Edgar Filing: KINDRED HEALTHCARE, INC

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Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2013

¨	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 x 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 x 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.

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

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 July 31, 2013
Common stock, $0.25 par value		54,156,725 shares

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 June 30, 2013 and 2012 and for the six months ended June 30, 2013 and 2012		3

	Condensed Consolidated Statement of Comprehensive Income – for the three months ended June 30, 2013 and 2012 and for the six months ended June 30, 2013 and 2012		4

	Condensed Consolidated Balance Sheet – June 30, 2013 and December 31, 2012		5

	Condensed Consolidated Statement of Cash Flows – for the three months ended June 30, 2013 and 2012 and for the six months ended June 30, 2013 and 2012		6

	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		39

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		70

Item 4.	Controls and Procedures		71

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		72

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		72

Item 6.	Exhibits		73

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Revenues	$	1,410,360		$	1,424,918		$	2,896,678		$	2,891,603

Salaries, wages and benefits		829,407			848,342			1,735,413			1,732,580
Supplies		97,818			101,648			199,698			206,279
Rent		97,741			96,420			194,542			191,594
Other operating expenses		284,538			282,256			572,396			561,371
Other income		(24	)		(3,154	)		(1,022	)		(6,292	)
Impairment charges		16,228			279			16,588			1,053
Depreciation and amortization		46,338			46,499			95,651			91,751
Interest expense		29,086			26,715			57,260			53,292
Investment income		(1,481	)		(265	)		(1,571	)		(550	)

		1,399,651			1,398,740			2,868,955			2,831,078

Income from continuing operations before income taxes		10,709			26,178			27,723			60,525
Provision for income taxes		4,409			10,837			10,770			24,814

Income from continuing operations		6,300			15,341			16,953			35,711
Discontinued operations, net of income taxes:
Income (loss) from operations		(3,533	)		278			(9,469	)		(280	)
Loss on divestiture of operations		(940	)		(356	)		(2,184	)		(1,526	)

Loss from discontinued operations		(4,473	)		(78	)		(11,653	)		(1,806	)

Net income		1,827			15,263			5,300			33,905
(Earnings) loss attributable to noncontrolling interests		(82	)		239			(498	)		(212	)

Income attributable to Kindred	$	1,745		$	15,502		$	4,802		$	33,693

Amounts attributable to Kindred stockholders:
Income from continuing operations	$	6,218		$	15,580		$	16,455		$	35,499
Loss from discontinued operations		(4,473	)		(78	)		(11,653	)		(1,806	)

Net income	$	1,745		$	15,502		$	4,802		$	33,693

Earnings per common share:
Basic:
Income from continuing operations	$	0.12		$	0.29		$	0.31		$	0.67
Discontinued operations:
Income (loss) from operations		(0.07	)		0.01			(0.18	)		—
Loss on divestiture of operations		(0.02	)		(0.01	)		(0.04	)		(0.03	)

Loss from discontinued operations		(0.09	)		—			(0.22	)		(0.03	)

Net income	$	0.03		$	0.29		$	0.09		$	0.64

Diluted:
Income from continuing operations	$	0.12		$	0.29		$	0.31		$	0.67
Discontinued operations:
Income (loss) from operations		(0.07	)		0.01			(0.18	)		—
Loss on divestiture of operations		(0.02	)		(0.01	)		(0.04	)		(0.03	)

Loss from discontinued operations		(0.09	)		—			(0.22	)		(0.03	)

Net income	$	0.03		$	0.29		$	0.09		$	0.64

Shares used in computing earnings per common share:
Basic		52,265			51,664			52,164			51,633
Diluted		52,284			51,675			52,184			51,657

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Net income	$	1,827		$	15,263		$	5,300		$	33,905
Other comprehensive income (loss):
Available-for-sale securities (Note 9):
Change in unrealized investment gains (losses)		15			(199	)		1,628			1,003
Reclassification of gains realized in net income		(1,228	)		(8	)		(1,109	)		(85	)

Net change		(1,213	)		(207	)		519			918
Interest rate swaps (Note 1):
Change in unrealized gains (losses)		472			(1,132	)		1,316			(1,263	)
Reclassification of ineffectiveness realized in net income		(276	)		—			(276	)		—
Reclassification of (gains) losses realized in net income, net of payments		3			—			(2	)		201

Net change		199			(1,132	)		1,038			(1,062	)
Income tax expense (benefit) related to items of other comprehensive income (loss)		239			588			(698	)		168

Other comprehensive income (loss)		(775	)		(751	)		859			24

Comprehensive income		1,052			14,512			6,159			33,929
(Earnings) loss attributable to noncontrolling interests		(82	)		239			(498	)		(212	)

Comprehensive income attributable to Kindred	$	970		$	14,751		$	5,661		$	33,717

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	June 30, 2013			December 31, 2012
ASSETS
Current assets:
Cash and cash equivalents	$	37,427		$	50,007
Cash—restricted		5,046			5,197
Insurance subsidiary investments		93,952			86,168
Accounts receivable less allowance for loss of $33,916 – June 30, 2013 and $23,959 – December 31, 2012		1,036,562			1,038,605
Inventories		30,723			32,021
Deferred tax assets		20,433			12,663
Income taxes		14,901			13,573
Other		32,725			35,532

		1,271,769			1,273,766
Property and equipment		2,168,640			2,226,903
Accumulated depreciation		(1,071,595	)		(1,083,777	)

		1,097,045			1,143,126
Goodwill		1,041,796			1,041,266
Intangible assets less accumulated amortization of $46,228 – June 30, 2013 and $34,854 – December 31, 2012		429,752			439,767
Assets held for sale		2,803			4,131
Insurance subsidiary investments		150,034			116,424
Other		221,452			219,466

Total assets	$	4,214,651		$	4,237,946

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	190,279		$	210,668
Salaries, wages and other compensation		370,082			389,009
Due to third party payors		26,205			35,420
Professional liability risks		59,362			54,088
Other accrued liabilities		123,824			137,204
Long-term debt due within one year		8,356			8,942

