Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

þQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

Large accelerated filer  ¨     Accelerated filer  þ    Non-accelerated filer  ¨    Smaller reporting  company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    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, 2010

Common stock, $0.25 par value   39,480,570 shares

 

 

 

 

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KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX

 

          Page  

PART I.

   FINANCIAL INFORMATION   

Item 1.

  

Financial Statements (Unaudited):

  
  

Condensed Consolidated Statement of Operations — for the three months ended September 30,  2010 and 2009 and for the nine months ended September 30, 2010
and 2009

     3   
  

Condensed Consolidated Balance Sheet — September 30, 2010 and December 31, 2009

     4   
  

Condensed Consolidated Statement of Cash Flows — for the three months ended  September 30, 2010 and 2009 and for the nine months ended September 30, 2010 and 2009

     5   
  

Notes to Condensed Consolidated Financial Statements

     6   

Item 2.

  

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

     21   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     45   

Item 4.

  

Controls and Procedures

     46   

PART II.

  

OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

     47   

Item 6.

  

Exhibits

     47   

 

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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,
 
     2010     2009     2010     2009  

Revenues

   $ 1,053,012      $ 1,057,488      $ 3,224,213      $ 3,200,016   
                                

Salaries, wages and benefits

     613,607        629,077        1,852,987        1,865,125   

Supplies

     83,753        82,400        255,094        246,648   

Rent

     89,295        88,081        266,595        260,164   

Other operating expenses

     234,968        221,524        707,859        663,684   

Other income

     (2,794     (2,870     (8,735     (8,565

Depreciation and amortization

     29,167        31,992        90,140        93,837   

Interest expense

     1,642        1,741        4,247        6,448   

Investment income

     (403     (746     (903     (3,254
                                
     1,049,235        1,051,199        3,167,284        3,124,087   
                                

Income from continuing operations before income taxes

     3,777        6,289        56,929        75,929   

Provision (benefit) for income taxes

     (1,323     901        20,538        29,662   
                                

Income from continuing operations

     5,100        5,388        36,391        46,267   

Discontinued operations, net of income taxes:

        

Income (loss) from operations

     (260     13        (327     (1,465

Gain (loss) on divestiture of operations

     86        52        3        (23,999
                                

Net income

   $ 4,926      $ 5,453      $ 36,067      $ 20,803   
                                

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 0.13      $ 0.14      $ 0.92      $ 1.19   

Discontinued operations:

        

Income (loss) from operations

     (0.01            (0.01     (0.04

Gain (loss) on divestiture of operations

                          (0.62
                                

Net income

   $ 0.12      $ 0.14      $ 0.91      $ 0.53   
                                

Diluted:

        

Income from continuing operations

   $ 0.13      $ 0.14      $ 0.92      $ 1.18   

Discontinued operations:

        

Income (loss) from operations

     (0.01            (0.01     (0.04

Gain (loss) on divestiture of operations

                          (0.61
                                

Net income

   $ 0.12      $ 0.14      $ 0.91      $ 0.53   
                                

Shares used in computing earnings per common share:

        

Basic

     38,778        38,398        38,720        38,297   

Diluted

     38,838        38,524        38,855        38,419   

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)

 

     September 30,
2010
    December 31,
2009
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 15,321      $ 16,303   

Cash – restricted

     5,383        5,820   

Insurance subsidiary investments

     63,344        106,834   

Accounts receivable less allowance for loss of $16,775 – September 30, 2010 and $20,156 – December 31, 2009

     613,951        610,959   

Inventories

     22,313        22,303   

Deferred tax assets

     29,107        42,791   

Income taxes

     13,481        17,447   

Other

     21,366        21,194   
                
     784,266        843,651   

Property and equipment

     1,682,692        1,515,700   

Accumulated depreciation

     (834,096     (765,602
                
     848,596        750,098   

Goodwill

     86,711        81,223   

Intangible assets less accumulated amortization of $3,312 – September 30, 2010 and
$2,647 – December 31, 2009

     71,038        64,491   

Assets held for sale

     11,279        8,806   

Insurance subsidiary investments

     116,348        100,223   

Deferred tax assets

     114,183        110,930   

Other

     68,606        62,802   
                
   $ 2,101,027      $ 2,022,224   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 149,037      $ 161,066   

Salaries, wages and other compensation

     284,506        287,772   

Due to third party payors

     38,575        28,261   

Professional liability risks

     42,892        47,076   

Other accrued liabilities

     84,177        78,358   

Long-term debt due within one year

     89        86   
                
     599,276        602,619   

Long-term debt

     165,080        147,647   

Professional liability risks

     216,146        195,126   

Deferred credits and other liabilities

     111,693        110,238   

Commitments and contingencies

    

Stockholders’ equity:

    

Common stock, $0.25 par value; authorized 175,000 shares; issued 39,476 shares –
September 30, 2010 and 39,104 shares – December 31, 2009

     9,869        9,776   

Capital in excess of par value

     826,060        820,407   

Accumulated other comprehensive income (loss)

     162        (423

Retained earnings

     172,741        136,834   
                
     1,008,832        966,594   
                
   $ 2,101,027      $ 2,022,224   
                

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,
 
     2010     2009     2010     2009  

Cash flows from operating activities:

        

Net income

   $ 4,926      $ 5,453      $ 36,067      $ 20,803   

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

        

Depreciation and amortization

     29,167        31,992        90,140        94,511   

Amortization of stock-based compensation costs

     2,593        2,449        8,114        7,548   

Provision for doubtful accounts

     6,110        7,100        18,387        21,747   

Deferred income taxes

     (3,017     4,286        (13,744     (5,221

(Gain) loss on divestiture of discontinued operations

     (86     (52     (3     23,999   

Other

     (2,792     (1,428     (1,866     (1,192

Change in operating assets and liabilities:

        

Accounts receivable

     8,146        (11,934     (21,379     (76,075

Inventories and other assets

     (1,088     (2,194     (7,574     (11,755

Accounts payable

     (7,515     7,972        (15,693     (4,122

Income taxes

     3,981        (7,727     25,734        38,374   

Due to third party payors

     12,123        5,413        10,099        (4,340

Other accrued liabilities

     15,361        16,062        22,573        37,932   
                                

Net cash provided by operating activities

     67,909        57,392        150,855        142,209   
                                

Cash flows from investing activities:

        

Routine capital expenditures

     (28,623     (22,494     (69,108     (74,468

Development capital expenditures

     (20,364     (11,481     (40,219     (38,389

Acquisitions

     (38,379     (8,035     (87,869     (83,432

Sale of assets

            14,019               14,019   

Purchase of insurance subsidiary investments

     (10,566     (18,808     (34,684     (77,480

Sale of insurance subsidiary investments

     11,138        17,658        72,971        97,677   

Net change in insurance subsidiary cash and cash equivalents

     (3,111     1,177        (10,612     16,852   

Change in other investments

            2        2        2,002   

Other

     698        (517     1,279        3,877   
                                

Net cash used in investing activities

     (89,207     (28,479     (168,240     (139,342
                                

Cash flows from financing activities:

        

Proceeds from borrowings under revolving credit

     457,900        295,600        1,109,900        952,500   

Repayment of borrowings under revolving credit

     (432,800     (319,300     (1,092,400     (1,050,800

Payment of deferred financing costs

     (1,361     (177     (1,414     (604

Issuance of common stock

            568        35        568   

Other

     (22     (28     282        (23
                                

Net cash provided by (used in) financing activities

     23,717        (23,337     16,403        (98,359
                                

Change in cash and cash equivalents

     2,419        5,576        (982     (95,492

Cash and cash equivalents at beginning of period

     12,902        39,727        16,303        140,795   
                                

Cash and cash equivalents at end of period

   $ 15,321      $ 45,303      $ 15,321      $ 45,303   
                                

Supplemental information:

        

Interest payments

   $ 1,110      $ 1,491      $ 3,376      $ 5,398   

Income tax payments (refunds)

     468        6,092        11,021        (2,711

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 and rehabilitation centers and a contract rehabilitation services business across the United States (collectively, the “Company”). At September 30, 2010, the Company’s hospital division operated 83 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s nursing center division operated 226 nursing and rehabilitation centers in 28 states. The Company’s rehabilitation division provided rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing and rehabilitation centers 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, 2010 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 2 for a summary of discontinued operations.

Recently issued accounting requirements

In January 2010, the Financial Accounting Standards Board (the “FASB”) issued authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 classifications (as described in Note 13). The provisions also require a reconciliation of the activity in Level 3 recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on the Company’s business, financial position, results of operations or liquidity.

In June 2009, the FASB issued revised authoritative guidance related to the consolidation criteria for variable interest entities (“VIE”). The guidance, among other things, requires a qualitative rather than a quantitative analysis to determine the primary beneficiary of a VIE; requires continuous assessments of whether an enterprise is the primary beneficiary of a VIE; enhances disclosures regarding an enterprise’s involvement with a VIE; and amends certain guidance for determining whether an entity is a VIE. Under the guidance, a VIE must be consolidated if the enterprise has both (a) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. The guidance was effective as of January 1, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on the Company’s business, financial position, results of operations or liquidity.

Upon adoption of the VIE guidance on January 1, 2010, the Company reassessed its three investment partnerships and its lease agreements under the new accounting guidance. Although the investment partnerships were determined to be VIEs, they do not require the Company to absorb losses or receive benefits that could potentially be significant to the VIEs, nor can the Company direct the activities that most significantly impact the VIEs’ economic performance. As a result, the investment partnerships continue to be accounted for under the equity method of accounting and are not consolidated. The Company also determined that three of its lease agreements were considered VIEs. However, the Company is not the primary beneficiary of these leases as it

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Recently issued accounting requirements (Continued)

 

lacks the power to direct activities of the lessor that most significantly impact the economic performance under these leases. In addition, the Company’s investments and involvement in lease arrangements related to these VIEs were not significant to its accompanying unaudited condensed consolidated financial statements.

Comprehensive income

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

 

     Three months ended
September 30,
     Nine months ended
September 30,
 
         2010              2009              2010              2009      

Net income

   $ 4,926       $ 5,453       $ 36,067       $ 20,803   

Net unrealized investment gains, net of income taxes

     786         1,081         585         1,396   
                                   

Comprehensive income

   $ 5,712       $ 6,534       $ 36,652       $ 22,199   
                                   

Other information

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q of Regulation S-X and 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, 2009 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2009 was derived from audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles.

