    

Common stock, $0.25 par value; authorized 175,000 shares; issued
39,889 shares – September 30, 2006 and 37,331 shares – December 31, 2005

     9,972       9,333  

Capital in excess of par value

     702,186       673,358  

Deferred compensation

           (14,228 )

Accumulated other comprehensive income (loss)

     683       (60 )

Retained earnings

     169,286       202,133  
                
     882,127       870,536  
                
   $ 2,023,558     $ 1,760,561  
                

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Cash flows from operating activities:

        

Net income

   $ 2,938     $ 16,354     $ 56,570     $ 119,311  

Adjustments to reconcile net income to net cash provided by operating activities:

        

Depreciation and amortization

     32,673       26,826       91,566       76,526  

Amortization of stock-based deferred compensation costs

     4,397       2,665       14,360       6,661  

Provision for doubtful accounts

     10,024       3,725       28,913       13,199  

Deferred income taxes

     657             (14,280 )      

(Gain) loss on divestiture of discontinued operations

     (126 )     3,147       25       500  

Reorganization items

                       (1,371 )

Other

     (2,868 )     (1,257 )     (4,317 )     (2,455 )

Change in operating assets and liabilities:

        

Accounts receivable

     (56,219 )     (6,048 )     (182,053 )     (171,408 )

Inventories and other assets

     (4,679 )     (1,380 )     (14,691 )     (6,899 )

Accounts payable

     (60 )     (1,267 )     5,979       (1,004 )

Income taxes

     (16,189 )     10,784       3,491       74,668  

Due to third party payors

     8,731       5,802       1,775       (10,077 )

Other accrued liabilities

     43,500       (8,813 )     53,681       9,512  
                                

Net cash provided by operating activities

     22,779       50,538       41,019       107,163  
                                

Cash flows from investing activities:

        

Purchase of property and equipment

     (37,719 )     (33,552 )     (99,754 )     (80,113 )

Acquisitions

     (11,086 )     (42 )     (134,667 )     (73,919 )

Sale of assets

     205       92       10,510       11,196  

Purchase of insurance subsidiary investments

     (81,207 )     (61,620 )     (165,487 )     (266,816 )

Sale of insurance subsidiary investments

     82,725       52,795       177,609       243,157  

Net change in insurance subsidiary cash and cash equivalents

     1,185       (3,445 )     (4,288 )     20,952  

Net change in other investments

     (1,101 )     (250 )     743       3,469  

Other

     (2,033 )     (713 )     927       1,794  
                                

Net cash used in investing activities

     (49,031 )     (46,735 )     (214,407 )     (140,280 )
                                

Cash flows from financing activities:

        

Net change in revolving credit borrowings

     30,700             173,300        

Repayment of long-term debt

     (321 )     (1,363 )     (3,294 )     (3,881 )

Payment of deferred financing costs

     (223 )     (168 )     (1,170 )     (371 )

Issuance of common stock

     178       976       143,366       23,711  

Repurchase of common stock

                 (194,310 )      

Other

     (5,763 )     1,493       (14,570 )     (17,360 )
                                

Net cash provided by financing activities

     24,571       938       103,322       2,099  
                                

Change in cash and cash equivalents

     (1,681 )     4,741       (70,066 )     (31,018 )

Cash and cash equivalents at beginning of period

     15,035       33,369       83,420       69,128  
                                

Cash and cash equivalents at end of period

   $ 13,354     $ 38,110     $ 13,354     $ 38,110  
                                

Supplemental information:

        

Interest payments

   $ 2,340     $ 2,513     $ 7,467     $ 5,024  

Income tax payments

     18,833       2,452       52,758       5,398  

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States (collectively, “Kindred” or the “Company”). At September 30, 2006, the Company’s hospital division operated 80 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s health services division operated 242 nursing centers in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 45 pharmacies in 26 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at September 30, 2006 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 4 for a summary of discontinued operations.

Impact of recent accounting pronouncements

On September 29, 2006, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 158 (“SFAS 158”), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position, and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position and revises certain disclosure requirements. The benefit obligation is defined as the projected benefit obligation for pension plans and as the accumulated postretirement benefit obligation for any other postretirement benefit plan, such as a retiree health care plan. The Company is required to adopt SFAS 158 prospectively in the fourth quarter of 2006. The adoption of SFAS 158 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

On September 15, 2006, the FASB issued SFAS No. 157 (“SFAS 157”), “Fair Value Measurements,” which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

On September 13, 2006, the Securities and Exchange Commission (the “SEC”) staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 was issued to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 is not expected to affect the Company’s consolidated financial statements.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Impact of recent accounting pronouncements (Continued)

 

On July 13, 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” The interpretation clarifies the accounting for uncertain income tax issues recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 is not expected to have a material impact on the Company’s financial position, results of operations or liquidity.

Stock option accounting

In December 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. In connection with the adoption of SFAS 123R, the Company began to recognize compensation expense prospectively in its consolidated financial statements for non-vested stock options beginning January 1, 2006. See Note 14.

Prior to the adoption of SFAS 123R, the Company followed Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its employee stock options.

Pro forma information regarding net income and earnings per share determined as if the Company had accounted for its employee stock options granted under the fair value method of SFAS 123R as of January 1, 2005 follows (in thousands, except per share amounts):

 

     Three months ended
September 30, 2005
   

Nine months ended

September 30, 2005

 

Net income, as reported

   $ 16,354     $ 119,311  

Adjustments:

    

Stock-based employee compensation expense included in reported net income

     1,639       4,117  

Stock-based employee compensation expense determined under fair value based method

     (3,668 )     (9,695 )
                

Pro forma net income

   $ 14,325     $ 113,733  
                

Earnings per common share:

    

As reported:

    

Basic

   $ 0.43     $ 3.20  

Diluted

   $ 0.36     $ 2.61  

Pro forma:

    

Basic

   $ 0.38     $ 3.05  

Diluted

   $ 0.31     $ 2.46  

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

 

Comprehensive income

The following table sets forth the computation of comprehensive income (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006    2005     2006    2005  

Net income

   $ 2,938    $ 16,354     $ 56,570    $ 119,311  

Net unrealized investment gains (losses), net of income taxes

     846      (236 )     743      (734 )
                              

Comprehensive income

   $ 3,784    $ 16,118     $ 57,313    $ 118,577  
                              

Other information

The accompanying unaudited condensed consolidated financial statements do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2005 filed with the SEC on Form 10-K.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. Management believes that financial information included herein reflects all adjustments necessary for a fair presentation of interim results and, except as otherwise disclosed, all such adjustments are of a normal and recurring nature.

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation. These changes did not have any impact on the Company’s financial position, results of operations or liquidity.

NOTE 2 – PROPOSED SPIN-OFF TRANSACTION

On October 25, 2006, the Company signed a definitive agreement with AmerisourceBergen Corporation (“AmerisourceBergen”) to combine their respective institutional pharmacy businesses, Kindred Pharmacy Services (“KPS”) and PharMerica Long-Term Care (“PharMerica LTC”), into a new, independent, publicly traded company. The transaction is intended to be tax-free to shareholders of both Kindred and AmerisourceBergen and is expected to be completed in the first quarter of 2007.

Under the terms of the agreement, both KPS and PharMerica LTC will each borrow up to $150 million and use such proceeds to fund a one-time cash distribution, intended to be tax-free, to their respective parent companies. Following the cash distribution, each institutional pharmacy business is expected to be spun off to the shareholders of their respective parent companies. Immediately thereafter, a stock-for-stock merger will be effected that would result in Kindred and AmerisourceBergen shareholders each owning 50% of the new publicly traded company. The proposed transaction is subject to certain conditions, including the completion of the registration statement to be filed with the SEC and a favorable determination by the Internal Revenue Service (the “IRS”). The closing of the proposed transaction also will require the receipt of required regulatory approvals and the satisfaction of certain other conditions.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – PROPOSED SPIN-OFF TRANSACTION (Continued)

 

For accounting purposes, the historical operating results of the Company’s pharmacy segment will be reclassified as discontinued operations upon the consummation of the proposed transaction.

NOTE 3 – VENTAS RENT RESET

At September 30, 2006, the Company leased from Ventas, Inc. and its affiliates (“Ventas”) 39 LTAC hospitals and 186 nursing centers under four master leases (the “Master Leases”).

On October 12, 2006, Ventas exercised a one-time right to reset rent under each of the four Master Leases. These new aggregate annual rents of approximately $239 million became effective retroactively to July 19, 2006 and were determined as fair market rentals by the final independent appraisers engaged in connection with the rent reset process under the four Master Leases. Aggregate annual Ventas rents prior to the rent reset approximated $206 million. As required, Ventas paid the Company a reset fee of approximately $4.6 million which will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases. In connection with the exercise of the rent reset, the new annual rents were allocated among the facilities subject to the Master Leases in accordance with the determinations made by the final appraisers during the rent reset process. The new contingent annual rent escalator will be 2.7% for Master Leases 1, 3 and 4. The escalator for Master Lease 2 is based upon the Consumer Price Index (the “CPI”) with a floor of 2.25% and a ceiling of 4%. Prior to the rent reset, the contingent annual Ventas rent escalator under each Master Lease was 3.5%.

In 2003, the Company had agreed to pay Ventas additional rents in varying amounts generally over seven years in consideration for the divestiture of the Company’s former Florida and Texas nursing centers. For accounting purposes, these additional rent payments were classified as long-term debt. As a result of the rent reset, the remaining obligations under the 2003 agreement were extinguished. For accounting purposes, the Company’s remaining debt obligation to Ventas of $28.3 million as of July 18, 2006 has been reclassified as a deferred credit in the accompanying unaudited condensed consolidated balance sheet and will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases.

NOTE 4 – DISCONTINUED OPERATIONS

Nursing center dispositions

On August 8, 2006, the Company entered into definitive agreements with Health Care Property Investors, Inc. (“HCP”) to acquire the real estate related to 11 unprofitable leased nursing centers operated by the Company for resale in exchange for three hospitals currently owned by the Company. As part of the transaction, the Company will continue to operate the hospitals under a long-term lease arrangement with HCP. In addition, the Company will pay HCP a one-time cash payment of approximately $36 million. The Company also will amend its existing master lease with HCP to (1) terminate the current annual rent of approximately $9.9 million on the 11 nursing centers, (2) add the three hospitals to the master lease with a current annual rent of approximately $6.3 million and (3) extend the initial expiration date of the master lease until September 30, 2016.