		778,108			835,331
Long-term debt		1,662,286			1,648,706
Professional liability risks		246,386			236,630
Deferred tax liabilities		10,622			9,764
Deferred credits and other liabilities		218,072			214,671
Commitments and contingencies (Note 11)

Equity:
Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 54,052 shares – June 30, 2013 and 53,280 shares – December 31, 2012		13,513			13,320
Capital in excess of par value		1,147,787			1,145,922
Accumulated other comprehensive loss		(1,023	)		(1,882	)
Retained earnings		103,227			98,799

		1,263,504			1,256,159
Noncontrolling interests		35,673			36,685

Total equity		1,299,177			1,292,844

Total liabilities and equity	$	4,214,651		$	4,237,946

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Cash flows from operating activities:
Net income	$	1,827		$	15,263		$	5,300		$	33,905
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		46,960			49,802			99,914			98,492
Amortization of stock-based compensation costs		3,840			3,077			6,088			4,879
Amortization of deferred financing costs		4,407			2,359			7,020			4,716
Payment of lender fees related to debt issuance		(1,600	)		—			(1,600	)		—
Provision for doubtful accounts		10,071			6,041			21,337			13,537
Deferred income taxes		(24,977	)		(13,243	)		(25,321	)		(16,905	)
Impairment charges		16,279			329			16,715			1,196
Loss on divestiture of discontinued operations		940			356			2,184			1,526
Other		(1,284	)		1,690			(864	)		1,967
Change in operating assets and liabilities:
Accounts receivable		48,294			(23,891	)		(19,117	)		(81,088	)
Inventories and other assets		4,747			498			(3,400	)		(15,407	)
Accounts payable		(3,288	)		(2,983	)		(19,078	)		(12,533	)
Income taxes		3,622			455			15,792			31,697
Due to third party payors		(8,187	)		(1,963	)		(9,215	)		(10,939	)
Other accrued liabilities		(48,017	)		15,233			(17,288	)		(5,445	)

Net cash provided by operating activities		53,634			53,023			78,467			49,598

Cash flows from investing activities:
Routine capital expenditures		(17,430	)		(28,759	)		(39,800	)		(50,865	)
Development capital expenditures		(5,086	)		(12,376	)		(7,474	)		(22,998	)
Acquisitions, net of cash acquired		(26,933	)		(17,420	)		(26,933	)		(67,868	)
Acquisition deposit		—			16,866			—			—
Sale of assets		7,243			—			12,303			1,110
Purchase of insurance subsidiary investments		(11,759	)		(7,425	)		(22,595	)		(21,198	)
Sale of insurance subsidiary investments		15,526			8,004			25,528			22,010
Net change in insurance subsidiary cash and cash equivalents		(9,782	)		(1,363	)		(42,878	)		(14,486	)
Change in other investments		39			182			358			451
Other		(77	)		(255	)		(221	)		(1,004	)

Net cash used in investing activities		(48,259	)		(42,546	)		(101,712	)		(154,848	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		377,900			449,300			861,400			964,700
Repayment of borrowings under revolving credit		(385,200	)		(457,500	)		(844,400	)		(854,500	)
Repayment of other long-term debt		(2,060	)		(2,645	)		(4,726	)		(5,311	)
Payment of deferred financing costs		(455	)		(270	)		(657	)		(313	)
Contribution made by noncontrolling interests		—			200			—			200
Distribution made to noncontrolling interests		(1,019	)		(2,133	)		(1,510	)		(3,521	)
Issuance of common stock		203			—			207			—
Other		19			—			351			—

Net cash provided by (used in) financing activities		(10,612	)		(13,048	)		10,665			101,255

Change in cash and cash equivalents		(5,237	)		(2,571	)		(12,580	)		(3,995	)
Cash and cash equivalents at beginning of period		42,664			40,137			50,007			41,561

Cash and cash equivalents at end of period	$	37,427		$	37,566		$	37,427		$	37,566

Supplemental information:
Interest payments	$	42,753		$	35,526		$	55,845		$	47,634
Income tax payments		23,461			23,802			13,830			9,846

See accompanying notes.

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 transitional care (“TC”) hospitals, inpatient rehabilitation hospitals (“IRFs”), nursing centers, assisted living facilities, a contract rehabilitation services business and a home health and hospice business across the United States (collectively, the “Company” or “Kindred”). At June 30, 2013, the Company’s hospital division operated 116 TC hospitals (licensed as long-term acute care (“LTAC”) hospitals under the Medicare program) and six IRFs in 26 states. The Company’s nursing center division operated 169 nursing centers and six assisted living facilities in 26 states. The Company’s rehabilitation division provided rehabilitation services primarily in hospitals and long-term care settings. The Company’s home health and hospice division provided home health, hospice and private duty services from 105 locations in ten states.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing centers to improve its future operating results. For accounting purposes, the operating results of these businesses and the 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 held for sale at June 30, 2013 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 Notes 2 and 3 for a summary of divestitures and discontinued operations.

Recently issued accounting requirements

In July 2013, the Financial Accounting Standards Board (the “FASB”) issued authoritative guidance related to financial statement presentation of an unrecognized tax benefit. The main provisions of the guidance state that an entity must present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2014. Early adoption is permitted for all entities. The adoption of the guidance is not expected to have a material impact on the Company’s business, financial position, results of operations or liquidity.