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.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include amounts based upon the estimates and judgments of management. Actual amounts may differ from those estimates.

Reclassifications

Certain prior period amounts have been reclassified to conform with the current period presentation.

The Company reclassified $4.6 million and $2.4 million of book overdrafts for the third quarter and nine months ended September 30, 2009, respectively, from net cash provided by financing activities to net cash provided by operating activities in the accompanying unaudited condensed consolidated statement of cash flows to conform with the current period presentation. The reclassification had no impact on the Company’s business, financial position, results of operations or liquidity.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

NOTE 2 – DISCONTINUED OPERATIONS

In accordance with the authoritative guidance for the impairment or disposal of long-lived assets, the divestitures of unprofitable businesses discussed in Note 1 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, 2010, the Company held for sale one nursing and rehabilitation center and two hospitals reported as discontinued operations.

In June 2009, the Company purchased for resale six under-performing nursing and rehabilitation centers (the “Nursing Centers”) previously leased from Ventas, Inc. (“Ventas”) for $55.7 million. In addition, the Company paid a lease termination fee of $2.3 million. The Nursing Centers were included in master lease agreements with Ventas. The Company does not have the ability to terminate a lease of an individual facility under the master lease agreements. The Nursing Centers, which contained 777 licensed beds, generated pretax losses of $2.0 million for the nine months ended September 30, 2009. The Company recorded a pretax loss of $39.0 million ($24.0 million net of income taxes) for the nine months ended September 30, 2009 related to these divestitures.

A summary of discontinued operations follows (in thousands):

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2010     2009     2010     2009  

Revenues

   $ 2,508      $ 17,068      $ 9,956      $ 50,150   
                                

Salaries, wages and benefits

     2,348        10,077        7,359        29,064   

Supplies

     161        1,017        556        3,001   

Rent

     31        223        103        3,520   

Other operating expenses

     390        5,734        2,495        16,274   

Depreciation

                          674   

Interest expense

     1        2        1        9   

Investment income

     (1     (7     (27     (11
                                
     2,930        17,046        10,487        52,531   
                                

Income (loss) from operations before income taxes

     (422     22        (531     (2,381

Provision (benefit) for income taxes

     (162     9        (204     (916
                                

Income (loss) from operations

     (260     13        (327     (1,465

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

     86        52        3        (23,999
                                
   $ (174   $ 65      $ (324   $ (25,464
                                

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

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2010     2009     2010     2009  

Revenues:

        

Hospital division

   $ (196   $ 1,469      $ (89   $ 3,818   

Nursing center division

     2,704        15,599        10,045        46,332   
                                
   $ 2,508      $ 17,068      $ 9,956      $ 50,150   
                                

Operating income (loss):

        

Hospital division

   $ (348   $ (547   $ (1,185   $ (2,039

Nursing center division

     (43     787        731        3,850   
                                
   $ (391   $ 240      $ (454   $ 1,811   
                                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

 

 

     Three months ended
September 30,
     Nine months ended
September 30,
 
         2010              2009              2010              2009      

Rent:

           

Hospital division

   $ 29       $ 63       $ 93       $ 164   

Nursing center division

     2         160         10         3,356   
                                   
   $ 31       $ 223       $ 103       $ 3,520   
                                   

Depreciation:

           

Hospital division

   $       $       $       $   

Nursing center division

                             674   
                                   
   $       $       $       $ 674   
                                   

A summary of the net assets held for sale, including certain assets included in continuing operations, follows (in thousands):

 

     September 30,
2010
    December 31,
2009
 

Long-term assets:

    

Property and equipment, net

   $ 11,242      $ 8,723   

Other

     37        83   
                
     11,279        8,806   

Current liabilities (included in other accrued liabilities)

     (254     (422
                
   $ 11,025      $ 8,384   
                

NOTE 3 – ACQUISITIONS

The following is a summary of the Company’s significant acquisition activities. The operating results of the acquired businesses have been included in the accompanying unaudited condensed consolidated financial statements of the Company from the respective acquisition dates. The purchase price of the acquired businesses and acquired leased facilities resulted from negotiations with each of the sellers that were based upon both the historical and expected future cash flows of the respective businesses and real estate values. All of these acquisitions were financed through borrowings under the Company’s revolving credit facility. Unaudited pro formas related to acquired new businesses have not been presented because the acquisitions are not material, either individually or in the aggregate, to the Company’s consolidated financial statements.

In September 2010, the Company acquired three nursing and rehabilitation centers for $37.7 million. Goodwill and identifiable intangible assets recorded in connection with the acquisition aggregated $7.5 million.

In March 2010, the Company acquired a combined nursing and rehabilitation center and assisted living facility for $16.6 million. Goodwill and identifiable intangible assets recorded in connection with the acquisition aggregated $2.4 million.

In January 2010, the Company acquired the real estate of two previously leased hospitals and two previously leased nursing and rehabilitation centers for $31.1 million in cash and $2.4 million in unamortized prepaid rent. Annual rents associated with these four facilities aggregated $2.9 million.

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – ACQUISITIONS (Continued)

 

 

The fair value of each of the acquisitions completed during the nine months ended September 30, 2010 were measured using primarily discounted cash flow methodologies, a Level 3 (as described in Note 13) measurement technique.

In July 2009, the Company acquired a hospice business for $8.0 million. Goodwill and identifiable intangible assets recorded in connection with the acquisition aggregated $7.8 million. The fair value of the assets acquired were measured using primarily discounted cash flow methodologies, a Level 3 (as described in Note 13) measurement technique.

In March 2009, the Company acquired the real estate of a previously leased hospital for $15.6 million in cash and $1.6 million in unamortized prepaid rent. Annual rent associated with this facility aggregated $1.8 million. The fair value of the assets acquired were measured using Level 2 (as described in Note 13) observable inputs, including replacement costs and direct sales comparisons of similar properties in the same geographic market or region.

NOTE 4 – 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, Medicare Advantage 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,
 
     2010     2009     2010     2009  

Medicare

   $ 435,178      $ 437,845      $ 1,372,038      $ 1,356,872   

Medicaid

     265,004        276,461        794,431        811,788   

Medicare Advantage

     82,116        77,670        255,939        242,515   

Other

     347,057        337,935        1,031,151        1,003,974   
                                
     1,129,355        1,129,911        3,453,559        3,415,149   

Eliminations

     (76,343     (72,423     (229,346     (215,133
                                
   $ 1,053,012      $ 1,057,488      $ 3,224,213      $ 3,200,016   
                                

NOTE 5 – 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 includes the dilutive effect of stock options. On January 1, 2009, the Company adopted the provisions of the authoritative guidance for determining whether instruments granted in share-based payment transactions are participating securities, which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings per common share calculation pursuant to the two-class method.

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – 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,  
    2010     2009     2010     2009  
    Basic     Diluted     Basic     Diluted     Basic     Diluted     Basic     Diluted  

Earnings:

               

Income from continuing operations:

               

As reported in Statement of Operations

  $ 5,100      $ 5,100      $ 5,388      $ 5,388      $ 36,391      $ 36,391      $ 46,267      $ 46,267   

Allocation to participating unvested restricted stockholders

    (91     (91     (90     (90     (664     (662     (833     (830
                                                               

Available to common stockholders

  $ 5,009      $ 5,009      $ 5,298      $ 5,298      $ 35,727      $ 35,729      $ 45,434      $ 45,437   
                                                               

Discontinued operations, net of income taxes:

               

Income (loss) from operations:

               

As reported in Statement of Operations

  $ (260   $ (260   $ 13      $ 13      $ (327   $ (327   $ (1,465   $ (1,465

Allocation to participating unvested restricted stockholders

    5        5                      6        6        26        26   
                                                               

Available to common stockholders

  $ (255   $ (255   $ 13      $ 13      $ (321   $ (321   $ (1,439   $ (1,439
                                                               

Gain (loss) on divestiture of operations:

               

As reported in Statement of Operations

  $ 86      $ 86      $ 52      $ 52      $ 3      $ 3      $ (23,999   $ (23,999

Allocation to participating unvested restricted stockholders

    (2     (2     (1     (1                   432        431   
                                                               

Available to common stockholders

  $ 84      $ 84      $ 51      $ 51      $ 3      $ 3      $ (23,567   $ (23,568
                                                               

Net income:

               

As reported in Statement of Operations

  $ 4,926      $ 4,926      $ 5,453      $ 5,453      $ 36,067      $ 36,067      $ 20,803      $ 20,803   

Allocation to participating unvested restricted stockholders

    (88     (88     (91     (91     (658     (656     (375     (373
                                                               

Available to common stockholders

  $ 4,838      $ 4,838      $ 5,362      $ 5,362      $ 35,409      $ 35,411      $ 20,428      $ 20,430   
                                                               

Shares used in the computation:

               

Weighted average shares outstanding – basic computation

    38,778        38,778        38,398        38,398        38,720        38,720        38,297        38,297   
                                       

Dilutive effect of employee stock options

      60          126          135          122   
                                       

Adjusted weighted average shares outstanding – diluted computation

      38,838          38,524          38,855          38,419   
                                       

Earnings per common share:

               

Income from continuing operations

  $ 0.13      $ 0.13      $ 0.14      $ 0.14      $ 0.92      $ 0.92      $ 1.19      $ 1.18   

Discontinued operations:

               

Income (loss) from operations

    (0.01     (0.01                   (0.01     (0.01     (0.04     (0.04

Gain (loss) on divestiture of operations

                                              (0.62     (0.61
                                                               

Net income

  $ 0.12      $ 0.12      $ 0.14      $ 0.14      $ 0.91      $ 0.91      $ 0.53      $ 0.53   
                                                               

Number of antidilutive stock options excluded from shares used in the diluted earnings per common share computation

      2,959          3,021          2,496          3,030   

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

NOTE 6 – BUSINESS SEGMENT DATA

At September 30, 2010, the Company operated three business segments: the hospital division, the nursing center division and the rehabilitation division. The hospital division operates LTAC hospitals. The nursing center division operates nursing and rehabilitation centers. The rehabilitation division provides rehabilitation services primarily in long-term care settings. For segment purposes, 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.

Operating income in the third quarter of 2010 included transaction costs approximating $0.4 million for the hospital division, $0.3 million for the nursing center division and $0.1 million for the rehabilitation division. Operating income for the nine months ended September 30, 2010 included severance and retirement costs approximating $1.1 million for the hospital division, $0.5 million for the nursing center division and $1.3 million for corporate. Operating income for the nine months ended September 30, 2010 also included transaction costs approximating $1.7 million for the hospital division, $0.7 million for the nursing center division and $0.1 million for the rehabilitation division.