On November 7, 2006, the Company entered into a definitive agreement to sell the real estate and related operations of these 11 nursing centers for $78 million (the “Sale Transaction”). The Sale Transaction is subject to the receipt of required approvals and the satisfaction of several conditions to closing, including without limitation, the successful closing of the HCP transaction.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Nursing center dispositions (Continued)

 

The 11 nursing centers, which contain 1,754 licensed beds, generated pretax losses of approximately $4.0 million for the year ended December 31, 2005 and $2.5 million for the nine months ended September 30, 2006. The HCP transaction and the Sale Transaction are subject to various regulatory approvals and the satisfaction of several conditions to closing. Upon completion of the HCP transaction, the Company expects to record a pretax loss ranging from $7 million to $10 million.

For accounting purposes, the operating results of the 11 nursing centers have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented.

Discontinued operations summary

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” divestitures over the past several years have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the gains or losses related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At September 30, 2006, the Company held for sale 11 nursing centers and one closed hospital.

Discontinued operations included favorable pretax adjustments of $0.4 million and $4.1 million for the third quarter of 2006 and 2005, respectively, and $17.3 million and $36.7 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas.

A summary of discontinued operations follows (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Revenues

   $ 22,237     $ 31,517     $ 68,259     $ 103,860  
                                

Salaries, wages and benefits

     10,885       17,383       34,958       57,051  

Supplies

     1,209       2,333       4,259       7,589  

Rent

     2,485       3,162       7,488       10,068  

Other operating expenses

     8,262       9,275       8,574       4,332  

Depreciation

     627       910       1,846       2,674  

Interest expense

                        

Investment income

     (1 )     (57 )     (5 )     (390 )
                                
     23,467       33,006       57,120       81,324  
                                

Income (loss) from operations before income taxes

     (1,230 )     (1,489 )     11,139       22,536  

Income tax provision (benefit)

     (473 )     (573 )     4,289       8,677  
                                

Income (loss) from operations

     (757 )     (916 )     6,850       13,859  

Gain (loss) on divestiture of operations, net of income taxes

     126       (3,147 )     (25 )     (500 )
                                
   $ (631 )   $ (4,063 )   $ 6,825     $ 13,359  
                                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Discontinued operations summary (Continued)

 

The following table sets forth certain discontinued operating data by business segment (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006    2005     2006    2005  

Revenues:

          

Hospital division:

          

Hospitals

   $ 753    $ 1,402     $ 3,055    $ 10,126  

Ancillary services

     1            2      11  
                              
     754      1,402       3,057      10,137  

Health services division

     21,483      30,115       65,202      93,723  

Pharmacy division

                      
                              
   $ 22,237    $ 31,517     $ 68,259    $ 103,860  
                              

Operating income (loss):

          

Hospital division:

          

Hospitals

   $ 461    $ (469 )   $ 106    $ (312 )

Ancillary services

     1      9       1      20  
                              
     462      (460 )     107      (292 )

Health services division

     1,419      2,986       20,361      35,170  

Pharmacy division

                     10  
                              
   $ 1,881    $ 2,526     $ 20,468    $ 34,888  
                              

Rent:

          

Hospital division:

          

Hospitals

   $    $ 33     $ 38    $ 114  

Ancillary services

          2            2  
                              
          35       38      116  

Health services division

     2,485      3,127       7,450      9,952  

Pharmacy division

                      
                              
   $ 2,485    $ 3,162     $ 7,488    $ 10,068  
                              

Depreciation:

          

Hospital division:

          

Hospitals

   $    $     $    $  

Ancillary services

                      
                              
                      

Health services division

     627      910       1,846      2,674  

Pharmacy division

                      
                              
   $ 627    $ 910     $ 1,846    $ 2,674  
                              

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4 – DISCONTINUED OPERATIONS (Continued)

Discontinued operations summary (Continued)

 

A summary of the net assets held for sale follows (in thousands):

 

     September 30,
2006
    December 31,
2005
 

Current assets:

    

Property and equipment, net

   $ 11,780     $ 11,587  

Other

     350       469  
                
     12,130       12,056  

Current liabilities (included in other accrued liabilities)

     (1,346 )     (266 )
                
   $ 10,784     $ 11,790  
                

NOTE 5 – SIGNIFICANT QUARTERLY ADJUSTMENTS

Operating results for the third quarter of 2006 included pretax income of $1.3 million related to an insurance recovery and a favorable adjustment of a prior year tax dispute, and a pretax charge of $3.5 million for costs incurred in connection with the planned spin-off of the Company’s institutional pharmacy business and professional fees incurred in connection with the Ventas rent reset issue. Third quarter 2006 results also included a charge of $0.6 million related to a change in estimate of the Company’s annual effective income tax rate.

Operating results for the nine months ended September 30, 2006 also included a $1.3 million pretax gain from an institutional pharmacy joint venture transaction, a pretax charge of $2.7 million related primarily to revisions to prior estimates for accrued contract labor costs in the Company’s rehabilitation division, a $3.0 million pretax charge in connection with the settlement of a prior year tax dispute, and a pretax charge of $4.3 million for costs related to investment banking services and professional fees incurred in connection with the Ventas rent reset issue.

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $5.9 million for the third quarter of 2005, and $6.2 million and $63.4 million for the nine months ended September 30, 2006 and 2005, respectively.

Operating results for the third quarter of 2005 included costs associated with Hurricane Katrina and Hurricane Rita which reduced hospital pretax income by $2.1 million.

Operating results for the nine months ended September 30, 2005 included pretax charges of $13.7 million (including a $0.7 million favorable adjustment recorded in the third quarter of 2005) related to a special recognition payment to non-executive caregivers and employees and $5.0 million related to a charitable donation. The allocation of these costs by segment follows (in thousands):

 

    

Recognition

payment

  

Charitable

donation

Hospital division

   $ 3,703    $

Health services division

     8,038     

Rehabilitation division

     1,024     

Pharmacy division

     697     

Corporate

     216      5,000
             
   $ 13,678    $ 5,000
             

 

12


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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – SIGNIFICANT QUARTERLY ADJUSTMENTS (Continued)

 

Operating results for the nine months ended September 30, 2005 included pretax income of $15.8 million ($31.2 million of revenues less $15.4 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2.1 million related to the first quarter of 2005 and approximately $13.7 million related to prior years.

NOTE 6 – REORGANIZATION ITEMS

Transactions related to the Company’s emergence from bankruptcy have been classified separately in the accompanying unaudited condensed consolidated statement of operations. Operating results for the nine months ended September 30, 2005 included income of $1.4 million resulting from changes in estimates for accrued professional and administrative costs related to the Company’s emergence from bankruptcy.

NOTE 7 – ACQUISITIONS

The following is a summary of the Company’s significant acquisition activities. The operating results of these acquired businesses have been included in the accompanying unaudited condensed consolidated financial statements of the Company since the respective acquisition dates. The purchase price of these acquired businesses resulted from negotiations with each of the sellers that were based upon both the historical and expected future cash flows of the respective businesses.

Commonwealth acquisition

On February 28, 2006, the Company acquired the operations of the LTAC hospitals, skilled nursing facilities and assisted living facilities operated by Commonwealth Communities Holdings LLC and certain of its affiliates (the “Commonwealth Acquisition”). The transaction was financed primarily through the use of the Company’s revolving credit facility. Goodwill recorded in connection with the Commonwealth Acquisition aggregated $32.9 million. The purchase price also included identifiable intangible assets of $75.9 million related to the value of acquired certificates of need with indefinite lives and other intangible assets of $5.2 million which will be amortized over approximately three years. Additional adjustments to the purchase price of approximately $7 million may occur through February 2008 as a result of contingent consideration in accordance with the acquisition agreement.

A preliminary summary of the Commonwealth Acquisition follows (in thousands):

 

Fair value of assets acquired, including goodwill and other intangible assets

   $ 130,645  

Fair value of liabilities assumed

     (6,991 )
        

Net cash paid

   $ 123,654  
        

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – ACQUISITIONS (Continued)

Commonwealth acquisition (Continued)

 

The pro forma effect of the Commonwealth Acquisition assuming the transaction occurred on January 1, 2006 or January 1, 2005 follows (in thousands, except per share amounts):

 

     Three months ended
September 30, 2005
   Nine months ended
September 30,
        2006    2005

Revenues

   $ 1,010,769    $ 3,203,407    $ 3,055,480

Income from continuing operations

     22,033      49,771      110,594

Net income

     17,970      56,596      123,953

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 0.58    $ 1.27    $ 2.97

Net income

   $ 0.47    $ 1.45    $ 3.33

Diluted:

        

Income from continuing operations

   $ 0.48    $ 1.20    $ 2.42

Net income

   $ 0.39    $ 1.37    $ 2.71

Pro forma financial data have been derived by combining the historical financial results of the Company and the operations acquired in the Commonwealth Acquisition for all periods presented.

Pharmacy acquisitions

On March 2, 2005, the Company acquired the assets of Pharmacy Partners, Inc., an operator of two institutional pharmacies in Pennsylvania (the “PPI Acquisition”). The transaction was financed through the use of existing cash. Goodwill recorded in connection with the PPI Acquisition aggregated $11.6 million. The purchase price also included acquired identifiable intangible assets totaling $11.3 million that will be amortized over approximately 12 years.

On April 1, 2005, the Company acquired the assets of Skilled Care Pharmacy, an operator of two institutional pharmacies in California (the “SCP Acquisition”). The transaction was financed through the use of existing cash and the Company’s revolving credit facility. Goodwill recorded in connection with the SCP Acquisition aggregated $16.5 million. The purchase price also included acquired identifiable intangible assets totaling $10.4 million that will be amortized over approximately 13 years.

A summary of both the PPI Acquisition and the SCP Acquisition follows (in thousands):

 

    

PPI

Acquisition

   

SCP

Acquisition

 

Fair value of assets acquired, including goodwill and other intangible assets

   $ 31,085     $ 37,480  

Fair value of liabilities assumed

     (213 )     (732 )
                

Net cash paid through September 30, 2005

     30,872       36,748  

Additional payment of transaction costs

     1        
                

Total cash paid through September 30, 2006

   $ 30,873     $ 36,748  
                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – ACQUISITIONS (Continued)

Pharmacy acquisitions (Continued)

 

During the third quarter of 2006, the Company acquired three institutional pharmacies for an aggregate cost of $14.5 million. Goodwill recorded in connection with these acquisitions aggregated $3.9 million. The purchase price also included acquired identifiable intangible assets totaling $7.1 million that will be amortized over approximately 10 years. Additional adjustments to the purchase price of approximately $2 million may occur through July 2008 as a result of contingent consideration in accordance with the acquisition agreements.