In February 2013, the FASB amended its authoritative guidance issued in December 2011 related to the deferral of the requirement to present reclassification adjustments out of accumulated other comprehensive income in both the statement in which net income is presented and the statement in which other comprehensive income is presented. The amended provisions require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under United States generally accepted accounting principles to be reclassified to net income in its entirety in the same reporting period. For all other amounts, an entity is required to cross-reference to other disclosures that provide additional details about these amounts. All other requirements of the original June 2011 update were not impacted by the amendment which became effective for all interim and annual reporting periods beginning after December 15, 2012. The adoption of the guidance did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Equity

The following table sets forth the changes in equity attributable to noncontrolling interests and equity attributable to Kindred stockholders for the six months ended June 30, 2013 and 2012 (in thousands):


For the six months ended June 30, 2013:	Redeemable noncontrolling interests			Amounts attributable to Kindred stockholders			Nonredeemable noncontrolling interests			Total equity
Balance at December 31, 2012	$	—		$	1,256,159		$	36,685		$	1,292,844
Comprehensive income:
Net income		—			4,802			498			5,300
Other comprehensive income		—			859			—			859

		—			5,661			498			6,159
Issuance of common stock in connection with employee benefit plans		—			207			—			207
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(2,964	)		—			(2,964	)
Income tax provision in connection with the issuance of common stock under employee benefit plans		—			(1,647	)		—			(1,647	)
Stock-based compensation amortization		—			6,088			—			6,088
Distribution made to noncontrolling interests		—			—			(1,510	)		(1,510	)

Balance at June 30, 2013	$	—		$	1,263,504		$	35,673		$	1,299,177


For the six months ended June 30, 2012:
Balance at December 31, 2011	$	9,704		$	1,288,921		$	31,620		$	1,320,541
Comprehensive income (loss):
Net income (loss)		240			33,693			(28	)		33,665
Other comprehensive income		—			24			—			24

		240			33,717			(28	)		33,689
Shares tendered by employees for statutory tax withholdings upon issuance of common stock		—			(1,821	)		—			(1,821	)
Income tax provision in connection with the issuance of common stock under employee benefit plans		—			(2,210	)		—			(2,210	)
Stock-based compensation amortization		—			4,879			—			4,879
Contribution made by noncontrolling interests		—			—			200			200
Distribution made to noncontrolling interests		(571	)		—			(2,950	)		(2,950	)

Balance at June 30, 2012	$	9,373		$	1,323,486		$	28,842		$	1,352,328

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Derivative financial instruments

In December 2011, the Company entered into two interest rate swap agreements to hedge its floating interest rate on an aggregate of $225 million of outstanding senior secured term loan facility debt (the “Term Loan Facility”) entered into in June 2011. The interest rate swaps have an effective date of January 9, 2012, and expire on January 11, 2016. The Company is required to make payments based upon a fixed interest rate of 1.8925% calculated on the notional amount of $225 million. In exchange, the Company will receive interest on $225 million at a variable interest rate that is based upon the three-month London Interbank Offered Rate (“LIBOR”), subject to a minimum rate of 1.5%. The Company determined the interest rate swaps continue to qualify for cash flow hedge accounting treatment at June 30, 2013. However, the Term Loan Facility amendment completed in May 2013 reduces the LIBOR floor from 1.5% to 1.0%, therefore some partial ineffectiveness will result through the expiration of the interest rate swap agreement. For the three and six months ended June 30, 2013, there was $0.3 million of ineffectiveness recognized related to the interest rate swaps and recorded in interest expense. The fair value of the interest rate swaps recorded in other accrued liabilities was $1.3 million and $2.6 million at June 30, 2013 and December 31, 2012, respectively. See Note 10.

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, 2012 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2012 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 statement 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.

NOTE 2 – DIVESTITURES

On July 31, 2013, the Company completed the sale of seven non-strategic nursing centers (the “Signature Facilities”) for $47 million to affiliates of Signature Healthcare, LLC (“Signature”).

The Signature Facilities contain 900 licensed beds. Five of the Signature Facilities were owned facilities and the remaining Signature Facilities were leased. The Signature Facilities generated revenues of approximately $63 million and segment operating income of approximately $11 million (excluding the allocation of approximately $2 million of overhead costs) for the year ended December 31, 2012. The Signature Facilities had aggregate rent expense of approximately $2 million for the year ended December 31, 2012.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DIVESTITURES (Continued)

The results of operations for the Signature Facilities will be reclassified to discontinued operations in the third quarter of 2013. The Signature Facilities did not meet the conditions of discontinued operations at June 30, 2013.

On April 25, 2013, the Company announced that it signed a definitive agreement to sell 17 non-strategic facilities (the “Vibra Facilities”) for $187 million to an affiliate of Vibra Healthcare, LLC (“Vibra”).

The Vibra Facilities consist of 15 TC hospitals containing 1,052 licensed beds, one IRF containing 44 licensed beds and one nursing center containing 135 licensed beds. Six of the TC hospitals and the one nursing center are owned facilities. The remaining Vibra Facilities are leased. The Vibra Facilities generated revenues of approximately $289 million and segment operating income of approximately $43 million (excluding the allocation of approximately $9 million of overhead costs) for the year ended December 31, 2012. The Vibra Facilities had aggregate rent expense of approximately $14 million for the year ended December 31, 2012.

The transaction is subject to Vibra finalizing its financing for the transaction and to regulatory approvals and other conditions to closing. The Company expects to complete the transaction through one or more closings occurring during the third and fourth quarters of 2013 as these conditions are satisfied.

The results of operations for the Vibra Facilities will be reclassified to discontinued operations when they meet the conditions of discontinued operations.

During the second quarter of 2013, the Company recorded an asset impairment charge of $15.6 million related to the planned sale of the Vibra Facilities. These charges reflect the amount by which the carrying value of certain property and equipment exceeded its estimated fair value.

On April 27, 2012, the Company announced that it would not renew seven renewal bundles containing 54 nursing centers (the “Expiring Facilities”) under operating leases with Ventas, Inc. (“Ventas”) that expired on April 30, 2013. The Expiring Facilities contain 6,140 licensed nursing center beds and generated revenues of approximately $475 million for the year ended December 31, 2012. The annual rent for these facilities approximated $57 million. The Company may be required to pay for additional capital obligations for the Expiring Facilities under the master lease agreements with Ventas. The Company transferred the operations of all of the 54 nursing centers to new operators during the six months ended June 30, 2013. The Company reclassified the results of operations and losses associated with the Expiring Facilities to discontinued operations, net of income taxes, for all periods presented. The Company received cash proceeds of $7.2 million and $12.3 million for the three months and six months ended June 30, 2013, respectively, for the sale of property and equipment and inventory related to the Expiring Facilities.

