Form 10-Q (Q.E. 6/30/2006)
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2006

OR

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

For the transition period from              to             .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   61-1323993
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

 

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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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

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

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.    Yes  þ    No  ¨

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, 2006

Common stock, $0.25 par value    39,903,887 shares

 


 

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Table of Contents

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX

 

          Page

PART I.

   FINANCIAL INFORMATION   
Item 1.   

Financial Statements:

  
  

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

   3
  

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

   4
  

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

   5
  

Notes to Condensed Consolidated Financial Statements

   6
Item 2.   

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

   23
Item 3.   

Quantitative and Qualitative Disclosures About Market Risk

   42
Item 4.   

Controls and Procedures

   43

PART II.

   OTHER INFORMATION   
Item 1.   

Legal Proceedings

   44
Item 2.   

Unregistered Sales of Equity Securities and Use of Proceeds

   44
Item 4.   

Submission of Matters to a Vote of Security Holders

   45
Item 6.   

Exhibits

   45

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Revenues

   $ 1,093,999     $ 1,035,865     $ 2,142,156     $ 1,966,338  
                                

Salaries, wages and benefits

     592,762       535,605       1,165,654       1,044,285  

Supplies

     168,798       145,329       333,531       272,944  

Rent

     77,379       68,783       149,164       135,967  

Other operating expenses

     181,516       175,603       357,634       324,603  

Depreciation and amortization

     30,439       25,213       58,893       48,981  

Interest expense

     3,534       2,439       6,183       4,439  

Investment income

     (3,444 )     (3,031 )     (7,135 )     (5,378 )
                                
     1,050,984       949,941       2,063,924       1,825,841  
                                

Income from continuing operations before reorganization items and income taxes

     43,015       85,924       78,232       140,497  

Reorganization items

                       (1,371 )
                                

Income from continuing operations before income taxes

     43,015       85,924       78,232       141,868  

Provision for income taxes

     18,399       34,533       33,194       57,100  
                                

Income from continuing operations

     24,616       51,391       45,038       84,768  

Discontinued operations, net of income taxes:

        

Income from operations

     5,365       12,029       8,745       15,542  

Gain (loss) on divestiture of operations

     (308 )     2,647       (151 )     2,647  
                                

Net income

   $ 29,673     $ 66,067     $ 53,632     $ 102,957  
                                

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 0.59     $ 1.37     $ 1.15     $ 2.30  

Discontinued operations:

        

Income from operations

     0.13       0.32       0.22       0.42  

Gain (loss) on divestiture of operations

     (0.01 )     0.07             0.07  
                                

Net income

   $ 0.71     $ 1.76     $ 1.37     $ 2.79  
                                

Diluted:

        

Income from continuing operations

   $ 0.57     $ 1.11     $ 1.07     $ 1.87  

Discontinued operations:

        

Income from operations

     0.13       0.26       0.21       0.34  

Gain (loss) on divestiture of operations

     (0.01 )     0.06             0.06  
                                

Net income

   $ 0.69     $ 1.43     $ 1.28     $ 2.27  
                                

Shares used in computing earnings per common share:

        

Basic

     41,695       37,495       39,150       36,907  

Diluted

     42,956       46,367       42,082       45,456  

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)

 

     June 30,
2006
    December 31,
2005
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 15,035     $ 83,420  

Cash – restricted

     5,786       5,135  

Insurance subsidiary investments

     220,947       231,134  

Accounts receivable less allowance for loss of $65,113 – June 30, 2006 and $62,078 – December 31, 2005

     586,872       479,605  

Inventories

     44,845       43,731  

Deferred tax assets

     64,572       61,078  

Assets held for sale

     3,215       12,056  

Other

     28,016       28,805  
                
     969,288       944,964  

Property and equipment

     958,521       891,009  

Accumulated depreciation

     (425,330 )     (369,393 )
                
     533,191       521,616  

Goodwill

     102,218       69,879  

Intangible assets less accumulated amortization of $4,049 – June 30, 2006 and $1,763 – December 31, 2005