NOTE 8 – REVENUES

Revenues are recorded based upon estimated amounts due from patients and third party payors for healthcare services provided, including anticipated settlements under reimbursement agreements with Medicare, Medicaid and other third party payors.

A summary of revenues by payor type follows (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Medicare

   $ 476,442     $ 400,126     $ 1,475,528     $ 1,264,689  

Medicaid

     288,435       307,445       835,790       899,747  

Private and other

     387,564       324,860       1,127,028       953,060  
                                
     1,152,441       1,032,431       3,438,346       3,117,496  

Eliminations:

        

Rehabilitation

     (57,019 )     (49,779 )     (168,065 )     (144,916 )

Pharmacy

     (36,530 )     (31,387 )     (106,665 )     (91,081 )
                                
     (93,549 )     (81,166 )     (274,730 )     (235,997 )
                                
   $ 1,058,892     $ 951,265     $ 3,163,616     $ 2,881,499  
                                

NOTE 9 – EARNINGS PER SHARE

Earnings per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings per common share for all periods includes the dilutive effect of warrants, stock options and non-vested restricted stock.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – EARNINGS PER SHARE (Continued)

 

A computation of earnings per common share follows (in thousands, except per share amounts):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Earnings:

        

Income from continuing operations

   $ 3,569     $ 20,417     $ 49,745     $ 105,952  

Discontinued operations, net of income taxes:

        

Income (loss) from operations

     (757 )     (916 )     6,850       13,859  

Gain (loss) on divestiture of operations

     126       (3,147 )     (25 )     (500 )
                                

Net income

   $ 2,938     $ 16,354     $ 56,570     $ 119,311  
                                

Shares used in the computation:

        

Weighted average shares outstanding – basic computation

     39,014       38,013       39,104       37,279  

Dilutive effect of certain securities:

        

Warrants

           6,752       1,497       6,875  

Employee stock options

     514       931       435       1,022  

Non-vested restricted stock

     241       337       264       472  
                                

Adjusted weighted average shares outstanding – diluted computation

     39,769       46,033       41,300       45,648  
                                

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 0.09     $ 0.54     $ 1.27     $ 2.84  

Discontinued operations:

        

Income (loss) from operations

     (0.02 )     (0.03 )     0.18       0.37  

Gain (loss) on divestiture of operations

           (0.08 )           (0.01 )
                                

Net income

   $ 0.07     $ 0.43     $ 1.45     $ 3.20  
                                

Diluted:

        

Income from continuing operations

   $ 0.09     $ 0.45     $ 1.20     $ 2.32  

Discontinued operations:

        

Income (loss) from operations

     (0.02 )     (0.02 )     0.17       0.30  

Gain (loss) on divestiture of operations

           (0.07 )           (0.01 )
                                

Net income

   $ 0.07     $ 0.36     $ 1.37     $ 2.61  
                                

NOTE 10 – STOCKHOLDERS’ EQUITY

The Company’s Series A warrants and Series B warrants expired on April 20, 2006. In connection with the exercise of these warrants, the Company issued approximately 10.1 million shares of common stock and received net proceeds of approximately $142.3 million. These proceeds were used to repurchase approximately 5.8 million shares of the Company’s common stock in the open market during the second quarter of 2006.

The Company also repurchased approximately two million shares of its common stock in the open market during the second quarter of 2006 at an aggregate cost of approximately $52 million, thereby completing a $100 million share repurchase program authorized by the Company’s Board of Directors in August 2005.

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 11 – BUSINESS SEGMENT DATA

The Company operates four business segments: the hospital division, the health services division, the rehabilitation division and the pharmacy division. The hospital division operates LTAC hospitals. The health services division operates nursing centers. The rehabilitation division provides rehabilitation services primarily to nursing centers and LTAC hospitals. The pharmacy division provides pharmacy services to nursing centers and other healthcare providers. The Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Operating income reported for each of the Company’s business segments excludes the allocation of corporate overhead.

The Company identifies its segments in accordance with the aggregation provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics.

The following table sets forth certain data by business segment (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Revenues:

        

Hospital division

   $ 406,923     $ 389,776     $ 1,277,045     $ 1,217,378  

Health services division

     499,072       441,937       1,452,177       1,329,282  

Rehabilitation division

     76,003       65,553       221,541       195,865  

Pharmacy division

     170,443       135,165       487,583       374,971  
                                
     1,152,441       1,032,431       3,438,346       3,117,496  

Eliminations:

        

Rehabilitation

     (57,019 )     (49,779 )     (168,065 )     (144,916 )

Pharmacy

     (36,530 )     (31,387 )     (106,665 )     (91,081 )
                                
     (93,549 )     (81,166 )     (274,730 )     (235,997 )
                                
   $ 1,058,892     $ 951,265     $ 3,163,616     $ 2,881,499  
                                

Income from continuing operations:

        

Operating income (loss):

        

Hospital division

   $ 74,793     $ 90,728     $ 284,164     $ 326,792  

Health services division

     61,293       48,286       172,515       162,744  

Rehabilitation division

     8,857       7,913       21,549       24,613  

Pharmacy division

     16,152       14,455       48,020       39,207  

Corporate:

        

Overhead

     (37,683 )     (32,631 )     (118,274 )     (99,798 )

Insurance subsidiary

     (1,634 )     (2,692 )     (5,178 )     (7,662 )
                                
     (39,317 )     (35,323 )     (123,452 )     (107,460 )
                                
     121,778       126,059       402,796       445,896  

Reorganization items

                       1,371  
                                

Operating income

     121,778       126,059       402,796       447,267  

Rent

     (81,252 )     (66,457 )     (225,466 )     (197,553 )

Depreciation and amortization

     (32,046 )     (25,916 )     (89,720 )     (73,852 )

Interest, net

     (1,137 )     540       (185 )     1,479  
                                

Income from continuing operations before income taxes

     7,343       34,226       87,425       177,341  

Provision for income taxes

     3,774       13,809       37,680       71,389  
                                
   $ 3,569     $ 20,417     $ 49,745     $ 105,952  
                                

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – BUSINESS SEGMENT DATA (Continued)

 

     Three months ended
September 30,
   Nine months ended
September 30,
     2006    2005    2006    2005

Rent:

           

Hospital division

   $ 32,245    $ 25,366    $ 88,452    $ 75,327

Health services division

     46,552      38,969      130,047      116,201

Rehabilitation division

     932      817      2,698      2,434

Pharmacy division

     1,448      1,226      4,044      3,321

Corporate

     75      79      225      270
                           
   $ 81,252    $ 66,457    $ 225,466    $ 197,553
                           

Depreciation and amortization:

           

Hospital division

   $ 12,363    $ 10,579    $ 35,128    $ 29,969

Health services division

     10,966      7,721      30,513      22,066

Rehabilitation division

     127      57      322      167

Pharmacy division

     2,594      1,525      6,248      3,972

Corporate

     5,996      6,034      17,509      17,678
                           
   $ 32,046    $ 25,916    $ 89,720    $ 73,852
                           

Capital expenditures, excluding acquisitions (including discontinued operations):

           

Hospital division

   $ 16,535    $ 11,634    $ 46,005    $ 31,158

Health services division

     12,849      14,488      29,225      32,431

Rehabilitation division

     146      17      295      115

Pharmacy division

     2,581      1,562      6,857      4,143

Corporate:

           

Information systems

     5,376      5,580      16,848      11,213

Other

     232      271      524      1,053
                           
   $ 37,719    $ 33,552    $ 99,754    $ 80,113
                           

 

     September 30,
2006
   December 31,
2005

Assets at end of period:

     

Hospital division

   $ 750,211    $ 560,767

Health services division

     468,278      385,864

Rehabilitation division

     10,723      7,124

Pharmacy division

     227,057      188,914

Corporate

     567,289      617,892
             
   $ 2,023,558    $ 1,760,561
             

Goodwill:

     

Hospital division

   $ 62,783    $ 29,862

Pharmacy division

     45,346      40,017
             
   $ 108,129    $ 69,879
             

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 12 – INSURANCE RISKS

The Company insures a substantial portion of its professional liability risks and workers compensation risks through a wholly owned limited purpose insurance subsidiary. Provisions for loss for these risks are based upon independent actuarially determined estimates.

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited. See Note 4.

The provision for loss for insurance risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, follows (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006    2005     2006     2005  

Professional liability:

         

Continuing operations

   $ 13,539    $ 17,166     $ 51,820     $ 53,985  

Discontinued operations

     2,866      (1,035 )     (8,761 )     (27,066 )

Workers compensation:

         

Continuing operations

   $ 8,918    $ 11,652     $ 32,845     $ 36,217  

Discontinued operations

     327      712       1,215       2,201  

A summary of the assets and liabilities related to insurance risks included in the accompanying unaudited condensed consolidated balance sheet follows (in thousands):

 

    September 30, 2006   December 31, 2005
    Professional
liability
  Workers
compensation
  Total   Professional
liability
  Workers
compensation
  Total

Assets:

           

Current:

           

Insurance subsidiary investments

  $ 145,477   $ 83,198   $ 228,675   $ 142,654   $ 88,480   $ 231,134

Reinsurance recoverables

    1,908         1,908     2,404         2,404
                                   
    147,385     83,198     230,583     145,058     88,480     233,538

Non-current:

           

Insurance subsidiary investments

    45,640         45,640     48,796         48,796

Reinsurance recoverables

    8,770         8,770     8,186         8,186

Deposits

    7,250     1,502     8,752     7,250     1,720     8,970

Other

        204     204     3     102     105
                                   
    61,660     1,706     63,366     64,235     1,822     66,057
                                   
  $ 209,045   $ 84,904   $ 293,949   $ 209,293   $ 90,302   $ 299,595
                                   

Liabilities:

           

Allowance for insurance risks:

           

Current

  $ 65,521   $ 25,131   $ 90,652   $ 70,090   $ 24,707   $ 94,797

Non-current

    191,096     60,091     251,187     182,113     53,421     235,534
                                   
  $ 256,617   $ 85,222   $ 341,839   $ 252,203   $ 78,128   $ 330,331
                                   

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – INSURANCE RISKS (Continued)

 

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $269 million at September 30, 2006 and $266 million at December 31, 2005.

Provisions for loss for workers compensation risks retained by the limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually.