NOTE 3 – 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 losses associated with these transactions have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations. At June 30, 2013, the Company held for sale one hospital.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

A summary of discontinued operations follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Revenues	$	34,418		$	122,759		$	138,432		$	248,231

Salaries, wages and benefits		17,743			58,570			71,121			119,536
Supplies		1,957			6,593			7,599			13,257
Rent		3,651			14,514			16,499			29,037
Other operating expenses		16,189			39,277			54,284			79,987
Other (income) expense		30			6			142			1
Impairment charges		51			50			127			143
Depreciation		622			3,303			4,263			6,741
Interest expense		—			1			2			2
Investment income		(9	)		(10	)		(19	)		(17	)

		40,234			122,304			154,018			248,687

Income (loss) from operations before income taxes		(5,816	)		455			(15,586	)		(456	)
Provision (benefit) for income taxes		(2,283	)		177			(6,117	)		(176	)

Income (loss) from operations		(3,533	)		278			(9,469	)		(280	)
Loss on divestiture of operations		(940	)		(356	)		(2,184	)		(1,526	)

Loss from discontinued operations	$	(4,473	)	$	(78	)	$	(11,653	)	$	(1,806	)

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


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Revenues:
Hospital division	$	(61	)	$	2,884		$	(117	)	$	6,669
Nursing center division		34,479			119,875			138,549			241,562

	$	34,418		$	122,759		$	138,432		$	248,231

Operating income (loss):
Hospital division	$	(281	)	$	(726	)	$	(954	)	$	(2,472	)
Nursing center division		(1,271	)		18,989			6,113			37,779

	$	(1,552	)	$	18,263		$	5,159		$	35,307

Rent:
Hospital division	$	—		$	265		$	16		$	640
Nursing center division		3,651			14,249			16,483			28,397

	$	3,651		$	14,514		$	16,499		$	29,037

Depreciation:
Hospital division	$	—		$	58		$	4		$	315
Nursing center division		622			3,245			4,259			6,426

	$	622		$	3,303		$	4,263		$	6,741

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – DISCONTINUED OPERATIONS (Continued)

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


	June 30, 2013			December 31, 2012
Long-term assets:
Property and equipment, net	$	2,803		$	4,126
Other		—			5

		2,803			4,131
Current liabilities (included in other accrued liabilities)		(57	)		—

	$	2,746		$	4,131

NOTE 4 – ACQUISITIONS

In May 2013, the Company acquired the real estate of a previously leased hospital for $25.2 million. Annual rent associated with the hospital aggregated $2.5 million.

In May 2013, the Company acquired two home health and hospice businesses for $1.7 million.

During the six months ended June 30, 2012, the Company acquired the real estate of two previously leased hospitals for $67.9 million. Annual rent associated with the hospitals aggregated $5.5 million.

The purchase price of 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 operating cash flows and borrowings under the Company’s revolving credit facility.

The fair value of each of the acquisitions noted above was measured using discounted cash flow methodologies which are considered Level 3 inputs (as described in Note 12).

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – 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 June 30,						Six months ended June 30,
	2013			2012			2013			2012
Medicare	$	593,557		$	601,890		$	1,243,279		$	1,238,172
Medicaid		209,145			214,120			418,684			427,201
Medicare Advantage		110,611			106,737			223,187			213,891
Other		570,859			574,995			1,160,094			1,159,493

		1,484,172			1,497,742			3,045,244			3,038,757
Eliminations		(73,812	)		(72,824	)		(148,566	)		(147,154	)

	$	1,410,360		$	1,424,918		$	2,896,678		$	2,891,603

NOTE 6 – 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. The Company follows 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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – EARNINGS PER SHARE (Continued)

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


	Three months ended June 30,												Six months ended June 30,
	2013						2012						2013						2012
	Basic			Diluted			Basic			Diluted			Basic			Diluted			Basic			Diluted
Earnings:
Amounts attributable to Kindred stockholders:
Income from continuing operations:
As reported in Statement of Operations	$	6,218		$	6,218		$	15,580		$	15,580		$	16,455		$	16,455		$	35,499		$	35,499
Allocation to participating unvested restricted stockholders		(205	)		(205	)		(374	)		(373	)		(504	)		(504	)		(669	)		(669	)

Available to common stockholders	$	6,013		$	6,013		$	15,206		$	15,207		$	15,951		$	15,951		$	34,830		$	34,830

Discontinued operations, net of income taxes:
Income (loss) from operations:
As reported in Statement of Operations	$	(3,533	)	$	(3,533	)	$	278		$	278		$	(9,469	)	$	(9,469	)	$	(280	)	$	(280	)
Allocation to participating unvested restricted stockholders		117			117			(7	)		(7	)		290			290			5			5

Available to common stockholders	$	(3,416	)	$	(3,416	)	$	271		$	271		$	(9,179	)	$	(9,179	)	$	(275	)	$	(275	)

Loss on divestiture of operations:
As reported in Statement of Operations	$	(940	)	$	(940	)	$	(356	)	$	(356	)	$	(2,184	)	$	(2,184	)	$	(1,526	)	$	(1,526	)
Allocation to participating unvested restricted stockholders		31			31			9			9			67			67			29			29

Available to common stockholders	$	(909	)	$	(909	)	$	(347	)	$	(347	)	$	(2,117	)	$	(2,117	)	$	(1,497	)	$	(1,497	)

Loss from discontinued operations:
As reported in Statement of Operations	$	(4,473	)	$	(4,473	)	$	(78	)	$	(78	)	$	(11,653	)	$	(11,653	)	$	(1,806	)	$	(1,806	)
Allocation to participating unvested restricted stockholders		148			148			2			2			357			357			34			34

Available to common stockholders	$	(4,325	)	$	(4,325	)	$	(76	)	$	(76	)	$	(11,296	)	$	(11,296	)	$	(1,772	)	$	(1,772	)