     113,111       34,317  

Insurance subsidiary investments

     54,466       48,796  

Deferred tax assets

     82,801       73,750  

Other

     81,177       67,239  
                
   $ 1,936,252     $ 1,760,561  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 128,408     $ 134,547  

Salaries, wages and other compensation

     250,223       244,851  

Due to third party payors

     19,686       26,642  

Professional liability risks

     66,762       70,090  

Other accrued liabilities

     77,247       79,704  

Income taxes

     75,694       58,572  

Long-term debt due within one year

     6,734       6,221  
                
     624,754       620,627  

Long-term debt

     165,437       26,323  

Professional liability risks

     191,018       182,113  

Deferred credits and other liabilities

     72,521       60,962  

Commitments and contingencies

    

Stockholders’ equity:

    

Common stock, $0.25 par value; authorized 175,000 shares; issued 39,965 shares – June 30, 2006 and 37,331 shares – December 31, 2005

     9,991       9,333  

Capital in excess of par value

     705,723       673,358  

Deferred compensation

           (14,228 )

Accumulated other comprehensive loss

     (163 )     (60 )

Retained earnings

     166,971       202,133  
                
     882,522       870,536  
                
   $ 1,936,252     $ 1,760,561  
                

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Cash flows from operating activities:

        

Net income

   $ 29,673     $ 66,067     $ 53,632     $ 102,957  

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

        

Depreciation and amortization

     30,439       25,586       58,893       49,700  

Amortization of stock-based deferred compensation costs

     5,269       2,084       9,963       3,996  

Provision for doubtful accounts

     10,172       4,487       18,889       9,474  

Deferred income taxes

     (14,937 )           (14,937 )      

(Gain) loss on divestiture of discontinued operations

     308       (2,647 )     151       (2,647 )

Reorganization items

                       (1,371 )

Other

     155       (1,012 )     (1,449 )     (1,198 )

Change in operating assets and liabilities:

        

Accounts receivable

     (32,156 )     (106,228 )     (125,834 )     (165,360 )

Inventories and other assets

     8,965       4,840       (10,012 )     (5,519 )

Accounts payable

     2,390       2,708       6,039       263  

Income taxes

     3,386       38,552       19,680       63,884  

Due to third party payors

     (3,273 )     (5,300 )     (6,956 )     (15,879 )

Other accrued liabilities

     2,219       9,534       10,181       18,325  
                                

Net cash provided by operating activities

     42,610       38,671       18,240       56,625  
                                

Cash flows from investing activities:

        

Purchase of property and equipment

     (36,740 )     (28,598 )     (62,035 )     (46,561 )

Acquisition of healthcare businesses

     (508 )     (46,277 )     (123,581 )     (73,877 )

Acquisition deposit

           31,500              

Sale of assets

           10,049       10,305       11,104  

Purchase of insurance subsidiary investments

     (43,549 )     (91,312 )     (84,280 )     (205,196 )

Sale of insurance subsidiary investments

     36,324       105,771       94,884       190,362  

Net change in insurance subsidiary cash and cash equivalents

     2,679       11,286       (5,473 )     24,397  

Net change in other investments

     1,844       3,719       1,844       3,719  

Other

     668       2,606       2,960       2,507  
                                

Net cash used in investing activities

     (39,282 )     (1,256 )     (165,376 )     (93,545 )
                                

Cash flows from financing activities:

        

Net change in revolving credit borrowings

     30,900       (25,200 )     142,600        

Repayment of long-term debt

     (1,533 )     (1,302 )     (2,973 )     (2,518 )

Payment of deferred financing costs

     (461 )     (165 )     (947 )     (203 )

Issuance of common stock

     142,898       6,036       143,188       22,735  

Repurchase of common stock

     (194,310 )           (194,310 )      

Other

     10,201       1,014       (8,807 )     (18,853 )
                                

Net cash provided by (used in) financing activities

     (12,305 )     (19,617 )     78,751       1,161  
                                

Change in cash and cash equivalents

     (8,977 )     17,798       (68,385 )     (35,759 )

Cash and cash equivalents at beginning of period

     24,012       15,571       83,420       69,128  
                                

Cash and cash equivalents at end of period

   $ 15,035     $ 33,369     $ 15,035     $ 33,369  
                                

Supplemental information:

        

Interest payments

   $ 3,050     $ 1,477     $ 5,127     $ 2,511  

Income tax payments

     33,308       3,512       33,925       2,946  

See accompanying notes.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States (collectively, “Kindred” or the “Company”). At June 30, 2006, the Company’s hospital division operated 80 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s health services division operated 253 nursing centers in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 39 pharmacies in 24 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2006 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 2 for a summary of discontinued operations.