NOTE 13 – LEASES

The Company leases real estate and equipment under cancelable and non-cancelable arrangements. The following table sets forth rent expense by business segment (in thousands):

 

     Three months ended
September 30,
   Nine months ended
September 30,
     2006    2005    2006    2005

Hospital division:

           

Buildings:

           

Ventas

   $ 19,522    $ 15,851    $ 51,933    $ 47,206

Other landlords

     6,486      3,628      17,904      10,881

Equipment

     6,237      5,887      18,615      17,240
                           
     32,245      25,366      88,452      75,327

Health services division:

           

Buildings:

           

Ventas

     35,922      31,565      100,455      94,009

Other landlords

     9,862      6,707      27,305      20,039

Equipment

     768      697      2,287      2,153
                           
     46,552      38,969      130,047      116,201

Rehabilitation division:

           

Buildings

     19      18      57      53

Equipment

     913      799      2,641      2,381
                           
     932      817      2,698      2,434

Pharmacy division:

           

Buildings

     1,270      1,025      3,422      2,801

Equipment

     178      201      622      520
                           
     1,448      1,226      4,044      3,321

Corporate:

           

Buildings

     70      74      204      241

Equipment

     5      5      21      29
                           
     75      79      225      270
                           
   $ 81,252    $ 66,457    $ 225,466    $ 197,553
                           

Rent expense for the third quarter of 2006 included increased rents, net of deferred credit amortization, associated with the Ventas rent reset of $3.1 million in the hospital division and $3.3 million in the health services division.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 14 – STOCK-BASED COMPENSATION

The Company maintains plans under which up to ten million restricted stock awards and options to purchase common stock may be granted to officers, directors and key employees. Exercise provisions vary, but most stock options are exercisable in whole or in part beginning one to four years after grant and ending seven to ten years after grant. Shares of common stock available for future grants were 2,049,617 at September 30, 2006.

Stock options

As discussed in Note 1, the Company adopted SFAS 123R as of January 1, 2006. The fair value of each stock option is estimated at the date of grant using a Black-Scholes option valuation model with the following weighted average assumptions for the nine months ended September 30, 2006: risk-free interest rate of 4.61%; no dividend yield; expected term of five years; and volatility factors based upon the historical price of the Company’s common stock of 0.51. The expected term represents the period of time that stock options granted are expected to be outstanding. As required by SFAS 123R, an estimate of expected forfeitures was determined and compensation expense was recognized only for those stock options expected to vest. The weighted average fair value of stock options granted during the nine months ended September 30, 2006 under a Black-Scholes valuation model was $10.95.

At September 30, 2006, unearned compensation costs related to non-vested stock options aggregated $7.5 million. These costs will be expensed over the remaining weighted average vesting period of approximately two years. Compensation expense related to stock options approximated $1.9 million ($1.6 million net of income taxes or $0.04 per diluted share) for the third quarter of 2006 and $5.5 million ($4.6 million net of income taxes or $0.11 per diluted share) for the nine months ended September 30, 2006.

Activity in the various plans is summarized below:

 

     Shares
under
option
   

Option price

per share

  

Weighted

average

exercise price

Balances, December 31, 2005

   3,087,197     $  6.39 to $37.17    $ 21.97

Granted

   515,443       21.99 to 28.89      22.44

Exercised

   (71,819 )     6.39 to 24.53      14.66

Canceled

   (108,869 )     6.39 to 29.72      19.02
           

Balances, September 30, 2006

   3,421,952     $  6.39 to $37.17    $ 22.29
           

The intrinsic value of the stock options exercised during the nine months ended September 30, 2006 approximated $0.8 million.

A summary of stock options outstanding at September 30, 2006 follows:

 

     Options outstanding    Options exercisable

Range of exercise prices

   Number
outstanding
at September 30,
2006
   Weighted
average
remaining
contractual
life
   Weighted
average
exercise
price
   Number
exercisable
at September 30,
2006
   Weighted
average
exercise
price

$ 6.39 to $11.04

   560,551    7 years    $ 10.55    516,501    $ 10.69

$15.91 to $20.00

   718,023    6 years      17.66    662,023      17.48

$21.99 to $29.72

   1,312,170    7 years      24.22    533,482      25.57

$30.42 to $37.17

   831,208    6 years      31.18    831,208      31.18
                  
   3,421,952    6 years    $ 22.29    2,543,214    $ 22.27
                  

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 14 – STOCK-BASED COMPENSATION (Continued)

Stock options (Continued)

 

The intrinsic value of the stock options outstanding and stock options that are exercisable as of September 30, 2006 approximated $26.7 million and $20.2 million, respectively.

Restricted stock

At September 30, 2006, unearned compensation costs related to non-vested restricted stock aggregated $11.4 million. These costs will be expensed over the remaining weighted average vesting period of approximately three years. Compensation expense related to these awards approximated $2.5 million ($1.5 million net of income taxes or $0.04 per diluted share) for the third quarter of 2006 and $8.9 million ($5.4 million net of income taxes or $0.13 per diluted share) for the nine months ended September 30, 2006 and $2.7 million ($1.6 million net of income taxes or $0.04 per diluted share) for the third quarter of 2005 and $6.6 million ($4.0 million net of income taxes or $0.09 per diluted share) for the nine months ended September 30, 2005.

A summary of non-vested restricted shares follows:

 

     Non-vested
restricted shares
   

Weighted average
fair value at

date of grant

Balances, December 31, 2005

   890,216     $ 26.05

Granted

   274,650       21.99

Vested

   (356,880 )     21.79
        

Balances, September 30, 2006

   807,986     $ 26.55
        

NOTE 15 – CONTINGENCIES

Management continually evaluates contingencies based upon the best available information. In addition, allowances for loss are provided currently for disputed items that have continuing significance, such as certain third party reimbursements and deductions that continue to be claims in current cost reports and tax returns.

Management believes that allowances for losses have been provided to the extent necessary and that its assessment of contingencies is reasonable.

Principal contingencies are described below:

Revenues – Certain third party payments are subject to examination by agencies administering the various programs. The Company is contesting certain issues raised in audits of prior year cost reports.

Professional liability risks – The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Notes 4 and 12.

Income taxes – The IRS has proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns which the Company is contesting. The principal proposed adjustment relates to the manner of reduction of the Company’s tax attributes, primarily its net operating loss carryforwards (“NOLs”), in connection with the Company’s emergence from bankruptcy in 2001. These proposed adjustments could have the effect of substantially eliminating the Company’s NOLs.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 15 – CONTINGENCIES (Continued)

 

Litigation – The Company is a party to certain material litigation as well as various suits and claims arising in the ordinary course of business. See Note 16.

Other indemnifications – In the ordinary course of business, the Company enters into contracts containing standard indemnification provisions and indemnifications specific to a transaction such as a disposal of an operating facility. These indemnifications may cover claims against employment-related matters, governmental regulations, environmental issues, and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally would be initiated by a breach of the terms of the contract or by a third party claim or event.

NOTE 16 – LITIGATION

A summary description of significant litigation follows.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the Company filed a renewed motion to dismiss, as to all defendants, based upon the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. On July 26, 2005, the court granted defendants’ motion to dismiss based upon the plaintiff’s failure to make a statutorily required demand for remedy upon the appropriate board of directors. On August 25, 2005, the plaintiff filed an appeal with the Court of Appeals of Kentucky. By a decision dated September 24, 2006, the Kentucky Court of Appeals ordered the dismissal of this case with prejudice. This decision is final since the appeal period has expired.

The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations and sanctions arising in the ordinary course of its business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. In addition, there can be no assurance that the U.S. Department of Justice (the “DOJ”), the Centers for Medicare and Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies will not initiate additional investigations related to the Company’s businesses in the future, nor can there be any assurance that the resolution of any litigation or investigations, either individually or in the aggregate, would not have a material adverse effect on the Company’s financial position, results of operations and liquidity.

 

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

Cautionary Statement

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, capital expenditures, competitive positions, growth opportunities, plans and objectives of management and statements containing the words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements.

Such forward-looking statements are inherently uncertain, and stockholders and other potential investors must recognize that actual results may differ materially from the Company’s expectations as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based upon management’s current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company’s actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements. These statements involve risks, uncertainties and other factors discussed below and detailed from time to time in the Company’s filings with the SEC. Factors that may affect the Company’s plans or results include, without limitation:

 

    the Company’s ability to operate pursuant to the terms of its debt obligations and its Master Leases with Ventas,

 

    the Company’s ability to meet its rental and debt service obligations,

 

    the Company’s and AmerisourceBergen’s ability to complete the proposed merger of their respective institutional pharmacy operations, including the receipt of all required regulatory approvals and the satisfaction of other closing conditions to the proposed transaction,

 

    adverse developments with respect to the Company’s results of operations or liquidity,

 

    the Company’s ability to attract and retain key executives and other healthcare personnel,

 

    increased operating costs due to shortages in qualified nurses, therapists and other healthcare personnel,

 

    the effects of healthcare reform and government regulations, interpretation of regulations and changes in the nature and enforcement of regulations governing the healthcare industry,

 

    changes in the reimbursement rates or methods of payment from third party payors, including the Medicare and Medicaid programs, changes arising from and related to the Medicare prospective payment system for LTAC hospitals (“LTAC PPS”), including the final Medicare payment rules issued in May 2006, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“Medicare Part D”), and changes in Medicare and Medicaid reimbursements for the Company’s nursing centers,

 

    national and regional economic conditions, including their effect on the availability and cost of labor, materials and other services,

 

    the Company’s ability to control costs, including labor and employee benefit costs,

 

    the Company’s ability to successfully pursue its development activities and successfully integrate new operations, including the realization of anticipated revenues, economies of scale, cost savings and productivity gains associated with such operations,

 

    the increase in the costs of defending and insuring against alleged professional liability claims and the Company’s ability to predict the estimated costs related to such claims,

 

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

Cautionary Statement (Continued)

 

    the Company’s ability to successfully reduce (by divestiture of operations or otherwise) its exposure to professional liability claims,

 

    the Company’s ability to successfully dispose of unprofitable facilities, and

 

    the Company’s ability to ensure and maintain an effective system of internal controls over financial reporting.

Many of these factors are beyond the Company’s control. The Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance. The Company disclaims any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments.

General

The quarterly adjustment information in Note 5 and the business segment data in Note 11 should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States. At September 30, 2006, the Company’s hospital division operated 80 LTAC hospitals (6,359 licensed beds) in 24 states. The Company’s health services division operated 242 nursing centers (30,679 licensed beds) in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 45 pharmacies in 26 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

On October 25, 2006, the Company signed a definitive agreement with AmerisourceBergen to combine their respective institutional pharmacy businesses, KPS and PharMerica LTC, into a new, independent, publicly traded company. See Note 2.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at September 30, 2006 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 4.

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. The Company relies on historical experience and on various other assumptions that management believes to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.