Net income:
As reported in Statement of Operations	$	1,745		$	1,745		$	15,502		$	15,502		$	4,802		$	4,802		$	33,693		$	33,693
Allocation to participating unvested restricted stockholders		(57	)		(57	)		(372	)		(371	)		(147	)		(147	)		(635	)		(635	)

Available to common stockholders	$	1,688		$	1,688		$	15,130		$	15,131		$	4,655		$	4,655		$	33,058		$	33,058

Shares used in the computation:
Weighted average shares outstanding – basic computation		52,265			52,265			51,664			51,664			52,164			52,164			51,633			51,633

Dilutive effect of employee stock options					19						11						20						24

Adjusted weighted average shares outstanding – diluted computation					52,284						51,675						52,184						51,657

Earnings per common share:
Income from continuing operations	$	0.12		$	0.12		$	0.29		$	0.29		$	0.31		$	0.31		$	0.67		$	0.67
Discontinued operations:
Income (loss) from operations		(0.07	)		(0.07	)		0.01			0.01			(0.18	)		(0.18	)		—			—
Loss on divestiture of operations		(0.02	)		(0.02	)		(0.01	)		(0.01	)		(0.04	)		(0.04	)		(0.03	)		(0.03	)

Loss from discontinued operations		(0.09	)		(0.09	)		—			—			(0.22	)		(0.22	)		(0.03	)		(0.03	)

Net income	$	0.03		$	0.03		$	0.29		$	0.29		$	0.09		$	0.09		$	0.64		$	0.64

Number of antidilutive stock options excluded from shares used in the diluted earnings per common share computation					1,235						2,296						1,270						2,296

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA

The Company is organized into four operating divisions: the hospital division, the nursing center division, the rehabilitation division and the home health and hospice division. Based upon the authoritative guidance for business segments, the operating divisions represent five reportable operating segments, including (1) hospitals, (2) nursing centers, (3) skilled nursing rehabilitation services, (4) hospital rehabilitation services and (5) home health and hospice services. These reportable operating segments are consistent with information used by the Company’s President and Chief Operating Officer to assess performance and allocate resources. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. Prior period segment information has been reclassified to conform with the current period presentation.

For segment purposes, the Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Segment operating income reported for each of the Company’s operating segments excludes impairment charges, transaction costs and the allocation of corporate overhead.

On January 1, 2013, the Company transferred the operations of its hospital-based sub-acute unit business from the hospital division to the nursing center division. Historical amounts have been reclassified to conform with the current period presentation.

Segment operating income for the six months ended June 30, 2013 included one-time bonus costs paid to employees who do not participate in the Company’s incentive compensation program of $24.5 million (hospital division – $8.8 million, nursing center division – $8.3 million, rehabilitation division – $6.3 million (skilled nursing rehabilitation services – $5.0 million and hospital rehabilitation services – $1.3 million), home health and hospice division – $0.8 million and corporate – $0.3 million).

Segment operating income for the hospital division also included employee retention costs of $0.2 million and $0.5 million for the three months ended June 30, 2013 and for the six months ended June 30, 2013, respectively, incurred in connection with the planned divestiture of the Vibra Facilities.

Segment operating income for the hospital division for the three months ended June 30, 2012 included severance ($0.5 million) and other miscellaneous costs ($0.9 million) incurred in connection with the closing of two TC hospitals and $5.0 million for employment-related lawsuits. Operating income for the hospital division for the six months ended June 30, 2012 included severance ($2.5 million) and other miscellaneous costs ($1.0 million) incurred in connection with the closing of a regional office and two TC hospitals, and $5.0 million for employment-related lawsuits.

Segment operating income for the nursing center division for both the three months ended June 30, 2012 and the six months ended June 30, 2012 included $0.9 million incurred in connection with the cancellation of a sub-acute unit project.

Rent expense for the hospital division included $0.9 million in both the three months ended June 30, 2012 and the six months ended June 30, 2012 incurred in connection with the closing of a TC hospital.

Interest expense for corporate included $1.4 million in both the three months ended June 30, 2013 and the six months ended June 30, 2013 related to charges associated with the modification of certain of the Company’s senior debt. See Note 10.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)

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


	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Revenues:
Hospital division	$	691,316		$	714,517		$	1,439,530		$	1,463,900
Nursing center division		419,497			425,812			846,691			859,220
Rehabilitation division:
Skilled nursing rehabilitation services		250,543			255,139			510,063			510,562
Hospital rehabilitation services		69,777			73,402			144,300			147,771

		320,320			328,541			654,363			658,333
Home health and hospice division		53,039			28,872			104,660			57,304

		1,484,172			1,497,742			3,045,244			3,038,757
Eliminations:
Skilled nursing rehabilitation services		(44,958	)		(43,353	)		(89,659	)		(87,880	)
Hospital rehabilitation services		(27,308	)		(27,646	)		(55,302	)		(55,807	)
Nursing centers		(1,546	)		(1,825	)		(3,605	)		(3,467	)

		(73,812	)		(72,824	)		(148,566	)		(147,154	)

	$	1,410,360		$	1,424,918		$	2,896,678		$	2,891,603

Income from continuing operations:
Operating income (loss):
Hospital division	$	142,907		$	142,668		$	304,726		$	304,494
Nursing center division		54,034			56,952			97,180			109,471
Rehabilitation division:
Skilled nursing rehabilitation services		22,519			21,477			36,528			34,209
Hospital rehabilitation services		19,573			17,860			37,705			33,976

		42,092			39,337			74,233			68,185
Home health and hospice division		3,961			2,789			6,747			5,130
Corporate:
Overhead		(43,199	)		(44,723	)		(88,781	)		(87,451	)
Insurance subsidiary		(384	)		(600	)		(893	)		(1,082	)

		(43,583	)		(45,323	)		(89,674	)		(88,533	)
Impairment charges		(16,228	)		(279	)		(16,588	)		(1,053	)
Transaction costs		(790	)		(597	)		(3,019	)		(1,082	)