In April 2001, the Company and its subsidiaries emerged from proceedings under Chapter 11 of Title 11 of the United States Code (the “Bankruptcy Code”) pursuant to the terms of the Company’s Fourth Amended Joint Plan of Reorganization (the “Plan of Reorganization”), as modified at the confirmation hearing by the United States Bankruptcy Court for the District of Delaware. In connection with its emergence, the Company changed its name to Kindred Healthcare, Inc.

Impact of recent accounting pronouncement

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

 

Stock option accounting

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. In connection with the adoption of SFAS 123R, the Company began to recognize compensation expense prospectively in its consolidated financial statements for non-vested stock options beginning January 1, 2006. See Note 12.

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

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Stock option accounting (Continued)

 

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

 

    

Three months ended

June 30, 2005

   

Six months ended

June 30, 2005

 

Net income, as reported

   $ 66,067     $ 102,957  

Adjustments:

    

Stock-based employee compensation expense included in reported net income

     1,287       2,478  

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

     (3,100 )     (6,027 )
                

Pro forma net income

   $ 64,254     $ 99,408  
                

Earnings per common share:

    

As reported:

    

Basic

   $ 1.76     $ 2.79  

Diluted

   $ 1.43     $ 2.27  

Pro forma:

    

Basic

   $ 1.71     $ 2.69  

Diluted

   $ 1.34     $ 2.12  

Comprehensive income

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

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Net income

   $ 29,673     $ 66,067     $ 53,632     $ 102,957  

Net unrealized investment losses, net of income taxes

     (98 )     (36 )     (103 )     (498 )
                                

Comprehensive income

   $ 29,575     $ 66,031     $ 53,529     $ 102,459  
                                

Other information

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

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

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

 

Reclassifications

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

NOTE 2 – DISCONTINUED OPERATIONS

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the divestitures 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 June 30, 2006, the Company held for sale one closed hospital.

Discontinued operations included favorable pretax adjustments of $9.9 million and $23.0 million for the second quarter of 2006 and 2005, respectively, and $16.9 million and $32.6 million for the six months ended June 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas.

A summary of discontinued operations follows (in thousands):

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Revenues

   $ 472     $ 14,541     $ 4,527     $ 31,963  
                                

Salaries, wages and benefits

     489       8,535       3,227       19,342  

Supplies

     (18 )     1,282       685       2,890  

Rent

     2       992       53       2,035  

Other operating expenses (income)

     (8,722 )     (16,035 )     (13,653 )     (17,962 )

Depreciation

           373             719  

Interest expense

                        

Investment income

     (2 )     (166 )     (4 )     (333 )
                                
     (8,251 )     (5,019 )     (9,692 )     6,691  
                                

Income from operations before income taxes

     8,723       19,560       14,219       25,272  

Income tax provision

     3,358       7,531       5,474       9,730  
                                

Income from operations

     5,365       12,029       8,745       15,542  

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

     (308 )     2,647       (151 )     2,647  
                                
   $ 5,057     $ 14,676     $ 8,594     $ 18,189  
                                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

 

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

 

     Three months ended
June 30,
   Six months ended
June 30,
     2006     2005    2006     2005

Revenues:

         

Hospital division:

         

Hospitals

   $ 226     $ 3,083    $ 2,302     $ 8,724

Ancillary services

           5      1       11
                             
     226       3,088      2,303       8,735

Health services division

     246       11,453      2,224       23,228

Pharmacy division

                     
                             
   $ 472     $ 14,541    $ 4,527     $ 31,963
                             

Operating income (loss):

         

Hospital division:

         