The Company identifies its segments in accordance with the aggregation provisions of the authoritative guidance for segment reporting. This information is consistent with information used by the Company in managing its businesses and aggregates businesses with similar economic characteristics. The Company includes operating data for its hospice business in the rehabilitation division.

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

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2010     2009     2010     2009  

Revenues:

        

Hospital division

   $ 465,198      $ 468,069      $ 1,465,661      $ 1,447,723   

Nursing center division

     539,914        539,217        1,621,450        1,606,704   

Rehabilitation division

     124,243        122,625        366,448        360,722   
                                
     1,129,355        1,129,911        3,453,559        3,415,149   

Eliminations

     (76,343     (72,423     (229,346     (215,133
                                
   $ 1,053,012      $ 1,057,488      $ 3,224,213      $ 3,200,016   
                                

Income from continuing operations:

        

Operating income (loss):

        

Hospital division

   $ 75,373      $ 78,674      $ 261,299      $ 270,600   

Nursing center division

     69,077        73,383        215,819        228,479   

Rehabilitation division

     14,148        10,912        42,861        39,964   

Corporate:

        

Overhead

     (34,337     (33,843     (100,917     (101,516

Insurance subsidiary

     (783     (1,769     (2,054     (4,403
                                
     (35,120     (35,612     (102,971     (105,919
                                

Operating income

     123,478        127,357        417,008        433,124   

Rent

     (89,295     (88,081     (266,595     (260,164

Depreciation and amortization

     (29,167     (31,992     (90,140     (93,837

Interest, net

     (1,239     (995     (3,344     (3,194
                                

Income from continuing operations before income taxes

     3,777        6,289        56,929        75,929   

Provision (benefit) for income taxes

     (1,323     901        20,538        29,662   
                                
   $ 5,100      $ 5,388      $ 36,391      $ 46,267   
                                

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)

 

     Three months ended
September 30,
     Nine months ended
September 30,
 
     2010      2009      2010      2009  

Rent:

           

Hospital division

   $ 38,122       $ 37,062       $ 113,580       $ 110,341   

Nursing center division

     49,627         49,471         148,458         145,310   

Rehabilitation division

     1,502         1,495         4,447         4,405   

Corporate

     44         53         110         108   
                                   
   $ 89,295       $ 88,081       $ 266,595       $ 260,164   
                                   

Depreciation and amortization:

           

Hospital division

   $ 12,655       $ 13,275       $ 38,218       $ 38,805   

Nursing center division

     10,527         12,408         33,825         36,131   

Rehabilitation division

     668         584         1,879         1,680   

Corporate

     5,317         5,725         16,218         17,221   
                                   
   $ 29,167       $ 31,992       $ 90,140       $ 93,837   
                                   

Capital expenditures, excluding acquisitions (including discontinued operations):

           

Hospital division:

           

Routine

   $ 9,113       $ 10,226       $ 23,132       $ 20,405   

Development

     12,900         10,884         28,883         32,765   
                                   
     22,013         21,110         52,015         53,170   

Nursing center division:

           

Routine

     11,548         5,774         24,732         34,533   

Development

     7,464         597         11,336         5,624   
                                   
     19,012         6,371         36,068         40,157   

Rehabilitation division

     351         269         899         631   

Corporate:

           

Information systems

     6,625         6,152         18,624         18,443   

Other

     986         73         1,721         456   
                                   
   $ 48,987       $ 33,975       $ 109,327       $ 112,857   
                                   
                   September 30,
2010
     December 31,
2009
 

Assets at end of period:

           

Hospital division

  

   $ 919,231       $ 867,332   

Nursing center division

  

     618,954         566,592   

Rehabilitation division

  

     63,174         53,856   

Corporate

  

     499,668         534,444   
                       
         $ 2,101,027       $ 2,022,224   
                       

Goodwill:

           

Hospital division

  

   $ 68,875       $ 68,577   

Nursing center division

  

     6,079         889   

Rehabilitation division

  

     11,757         11,757   
                       
         $ 86,711       $ 81,223   
                       

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

NOTE 7 – INSURANCE RISKS

The Company insures a substantial portion of its professional liability risks and workers compensation risks through its wholly owned limited purpose insurance subsidiary. Provisions for loss for these risks are based upon management’s best available information including 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 expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited.

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,
 
     2010     2009     2010     2009  

Professional liability:

        

Continuing operations

   $ 13,123      $ 12,095      $ 45,961      $ 41,888   

Discontinued operations

     (934     692        (1,763     1,200   

Workers compensation:

        

Continuing operations

   $ 10,049      $ 8,803      $ 31,763      $ 27,966   

Discontinued operations

     (103     (32     (1,104     (922

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, 2010     December 31, 2009  
    Professional
liability
    Workers
compensation
    Total     Professional
liability
    Workers
compensation
    Total  

Assets:

           

Current:

           

Insurance subsidiary investments

  $ 42,892      $ 20,452      $ 63,344      $ 84,953      $ 21,881      $ 106,834   

Reinsurance recoverables

    104               104        89               89   

Other

           320        320               321        321   
                                               
    42,996        20,772        63,768        85,042        22,202        107,244   

Non-current:

           

Insurance subsidiary investments

    51,592        64,756        116,348        43,272        56,951        100,223   

Reinsurance and other recoverables

    39,057        2,924        41,981        29,446        2,030        31,476   

Deposits

    3,000        1,412        4,412        5,000        1,410        6,410   

Other

           45        45               36        36   
                                               
    93,649        69,137        162,786        77,718        60,427        138,145   
                                               
  $ 136,645      $ 89,909      $ 226,554      $ 162,760      $ 82,629      $ 245,389   
                                               

Liabilities:

           

Allowance for insurance risks:

           

Current

  $ 42,892      $ 22,531      $ 65,423      $ 47,076      $ 23,934      $ 71,010   

Non-current

    216,146        61,082        277,228        195,126        58,188        253,314   
                                               
  $ 259,038      $ 83,613      $ 342,651      $ 242,202      $ 82,122      $ 324,324   
                                               

 

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Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – INSURANCE RISKS (Continued)

 

 

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2010 policy year and 2% for the 2009 policy year. The discount rates are based upon the risk free interest rate for the respective year. 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 $263.0 million at September 30, 2010 and $247.3 million at December 31, 2009.

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.

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS

The Company maintains investments, consisting principally of cash and cash equivalents, debt securities, equities and commercial paper for the payment of claims and expenses related to professional liability and workers compensation risks. These investments have been categorized as available-for-sale and are reported at fair value.

The amortized cost and estimated fair value of the Company’s insurance subsidiary investments follows (in thousands):

 

    September 30, 2010     December 31, 2009  
    Amortized
cost
    Unrealized
gains
    Unrealized
losses
    Fair
value
    Amortized
cost
    Unrealized
gains
    Unrealized
losses
    Fair
value
 

Cash and cash equivalents (a)

  $ 106,755      $      $      $ 106,755      $ 96,143      $      $      $ 96,143   

Debt securities:

               

Corporate bonds

    34,604        672        (49     35,227        47,528        770        (102     48,196   

Debt securities issued by U.S. government agencies

    17,258        203        (8     17,453        37,788        223        (43     37,968   

U.S. Treasury notes

    1,579        14               1,593        2,801        19               2,820   

Debt securities issued by foreign governments

    1,252        17               1,269        624               (5     619   

Commercial mortgage-backed securities

    389        22               411        610        27               637   
                                                               
    55,082        928        (57     55,953        89,351        1,039        (150     90,240   

Equities by industry:

               

Healthcare

    1,573        14        (265     1,322        1,573        16        (171     1,418   

Financial services

    1,284        132        (168     1,248        1,284        162        (155     1,291   

Oil and gas

    921        31        (143     809        1,257        8        (303     962   

Real estate

    148        3        (5     146        147        2        (24     125   

Other

    7,446        397        (587     7,256        8,470        80        (1,132     7,418   
                                                               
    11,372        577        (1,168     10,781        12,731        268        (1,785     11,214   

Commercial paper

    6,200        4        (1     6,203        9,449        14        (3     9,460   
                                                               
  $ 179,409      $ 1,509      $ (1,226   $ 179,692      $ 207,674      $ 1,321      $ (1,938   $ 207,057   
                                                               

 

(a) Includes $1.6 million and $4.7 million of money market funds at September 30, 2010 and December 31, 2009, respectively.

 

15


Table of Contents

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS (Continued)

 

 

The Company’s investment policy governing insurance subsidiary investments precludes the investment portfolio managers from selling any security at a loss without prior authorization from the Company. The investment managers also limit the exposure to any one issue, issuer or type of investment. The Company intends, and has the ability, to hold insurance subsidiary investments for a long duration without the necessity of selling securities to fund the underwriting needs of its insurance subsidiary. This ability to hold securities allows sufficient time for recovery of temporary declines in the market value of equity securities and the par value of debt securities as of their stated maturity date.

The Company considered the severity and duration of its unrealized losses and recognized a $0.7 million pretax other-than-temporary impairment for the nine months ended September 30, 2010 for various investments held in its insurance subsidiary investment portfolio. These investments were determined to be impaired after considering the duration of the declines in value and the likelihood of near term price recovery of each investment. Because the Company considered the remaining unrealized losses at September 30, 2010 and all unrealized losses at September 30, 2009 to be temporary, the Company did not record any impairment losses related to these investments.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received distributions of $22 million and $34 million during the nine months ended September 30, 2010 and 2009, respectively, from its limited purpose insurance subsidiary in accordance with applicable regulations. These distributions had no impact on earnings and the proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

NOTE 9 – LONG-TERM DEBT

In September 2010, the Company completed an amendment to its revolving credit facility that increased the amount permitted for acquisitions and certain investments by the Company by $250 million. However, the aggregate amount of credit under the revolving credit facility did not change.

NOTE 10 – LEASES

In April 2009, the Company entered into agreements with Ventas to renew the master lease agreements for an additional five years for 86 nursing and rehabilitation centers and 22 LTAC hospitals (collectively, the “Renewal Facilities”). The initial lease term for the Renewal Facilities was scheduled to expire in April 2010. The Company’s option to renew the leases on the Renewal Facilities would have expired on April 30, 2009. No additional rent or other consideration was paid in connection with these renewals.