Operating income		182,393			195,547			373,605			396,612
Rent		(97,741	)		(96,420	)		(194,542	)		(191,594	)
Depreciation and amortization		(46,338	)		(46,499	)		(95,651	)		(91,751	)
Interest, net		(27,605	)		(26,450	)		(55,689	)		(52,742	)

Income from continuing operations before income taxes		10,709			26,178			27,723			60,525
Provision for income taxes		4,409			10,837			10,770			24,814

	$	6,300		$	15,341		$	16,953		$	35,711

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,				Six months ended June 30,
	2013		2012		2013		2012
Rent:
Hospital division	$	53,855	$	54,079	$	107,003	$	107,230
Nursing center division		40,890		39,699		81,479		79,011
Rehabilitation division:
Skilled nursing rehabilitation services		1,197		1,408		2,432		2,848
Hospital rehabilitation services		19		39		36		117

		1,216		1,447		2,468		2,965
Home health and hospice division		1,155		609		2,341		1,224
Corporate		625		586		1,251		1,164

	$	97,741	$	96,420	$	194,542	$	191,594

Depreciation and amortization:
Hospital division	$	21,752	$	22,807	$	45,693	$	45,153
Nursing center division		10,371		9,957		21,208		19,485
Rehabilitation division:
Skilled nursing rehabilitation services		2,878		2,752		5,990		5,412
Hospital rehabilitation services		2,319		2,323		4,650		4,647

		5,197		5,075		10,640		10,059
Home health and hospice division		1,615		925		3,141		1,823
Corporate		7,403		7,735		14,969		15,231

	$	46,338	$	46,499	$	95,651	$	91,751

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division:
Routine	$	5,593	$	9,095	$	15,864	$	19,440
Development		5,079		11,289		7,467		21,238

		10,672		20,384		23,331		40,678

Nursing center division:
Routine		4,259		3,417		10,078		7,646
Development		7		1,087		7		1,760

		4,266		4,504		10,085		9,406

Rehabilitation division:
Skilled nursing rehabilitation services:
Routine		464		569		1,069		895
Development		—		—		—		—

		464		569		1,069		895

Hospital rehabilitation services:
Routine		45		60		77		106
Development		—		—		—		—

		45		60		77		106

Home health and hospice division:
Routine		339		145		534		269
Development		—		—		—		—

		339		145		534		269

Corporate:
Routine:
Information systems		6,436		15,195		11,725		22,059
Other		294		278		453		450

	$	22,516	$	41,135	$	47,274	$	73,863

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – BUSINESS SEGMENT DATA (Continued)


	June 30, 2013		December 31, 2012
Assets at end of period:
Hospital division	$	2,111,019	$	2,129,303
Nursing center division		587,382		626,016
Rehabilitation division:
Skilled nursing rehabilitation services		354,427		336,445
Hospital rehabilitation services		333,721		340,668

		688,148		677,113
Home health and hospice division		208,774		202,156
Corporate		619,328		603,358

	$	4,214,651	$	4,237,946

Goodwill:
Hospital division	$	747,065	$	747,065
Rehabilitation division:
Skilled nursing rehabilitation services		—		—
Hospital rehabilitation services		168,019		168,019

		168,019		168,019
Home health and hospice division		126,712		126,182

	$	1,041,796	$	1,041,266

NOTE 8 – 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 June 30,				Six months ended June 30,
	2013		2012		2013		2012
Professional liability:
Continuing operations	$	20,217	$	18,152	$	40,641	$	34,867
Discontinued operations		1,503		2,422		6,544		4,456
Workers compensation:
Continuing operations	$	13,353	$	13,911	$	27,099	$	27,265
Discontinued operations		1,244		1,625		2,970		3,242

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE RISKS (Continued)

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


	June 30, 2013						December 31, 2012
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	58,500	$	35,452	$	93,952	$	53,133	$	33,035	$	86,168
Reinsurance recoverables		4,814		—		4,814		5,382		—		5,382
Other		—		150		150		—		150		150

		63,314		35,602		98,916		58,515		33,185		91,700
Non-current:
Insurance subsidiary investments		72,101		77,933		150,034		46,546		69,878		116,424
Reinsurance and other recoverables		66,549		74,911		141,460		58,025		76,794		134,819
Deposits		4,238		1,489		5,727		3,977		1,574		5,551
Other		—		40		40		—		40		40

		142,888		154,373		297,261		108,548		148,286		256,834

	$	206,202	$	189,975	$	396,177	$	167,063	$	181,471	$	348,534

Liabilities:
Allowance for insurance risks:
Current	$	59,362	$	39,567	$	98,929	$	54,088	$	37,096	$	91,184
Non-current		246,386		158,840		405,226		236,630		156,265		392,895

	$	305,748	$	198,407	$	504,155	$	290,718	$	193,361	$	484,079

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 2013 and 2012 policy years. 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 $308.6 million at June 30, 2013 and $293.3 million at December 31, 2012.

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 9 – INSURANCE SUBSIDIARY INVESTMENTS

The Company maintains investments, consisting principally of cash and cash equivalents, debt securities, equities and certificates of deposit 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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – INSURANCE SUBSIDIARY INVESTMENTS (Continued)

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


	June 30, 2013									December 31, 2012
	Cost		Unrealized gains		Unrealized losses			Fair value		Cost		Unrealized gains		Unrealized losses			Fair value
Cash and cash equivalents (a)	$	183,040	$	—	$	—		$	183,040	$	140,162	$	—	$	—		$	140,162
Debt securities:
Corporate bonds		19,030		37		(38	)		19,029		21,352		118		(16	)		21,454
Debt securities issued by U.S. government agencies		18,987		47		(22	)		19,012		16,624		89		—			16,713
U.S. Treasury notes		7,108		3		(4	)		7,107		6,131		3		—			6,134

		45,125		87		(64	)		45,148		44,107		210		(16	)		44,301
Equities by industry:
Consumer		1,472		727		—			2,199		2,171		599		(15	)		2,755
Industrials		1,578		363		(26	)		1,915		2,039		331		(53	)		2,317
Financial services		1,049		362		(54	)		1,357		1,419		284		(86	)		1,617
Technology		1,002		286		—			1,288		1,482		268		(70	)		1,680
Healthcare		979		285		—			1,264		1,474		179		(14	)		1,639
Other		1,839		705		(73	)		2,471		2,554		706		(243	)		3,017

		7,919		2,728		(153	)		10,494		11,139		2,367		(481	)		13,025
Certificates of deposit		5,300		4		—			5,304		5,101		3		—			5,104

	$	241,384	$	2,819	$	(217	)	$	243,986	$	200,509	$	2,580	$	(497	)	$	202,592

(a)	Includes $7.2 million and $3.7 million of money market funds at June 30, 2013 and December 31, 2012, respectively.