Hospitals

   $ (45 )   $ 145    $ (355 )   $ 157

Ancillary services

           5            11
                             
     (45 )     150      (355 )     168

Health services division

     8,768       20,607      14,623       27,515

Pharmacy division

           2            10
                             
   $ 8,723     $ 20,759    $ 14,268     $ 27,693
                             

Rent:

         

Hospital division:

         

Hospitals

   $ 1     $ 31    $ 38     $ 81

Ancillary services

                     
                             
     1       31      38       81

Health services division

     1       961      15       1,954

Pharmacy division

                     
                             
   $ 2     $ 992    $ 53     $ 2,035
                             

Depreciation:

         

Hospital division:

         

Hospitals

   $     $    $     $

Ancillary services

                     
                             
                     

Health services division

           373            719

Pharmacy division

                     
                             
   $     $ 373    $     $ 719
                             

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

 

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

 

     June 30,
2006
    December 31,
2005
 

Current assets:

    

Property and equipment, net

   $ 3,215     $ 11,587  

Other

           469  
                
     3,215       12,056  

Current liabilities (included in other accrued liabilities)

     (13 )     (266 )
                
   $ 3,202     $ 11,790  
                

NOTE 3 – SIGNIFICANT QUARTERLY ADJUSTMENTS

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $4.3 million and $54.6 million for the second quarter of 2006 and 2005, respectively, and $6.2 million and $57.5 million for the six months ended June 30, 2006 and 2005, respectively.

Operating results for the second quarter of 2006 included a $3.3 million pretax charge in connection with the settlement of a prior year tax dispute and a pretax charge of $1 million for investment banking services and costs related to the rent reset issue with Ventas, Inc. (“Ventas”). For the six months ended June 30, 2006, the Company recorded a $1.3 million pretax gain from an institutional pharmacy joint venture transaction, a pretax charge of $2.7 million related primarily to revisions to prior estimates for accrued contract labor costs in the Company’s rehabilitation division, and a pretax charge of $2.3 million for investment banking services and costs related to the rent reset issue with Ventas.

Operating results for the second quarter of 2005 included pretax charges of $14.8 million related to a special recognition payment to non-executive caregivers and employees and $5.0 million related to a charitable donation. The allocation of these costs by segment follows (in thousands):

 

     Recognition
payment
   Charitable
donation

Hospital division

   $ 3,863    $

Health services division

     9,013     

Rehabilitation division

     1,039     

Pharmacy division

     658     

Corporate

     225      5,000
             
   $ 14,798    $ 5,000
             

Operating results for the second quarter of 2005 included pretax income of $15.8 million ($31.8 million of revenues net of $16.0 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2.1 million related to the first quarter of 2005 and approximately $13.7 million related to prior years.

NOTE 4 – REORGANIZATION ITEMS

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

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 5 – ACQUISITIONS

Commonwealth acquisition

On February 28, 2006, the Company acquired the operations of the LTAC hospitals, skilled nursing facilities and assisted living facilities operated by Commonwealth Communities Holdings LLC and certain of its affiliates (the “Commonwealth Acquisition”). The transaction was financed primarily through the use of the Company’s revolving credit facility. Goodwill recorded in connection with the Commonwealth Acquisition aggregated $31.6 million. The purchase price also included identifiable intangible assets of $75.9 million related to the value of acquired certificates of need with indefinite lives and other intangible assets of $5.2 million which will be amortized over approximately three years. Additional adjustments to the purchase price of up to approximately $9 million may occur through February 2008 as a result of contingent consideration in accordance with the acquisition agreement.