NOTE 11 – INCOME TAXES

The provision for income taxes for the third quarter of 2010 and for the nine months ended September 30, 2010 included a favorable adjustment of $2.9 million related to the resolution of certain income tax contingencies from prior years. As a result, the Company reduced its unrecognized tax benefits and related accrued interest by $4.5 million. The deferred tax asset associated with unrecognized tax benefits also was reduced by $1.6 million. As of September 30, 2010, the Company’s unrecognized tax benefits totaled $3.2 million and accrued interest related to uncertain tax positions totaled $0.2 million.

The provision for income taxes for the third quarter of 2009 and for the nine months ended September 30, 2009 included a favorable adjustment of $1.7 million related to the resolution of certain income tax contingencies from prior years.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – INCOME TAXES (Continued)

 

 

The federal statute of limitations remains open for tax years 2007 through 2009 and the Company is currently under examination by the Internal Revenue Service (the “IRS”) for each of these years.

State jurisdictions generally have statutes of limitations ranging from three to five years. The state impact of federal income tax changes remains subject to examination by various states for a period of up to one year after formal notification to the states. Currently, the Company has various state income tax returns under examination.

During the nine months ended September 30, 2010, the Company received approval from the IRS for an accounting method change for income tax purposes that will result in a non-recurring reduction in income tax payments of approximately $25 million during 2010.

NOTE 12 – CONTINGENCIES

Management continually evaluates contingencies based upon the best available information. In addition, allowances for losses are provided currently for disputed items that have continuing significance, such as certain third party reimbursements and deductions that continue to be claimed 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 reimbursement programs. The Company is contesting certain issues raised in audits of prior year cost reports.

Professional liability risks – The Company has provided for losses for professional liability risks based upon management’s best available information including actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Note 7.

Income taxes – The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. In addition, the Company is a party to a tax matters agreement with PharMerica Corporation, which sets forth the Company’s rights and obligations related to taxes for periods before and after the Company’s spin-off of its former institutional pharmacy business in 2007 and the related merger transaction which created PharMerica Corporation.

Litigation – The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. These legal actions and investigations could potentially subject the Company to sanctions, damages, recoupments, fines and other penalties. 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 may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – CONTINGENCIES (Continued)

 

 

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 related to 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 are initiated by a breach of the terms of a contract or by a third party claim or event.

NOTE 13 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The guidance related to fair value measures referenced in Note 1 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:

 

Level 1

Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury, other U.S. Government and agency asset backed debt securities that are highly liquid and are actively traded in over-the-counter markets.

 

Level 2

Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

 

 

The Company’s assets and liabilities measured at fair value on a recurring and non-recurring basis and any associated losses are summarized below (in thousands):

 

     Fair value measurements      Assets/liabilities
at fair value
     Total
losses
 
     Level 1      Level 2      Level 3        

September 30, 2010:

              

Recurring:

              

Assets:

              

Available-for-sale debt securities:

              

Corporate bonds

   $       $ 35,227       $       $ 35,227       $   

Debt securities issued by U.S. government agencies

             17,453                 17,453           

U.S. Treasury notes

     1,593                         1,593           

Debt securities issued by foreign governments

             1,269                 1,269           

Commercial mortgage-backed securities

             411                 411           
                                            
     1,593         54,360                 55,953           

Available-for-sale equity securities

     10,781                         10,781           

Commercial paper

             6,203                 6,203           

Money market funds

     1,591                         1,591           
                                            

Total available-for-sale investments

     13,965         60,563                 74,528           

Deposits held in money market funds

     358         3,001                 3,359           
                                            
   $ 14,323       $ 63,564       $       $ 77,887       $   
                                            

Liabilities

   $       $       $       $       $   
                                            

Non-recurring:

              

Assets

   $       $       $       $       $   
                                            

Liabilities

   $       $       $       $       $   
                                            

December 31, 2009:

              

Recurring:

              

Assets:

              

Available-for-sale debt securities:

              

Corporate bonds

   $       $ 48,196       $       $ 48,196       $   

Debt securities issued by U.S. government agencies

             37,968                 37,968           

U.S. Treasury notes

     2,820                         2,820           

Debt securities issued by foreign governments

             619                 619           

Commercial mortgage-backed securities

             637                 637           
                                            
     2,820         87,420                 90,240           

Available-for-sale equity securities

     11,214                         11,214           

Commercial paper

             9,460                 9,460           

Money market funds

     4,692                         4,692           
                                            

Total available-for-sale investments

     18,726         96,880                 115,606           

Deposits held in money market funds

     351         3,000                 3,351           
                                            
   $ 19,077       $ 99,880       $       $ 118,957       $   
                                            

Liabilities

   $       $       $       $       $   
                                            

Non-recurring:

              

Assets:

              

Acquired previously leased hospital

   $       $ 18,000       $       $ 18,000       $   

Nursing and rehabilitation centers available for sale

                     1,000         1,000         (21,870
                                            
   $       $ 18,000       $ 1,000       $ 19,000       $ (21,870
                                            

Liabilities

   $       $       $       $       $   
                                            

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

 

 

Recurring measurements

The Company’s available-for-sale investments are held by its limited purpose insurance subsidiary and consist of debt securities, equities, commercial paper and money market funds. These available-for-sale investments and the insurance subsidiary’s cash and cash equivalents of $105.2 million as of September 30, 2010 and $91.5 million as of December 31, 2009, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

The Company’s deposits held in money market funds consist primarily of cash and cash equivalents held for general corporate purposes.

The fair value of actively traded debt and equity securities and money market funds are based upon quoted market prices and are generally classified as Level 1. The fair value of inactively traded debt securities and commercial paper are based upon either quoted market prices of similar securities or observable inputs such as interest rates using either a market or income valuation approach and are generally classified as Level 2. The Company’s investment advisors obtain and review pricing for each security. The Company is responsible for the determination of fair value and as such the Company reviews the pricing information from its advisors in determining reasonable estimates of fair value. Based upon the Company’s internal review procedures, there were no adjustments to the prices during the third quarter or nine months ended September 30, 2010 or September 30, 2009.

The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments. The carrying value is equal to fair value for financial instruments that are based upon quoted market prices or current market rates.

 

     September 30, 2010      December 31, 2009  

(In thousands)

   Carrying
value
     Fair
value
     Carrying
value
     Fair
value
 

Cash and cash equivalents

   $ 15,321       $ 15,321       $ 16,303       $ 16,303   

Cash–restricted

     5,383         5,383         5,820         5,820   

Insurance subsidiary investments

     179,692         179,692         207,057         207,057   

Tax refund escrow investments

     213         213         215         215   

Long-term debt, including amounts due within one year

     165,169         165,134         147,733         147,724   

NOTE 14 – SUBSEQUENT EVENT

On November 1, 2010, the Company completed the acquisition of five LTAC hospitals from Vista Healthcare, LLC (“Vista”) for a purchase price of $178 million in cash (the “Vista Acquisition”). The Company financed the Vista Acquisition with proceeds from its revolving credit facility.

The Vista Acquisition includes four freestanding hospitals and one hospital-in-hospital with a total of 250 beds all located in southern California. The Company did not acquire the working capital of Vista or assume any of its liabilities. All of the Vista hospitals are leased.

 

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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, development opportunities, plans and objectives of management and statements containing 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 impact of healthcare reform, which will initiate significant reforms to the United States healthcare system, including potential material changes to the delivery of healthcare services and the reimbursement paid for such services by the government or other third party payors. Healthcare reform will impact each of the Company’s businesses in some manner. Due to the substantial regulatory changes that will need to be implemented by CMS and others, and the numerous processes required to implement these reforms, the Company cannot predict which healthcare initiatives will be implemented at the federal or state level, the timing of any such reforms, or the effect such reforms or any other future legislation or regulation will have on the Company’s business, financial position, results of operations and liquidity,

 

   

changes in the reimbursement rates or the methods or timing 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 potential changes in the Medicare payment rules, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, and changes in Medicare and Medicaid reimbursements for the Company’s nursing and rehabilitation centers, and the expiration of the Medicare Part B therapy cap exception process,

 

   

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

 

   

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

 

   

the impact of the Medicare, Medicaid and SCHIP Extension Act of 2007 (the “SCHIP Extension Act”), including the ability of the Company’s hospitals to adjust to potential LTAC certification, medical necessity reviews and the moratorium on future hospital development,

 

   

the impact of the expiration of several moratoriums under the SCHIP Extension Act which could impact the short stay rules, the budget neutrality adjustment as well as implement the policy known as the “25 Percent Rule,” which would limit certain patient admissions,

 

   

failure of the Company’s facilities to meet applicable licensure and certification requirements,

 

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

Cautionary Statement (Continued)

 

 

   

the further consolidation and cost containment efforts of managed care organizations and other third party payors,

 

   

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

 

   

the Company’s ability to operate pursuant to the terms of its debt obligations and its master lease agreements with Ventas,

 

   

the condition of the financial markets, including volatility and deterioration in the equity, capital and credit markets, which could limit the availability and terms of debt and equity financing sources to fund the requirements of the Company’s businesses, or which could negatively impact the Company’s investment portfolio,

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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, including the impact of differences in actuarial assumptions and estimates compared to eventual outcomes,

 

   

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,

 

   

events or circumstances which could result in impairment of an asset or other charges,

 

   

changes in generally accepted accounting principles or practices, and

 

   

the Company’s ability to maintain an effective system of internal control 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 accompanying unaudited condensed consolidated financial statements, including the notes thereto, 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 and rehabilitation centers and a contract rehabilitation services business across the United States. At September 30, 2010, the Company’s hospital division operated 83 LTAC hospitals (6,563 licensed beds) in 24 states. The Company’s nursing center division operated 226 nursing and rehabilitation centers (27,978 licensed beds) in 28 states. The Company’s rehabilitation division provided rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several strategic divestitures to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with

 

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

General (Continued)

 

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, 2010 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.

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.

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, Medicare Advantage, 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.

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 and customers. 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 $6 million and $7 million for the third quarter of 2010 and 2009, respectively, and $18 million and $22 million for the nine months ended September 30, 2010 and 2009, respectively.