 

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Table of Contents

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

Critical Accounting Policies (Continued)

 

The Company believes the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue recognition

The Company has agreements with third party payors that provide for payments to each of its operating divisions. These payment arrangements may be based upon prospective rates, reimbursable costs, established charges, discounted charges or per diem payments. Net patient service revenue is recorded at the estimated net realizable amounts from Medicare, Medicaid, other third party payors and individual patients for services rendered. Retroactive adjustments that are likely to result from future examinations by third party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based upon new information or final settlements.

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $5 million for the third quarter of 2005, and $6 million and $63 million for the nine months ended September 30, 2006 and 2005, respectively.

Operating results for the nine months ended September 30, 2005 included pretax income of $16 million ($31 million of revenues less $15 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2 million related to the first quarter of 2005 and approximately $14 million related to prior years.

See Note 8 for a summary of the Company’s revenues.

Collectibility of accounts receivable

Accounts receivable consist primarily of amounts due from the Medicare and Medicaid programs, other government programs, managed care health plans, commercial insurance companies and individual patients. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected.

In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third party payors and general industry conditions. Actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change.

The provision for doubtful accounts totaled $10 million and $4 million for the third quarter of 2006 and 2005, respectively, and totaled $28 million and $12 million for the nine months ended September 30, 2006 and 2005, respectively.

Allowances for insurance risks

The Company insures a substantial portion of its professional liability risks and workers compensation risks through a wholly owned limited purpose insurance subsidiary. Provisions for loss for these risks are based upon independent actuarially determined estimates.

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are

 

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Table of Contents

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

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

 

necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $257 million at September 30, 2006 and $252 million at December 31, 2005. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $269 million at September 30, 2006 and $266 million at December 31, 2005.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received a return of capital of $34 million and $30 million during the nine months ended September 30, 2006 and 2005, respectively, from its limited purpose insurance subsidiary. These proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

Changes in the number of professional liability claims and the increasing cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at September 30, 2006 would impact the Company’s operating income by approximately $3 million. The Company recorded favorable pretax adjustments of $0.4 million and $4 million for the third quarter of 2006 and 2005, respectively, and $17 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas (included in discontinued operations).

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $14 million and $17 million for the third quarter of 2006 and 2005, respectively, and $52 million and $54 million for the nine months ended September 30, 2006 and 2005, respectively.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $85 million at September 30, 2006 and $78 million at December 31, 2005. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $9 million and $11 million for the third quarter of 2006 and 2005, respectively, and $33 million and $36 million for the nine months ended September 30, 2006 and 2005, respectively.

See Note 12 for a summary of the Company’s insurance activities.

 

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Table of Contents

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

Critical Accounting Policies (Continued)

 

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. The Company also recognizes as deferred tax assets the future tax benefits from net operating and capital loss carryforwards. A valuation allowance is provided for these deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

The effective income tax rate for the third quarter of 2006 was 51.4% compared to 40.3% for the third quarter of 2005. Operating results in the third quarter of 2006 included a charge of approximately $1 million related to a change in estimate of the Company’s annual effective income tax rate. The effective income tax rate for the nine months ended September 30, 2006 was 43.1% compared to 40.3% for the same period a year ago.

There are significant uncertainties with respect to professional liability costs, future government payments to both the Company’s hospitals and nursing centers and the outcome of income tax examinations which, among other things, could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is unlikely. The Company recognized deferred tax assets totaling $159 million at September 30, 2006 and $135 million at December 31, 2005.

In November 2004, the IRS proposed certain adjustments to the Company’s 2000 and 2001 federal income tax returns. The principal proposed adjustment relates to the manner of reduction of the Company’s tax attributes, primarily its NOLs, in connection with the Company’s emergence from bankruptcy in 2001. These proposed adjustments could have the effect of substantially eliminating the Company’s NOLs. However, the Company is vigorously contesting the proposed adjustments with the IRS appeals division. Management believes that the ultimate resolution of these disputes will not have a material effect on the Company’s financial position, results of operations or liquidity.

The Company is subject to various income tax audits at the federal and state levels in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. While the Company believes its tax positions are appropriate, there can be no assurance that the various authorities engaged in the examination of its income tax returns will not challenge the Company’s positions.

Valuation of long-lived assets and goodwill

The Company regularly reviews the carrying value of certain long-lived assets and identifiable intangible assets with respect to any events or circumstances that indicate an impairment or an adjustment to the amortization period is necessary. If circumstances suggest the recorded amounts cannot be recovered based upon estimated future undiscounted cash flows, the carrying values of such assets are reduced to fair value.

In assessing the carrying values of long-lived assets, the Company estimates future cash flows at the lowest level for which there are independent, identifiable cash flows. For this purpose, these cash flows are aggregated based upon the contractual agreements underlying the operation of the facility or group of facilities. Generally, an individual facility is considered the lowest level for which there are independent, identifiable cash flows. However, to the extent that groups of facilities are leased under a master lease in which the operations of a facility and compliance with the lease terms are interdependent upon other facilities in the agreement (including

 

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

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

 

the Company’s ability to renew the lease or divest a particular property), the Company defines the group of facilities under a master lease as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease are aggregated for purposes of evaluating the carrying values of long-lived assets.

In connection with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company is required to perform an impairment test for goodwill at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual impairment test at the end of each year. No impairment charge was recorded at December 31, 2005 in connection with the annual impairment test.

Recent Developments

CMS issued final regulatory changes regarding Medicare reimbursement to LTAC hospitals (the “Hospital Medicare Rule”) on May 2, 2006. Based upon the Company’s historical Medicare patient volumes, the Company expects that the Hospital Medicare Rule will reduce Medicare revenues to the Company’s hospitals associated with short stay outliers and high cost outliers by approximately $46 million on an annual basis. This estimate does not include the negative impact resulting from the elimination of the annual market basket adjustment to the Medicare payment rates that also is contained in the Hospital Medicare Rule. The annual market basket adjustment has typically ranged between 3% and 4%, or approximately $25 million to $30 million annually. The Hospital Medicare Rule became effective for discharges occurring after June 30, 2006. The Hospital Medicare Rule also extends until July 1, 2008 CMS’s authority to impose a one-time prospective budget neutrality adjustment to LTAC hospital rates. This authority was scheduled to expire on October 1, 2006.

On August 1, 2006, CMS issued the final rule to reweight LTAC hospital diagnosis related groups (“DRGs”), among other things, beginning October 1, 2006 for the Company. CMS estimates that the effect of the proposal would decrease Medicare reimbursements to LTAC hospitals by an additional 1.3%. Based upon the Company’s historical Medicare patient volumes, the Company expects the revised DRG reweighting will reduce Medicare revenues to the Company’s hospitals by approximately $6 million to $8 million on an annual basis.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 4% to $407 million in the third quarter of 2006 from $389 million in the same period a year ago and 5% to $1.3 billion for the nine months ended September 30, 2006 from $1.2 billion in the same period a year ago. Revenue growth was primarily a result of new hospital development and the Commonwealth Acquisition. Revenues associated with the Commonwealth Acquisition approximated $27 million and $67 million in the third quarter and nine months ended September 30, 2006, respectively. Revenues for the nine months ended September 30, 2005 also included $63 million of favorable prior year Medicare cost report settlements.

Admissions rose 5% in the third quarter of 2006 and 8% for the nine months ended September 30, 2006 compared to the respective prior year periods. On a same-store basis, total admissions declined 3% in the third quarter of 2006 and increased 1% for the nine months ended September 30, 2006 compared to the respective prior year periods. Medicare same-store admissions declined 9% in the third quarter of 2006 and declined 3% for the nine months ended September 30, 2006 compared to the respective prior year periods.

Hospital wage and benefit costs increased 12% to $192 million in the third quarter of 2006 from $171 million in the same period a year ago and 11% to $570 million for the nine months ended September 30,

 

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

Results of Operations – Continuing Operations (Continued)

Hospital Division (Continued)

 

2006 from $514 million in the same period last year. Average hourly wage rates grew 3% in both the third quarter and nine months ended September 30, 2006 compared to the same periods a year ago, while employee benefit costs increased 11% in the third quarter of 2006 and 10% for the nine months ended September 30, 2006 compared to the same periods a year ago.

Professional liability costs were $5 million in the third quarter of both 2006 and 2005 and $16 million for the nine-month periods ended September 30, 2006 and 2005.

Hospital operating income declined 18% to $75 million in the third quarter of 2006 from $91 million a year ago and declined 13% to $284 million for the nine months ended September 30, 2006 from $327 million a year ago. The reduction in hospital operating income in the third quarter of 2006 was primarily attributable to the Hospital Medicare Rule, lower Medicare admissions and operating inefficiencies associated with reduced volume levels. Hospital operating results for the nine months ended September 30, 2005 were favorably impacted by $63 million of prior year Medicare cost report settlements. Aggregate operating costs per admission increased 6% in the third quarter and 3% for the nine months ended September 30, 2006 compared to the corresponding prior year periods. Operating income associated with the Commonwealth Acquisition approximated $1 million and $5 million in the third quarter and nine months ended September 30, 2006, respectively.

Health Services Division

Revenues increased 13% to $499 million in the third quarter of 2006 from $442 million in the same period a year ago and 9% to $1.5 billion for the nine months ended September 30, 2006 from $1.3 billion in the same period last year. Revenue growth was primarily a result of generally favorable reimbursement rates, an increase in patient days and the Commonwealth Acquisition. Aggregate patient days increased 8% in the third quarter of 2006 and 6% for the nine months ended September 30, 2006 compared to the respective prior year periods. On a same-store basis, aggregate patient days increased 1% in both the third quarter and nine months ended September 30, 2006 compared to the same prior year periods. Revenues associated with the Commonwealth Acquisition approximated $32 million and $73 million in the third quarter and nine months ended September 30, 2006, respectively.

Nursing center wage and benefit costs increased 12% to $266 million in the third quarter of 2006 from $238 million in the same period a year ago and 10% to $773 million for the nine months ended September 30, 2006 from $705 million in the same period a year ago. Average hourly wage rates increased 4% in both the third quarter and nine months ended September 30, 2006 compared to the respective prior year periods, while employee benefit costs increased 8% for the third quarter and 6% for the nine months ended September 30, 2006 compared to the respective prior year periods.

Professional liability costs were $9 million and $11 million in the third quarter of 2006 and 2005, respectively, and $35 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively.