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 at June 30, 2013 and recognized a $0.1 million pretax-other-than-temporary impairment during the six months ended June 30, 2013 for various investments held in its insurance subsidiary investment portfolio. The Company considered the severity and duration of its unrealized losses at June 30, 2012 for various investments held in its insurance subsidiary investment portfolio and determined that these unrealized losses were temporary and did not record any impairment losses related to these investments.

As a result of deterioration in professional liability and workers compensation underwriting results of the Company’s limited purpose insurance subsidiary in 2012 and 2011, the Company made capital contributions of $14.2 million and $8.6 million during the six months ended June 30, 2013 and 2012, respectively, to its limited purpose insurance subsidiary. These transactions were completed in accordance with applicable regulations. Neither capital contribution had any impact on earnings.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – LONG-TERM DEBT

During the second quarter of 2013, the Company completed an amendment and restatement of its Term Loan Facility to reduce its annual interest cost by 100 basis points. The applicable interest rate on the Term Loan Facility, which matures on June 1, 2018, was reduced by 50 basis points to LIBOR plus 325 basis points (previously LIBOR plus 375 basis points). In addition, the LIBOR floor was reduced to 1.00% from 1.50%. The Company recorded charges associated with the amendment and restatement of $1.4 million during the second quarter of 2013 which is included in interest expense in the accompanying unaudited condensed consolidated statement of operations.

NOTE 11 – 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 8.

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.

Legal and regulatory proceedings—The Company is a party to various legal actions (some of which are not insured), and regulatory and other governmental and internal audits and investigations in the ordinary course of business (including investigations resulting from the Company’s obligation to self-report suspected violations of law by the Company). The Company cannot predict the ultimate outcome of pending litigation and regulatory and other governmental audits and investigations. These matters 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. See Note 14.

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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

The Company follows the provisions of the authoritative guidance for fair value measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles.

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 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.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – 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		Assets/liabilities at fair value			Total losses
June 30, 2013:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	—	$	19,029		$	—	$	19,029		$	—
Debt securities issued by U.S. government agencies		—		19,012			—		19,012			—
U.S. Treasury notes		7,107		—			—		7,107			—

		7,107		38,041			—		45,148			—
Available-for-sale equity securities		10,494		—			—		10,494			—
Money market funds		10,541		—			—		10,541			—
Certificates of deposit		—		5,304			—		5,304			—

Total available-for-sale investments		28,142		43,345			—		71,487			—
Deposits held in money market funds		346		4,239			—		4,585			—

	$	28,488	$	47,584		$	—	$	76,072		$	—

Liabilities:
Interest rate swaps	$	—	$	(1,333	)	$	—	$	(1,333	)	$	—

Non-recurring:
Assets:
Hospital available for sale	$	—	$	—		$	3,250	$	3,250		$	(1,250	)
Property and equipment		—		—			3,307		3,307			(16,715	)

	$	—	$	—		$	6,557	$	6,557		$	(17,965	)

Liabilities	$	—	$	—		$	—	$	—		$	—

December 31, 2012:
Recurring:
Assets:
Available-for-sale debt securities:
Corporate bonds	$	—	$	21,454		$	—	$	21,454		$	—
Debt securities issued by U.S. government agencies		—		16,713			—		16,713			—
U.S. Treasury notes		6,134		—			—		6,134			—

		6,134		38,167			—		44,301			—
Available-for-sale equity securities		13,025		—			—		13,025			—
Money market funds		7,438		—			—		7,438			—
Certificates of deposit		—		5,104			—		5,104			—

Total available-for-sale investments		26,597		43,271			—		69,868			—
Deposits held in money market funds		347		3,978			—		4,325			—

	$	26,944	$	47,249		$	—	$	74,193		$	—

Liabilities:
Interest rate swaps	$	—	$	(2,649	)	$	—	$	(2,649	)	$	—

Non-recurring:
Assets:
Hospital available for sale	$	—	$	—		$	105	$	105		$	(569	)
Property and equipment		—		—			286		286			(3,630	)
Goodwill—skilled nursing rehabilitation services		—		—			—		—			(107,899	)
Intangible assets—Medicare license		—		—			—		—			(2,530	)

	$	—	$	—		$	391	$	391		$	(114,628	)

Liabilities	$	—	$	—		$	—	$	—		$	—

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Recurring measurements

The Company’s available-for-sale investments held by its limited purpose insurance subsidiary consist of debt securities, equities, money market funds and certificates of deposit. These available-for-sale investments and the insurance subsidiary’s cash and cash equivalents of $175.8 million as of June 30, 2013 and $136.5 million as of December 31, 2012, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

The Company also has available-for-sale investments totaling $3.4 million as of June 30, 2013 and $3.7 million as of December 31, 2012 related to a deferred compensation plan that is maintained for certain of the Company’s current and former employees.

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 certificates of deposit 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 three or six months ended June 30, 2013 or June 30, 2012.

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 the derivative liability associated with the interest rate swaps is estimated using industry-standard valuation models, which are Level 2 measurements. Such models project future cash flows and discount the future amounts to a present value using market-based observable inputs, including interest rate curves.

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. The Company’s long-term debt is based upon Level 2 inputs.