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

 

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

   $ 130,690  

Fair value of liabilities assumed

     (7,111 )
        

Net cash paid

   $ 123,579  
        

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

 

    

Three months ended
June 30, 2005

   Six months ended
June 30,
        2006    2005

Revenues

   $ 1,094,569    $ 2,181,947    $ 2,080,815

Income from continuing operations

     53,448      45,064      87,794

Net income

     68,124      53,658      105,983

Earnings per common share:

        

Basic:

        

Income from continuing operations

   $ 1.43    $ 1.15    $ 2.38

Net income

   $ 1.82    $ 1.37    $ 2.87

Diluted:

        

Income from continuing operations

   $ 1.15    $ 1.07    $ 1.93

Net income

   $ 1.47    $ 1.28    $ 2.33

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

Pharmacy acquisitions

On March 2, 2005, the Company acquired the assets of Pharmacy Partners, Inc., an operator of two institutional pharmacies in Pennsylvania (the “PPI Acquisition”). The transaction was financed through the use of existing cash. Goodwill recorded in connection with the PPI Acquisition aggregated $10.8 million. The purchase price also included acquired identifiable intangible assets totaling $11.3 million that will be amortized over approximately 12 years. Additional adjustments to the purchase price of up to approximately $1 million may occur through September 2006 as a result of contingent consideration in accordance with the acquisition agreement.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – ACQUISITIONS (Continued)

Pharmacy acquisitions (Continued)

 

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

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

 

    

PPI

Acquisition

   

SCP

Acquisition

 

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

   $ 31,086     $ 37,479  

Fair value of liabilities assumed

     (214 )     (773 )
                

Net cash paid through June 30, 2005

     30,872       36,706  

Additional payment of transaction costs

     1       42  
                

Total cash paid through June 30, 2006

   $ 30,873     $ 36,748  
                

The purchase price of the Commonwealth Acquisition, the PPI Acquisition and the SCP Acquisition resulted from negotiations with each of the sellers that were based upon both the historical and expected future cash flows of the respective businesses. The operating results of the Commonwealth Acquisition, the PPI Acquisition and the SCP Acquisition have been included in the accompanying unaudited condensed consolidated financial statements of the Company since the respective acquisition dates.

NOTE 6 – REVENUES

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

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

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Medicare

   $ 506,671     $ 464,377     $ 1,008,762     $ 874,695  

Medicaid

     301,972       334,973       572,654       616,565  

Private and other

     379,995       317,007       745,984       634,185  
                                
     1,188,638       1,116,357       2,327,400       2,125,445  

Eliminations:

        

Rehabilitation

     (58,155 )     (49,139 )     (113,319 )     (97,636 )

Pharmacy

     (36,484 )     (31,353 )     (71,925 )     (61,471 )
                                
     (94,639 )     (80,492 )     (185,244 )     (159,107 )
                                
   $ 1,093,999     $ 1,035,865     $ 2,142,156     $ 1,966,338  
                                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 7 – EARNINGS PER SHARE

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

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

 

     Three months ended
June 30,
   Six months ended
June 30,
     2006     2005    2006     2005

Earnings:

         

Income from continuing operations

   $ 24,616     $ 51,391    $ 45,038     $ 84,768

Discontinued operations, net of income taxes:

         

Income from operations

     5,365       12,029      8,745       15,542

Gain (loss) on divestiture of operations

     (308 )     2,647      (151 )     2,647
                             

Net income

   $ 29,673     $ 66,067    $ 53,632     $ 102,957
                             

Shares used in the computation:

         

Weighted average shares outstanding – basic computation

     41,695       37,495      39,150       36,907

Dilutive effect of certain securities:

         

Warrants

     540       7,201      2,258       6,937

Employee stock options

     409       1,146      394       1,069

Non-vested restricted stock

     312       525      280       543
                             

Adjusted weighted average shares outstanding – diluted computation

     42,956       46,367      42,082       45,456
                             

Earnings per common share:

         

Basic:

         

Income from continuing operations

   $ 0.59     $ 1.37    $ 1.15     $ 2.30

Discontinued operations:

         

Income from operations

     0.13       0.32      0.22       0.42

Gain (loss) on divestiture of operations

     (0.01 )     0.07            0.07
                             

Net income

   $ 0.71     $ 1.76    $ 1.37     $ 2.79
                             

Diluted:

         

Income from continuing operations

   $ 0.57     $ 1.11    $ 1.07     $ 1.87

Discontinued operations:

         

Income from operations

     0.13       0.26      0.21       0.34

Gain (loss) on divestiture of operations

     (0.01 )     0.06            0.06
                             

Net income

   $ 0.69     $ 1.43    $ 1.28     $ 2.27
                             

NOTE 8 – STOCKHOLDERS’ EQUITY

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

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

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 9 – BUSINESS SEGMENT DATA

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

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

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

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2006     2005     2006     2005  