Nursing center operating income increased 27% to $62 million in the third quarter of 2006 from $49 million in the same period a year ago and increased 6% to $173 million for the nine months ended September 30, 2006 from $163 million in the same period a year ago. Aggregate operating costs per patient day increased 3% in the third quarter of 2006 and 4% for the nine months ended September 30, 2006 compared to the respective prior year periods. Nursing center operating income in the third quarter and nine months ended September 30, 2006

 

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

Results of Operations – Continuing Operations (Continued)

Health Services Division (Continued)

 

increased primarily due to improved reimbursement rates and increases in patient days (particularly Medicare, private and other patient days). Operating income associated with the Commonwealth Acquisition approximated $3 million and $7 million in the third quarter and nine months ended September 30, 2006, respectively.

Rehabilitation Division

Revenues increased 16% to $76 million in the third quarter of 2006 from $66 million in the same period a year ago and 13% to $221 million for the nine months ended September 30, 2006 from $196 million in the same period a year ago. The increase in revenues in both periods was primarily attributable to price increases and growth in the volume of services provided to existing customers.

Operating income increased 12% in the third quarter of 2006 from the same period a year ago and declined 12% for the nine months ended September 30, 2006 from the same period a year ago. Operating income for the nine months ended September 30, 2006 included a pretax charge of approximately $3 million related primarily to revisions to prior estimates for accrued contract labor costs. Operating income in 2006 also was negatively impacted by increased costs associated with wage rate pressures resulting from an increasingly competitive marketplace for therapists.

Pharmacy Division

Revenues increased 26% to $171 million in the third quarter of 2006 from $135 million in the same period a year ago and 30% to $488 million for the nine months ended September 30, 2006 from $375 million in the same period a year ago due primarily to acquisitions, price increases and higher drug utilization. Revenues associated with pharmacy acquisitions completed in 2006 and 2005 approximated $42 million and $119 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $25 million and $53 million for the respective prior year periods. At September 30, 2006, the Company provided pharmacy services to nursing centers containing 102,500 licensed beds, including 30,200 licensed beds that it operates. At September 30, 2005, the Company provided pharmacy services to nursing centers containing 83,900 licensed beds, including 28,700 licensed beds that it operates.

On January 1, 2006, Medicare Part D became effective. Under this program, Medicare beneficiaries who were entitled to benefits under a state Medicaid program (so-called “dual eligibles”) now have their outpatient prescription drug costs covered by Medicare Part D, subject to certain limitations. Most of the Company’s nursing center residents whose drug costs were previously covered by state Medicaid programs are dual eligibles who qualify for the Medicare Part D drug benefit. Accordingly, since January 1, 2006, Medicaid is no longer a primary payor for the pharmacy services provided to these residents. In fiscal 2005, the Company’s pharmacy division derived approximately 45% of its revenues from the state Medicaid programs.

Pharmacy operating income increased 12% to $16 million in the third quarter of 2006 from $14 million in the same period a year ago and 22% to $48 million for the nine months ended September 30, 2006 from $39 million in the same period a year ago. Operating margins were 9.5% and 9.8% in the third quarter and nine months ended September 30, 2006, respectively, compared to 10.7% and 10.5% in the same prior year periods. The cost of goods sold as a percentage of institutional pharmacy revenues were 63.6% and 64.6% in the third quarter and nine months ended September 30, 2006, respectively, compared to 65.9% and 65.3% in the same prior year periods. Pharmacy operating income in both periods increased from the same periods last year primarily due to acquisitions and volume growth. Operating income associated with pharmacy acquisitions completed in 2006 and 2005 approximated $4 million and $10 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $2 million and $5 million for the respective prior year periods.

 

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

Results of Operations – Continuing Operations (Continued)

 

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $38 million and $118 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $33 million and $100 million for the respective prior year periods. Corporate overhead as a percentage of consolidated revenues totaled 3.6% and 3.7% in the third quarter and nine months ended September 30, 2006, respectively, compared to 3.4% and 3.5% in the same prior year periods. The increase in corporate overhead in the third quarter and nine months ended September 30, 2006 compared to the same periods last year was primarily attributable to increases in stock-based compensation and certain incentive compensation costs.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $1 million and $5 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $3 million and $8 million for the respective prior year periods.

Reorganization Items

Transactions related to the Company’s emergence from bankruptcy have been classified separately in the unaudited condensed consolidated statement of operations. Operating results for the nine months ended September 30, 2005 included income of approximately $1 million resulting from changes in estimates for accrued professional and administrative costs related to the Company’s emergence from bankruptcy.

Capital Costs

Rent expense increased 22% to $82 million in the third quarter of 2006 from $67 million in the same period a year ago and 14% to $226 million for the nine months ended September 30, 2006 from $198 million in the same period a year ago. A substantial portion of the increase resulted from the Ventas rent reset in the third quarter of 2006, acquisition and development activities, and contractual inflation increases, including those associated with the Master Leases. See Note 3.

Depreciation and amortization expense increased 24% to $31 million in the third quarter of 2006 from $26 million in the same period a year ago and 21% to $89 million for the nine months ended September 30, 2006 from $74 million in the same period a year ago. The increase was primarily a result of the Company’s ongoing capital expenditure program and acquisition and development activities.

Interest expense increased to $5 million in the third quarter of 2006 from $2 million in the same period a year ago and to $11 million for the nine months ended September 30, 2006 from $6 million in the same period a year ago. The increase was primarily a result of increased borrowings under the Company’s revolving credit facility as a result of the Commonwealth Acquisition.

Investment income, related primarily to the Company’s excess cash balances and insurance subsidiary investments, approximated $3 million and $10 million in the third quarter and nine months ended September 30, 2006, respectively, compared to $3 million and $8 million for the respective prior year periods.

Consolidated Results

Income from continuing operations before income taxes declined 79% to $7 million in the third quarter of 2006 from $34 million in the same period a year ago and 51% to $87 million for the nine months ended September 30, 2006

 

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

Results of Operations – Continuing Operations (Continued)

Consolidated Results (Continued)

 

from $177 million in the same period a year ago. Net income from continuing operations declined 83% to $4 million in the third quarter of 2006 from $21 million in the same period a year ago and 53% to $50 million for the nine months ended September 30, 2006 from $106 million in the same period a year ago. See Note 5.

Discontinued Operations

Net loss from discontinued operations aggregated $1 million in the third quarter of both 2006 and 2005. Net income from discontinued operations aggregated $7 million for the nine months ended September 30, 2006 compared to $14 million for the same period a year ago. Net income from discontinued operations included favorable pretax adjustments of $0.4 million and $4 million for the third quarter of 2006 and 2005, respectively, and $17 million and $37 million for the nine months ended September 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas. See Notes 4 and 12.

Liquidity

Cash flows from operations (including discontinued operations) aggregated $41 million for the nine months ended September 30, 2006 compared to $107 million for the same period a year ago. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance acquisitions.

Cash and cash equivalents totaled $13 million at September 30, 2006 compared to $83 million at December 31, 2005. Based upon the Company’s existing cash levels, expected operating cash flows and capital spending (including planned acquisitions), and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

Long-term debt at September 30, 2006 aggregated $174 million (including $173 million of borrowings under the Company’s revolving credit facility). The Company expects to continue to utilize its revolving credit facility in 2006 to fund working capital and development needs. The Company was in compliance with the terms of its $400 million revolving credit facility at September 30, 2006.

Over the last few years, the Company’s limited purpose insurance subsidiary has achieved improved professional liability underwriting results. As a result, the Company received a return of capital of $34 million and $30 million during the nine months ended September 30, 2006 and 2005, respectively, from its limited purpose insurance subsidiary. These proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

The Company’s Series A warrants and Series B warrants expired on April 20, 2006. In connection with the exercise of these warrants, the Company issued approximately 10.1 million shares of common stock and received net proceeds of approximately $142 million. These proceeds were used to repurchase approximately 5.8 million shares of the Company’s common stock in the open market during the second quarter of 2006.

The Company also repurchased approximately two million shares of its common stock in the open market during the second quarter of 2006 at an aggregate cost of approximately $52 million, thereby completing a $100 million share repurchase program authorized by the Company’s Board of Directors in August 2005.

 

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

Liquidity (Continued)

 

During the past several years, the Company’s federal income tax payments have been significantly reduced primarily as a result of certain income tax benefits arising in connection with the Company’s reorganization, including the utilization of NOLs. Beginning in 2006, the Company expects that cash payments of federal income taxes will more closely reflect the Company’s provision for income taxes. Accordingly, the Company’s operating cash flows in 2006 may decline from the levels reported in 2005. Operating cash flows for the nine months ended September 30, 2006 included $44 million of federal income tax payments compared to $1 million in the same period a year ago.

As previously discussed, the Company is contesting certain proposed adjustments by the IRS to its 2000 and 2001 federal income tax returns related primarily to its NOLs.

On October 12, 2006, Ventas exercised a one-time right to reset rent under each of the four Master Leases. These new aggregate annual rents of approximately $239 million became effective retroactively to July 19, 2006 and were determined as fair market rentals by the final independent appraisers engaged in connection with the rent reset process under the four Master Leases. Aggregate annual Ventas rents prior to the rent reset approximated $206 million. As required, Ventas paid the Company a reset fee of approximately $5 million which will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases. In connection with the exercise of the rent reset, the new annual rents were allocated among the facilities subject to the Master Leases in accordance with the determinations made by the final appraisers during the rent reset process. The new contingent annual rent escalator will be 2.7% for Master Leases 1, 3 and 4. The escalator for Master Lease 2 is based upon the CPI with a floor of 2.25% and a ceiling of 4%. Prior to the rent reset, the contingent annual Ventas rent escalator under each Master Lease was 3.5%.

In 2003, the Company had agreed to pay Ventas additional rents in varying amounts generally over seven years in consideration for the divestiture of the Company’s former Florida and Texas nursing centers. For accounting purposes, these additional rent payments were classified as long-term debt. As a result of the rent reset, the remaining obligations under the 2003 agreement were extinguished. For accounting purposes, the Company’s remaining debt obligation to Ventas of $28 million as of July 18, 2006 has been reclassified as a deferred credit in the accompanying unaudited condensed consolidated balance sheet and will be amortized as a reduction of rent expense over the remaining original terms of the Master Leases.

On August 8, 2006, the Company entered into definitive agreements with HCP to acquire the real estate related to 11 unprofitable leased nursing centers operated by the Company for resale in exchange for three hospitals currently owned by the Company. As part of the transaction, the Company will continue to operate the hospitals under a long-term lease arrangement with HCP. In addition, the Company will pay HCP a one-time cash payment of approximately $36 million. The Company also will amend its existing master lease with HCP to (1) terminate the current annual rent of approximately $10 million on the 11 nursing centers, (2) add the three hospitals to the master lease with a current annual rent of approximately $6 million and (3) extend the initial expiration date of the master lease until September 30, 2016. The HCP transaction is subject to the receipt of required approvals and the satisfaction of several conditions to closing.