 

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

Critical Accounting Policies (Continued)

 

 

Allowances for insurance risks

The Company insures a substantial portion of its professional liability risks and workers compensation risks through its limited purpose insurance subsidiary. Provisions for loss for these risks are based upon management’s best available information including 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 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 Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 1% to 5% depending upon the policy year. The discount rate was 1% for the 2010 policy year and 2% for the 2009 policy year. The discount rates are based upon the risk free interest rate for the respective year. 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 $259 million at September 30, 2010 and $242 million at December 31, 2009. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $263 million at September 30, 2010 and $247 million at December 31, 2009.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received distributions of $22 million and $34 million during the nine months ended September 30, 2010 and 2009, respectively, from its limited purpose insurance subsidiary in accordance with applicable regulations. These distributions had no impact on earnings and the proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

Changes in the number of professional liability claims and the cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and 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, 2010 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $13 million for the third quarter of both 2010 and 2009, and $46 million and $42 million for the nine months ended September 30, 2010 and 2009, 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 $84 million at September 30, 2010 and $82 million at December 31, 2009. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $10 million and $9 million for the third quarter of 2010 and 2009, respectively, and $32 million and $28 million for the nine months ended September 30, 2010 and 2009, respectively.

 

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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 annual 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 Company’s effective income tax rate for the third quarter and nine months ended September 30, 2010 was favorably impacted by approximately $3 million related to the resolution of certain income tax contingencies from prior years, while the Company’s effective income tax rate for the third quarter and nine months ended September 30, 2009 was also favorably impacted by approximately $2 million related to the resolution of certain income tax contingencies from prior years.

There are significant uncertainties with respect to capital loss carryforwards that 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 that it is uncertain that the deferred tax asset will be realized. The Company recognized net deferred tax assets totaling $143 million at September 30, 2010 and $154 million at December 31, 2009.

During the nine months ended September 30, 2010, the Company received approval from the IRS for an accounting method change for income tax purposes that will result in a non-recurring reduction in income tax payments of approximately $25 million during 2010. The Company’s earnings will not be impacted by this transaction.

The Company is subject to various federal and state income tax audits 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 finite lived 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 that 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 agreement in which the operations of a facility and compliance with the lease terms are interdependent upon other facilities in the agreement (including the Company’s ability to renew the lease or divest a particular property), the Company defines the group of facilities under a master lease agreement as the lowest level for which there are independent, identifiable cash flows. Accordingly, the estimated cash flows of all facilities within a master lease agreement are aggregated for purposes of evaluating the carrying values of long-lived assets.

 

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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 other intangible assets with finite lives are amortized in accordance with the authoritative guidance for goodwill and other intangible assets using the straight-line method over their estimated useful lives ranging from one to 20 years.

In accordance with the authoritative guidance for goodwill and other intangible assets, the Company is required to perform an impairment test for goodwill and indefinite lived intangible assets 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 goodwill impairment test at the end of each fiscal year for each of its reporting units. A reporting unit is either an operating segment or one level below the operating segment, referred to as a component. When the components within the Company’s operating segments have similar economic characteristics, the Company aggregates the components of its operating segments into one reporting unit. Accordingly, the Company has determined that its reporting units are hospitals, nursing and rehabilitation centers, rehabilitation services and hospice. The carrying value of goodwill for each of the Company’s reporting units at September 30, 2010 and December 31, 2009 follows (in thousands):

 

     September 30,
2010
     December 31,
2009
 

Hospitals

   $ 68,875       $ 68,577   

Nursing and rehabilitation centers

     6,079         889   

Rehabilitation services

     3,363         3,363   

Hospice

     8,394         8,394   
                 
   $ 86,711       $ 81,223   
                 

The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit’s fair value to its carrying value. If the carrying value of the reporting unit is greater than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. Based upon the results of the step one impairment test for goodwill and the impairment test of indefinite lived intangible assets, no impairment charges were recorded in connection with the Company’s annual impairment tests at December 31, 2009. The Company did not believe that any of its reporting units were at risk of failing the step one impairment test at December 31, 2009.

Since quoted market prices for the Company’s reporting units are not available, the Company applies judgment in determining the fair value of these reporting units for purposes of performing the goodwill impairment test. The Company relies on widely accepted valuation techniques, including equally weighted discounted cash flows and market multiple analyses approaches, which capture both the future income potential of the reporting unit and the market behaviors and actions of market participants in the industry that includes the reporting unit. These types of analyses require management to make assumptions and estimates regarding future cash flows, industry-specific economic factors and the profitability of future business strategies. The discounted cash flow approach uses a projection of estimated operating results and cash flows that are discounted using a weighted average cost of capital. Under the discounted cash flow approach, the projection uses management’s best estimates of economic and market conditions over the projected period for each reporting unit including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital. The market multiple analysis estimates fair value by applying cash flow multiples to the reporting unit’s operating results. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics to the reporting units.

 

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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 fair values of the Company’s indefinite lived intangible assets, primarily hospital certificates of need, are estimated using an excess earnings method, a form of discounted cash flows, which is based upon the concept that net after-tax cash flows provide a return supporting all of the assets of a business enterprise. The fair values of the Company’s indefinite lived intangible assets are derived from projections at a facility level which include management’s best estimates of economic and market conditions over the projected period including growth rates in the number of admissions, patient days, reimbursement rates, operating costs, rent expense and capital expenditures. Other significant estimates and assumptions include terminal value growth rates, changes in working capital requirements and weighted average cost of capital.

The Company has determined that during the nine months ended September 30, 2010 there were no events or changes in circumstances since December 31, 2009 requiring an interim impairment test. Although the Company has determined that there was no goodwill or other indefinite lived intangible asset impairments as of September 30, 2010 and December 31, 2009, adverse changes in the operating environment and related key assumptions used to determine the fair value of the Company’s reporting units and indefinite lived intangible assets or declines in the value of the Company’s common stock may result in future impairment charges for a portion or all of these assets. Specifically, if the rate of growth of government and commercial revenues earned by the Company’s reporting units were to be less than projected or if healthcare reforms were to negatively impact the Company’s business, an impairment charge of a portion or all of the assets may be required. In addition, reductions in revenues in the Company’s rehabilitation services business that may result from the transition to RUGs IV (as defined) and reductions in Medicare Part B rates, could result in the impairment of a portion or all of the goodwill for that reporting unit. At September 30, 2010, the amount of goodwill associated with the Company’s rehabilitation services reporting unit aggregated $3 million. See “Other Information – Effects of inflation and changing prices.”

An impairment charge could have a material adverse effect on the Company’s business, financial position and results of operations, but would not be expected to have an impact on the Company’s cash flows or liquidity.

Recently Issued Accounting Requirements

In January 2010, the FASB issued authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 classifications (as described in Note 13 of the notes to condensed consolidated financial statements). The provisions also require a reconciliation of the activity in Level 3 recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on the Company’s business, financial position, results of operations or liquidity.

In June 2009, the FASB issued revised authoritative guidance related to the consolidation criteria for VIEs. The guidance, among other things, requires a qualitative rather than a quantitative analysis to determine the primary beneficiary of a VIE; requires continuous assessments of whether an enterprise is the primary beneficiary of a VIE; enhances disclosures regarding an enterprise’s involvement with a VIE; and amends certain guidance for determining whether an entity is a VIE. Under the guidance, a VIE must be consolidated if the enterprise has both (a) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. The guidance was effective as of January 1, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on the Company’s business, financial position, results of operations or liquidity.

 

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

Recently Issued Accounting Requirements (Continued)

 

 

Upon adoption of the VIE guidance on January 1, 2010, the Company reassessed its three investment partnerships and its lease agreements under the new accounting guidance. Although the investment partnerships were determined to be VIEs, they do not require the Company to absorb losses or receive benefits that could potentially be significant to the VIEs, nor can the Company direct the activities that most significantly impact the VIEs’ economic performance. As a result, the investment partnerships continue to be accounted for under the equity method of accounting and are not consolidated. The Company also determined that three of its lease agreements were considered VIEs. However, the Company is not the primary beneficiary of these leases as it lacks the power to direct activities of the lessor that most significantly impact the economic performance under these leases. In addition, the Company’s investments and involvement in lease arrangements related to these VIEs were not significant to its accompanying unaudited condensed consolidated financial statements.

Results of Operations – Continuing Operations

Hospital division

Revenues decreased 1% in the third quarter of 2010 to $465 million compared to $468 million in the third quarter of 2009 and increased 1% to $1.5 billion for the nine months ended September 30, 2010 from $1.4 billion in the same period in 2009. Revenues decreased in the third quarter of 2010 primarily as a result of lower admissions. Revenue growth for the nine months ended September 30, 2010 was primarily a result of increased admissions, the development of new hospitals and increases in Medicare reimbursement rates. Aggregate same-facility admissions decreased 3% in the third quarter of 2010 and were relatively unchanged for the nine months ended September 30, 2010 compared to the respective prior year periods. Commercial same-facility admissions were relatively unchanged in the third quarter of 2010 and increased 6% for the nine months ended September 30, 2010 compared to the respective prior year periods.

Hospital operating margins declined in the third quarter of 2010 and for the nine months ended September 30, 2010 compared to the same periods in 2009 as growth in supply expenses, ancillary expenses and professional liability costs exceeded the growth in overall revenues. Supply expenses increased 3% in both the third quarter of 2010 and for the nine months ended September 30, 2010 compared to the same periods in 2009 primarily as a result of price increases and increased utilization. Ancillary expenses, such as rehabilitation, pharmacy and outside services, increased 1% in the third quarter of 2010 and 3% for the nine months ended September 30, 2010 compared to the respective prior year periods. Operating results in the third quarter of 2010 included approximately $0.4 million related to transaction costs. Operating results for the nine months ended September 30, 2010 included approximately $3 million related to severance and transaction costs.

Hospital wage and benefit costs decreased 1% in the third quarter of 2010 to $215 million compared to $218 million in the third quarter of 2009 and increased 1% to $664 million for the nine months ended September 30, 2010 from $657 million in the same period in 2009. Average hourly wage rates increased 1% in the third quarter of 2010 and were relatively unchanged for the nine months ended September 30, 2010 compared to the respective prior year periods. Employee benefit costs decreased 3% in the third quarter of 2010 and 1% for the nine months ended September 30, 2010 compared to the respective prior year periods, primarily as a result of lower employee health insurance costs.

Professional liability costs were $6 million and $5 million in the third quarter of 2010 and 2009, respectively, and $22 million and $18 million for the nine months ended September 30, 2010 and 2009, respectively.