Revenues:

        

Hospital division

   $ 439,308     $ 434,562     $ 870,122     $ 827,602  

Health services division

     515,028       484,581       994,600       927,725  

Rehabilitation division

     74,376       65,365       145,538       130,312  

Pharmacy division

     159,926       131,849       317,140       239,806  
                                
     1,188,638       1,116,357       2,327,400       2,125,445  

Eliminations:

        

Rehabilitation

     (58,155 )     (49,139 )     (113,319 )     (97,636 )

Pharmacy

     (36,484 )     (31,353 )     (71,925 )     (61,471 )
                                
     (94,639 )     (80,492 )     (185,244 )     (159,107 )
                                
   $ 1,093,999     $ 1,035,865     $ 2,142,156     $ 1,966,338  
                                

Income from continuing operations:

        

Operating income (loss):

        

Hospital division

   $ 105,307     $ 134,263     $ 209,371     $ 236,064  

Health services division

     66,978       65,447       115,541       119,127  

Rehabilitation division

     8,453       6,989       12,692       16,700  

Pharmacy division

     15,139       13,298       31,868       24,752  

Corporate:

        

Overhead

     (43,257 )     (38,052 )     (80,591 )     (67,167 )

Insurance subsidiary

     (1,697 )     (2,617 )     (3,544 )     (4,970 )
                                
     (44,954 )     (40,669 )     (84,135 )     (72,137 )
                                
     150,923       179,328       285,337       324,506  

Reorganization items

                       1,371  
                                

Operating income

     150,923       179,328       285,337       325,877  

Rent

     (77,379 )     (68,783 )     (149,164 )     (135,967 )

Depreciation and amortization

     (30,439 )     (25,213 )     (58,893 )     (48,981 )

Interest, net

     (90 )     592       952       939  
                                

Income from continuing operations before income taxes

     43,015       85,924       78,232       141,868  

Provision for income taxes

     18,399       34,533       33,194       57,100  
                                
   $ 24,616     $ 51,391     $ 45,038     $ 84,768  
                                

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9 – BUSINESS SEGMENT DATA (Continued)

 

     Three months ended
June 30,
   Six months ended
June 30,
     2006    2005    2006    2005

Rent:

           

Hospital division

   $ 29,588    $ 25,244    $ 56,207    $ 49,961

Health services division

     45,506      41,429      88,445      82,103

Rehabilitation division

     897      817      1,766      1,617

Pharmacy division

     1,316      1,169      2,596      2,095

Corporate

     72      124      150      191
                           
   $ 77,379    $ 68,783    $ 149,164    $ 135,967
                           

Depreciation and amortization:

           

Hospital division

   $ 11,658    $ 9,836    $ 22,765    $ 19,390

Health services division

     10,871      7,914      20,766      15,390

Rehabilitation division

     115      56      195      110

Pharmacy division

     1,857      1,521      3,654      2,447

Corporate

     5,938      5,886      11,513      11,644
                           
   $ 30,439    $ 25,213    $ 58,893    $ 48,981
                           

Capital expenditures, excluding acquisitions (including discontinued operations):

           

Hospital division

   $ 14,105    $ 11,289    $ 29,470    $ 19,524

Health services division

     11,151      10,986      16,376      17,943

Rehabilitation division

     130      96      149      98

Pharmacy division

     2,219      1,506      4,276      2,581

Corporate:

           

Information systems

     8,958      4,171      11,472      5,633

Other

     177      550      292      782
                           
   $ 36,740    $ 28,598    $ 62,035    $ 46,561
                           

 

     June 30,
2006
   December 31,
2005

Assets at end of period:

     

Hospital division

   $ 730,424    $ 560,767

Health services division

     441,495      385,864

Rehabilitation division

     9,269      7,124

Pharmacy division

     199,969      188,914

Corporate

     555,095      617,892
             
   $ 1,936,252    $ 1,760,561
             

Goodwill:

     

Hospital division

   $ 61,478    $ 29,862

Pharmacy division

     40,740      40,017
             
   $ 102,218    $ 69,879
             

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 10 – INSURANCE RISKS

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

The allowance for professional liability risks includes an estimate of the expected cost to settle reported claims and an amount, based upon past experiences, for losses incurred but not reported. These liabilities are necessarily based upon estimates and, while management believes that the provision for loss is adequate, the ultimate liability may be in excess of or less than the amounts recorded. To the extent that subsequent expected ultimate claims costs vary from historical provisions for loss, future earnings will be charged or credited. See Note 2.