On November 7, 2006, the Company entered into a definitive agreement to sell the real estate and related operations of these 11 nursing centers for $78 million. The transaction to sell these 11 nursing centers is subject to the receipt of required approvals and the satisfaction of several conditions to closing, including without limitation, the successful closing of the HCP transaction.

Capital Resources

Excluding acquisitions, capital expenditures totaled $100 million in the nine months ended September 30, 2006 compared to $80 million for the same period a year ago. Excluding acquisitions, capital expenditures could

 

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

Capital Resources (Continued)

 

approximate $140 million to $150 million in 2006. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds. At September 30, 2006, the estimated cost to complete and equip construction in progress approximated $99 million.

The Commonwealth Acquisition was financed primarily through borrowings under the Company’s revolving credit facility.

During the third quarter of 2006, the Company acquired three institutional pharmacies for an aggregate cost of $15 million. During the first nine months of 2005, the Company acquired a hospital and completed both the PPI Acquisition and the SCP Acquisition. The Company financed these acquisitions through the use of operating cash flows and borrowings under the revolving credit facility.

The revolving credit facility includes certain covenants which limit the Company’s acquisitions and annual capital expenditures. At September 30, 2006, the Company’s remaining permitted acquisition amount under its revolving credit facility aggregated $219 million.

Other Information

Effects of Inflation and Changing Prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. Congress and certain state legislatures have enacted or may enact additional significant cost containment measures limiting the Company’s ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in the Company’s LTAC hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems. Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

The Company’s hospitals operate under LTAC PPS. Operating results under this system are subject to changes in patient acuity and expense levels in the Company’s hospitals. These factors, among others, are subject to significant change. Slight variations in patient acuity could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs as patient acuity levels change. Under this system, Medicare reimbursements to the Company’s hospitals are based upon a fixed payment system. Operating margins in the hospital division could be negatively impacted if the Company is unable to control the operating costs of the division. As a result of these uncertainties, the Company cannot predict the ultimate long-term impact of LTAC PPS on its hospital operating results and the Company can provide no assurances that such regulations or operational changes resulting from these regulations will not have a material adverse impact on its financial position, results of operations or liquidity. In addition, the Company can provide no assurances that LTAC PPS will not have a material adverse effect on revenues from private and commercial third party payors. Various factors, including a reduction in average length of stay, have had a negative impact on revenues from private and commercial third party payors.

LTAC PPS maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. To maintain certification under LTAC PPS, the average length of stay of Medicare patients must be at least 25 days. Under the previous system, compliance with the 25-day average length of stay threshold was based upon all patient discharges.

 

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

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

 

CMS is currently evaluating various certification criteria for designating a hospital as a LTAC hospital. If such certification criteria were developed and enacted into legislation, the Company’s hospitals may not be able to maintain their status as LTAC hospitals or may need to adjust their operations.

Medicare payments to the Company’s nursing centers are based upon certain resource utilization grouping (“RUG”) payment rates developed by CMS that provide various levels of reimbursement based upon patient acuity. Beginning January 1, 2006, CMS increased the indexing of RUG categories, expanded the total RUG categories from 44 to 53 and eliminated the 20% payment add-on for the care of higher acuity patients that had been in effect since 2000 under the Balanced Budget Refinement Act of 2000.

On February 1, 2006, Congress passed the Deficit Reduction Act of 2005. This legislation allows, among other things, an annual $1,740 Medicare Part B outpatient therapy cap which went into effect on January 1, 2006. The legislation also requires CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. The exception legislation is scheduled to expire on December 31, 2006.

In January 2005, CMS issued final regulations on Medicare Part D which became effective on January 1, 2006. Medicare beneficiaries who were entitled to benefits under a state Medicaid program (so-called “dual eligibles”) now have their outpatient prescription drug costs covered by Medicare Part D, subject to certain limitations. Most of the Company’s nursing center residents whose drug costs were previously covered by state Medicaid programs are dual eligibles who qualify for the Medicare Part D drug benefit. Accordingly, since January 1, 2006, Medicaid is no longer a primary payor for the pharmacy services provided to these residents.

At this time, the Company cannot assess the overall impact of Medicare Part D on its institutional pharmacy business. The impact of this legislation depends upon a variety of factors, including the Company’s ongoing relationships with the Part D plans and the patient mix of the Company’s customers. This legislation may reduce revenue and impose additional costs to the industry, particularly in the transition phase. In addition, there can be no assurance that Medicare Part D and the regulations promulgated under Medicare Part D will not have a material adverse effect on the Company’s institutional pharmacy business.

The Company believes that its operating margins may continue to be under pressure as the growth in operating expenses, particularly professional liability, labor and employee benefits costs, exceeds payment increases from third party payors. In addition, as a result of competitive pressures, the Company’s ability to maintain operating margins through price increases to private patients is limited.

Litigation

The Company is a party to certain material litigation. See Note 16.

 

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

 

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)

 

    2005 Quarters     2006 Quarters  
    First     Second     Third     Fourth     First     Second     Third  

Revenues

  $ 913,128     $ 1,017,106     $ 951,265     $ 971,476     $ 1,030,730     $ 1,073,994     $ 1,058,892  
                                                       

Salaries, wages and benefits

    498,882       525,089       520,875       526,474       562,461       582,354       589,753  

Supplies

    126,495       144,110       144,914       154,660       163,583       167,609       170,815  

Rent

    64,749       66,347       66,457       67,080       69,293       74,921       81,252  

Other operating expenses

    144,952       170,869       159,417       155,957       170,910       176,789       176,546  

Depreciation and amortization

    23,252       24,684       25,916       27,130       27,846       29,828       32,046  

Interest expense

    2,000       2,439       1,931       1,728       2,649       3,534       4,667  

Investment income

    (2,347 )     (3,031 )     (2,471 )     (3,210 )     (3,691 )     (3,444 )     (3,530 )
                                                       
    857,983       930,507       917,039       929,819       993,051       1,031,591       1,051,549  
                                                       

Income from continuing operations before reorganization items and income taxes

    55,145       86,599       34,226       41,657       37,679       42,403       7,343  

Reorganization items

    (1,371 )                 (268 )                  
                                                       

Income from continuing operations before income taxes

    56,516       86,599       34,226       41,925       37,679       42,403       7,343  

Provision for income taxes

    22,787       34,793       13,809       16,486       15,743       18,163       3,774  
                                                       

Income from continuing operations

    33,729       51,806       20,417       25,439       21,936       24,240       3,569  

Discontinued operations, net of income taxes:

             

Income (loss) from operations

    3,161       11,614       (916 )     1,040       1,866       5,741       (757 )

Gain (loss) on divestiture of operations

          2,647       (3,147 )     (881 )     157       (308 )     126  
                                                       

Net income

  $ 36,890     $ 66,067     $ 16,354     $ 25,598     $ 23,959     $ 29,673     $ 2,938  
                                                       

Earnings per common share:

             

Basic:

             

Income from continuing operations

  $ 0.93     $ 1.38     $ 0.54     $ 0.68     $ 0.60     $ 0.58     $ 0.09  

Discontinued operations:

             

Income (loss) from operations

    0.09       0.31       (0.03 )     0.03       0.05       0.14       (0.02 )

Gain (loss) on divestiture of operations

          0.07       (0.08 )     (0.03 )           (0.01 )      
                                                       

Net income

  $ 1.02     $ 1.76     $ 0.43     $ 0.68     $ 0.65     $ 0.71     $ 0.07  
                                                       

Diluted:

             

Income from continuing operations

  $ 0.76     $ 1.12     $ 0.45     $ 0.58     $ 0.53     $ 0.57     $ 0.09  

Discontinued operations:

             

Income (loss) from operations

    0.07       0.25       (0.02 )     0.03       0.05       0.13       (0.02 )

Gain (loss) on divestiture of operations

          0.06       (0.07 )     (0.02 )           (0.01 )      
                                                       

Net income

  $ 0.83     $ 1.43     $ 0.36     $ 0.59     $ 0.58     $ 0.69     $ 0.07  
                                                       

Shares used in computing earnings per common share:

             

Basic

    36,312       37,495       38,013       37,472       36,576       41,695       39,014  

Diluted

    44,410       46,367       46,033       43,736       41,091       42,956       39,769  

 

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

 

Operating Data

(Unaudited)

(In thousands)

 

    2005 Quarters     2006 Quarters  
    First     Second     Third     Fourth     First     Second     Third  

Revenues:

             

Hospital division

  $ 393,040     $ 434,562     $ 389,776     $ 390,742     $ 430,814     $ 439,308     $ 406,923  

Health services division

    423,605       463,740       441,937       450,727       460,038       493,067       499,072  

Rehabilitation division

    64,947       65,365       65,553       66,908       71,162       74,376       76,003  

Pharmacy division

    107,957       131,849       135,165       147,254       157,214       159,926       170,443  
                                                       
    989,549       1,095,516       1,032,431       1,055,631       1,119,228       1,166,677       1,152,441  

Eliminations:

             

Rehabilitation

    (47,231 )     (47,906 )     (49,779 )     (50,409 )     (53,975 )     (57,071 )     (57,019 )

Pharmacy

    (29,190 )     (30,504 )     (31,387 )     (33,746 )     (34,523 )     (35,612 )     (36,530 )
                                                       
    (76,421 )     (78,410 )     (81,166 )     (84,155 )     (88,498 )     (92,683 )     (93,549 )
                                                       
  $ 913,128     $ 1,017,106     $ 951,265     $ 971,476     $ 1,030,730     $ 1,073,994     $ 1,058,892  
                                                       

Income from continuing operations:

             

Operating income (loss):

             

Hospital division

  $ 101,801     $ 134,263     $ 90,728     $ 92,754     $ 104,064     $ 105,307     $ 74,793  (a)

Health services division

    51,301       63,157       48,286       53,771       47,925       63,297       61,293  

Rehabilitation division

    9,711       6,989       7,913       7,439       4,239       8,453       8,857  

Pharmacy division

    11,454       13,298       14,455       17,630       16,729       15,139       16,152 (b)

Corporate:

             

Overhead

    (29,115 )     (38,052 )     (32,631 )     (34,716 )     (37,334 )     (43,257 )     (37,683 ) (c)(d)

Insurance subsidiary

    (2,353 )     (2,617 )     (2,692 )     (2,493 )     (1,847 )     (1,697 )     (1,634 )
                                                       
    (31,468 )     (40,669 )     (35,323 )     (37,209 )     (39,181 )     (44,954 )     (39,317 )
                                                       
    142,799       177,038       126,059       134,385       133,776       147,242       121,778  

Reorganization items

    1,371                   268                    
                                                       

Operating income

    144,170       177,038       126,059       134,653       133,776       147,242       121,778  

Rent

    (64,749 )     (66,347 )     (66,457 )     (67,080 )     (69,293 )     (74,921 )     (81,252 )

Depreciation and amortization

    (23,252 )     (24,684 )     (25,916 )     (27,130 )     (27,846 )     (29,828 )     (32,046 )

Interest, net

    347       592       540       1,482       1,042       (90 )     (1,137 )
                                                       

Income from continuing operations before income taxes

    56,516       86,599       34,226       41,925       37,679       42,403       7,343  

Provision for income taxes

    22,787       34,793       13,809       16,486       15,743       18,163       3,774  
                                                       
  $ 33,729     $ 51,806     $ 20,417     $ 25,439     $ 21,936     $ 24,240     $ 3,569  
                                                       

(a) Includes income of $1.0 million related to an insurance recovery.
(b) Includes costs of $1.1 million incurred in connection with the planned spin-off of the Company’s institutional pharmacy business.
(c) Includes costs of $2.4 million incurred in connection with the planned spin-off of the Company’s institutional pharmacy business and professional fees incurred in connection with the rent reset issue with Ventas.
(d) Includes income of $0.3 million related to a favorable adjustment of a prior year tax dispute.