Nursing center division

Revenues were relatively unchanged in the third quarter of 2010 at $540 million compared to $538 million in the third quarter of 2009 and increased 1% to $1.6 billion for the nine months ended September 30, 2010

 

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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)

Nursing center division (Continued)

 

compared to the same period in 2009. Revenue growth in both periods was primarily attributable to reimbursement rate increases that reflected inflationary adjustments and higher average patient acuity. Aggregate admissions increased 9% in the third quarter of 2010 and 5% for the nine months ended September 30, 2010 compared to the respective prior year periods. Aggregate patient days declined 2% in both the third quarter and for the nine months ended September 30, 2010 compared to the respective prior year periods.

Nursing center operating margins declined in both the third quarter of 2010 and for the nine months ended September 30, 2010 compared to the same periods in 2009 primarily as a result of a 5% growth in both periods in ancillary expenses such as rehabilitation and pharmacy services. Growth in ancillary services in both periods resulted primarily from higher patient acuity levels. Operating results in the third quarter of 2010 included approximately $0.3 million related to transaction costs. Operating results for the nine months ended September 30, 2010 included approximately $1 million related to severance and transaction costs.

Nursing center wage and benefit costs declined 4% to $268 million in the third quarter of 2010 from $279 million in the same period in 2009 and declined 2% to $806 million for the nine months ended September 30, 2010 from $824 million in the same period in 2009. Average hourly wage rates increased 3% in both the third quarter of 2010 and for the nine months ended September 30, 2010 compared to the respective prior year periods. Employee benefit costs decreased 6% in the third quarter of 2010 and 4% for the nine months ended September 30, 2010 compared to the respective prior year periods, primarily as a result of lower employee health insurance costs.

Professional liability costs were $7 million in the third quarter of both 2010 and 2009, and $23 million for each of the nine months ended September 30, 2010 and 2009.

Rehabilitation division

Revenues increased 1% in the third quarter of 2010 to $124 million compared to $123 million in the third quarter of 2009 and increased 2% to $366 million for the nine months ended September 30, 2010 from $361 million in the same period in 2009. The increase in revenues in both periods was primarily attributable to growth in the volume of services provided to existing customers. Revenues derived from unaffiliated customers aggregated $48 million and $51 million in the third quarter of 2010 and 2009, respectively, and $137 million and $146 million for the nine months ended September 30, 2010 and 2009, respectively.

Operating margins increased for the third quarter of 2010 and for the nine months ended September 30, 2010 compared to the respective prior year periods primarily due to improvements in labor productivity and the volume of services provided to existing customers.

Corporate overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $34 million in the third quarter of both 2010 and 2009, and $101 million and $102 million for the nine months ended September 30, 2010 and 2009, respectively. As a percentage of consolidated revenues, corporate overhead totaled 3.3% and 3.2% in the third quarter of 2010 and 2009, respectively, and totaled 3.1% and 3.2% for the nine months ended September 30, 2010 and 2009, respectively. Operating results for the nine months ended September 30, 2010 included approximately $1 million related to retirement costs.

 

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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 (Continued)

 

 

Corporate expenses included operating losses from the Company’s limited purpose insurance subsidiary of $1 million and $2 million in the third quarter of 2010 and 2009, respectively, and $2 million and $4 million for the nine months ended September 30, 2010 and 2009, respectively.

Capital costs

Rent expense increased 1% to $89 million in the third quarter of 2010 compared to $88 million in the third quarter of 2009 and increased 2% to $267 million for the nine months ended September 30, 2010 from $260 million in the same period in 2009. The increase in both periods resulted primarily from contractual inflation and contingent rent increases.

Depreciation and amortization expense decreased 9% in the third quarter of 2010 to $29 million compared to $32 million in the third quarter of 2009 and decreased 4% to $90 million for the nine months ended September 30, 2010 from $94 million in the same period in 2009. The decrease in both periods was primarily the result of increases in assets becoming fully depreciated and, for the nine months ended September 30, 2010, lower routine capital expenditures.

Interest expense was relatively unchanged in the third quarter of 2010 and declined to $4 million for the nine months ended September 30, 2010 compared to $6 million in the same period in 2009. The decline for the nine months ended September 30, 2010 was primarily attributable to lower interest rates and lower borrowing levels under the Company’s revolving credit facility compared to the same period in 2009.

Investment income related primarily to the Company’s insurance subsidiary investments totaled $0.4 million in the third quarter of 2010 compared to $0.7 million in the third quarter of 2009, and totaled $1 million and $3 million for the nine months ended September 30, 2010 and 2009, respectively. Investment income for the nine months ended September 30, 2010 included a $1 million pretax other-than-temporary impairment of various investments held in the Company’s insurance subsidiary investment portfolio. These investments were determined to be impaired after considering the duration of the declines in value and the likelihood of near term price recovery of each investment. Because the Company considered the remaining unrealized losses at September 30, 2010 and all unrealized losses at September 30, 2009 to be temporary, the Company did not record any impairment losses related to these investments. In addition, the decline in investment income for the third quarter and nine months ended September 30, 2010 was primarily attributable to lower investment yields on the Company’s insurance subsidiary’s investment portfolio compared to the same periods last year.

Consolidated results

Income from continuing operations before income taxes decreased 40% to $4 million in the third quarter of 2010 compared to $6 million in the third quarter of 2009 and decreased 25% to $57 million for the nine months ended September 30, 2010 from $76 million in the same period in 2009. Income from continuing operations decreased 5% to $5 million in the third quarter of 2010 compared to the third quarter of 2009 and decreased 21% to $36 million for the nine months ended September 30, 2010 from $46 million in the same period in 2009.

Results of Operations – Discontinued Operations

Loss from discontinued operations was $0.2 million in the third quarter of 2010 compared to breakeven in the third quarter of 2009. Loss from discontinued operations was $0.3 million for the nine months ended September 30, 2010 compared to $2 million for the nine months ended September 30, 2009.

 

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

Results of Operations – Discontinued Operations (Continued)

 

 

The Company recorded a pretax loss on the divestiture of operations of $39 million ($24 million net of income taxes) for the nine months ended September 30, 2009 related to the planned divestiture of the Nursing Centers.

Liquidity

Operating cash flows

Cash flows provided by operations (including discontinued operations) aggregated $151 million for the nine months ended September 30, 2010 compared to $142 million for the same period in 2009. Operating cash flows were favorably impacted by improved accounts receivable collections in 2010. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance its ongoing development expenditures, as well as its acquisition and strategic divestiture activities.

Cash and cash equivalents totaled $15 million at September 30, 2010 compared to $16 million at December 31, 2009. The Company’s long-term debt, comprised principally of borrowings under the Company’s revolving credit facility, aggregated $165 million at September 30, 2010 compared to $148 million at December 31, 2009. Based upon the Company’s existing cash levels, expected operating cash flows and the availability of borrowings under the Company’s revolving credit facility ($336 million at September 30, 2010), management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs. The Company financed $178 million for the Vista Acquisition on November 1, 2010 with its revolving credit facility.

During the nine months ended September 30, 2010, the Company received approval from the IRS for an accounting method change for income tax purposes that will result in a non-recurring reduction in income tax payments of approximately $25 million during 2010. The Company’s earnings will not be impacted by this transaction.

Strategic divestitures

In June 2009, the Company purchased the Nursing Centers from Ventas for approximately $56 million. In addition, the Company paid a lease termination fee of approximately $2 million. The Nursing Centers were included in master lease agreements with Ventas. The Company does not have the ability to terminate a lease of an individual facility under the master lease agreements. The Nursing Centers, which contained 777 licensed beds, generated pretax losses of approximately $2 million for the nine months ended September 30, 2009.

Revolving credit facility and financing activities

Under the terms of the Company’s revolving credit facility, the aggregate amount of the credit may be increased from $500 million to $600 million at the Company’s option subject to lender approval and certain other conditions. If the Company elects to expand the available credit, the existing lenders are likely to demand new terms, including increases in the effective interest rate. The term of the Company’s revolving credit facility expires in July 2012.

Interest rates under the Company’s revolving credit facility are based, at the Company’s option, upon (a) the London Interbank Offered Rate (“LIBOR”) plus the applicable margin or (b) the applicable margin plus the higher of the prime rate or 0.5% over the federal funds rate. The Company’s revolving credit facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The terms of the Company’s revolving credit

 

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

Liquidity (Continued)

Revolving credit facility and financing activities (Continued)

 

facility include a certain defined fixed payment ratio covenant and covenants which limit acquisitions and annual capital expenditures. The Company was in compliance with the terms of its revolving credit facility at September 30, 2010.

In September 2010, the Company completed an amendment to its revolving credit facility that increased the amount permitted for acquisitions and certain investments by the Company by $250 million. However, the aggregate amount of credit under the revolving credit facility did not change.

Despite the instability within the financial markets both nationally and globally, the Company has not experienced any individual lender limitations to extend credit under its revolving credit facility. However, the obligations of each of the lending institutions in the Company’s revolving credit facility are separate and the availability of future borrowings under the Company’s revolving credit facility could be impacted by further volatility and disruptions in the financial credit markets or other events, including bankruptcy of a lending institution.

In April 2009, the Company entered into agreements with Ventas to renew the master lease agreements for an additional five years for the Renewal Facilities. The initial lease term for the Renewal Facilities was scheduled to expire in April 2010. The Company’s option to renew the leases on the Renewal Facilities would have expired on April 30, 2009. No additional rent or other consideration was paid in connection with these renewals.

As a result of improved professional liability underwriting results of the Company’s limited purpose insurance subsidiary, the Company received distributions of $22 million and $34 million during the nine months ended September 30, 2010 and 2009, respectively, from its limited purpose insurance subsidiary in accordance with applicable regulations. These distributions had no impact on earnings and the proceeds were used primarily to repay borrowings under the Company’s revolving credit facility.

Capital Resources

Excluding acquisitions, routine capital expenditures (expenditures necessary to maintain existing facilities that generally do not increase capacity or add services) totaled $69 million for the nine months ended September 30, 2010 compared to $75 million for the same period in 2009. Hospital development capital expenditures (primarily new facility construction) totaled $29 million for the nine months ended September 30, 2010 compared to $33 million for the same period in 2009. Nursing and rehabilitation center development capital expenditures (primarily the addition of transitional care services for higher acuity patients and new facility construction) totaled $11 million for the nine months ended September 30, 2010 compared to $5 million for the same period in 2009. Excluding acquisitions, the Company anticipates that routine capital expenditures in 2010 should approximate $105 million to $110 million, hospital development capital expenditures should approximate $40 million to $45 million and nursing and rehabilitation center development capital expenditures should approximate $20 million to $25 million. 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, 2010, the estimated cost to complete and equip construction in progress approximated $55 million.