	June 30, 2013				December 31, 2012
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	37,427	$	37,427	$	50,007	$	50,007
Cash–restricted		5,046		5,046		5,197		5,197
Insurance subsidiary investments		243,986		243,986		202,592		202,592
Tax refund escrow investments		207		207		207		207
Long-term debt, including amounts due within one year (excluding capital lease obligations totaling $18,000 and $0.6 million at June 30, 2013 and December 31, 2012, respectively)		1,670,624		1,679,193		1,657,039		1,630,649

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS (Continued)

Non-recurring measurements

In the second quarter of 2013, the Company recorded an asset impairment charge of $15.6 million related to the planned sale of the Vibra Facilities. These charges reflect the amount by which the carrying value of certain property and equipment exceeded its estimated fair value. The fair value of property and equipment was measured using a Level 3 input of the pending offer and replacement costs adjusted for depreciation, economic obsolescence and inflation.

During the six months ended June 30, 2013, the Company reduced the fair value of a hospital held for sale based upon a pending offer, which resulted in a pretax loss of $1.3 million recorded in discontinued operations. The primary reason for the reduction was to compensate for certain real estate restrictions associated with the property. The fair value of the asset was measured using a Level 3 input of the pending offer.

CMS issued final rules which, among other things, significantly reduced Medicare payments to nursing centers and changed the reimbursement for the provision for group rehabilitation therapy services to Medicare beneficiaries beginning October 1, 2011 (the “2011 CMS Rules”). The Company recorded pretax impairment charges aggregating $0.6 million and $1.0 million in the second quarter of 2013 and for the six months ended June 30, 2013, respectively, for property and equipment expenditures in the nursing center asset groups that were determined to be impaired by the 2011 CMS Rules. These charges reflected the amount by which the carrying value of certain assets exceeded their estimated fair value. The fair value of property and equipment was measured using Level 3 inputs such as replacement costs factoring in depreciation, economic obsolesce and inflation trends.

NOTE 13 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION

The accompanying unaudited condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X, Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The Company’s private placement of $550 million of senior notes due 2019 (the “Notes”) issued on June 1, 2011 are fully and unconditionally guaranteed, subject to certain customary release provisions, by substantially all of the Company’s domestic 100% owned subsidiaries. The equity method has been used with respect to the parent company’s investment in subsidiaries.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

The following unaudited condensed consolidating financial data present the financial position of the parent company/issuer, the guarantor subsidiaries and the non-guarantor subsidiaries as of June 30, 2013 and December 31, 2012, and the respective results of operations and cash flows for the three and six months ended June 30, 2013 and June 30, 2012.

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)


	Three months ended June 30, 2013
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,320,072		$	119,310		$	(29,022	)	$	1,410,360

Salaries, wages and benefits		—			785,604			43,803			—			829,407
Supplies		—			89,834			7,984			—			97,818
Rent		—			89,278			8,463			—			97,741
Other operating expenses		—			262,247			51,313			(29,022	)		284,538
Other (income) expense		—			199			(223	)		—			(24	)
Impairment charges		—			16,228			—			—			16,228
Depreciation and amortization		—			43,516			2,822			—			46,338
Management fees		—			(3,217	)		3,217			—			—
Intercompany interest (income) expense from affiliates		(25,976	)		17,362			8,614			—			—
Interest expense		29,025			12			49			—			29,086
Investment income		—			(93	)		(1,388	)		—			(1,481	)
Equity in net income of consolidating affiliates		(3,569	)		—			—			3,569			—

		(520	)		1,300,970			124,654			(25,453	)		1,399,651

Income (loss) from continuing operations before income taxes		520			19,102			(5,344	)		(3,569	)		10,709
Provision (benefit) for income taxes		(1,225	)		4,860			774			—			4,409

Income (loss) from continuing operations		1,745			14,242			(6,118	)		(3,569	)		6,300
Discontinued operations, net of income taxes:
Loss from operations		—			(3,533	)		—			—			(3,533	)
Loss on divestiture of operations		—			(940	)		—			—			(940	)

Loss from discontinued operations		—			(4,473	)		—			—			(4,473	)

Net income (loss)		1,745			9,769			(6,118	)		(3,569	)		1,827
Earnings attributable to noncontrolling interests		—			—			(82	)		—			(82	)

Income (loss) attributable to Kindred	$	1,745		$	9,769		$	(6,200	)	$	(3,569	)	$	1,745

Comprehensive income (loss)	$	970		$	9,769		$	(6,907	)	$	(2,780	)	$	1,052

Comprehensive income (loss) attributable to Kindred	$	970		$	9,769		$	(6,989	)	$	(2,780	)	$	970

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – CONDENSED CONSOLIDATING FINANCIAL INFORMATION (Continued)

Condensed Consolidating Statement of Operations and Comprehensive Income (Loss) (Continued)


	Three months ended June 30, 2012
(In thousands)	Parent company/ issuer			Guarantor subsidiaries			Non-guarantor subsidiaries			Consolidating and eliminating adjustments			Consolidated
Revenues	$	—		$	1,334,705		$	115,324		$	(25,111	)	$	1,424,918

Salaries, wages and benefits		—			807,388			40,954			—			848,342
Supplies		—			92,506			9,142			—			101,648
Rent		—			88,929			7,491			—			96,420
Other operating expenses		—			259,247			48,120			(25,111	)		282,256
Other income		—			(2,497	)		(657	)		—			(3,154	)
Impairment charges		—			279			—			—			279
Depreciation and amortization		—			43,686			2,813			—			46,499
Management fees		—			(3,029	)		3,029			—			—
Intercompany interest (income) expense from affiliates		(28,340	)		20,215			8,125			—			—
Interest expense		26,568			26			121			—			26,715
Investment income		—			(55	)		(210	)		—			(265	)
Equity in net income of consolidating affiliates		(14,026	)		—			—			14,026			—

		(15,798	)		1,306,695			118,928			(11,085	)		1,398,740

Income (loss) from continuing operations before income taxes		15,798			28,010			(3,604	)		(14,026	)		26,178
Provision for income taxes		296			10,313			228			—			10,837

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company