 

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

 

Operating Data (Continued)

(Unaudited)

(In thousands)

 

    2005 Quarters   2006 Quarters
    First   Second   Third   Fourth   First   Second   Third

Rent:

             

Hospital division

  $ 24,717   $ 25,244   $ 25,366   $ 25,529   $ 26,619   $ 29,588   $ 32,245

Health services division

    38,239     38,993     38,969     39,039     40,447     43,048     46,552

Rehabilitation division

    800     817     817     809     869     897     932

Pharmacy division

    926     1,169     1,226     1,614     1,280     1,316     1,448

Corporate

    67     124     79     89     78     72     75
                                         
  $ 64,749   $ 66,347   $ 66,457   $ 67,080   $ 69,293   $ 74,921   $ 81,252
                                         

Depreciation and amortization:

             

Hospital division

  $ 9,554   $ 9,836   $ 10,579   $ 10,979   $ 11,107   $ 11,658   $ 12,363

Health services division

    6,960     7,385     7,721     8,396     9,287     10,260     10,966

Rehabilitation division

    54     56     57     64     80     115     127

Pharmacy division

    926     1,521     1,525     1,779     1,797     1,857     2,594

Corporate

    5,758     5,886     6,034     5,912     5,575     5,938     5,996
                                         
  $ 23,252   $ 24,684   $ 25,916   $ 27,130   $ 27,846   $ 29,828   $ 32,046
                                         

Capital expenditures, excluding acquisitions (including discontinued operations):

             

Hospital division

  $ 8,235   $ 11,289   $ 11,634   $ 14,145   $ 15,365   $ 14,105   $ 16,535

Health services division

    6,957     10,986     14,488     17,915     5,225     11,151     12,849

Rehabilitation division

    2     96     17     538     19     130     146

Pharmacy division

    1,075     1,506     1,562     2,820     2,057     2,219     2,581

Corporate:

             

Information systems

    1,462     4,171     5,580     9,191     2,514     8,958     5,376

Other

    232     550     271     1,341     115     177     232
                                         
  $ 17,963   $ 28,598   $ 33,552   $ 45,950   $ 25,295   $ 36,740   $ 37,719
                                         

 

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Table of Contents

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

 

Operating Data (Continued)

(Unaudited)

 

     2005 Quarters    2006 Quarters
     First    Second    Third    Fourth    First    Second    Third

Hospital data:

                    

End of period data:

                    

Number of hospitals

     73      73      73      74      80      80      80

Number of licensed beds

     5,603      5,603      5,603      5,694      6,347      6,363      6,359

Revenue mix % (a):

                    

Medicare

     65      71      65      65      64      62      60

Medicaid

     6      6      7      6      7      9      10

Private and other

     29      23      28      29      29      29      30

Admissions:

                    

Medicare

     7,397      7,080      7,106      7,287      7,810      7,330      6,978

Medicaid

     727      823      845      827      913      1,018      1,031

Private and other

     1,564      1,528      1,495      1,503      1,919      1,957      1,891
                                                
     9,688      9,431      9,446      9,617      10,642      10,305      9,900
                                                

Admissions mix %:

                    

Medicare

     76      75      75      76      73      71      71

Medicaid

     8      9      9      8      9      10      10

Private and other

     16      16      16      16      18      19      19

Patient days:

                    

Medicare

     207,670      209,670      197,725      199,857      212,116      211,255      200,154

Medicaid

     26,660      28,361      30,489      29,867      37,635      50,232      51,743

Private and other

     61,052      55,622      53,535      57,633      66,399      70,880      71,991
                                                
     295,382      293,653      281,749      287,357      316,150      332,367      323,888
                                                

Average length of stay:

                    

Medicare

     28.1      29.6      27.8      27.4      27.2      28.8      28.7

Medicaid

     36.7      34.5      36.1      36.1      41.2      49.3      50.2

Private and other

     39.0      36.4      35.8      38.3      34.6      36.2      38.1

Weighted average

     30.5      31.1      29.8      29.9      29.7      32.3      32.7

Revenues per admission (a):

                    

Medicare

   $ 34,750    $ 43,798    $ 35,871    $ 34,960    $ 35,247    $ 37,025    $ 34,866

Medicaid

     30,295      30,887      32,385      29,014      34,228      40,231      40,604

Private and other

     72,872      64,824      71,913      74,516      64,766      64,874      64,394

Weighted average

     40,570      46,078      41,264      40,630      40,483      42,631      41,103

Revenues per patient day (a):

                    

Medicare

   $ 1,238    $ 1,479    $ 1,289    $ 1,275    $ 1,298    $ 1,285    $ 1,216

Medicaid

     826      896      898      803      830      815      809

Private and other

     1,867      1,781      2,008      1,943      1,872      1,791      1,691

Weighted average

     1,331      1,480      1,383      1,360      1,363      1,322      1,256

Medicare case mix index (discharged patients only)

     1.22      1.25      1.20      1.11      1.12      1.12      1.11

Average daily census

     3,282      3,227      3,062      3,123      3,513      3,652      3,521

Occupancy %

     61.2      59.9      56.9      58.5      65.3      63.3      61.2

(a) Includes income of $2.9 million in the first quarter of 2005, $54.6 million in the second quarter of 2005, $5.9 million in the third quarter of 2005, $1.9 million in the fourth quarter of 2005, $1.9 million in the first quarter of 2006 and $4.3 million in the second quarter of 2006 related to certain Medicare reimbursement issues.

 

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

 

Operating Data (Continued)

(Unaudited)

 

    2005 Quarters   2006 Quarters
    First   Second     Third   Fourth   First   Second   Third

Nursing center data:

             

End of period data:

             

Number of nursing centers:

             

Owned or leased

    225     226       226     226     237     237     237

Managed

    7     5       5     5     5     5     5
                                           
    232     231       231     231     242     242     242
                                           

Number of licensed beds:

             

Owned or leased

    28,407     28,512       28,510     28,510     30,064     30,074     30,074

Managed

    803     605       605     605     605     605     605
                                           
    29,210     29,117       29,115     29,115     30,669     30,679     30,679
                                           

Revenue mix %:

             

Medicare

    35     32       33     33     35     35     33

Medicaid

    47     51 (a)     49     48     46     46     47

Private and other

    18     17       18     19     19     19     20

Patient days (excludes managed facilities):

             

Medicare

    379,222     382,924       365,962     368,264     393,257     413,028     392,114

Medicaid

    1,473,126     1,475,430       1,508,298     1,499,119     1,484,160     1,551,903     1,584,093

Private and other

    369,405     367,998       380,276     397,870     396,482     429,822     453,304
                                           
    2,221,753     2,226,352       2,254,536     2,265,253     2,273,899     2,394,753     2,429,511
                                           

Patient day mix %:

             

Medicare

    17     17       16     16     17     17     16

Medicaid

    66     66       67     66     65     65     65

Private and other

    17     17       17     18     18     18     19

Revenues per patient day:

             

Medicare Part A

  $ 349   $ 348     $ 351   $ 365   $ 376   $ 377   $ 381

Total Medicare (including Part B)

    390     390       396     405     412     411     419

Medicaid

    135     160 (a)     145     145     143     147     149

Private and other

    207     212       207     212     217     221     219

Weighted average

    191     208       196     199     202     206     205

Average daily census

    24,686     24,465       24,506     24,622     25,266     26,316     26,408

Occupancy %

    86.5     85.8       85.9     86.4     87.1     87.9     88.1

Rehabilitation data:

             

Revenue mix %:

             

Company-operated

    76     77       78     77     78     78     75

Non-affiliated

    24     23       22     23     22     22     25

Pharmacy data:

             

Number of customer licensed beds at end of period:

             

Company-operated

    29,105     28,649       28,649     28,657     30,449     30,287     30,232

Non-affiliated

    46,745     56,112       55,201     64,625     63,683     65,036     72,268
                                           
    75,850     84,761       83,850     93,282     94,132     95,323     102,500
                                           

(a) Includes income of $30.5 million for periods prior to April 1, 2005 related to retroactive Medicaid rate increases in the state of Indiana. Related provider tax expense of $15.4 million under this program was recorded in other operating expenses.

 

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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion of the Company’s exposure to market risk contains “forward-looking statements” that involve risks and uncertainties. The information presented has been prepared utilizing certain assumptions considered reasonable in light of information currently available to the Company. Given the unpredictability of interest rates as well as other factors, actual results could differ materially from those projected in such forward-looking information.

The Company’s exposure to market risk relates to changes in the prime rate, federal funds rate and the London Interbank Offered Rate which affect the interest paid on certain borrowings.

The following table provides information about the Company’s financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted average interest rates by expected maturity date.

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)

 

     Expected maturities   

Fair

value

9/30/06

     2006     2007     2008     2009     2010     Thereafter     Total   

Liabilities:

                 

Long-term debt, including amounts due within one year:

                 

Fixed rate

   $ 17     $ 71     $ 76     $ 81     $ 86     $ 648     $ 979    $ 924

Average interest rate

     6.0 %     6.0 %     6.0 %     6.0 %     6.0 %     6.0 %     

Variable rate (a)

   $     $     $     $ 173,300     $     $     $ 173,300