In November 2010, the Company completed the Vista Acquisition for approximately $178 million.

In September 2010, the Company acquired three nursing and rehabilitation centers for approximately $38 million.

In March 2010, the Company acquired a combined nursing and rehabilitation center and assisted living facility for approximately $17 million.

 

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

Capital Resources (Continued)

 

 

In January 2010, the Company acquired the real estate of two previously leased hospitals and two previously leased nursing and rehabilitation centers for approximately $31 million in cash and approximately $2 million in unamortized prepaid rent. Annual rents associated with these four facilities approximated $3 million.

In July 2009, the Company acquired a hospice business for $8 million.

In March 2009, the Company acquired the real estate of a previously leased hospital for approximately $16 million in cash and approximately $2 million in unamortized prepaid rent. Annual rent associated with this facility approximated $2 million.

The acquisitions noted above were all financed through operating cash flows or borrowings under the Company’s revolving credit facility.

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 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 and rehabilitation 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. In addition, Medicaid reimbursement can be negatively impacted by state budgetary pressures.

Various healthcare reform provisions became law when the Patient Protection and Affordable Care Act was enacted on March 23, 2010 and the Healthcare Education and Reconciliation Act was enacted on March 30, 2010 (collectively, the Affordable Care Act (the “ACA”)). The reforms contained in these bills will impact each of the Company’s businesses in some manner. Several of the reforms are very significant and could ultimately change the nature of the Company’s services, the methods of payment for the Company’s services and the underlying regulatory environment. The reforms include modifications to the conditions of qualification for payment, bundling payments to cover both acute and post-acute care and the imposition of enrollment limitations on new providers. In addition, a primary goal of healthcare reform is to reduce costs, which includes reductions in the reimbursement paid to the Company and other healthcare providers. Moreover, healthcare reform could negatively impact insurance companies, other third party payors, the Company’s customers, as well as other healthcare providers, which may in turn negatively impact the Company’s business. As such, these healthcare reforms or other similar healthcare reforms could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

The ACA enacted a series of reductions to the annual market basket payment updates for LTAC hospitals. In addition to specific market basket reductions, Congress has mandated that the annual market basket payment update for a variety of providers, including both LTAC hospitals and nursing centers, be reduced for a “productivity adjustment” determined by CMS. These productivity adjustments may vary and will be determined annually by CMS. The productivity adjustments for LTAC hospitals and nursing centers are scheduled to be implemented on October 1, 2011.

 

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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)

 

 

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 fee for service Medicare patients must be at least 25 days.

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.

The SCHIP Extension Act became law on December 29, 2007. This legislation provides for, among other things:

 

  (1) a mandated study by the Secretary of Health and Human Services on the establishment of LTAC hospital certification criteria;

 

  (2) enhanced medical necessity review of LTAC hospital cases;

 

  (3) a three-year moratorium on the establishment of a LTAC hospital or satellite facility, subject to exceptions for facilities under development;

 

  (4) a three-year moratorium on an increase in the number of licensed beds at a LTAC hospital or satellite facility, subject to exceptions for states where there is only one other LTAC hospital and upon request following the closure or decrease in the number of licensed beds at a LTAC hospital within the state;

 

  (5) a three-year moratorium on the application of a one-time budget neutrality adjustment to payment rates to LTAC hospitals under LTAC PPS;

 

  (6) a three-year moratorium on very short-stay outlier payment reductions to LTAC hospitals initially implemented on May 1, 2007;

 

  (7) a three-year moratorium on the application of the policy known as the “25 Percent Rule” (described below) to freestanding LTAC hospitals;

 

  (8) a three-year period during which LTAC hospitals that are co-located with another hospital may admit up to 50% of their patients from their co-located hospital and still be paid according to LTAC PPS;

 

  (9) a three-year period during which LTAC hospitals that are co-located with an urban single hospital or a hospital that generates more than 25% of the Medicare discharges in a metropolitan statistical area (“MSA Dominant hospital”) may admit up to 75% of their patients from such urban single hospital or MSA Dominant hospital and still be paid according to LTAC PPS; and

 

  (10) the elimination of the July 1, 2007 market basket increase in the standard federal payment rate of 0.71%, effective for discharges occurring on or after April 1, 2008.

The ACA revised certain provisions of the SCHIP Extension Act. The moratoriums on the establishment of new LTAC hospitals or satellites and bed increases at LTAC hospitals or satellites, the application of a one-time budget neutrality adjustment to rates, the payment reductions due to the very short-stay outlier provisions and application of the “25 Percent Rule” to freestanding hospitals have been extended from three years to five years. In addition, the periods during which LTAC hospitals may admit up to 50% of their patients from co-located hospitals and during which LTAC hospitals may admit up to 75% of their patients from a MSA Dominant hospital have been extended from three years to five years as well.

 

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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)

 

 

On May 1, 2007, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2007 Final Rule”). In the 2007 Final Rule, the policy known as the “25 Percent Rule” was expanded to all LTAC hospitals, regardless of whether they are co-located with another hospital. Under the 2007 Final Rule, all LTAC hospitals were to be paid LTAC PPS rates for admissions from a single referral source up to 25% of aggregate Medicare admissions. Patients reaching high cost outlier status in the short-term hospital were not to be counted when computing the 25% limit. Admissions beyond the 25% threshold were to be paid at a lower amount based upon short-term acute care hospital rates. However, as set forth above, the SCHIP Extension Act initially placed a three-year moratorium on the expansion of the “25 Percent Rule” to freestanding hospitals. That moratorium was extended to five years by the ACA. In addition, the SCHIP Extension Act initially provided for a three-year period during which (1) LTAC hospitals may admit up to 50% of their patients from their co-located hospitals and still be paid according to LTAC PPS; and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single or MSA Dominant hospital and still be paid according to LTAC PPS. Those periods also were extended to five years under the ACA. The five-year moratorium of the “25 Percent Rule” threshold payment adjustment for freestanding hospitals and grandfathered hospitals with a host hospital (“HIH”) will expire for cost reporting periods beginning on or after July 1, 2012. The expansion of the admission limit to 50% for non-grandfathered LTAC hospitals from their co-located hospital will expire for cost reports beginning on or after October 1, 2012, the same time at which the 75% limit for MSA Dominant hospitals will expire.

On May 2, 2008, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2008 Final Rule”) that became effective for discharges occurring on or after July 1, 2008. The 2008 Final Rule projected an overall increase in payments to all Medicare certified LTAC hospitals of approximately 2.5%. Included in the 2008 Final Rule were (1) an increase to the standard federal payment rate of 2.7% (as compared to the adjusted federal rate for discharges occurring on or after April 1, 2008 by the SCHIP Extension Act); (2) adjustments to the wage index component of the federal payment resulting in projected reductions in payments of 0.1%; (3) an increase in the high cost outlier threshold per discharge to $22,960; and (4) an extension of the rate year cycle for one year to September 30, 2009, in order to be consistent thereafter with the federal fiscal year that begins October 1 of each year.

CMS has regulations governing payments to LTAC hospitals that are co-located with another hospital, such as a HIH. The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from its co-located hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period, the “25 Percent Rule.” There are limited exceptions for admissions from rural, urban single and MSA Dominant hospitals. Admissions that exceed this “25 Percent Rule” are paid using the short-term acute care inpatient payment system (“IPPS”). Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non co-located hospital, are eligible for the full payment under LTAC PPS. If the HIH’s admissions from the co-located hospital exceed the limit in a cost reporting period, Medicare will pay the lesser of (1) the amount payable under LTAC PPS; or (2) the amount payable under IPPS. At September 30, 2010, the Company operated 15 HIHs with 633 licensed beds.

On August 1, 2007, CMS issued final regulations regarding Medicare hospital inpatient payments to short-term acute care hospitals as well as certain provisions affecting LTAC hospitals. These regulations adopt a new system for LTAC hospitals for classifying patients into diagnostic categories called Medicare Severity Diagnosis Related Groups or more specifically, for LTAC hospitals, “MS-LTC-DRGs.” LTAC PPS is based upon discharged-based MS-LTC-DRGs similar to the system used to pay short-term acute care hospitals. This new

 

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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)

 

MS-LTC-DRG system replaced the previous diagnostic related group system for LTAC hospitals and became effective for discharges occurring on or after October 1, 2007. The MS-LTC-DRG system created additional severity-adjusted categories for most diagnoses.

On July 31, 2008, CMS issued final regulations regarding the re-weighting of MS-LTC-DRGs for discharges occurring on or after October 1, 2008. CMS announced that this update was made in a budget neutral manner, and that estimated aggregate LTAC Medicare payments would be unaffected by these regulations. Based upon the Company’s experience under these final regulations, it appears that the re-weighting increased payments for the care of higher acuity patients.

On May 29, 2009, CMS issued an interim final rule that revised the October 1, 2008 payment weights. Effective June 3, 2009, CMS reduced MS-LTC-DRG payment weights by 3.9%, resulting in approximately a 0.9% reduction of the estimated total LTAC PPS payments in the federal fiscal year ending September 30, 2009. No retroactive adjustments to payments were made. On July 31, 2009, CMS finalized this interim rule.

On July 31, 2009, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2009. Included in those final regulations is (1) a market basket increase to the standard federal payment rate of 2.5%; (2) an offset of 0.5% applied to the standard federal payment rate to account for the effect of documentation and coding changes; (3) adjustments to area wage indexes; and (4) a decrease in the high cost outlier threshold per discharge to $18,425. These final regulations also include a recalibration of the MS-LTC-DRG payment weights. CMS indicated that all of these changes will result in a 3.3% increase to average Medicare payments to LTAC hospitals. The 2.7% annualized reduction that resulted from a recalibration of MS-LTC-DRG payment weights on June 3, 2009 is incorporated into the final October 1, 2009 payment weights. On April 1, 2010, CMS reduced the October 1, 2009 standard federal payment rate by 0.25% as mandated by the ACA.

On July 30, 2010, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2010. Included in those final regulations is (1) a market basket increase to the standard federal payment rate of 2.5%; (2) an offset of 2.5% applied to the standard federal payment rate to account for the effect of documentation and coding changes; (3) an offset of 0.5% applied to the standard federal payment rate as mandated by the ACA; (4) adjustments to area wage indexes; and (5) an increase in the high cost outlier threshold per discharge to $18,785. CMS indicated that all of these changes will result in a 0.5% increase to average Medicare payments to LTAC hospitals.

The Company cannot predict the ultimate long-term impact of LTAC PPS. This payment system is subject to significant change. Slight variations in patient acuity or length of stay 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 to changes in patient acuity and length of stay or to changes in reimbursement rates. In addition, there can be no assurance that LTAC PPS will not have a material adverse effect on revenues from commercial third party payors. Various factors, including a reduction in average length of stay, have negatively impacted revenues from commercial third party payors in recent years.

On July 31, 2009, CMS issued final regulations regarding Medicare reimbursement for nursing centers for the fiscal year beginning October 1, 2009. Included in these regulations are (1) a market basket increase to the federal payment rates of 2.2%; (2) updates to the wage indexes which adjust the federal payment; and (3) a reduction in the resource utilization grouping (“RUG”) indexes attributed to a CMS forecast error in a prior year, resulting in a 3.3% reduction in payments. CMS estimated that these changes will result in a net decrease in Medicare payments to nursing and rehabilitation centers of 1.1%.

 

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Table of Contents

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)

 

 

In addition, for the fiscal year beginning October 1, 2010, CMS finalized provisions that would increase the number of RUG categories for nursing centers from 53 to 66 (i.e., RUGs IV) and amend the criteria, including the provision of therapy services, currently used to classify patients into these categories. CMS has indicated that these changes will be enacted in a budget neutral manner. However, the ACA enacted a delay in the implementation of RUGs IV until October 1, 2011, while maintaining the provisions related to concurrent therapy and look-back periods set forth in the July 31, 2009 final payment rule. While the Company is unable to estimate the impact of these changes, the operating results of its contract rehabilitation services business may be adversely affected. On July 16, 2010, CMS issued a notice that updates the payment rates for nursing centers for the fiscal year beginning October 1, 2010. That notice provided for an increase in rates of 1.7%, which is comprised of a market basket increase of 2.3% less a forecast error adjustment of 0.6%. In addition, CMS began paying claims, effective October 1, 2010, on an interim basis, using the RUGs IV system until CMS has created the infrastructure necessary to support a hybrid system required by the ACA. Once that infrastructure is in place, claims will be adjusted retroactively to October 1, 2010 as necessary. CMS intends that the conversion from RUGs IV to the hybrid classification system will be budget neutral.

On November 2, 2010, CMS issued a final rule related to rate changes to Medicare Part B therapy services included in the Medicare Physician Fee Schedule rule. The rule will become effective January 1, 2011. The rule provides for a rate reduction for reimbursement of therapy expenses for secondary procedures when multiple therapy services are provided on the same day. CMS projects that the rule will result in an approximate 7% rate reduction for Medicare Part B therapy services in calendar year 2011. Based upon the Company’s historical Medicare Part B therapy services data, the Company estimates that this rule would reduce the Company’s Medicare revenues related to Part B therapy services by approximately $7 million per year beginning in 2011.

Medicare Part B provides reimbursement for certain physician services, limited drug coverage and other outpatient services, such as therapy and other services, outside of a Medicare Part A covered patient stay. Since 2006, federal legislation has provided for an annual Medicare Part B outpatient therapy cap. In succeeding years, CMS subsequently increased the amount of the therapy cap. Legislation also was passed that required CMS to implement a broad process for reviewing medically necessary therapy claims, creating an exception to the cap. Legislation has annually extended the Medicare Part B outpatient therapy cap. The Medicare Improvements for Patients and Providers Act of 2008, enacted on July 15, 2008, extended the therapy cap exception process from July 1, 2008 to December 31, 2009. The ACA provided that the exception process remain in effect from January 1, 2010 through December 31, 2010.

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.

 

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Table of Contents

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)

 

    2009 Quarters     2010 Quarters  
    First     Second     Third     Fourth     First     Second     Third  

Revenues

  $ 1,069,474      $ 1,073,054      $ 1,057,488      $ 1,069,991      $ 1,089,837      $ 1,081,364      $ 1,053,012   
                                                       

Salaries, wages and benefits

    615,218        620,830        629,077        617,961        627,175        612,205        613,607   

Supplies

    80,336        83,912        82,400        86,408        85,886        85,455        83,753   

Rent

    85,201        86,882        88,081        88,084        88,319        88,981        89,295   

Other operating expenses

    220,405        221,755        221,524        222,521        234,204        238,687        234,968   

Other income

    (2,872     (2,823     (2,870     (2,947     (3,084     (2,857     (2,794

Depreciation and amortization

    30,490        31,355        31,992        31,893        31,121        29,852        29,167   

Interest expense

    2,478        2,229        1,741        1,432        1,307        1,298        1,642   

Investment (income) loss

    (1,475     (1,033     (746     (1,159     (877     377        (403
                                                       
    1,029,781        1,043,107        1,051,199        1,044,193        1,064,051        1,053,998        1,049,235   
                                                       

Income from continuing operations before income taxes

    39,693        29,947        6,289        25,798        25,786        27,366        3,777   

Provision (benefit) for income taxes

    16,352        12,409        901        9,453        10,631        11,230        (1,323
                                                       

Income from continuing operations

    23,341        17,538        5,388        16,345        15,155        16,136        5,100   

Discontinued operations, net of income taxes:

             

Income (loss) from operations

    (581     (897     13        2,396        (154     87        (260

Gain (loss) on divestiture of operations

           (24,051     52        567        (137     54        86   
                                                       

Net income (loss)

  $ 22,760      $ (7,410   $ 5,453      $ 19,308      $ 14,864      $ 16,277      $ 4,926   
                                                       

Earnings (loss) per common share:

             

Basic:

             

Income from continuing operations

  $ 0.60      $ 0.45      $ 0.14      $ 0.42      $ 0.38      $ 0.41      $ 0.13   

Discontinued operations:

             

Income (loss) from operations

    (0.02     (0.02            0.06                      (0.01

Gain (loss) on divestiture of operations

           (0.62            0.01                        
                                                       

Net income (loss)

  $ 0.58      $ (0.19   $ 0.14      $ 0.49      $ 0.38      $ 0.41      $ 0.12   
                                                       

Diluted:

             

Income from continuing operations

  $ 0.60      $ 0.45      $ 0.14      $ 0.42      $ 0.38      $ 0.41      $ 0.13   

Discontinued operations:

             

Income (loss) from operations

    (0.02     (0.02            0.06                      (0.01

Gain (loss) on divestiture of operations

           (0.62            0.01                        
                                                       

Net income (loss)

  $ 0.58      $ (0.19   $ 0.14      $ 0.49      $ 0.38      $ 0.41      $ 0.12   
                                                       

Shares used in computing earnings (loss) per common share:

             

Basic

    38,184        38,307        38,398        38,465        38,626        38,756        38,778   

Diluted

    38,315        38,415        38,524        38,693        38,859        38,914        38,838   

 

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Table of Contents

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

 

 

Operating Data

(Unaudited)

(In thousands)

 

    2009 Quarters     2010 Quarters  
    First     Second     Third     Fourth     First     Second     Third  

Revenues:

             

Hospital division

  $ 492,509      $ 487,145      $ 468,069      $ 485,169      $ 507,062      $ 493,401      $ 465,198   

Nursing center division

    529,942        537,545        539,217        543,638        539,321        542,215        539,914   

Rehabilitation division

    117,647        120,450        122,625        114,316        120,144        122,061        124,243   
                                                       
    1,140,098        1,145,140        1,129,911        1,143,123        1,166,527        1,157,677        1,129,355   

Eliminations

    (70,624     (72,086     (72,423     (73,132     (76,690     (76,313     (76,343
                                                       
  $ 1,069,474      $ 1,073,054      $ 1,057,488      $ 1,069,991      $ 1,089,837      $ 1,081,364      $ 1,053,012   
                                                       

Income from continuing operations:

             

Operating income (loss):

             

Hospital division

  $ 100,899      $ 91,027      $ 78,674      $ 93,211      $ 95,033      $ 90,893      $ 75,373 (a) 

Nursing center division

    75,574        79,522        73,383        77,111        70,249        76,493        69,077 (a) 

Rehabilitation division

    15,453        13,599        10,912        10,628        14,635        14,078        14,148 (a) 

Corporate:

             

Overhead

    (34,087     (33,586     (33,843     (33,120     (33,781     (32,799     (34,337

Insurance subsidiary

    (1,452     (1,182     (1,769     (1,782     (480     (791     (783
                                                       
    (35,539     (34,768     (35,612     (34,902     (34,261     (33,590     (35,120
                                                       

Operating income

    156,387        149,380        127,357        146,048        145,656        147,874        123,478   

Rent

    (85,201     (86,882     (88,081     (88,084     (88,319     (88,981     (89,295

Depreciation and amortization

    (30,490     (31,355     (31,992     (31,893     (31,121     (29,852     (29,167

Interest, net

    (1,003     (1,196     (995     (273     (430     (1,675     (1,239
                                                       

Income from continuing operations before income taxes

    39,693        29,947        6,289        25,798        25,786        27,366        3,777   

Provision (benefit) for income taxes

    16,352        12,409        901        9,453        10,631        11,230        (1,323 )(b) 
                                                       
  $ 23,341      $ 17,538      $ 5,388      $ 16,345      $ 15,155      $ 16,136      $ 5,100   
                                                       

 

(a) Includes transaction costs approximating $0.4 million for the hospital division, $0.3 million for the nursing center division and $0.1 million for the rehabilitation division.
(b) Includes a favorable prior year income tax reserve adjustment approximating $2.9 million.

 

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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)

(In thousands)

 

     2009 Quarters      2010 Quarters  
     First      Second      Third      Fourth      First      Second      Third  

Rent:

                    

Hospital division

   $ 36,445       $ 36,834       $ 37,062       $ 37,153       $ 37,415       $ 38,043       $ 38,122   

Nursing center division

     47,274         48,565         49,471         49,525         49,392         49,439         49,627   

Rehabilitation division

     1,451         1,459         1,495         1,373         1,475         1,470         1,502   

Corporate

     31         24         53         33         37         29         44   
                                                              
   $ 85,201       $ 86,882       $ 88,081       $ 88,084       $ 88,319       $ 88,981       $ 89,295