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,
 
     2006     2005     2006     2005  

Professional liability:

        

Continuing operations

   $ 20,072     $ 19,085     $ 42,264     $ 39,538  

Discontinued operations

     (8,988 )     (21,136 )     (15,610 )     (28,750 )

Workers compensation:

        

Continuing operations

   $ 11,599     $ 12,291     $ 24,434     $ 25,037  

Discontinued operations

     178       499       381       1,017  

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

Assets:

           

Current:

           

Insurance subsidiary investments

  $ 136,423   $ 84,524   $ 220,947   $ 142,654   $ 88,480   $ 231,134

Reinsurance recoverables

    1,826         1,826     2,404         2,404
                                   
    138,249     84,524     222,773     145,058     88,480     233,538

Non-current:

           

Insurance subsidiary investments

    54,466         54,466     48,796         48,796

Reinsurance recoverables

    8,567         8,567     8,186         8,186

Deposits

    7,250     1,729     8,979     7,250     1,720     8,970

Other

        254     254     3     102     105
                                   
    70,283     1,983     72,266     64,235     1,822     66,057
                                   
  $ 208,532   $ 86,507   $ 295,039   $ 209,293   $ 90,302   $ 299,595
                                   

Liabilities:

           

Allowance for insurance risks:

           

Current

  $ 66,762   $ 24,989   $ 91,751   $ 70,090   $ 24,707   $ 94,797

Non-current

    191,018     59,975     250,993     182,113     53,421     235,534
                                   
  $ 257,780   $ 84,964   $ 342,744   $ 252,203   $ 78,128   $ 330,331
                                   

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – INSURANCE RISKS (Continued)

 

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $271 million at June 30, 2006 and $266 million at December 31, 2005.

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

NOTE 11 – LEASES

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

 

     Three months ended
June 30,
   Six months ended
June 30,
     2006    2005    2006    2005

Hospital division:

           

Buildings:

           

Ventas

   $ 16,383    $ 15,851    $ 32,411    $ 31,355

Other landlords

     6,539      3,681      11,418      7,253

Equipment

     6,666      5,712      12,378      11,353
                           
     29,588      25,244      56,207      49,961

Health services division:

           

Buildings:

           

Ventas

     32,617      31,565      64,533      62,444

Other landlords

     12,124      9,051      22,350      18,151

Equipment

     765      813      1,562      1,508
                           
     45,506      41,429      88,445      82,103

Rehabilitation division:

           

Buildings

     19      20      38      35

Equipment

     878      797      1,728      1,582
                           
     897      817      1,766      1,617

Pharmacy division:

           

Buildings

     1,104      999      2,152      1,776

Equipment

     212      170      444      319
                           
     1,316      1,169      2,596      2,095

Corporate:

           

Buildings

     67      112      134      167

Equipment

     5      12      16      24
                           
     72      124      150      191
                           
   $ 77,379    $ 68,783    $ 149,164    $ 135,967
                           

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – LEASES (Continued)

 

Under the Plan of Reorganization, the Company assumed the original master lease agreements with Ventas and its affiliates and simultaneously amended and restated the agreements into four new master leases (the “Master Leases”). Under the Master Leases, Ventas has a right to sever properties from the existing leases in order to create additional leases, a device adopted to facilitate its financing flexibility. In such circumstances, the Company’s aggregate lease obligations remain unchanged. Ventas exercised this severance right in December 2001 with respect to Master Lease No. 1 to create a new lease of 40 nursing centers (the “CMBS Lease”) and mortgaged these properties in connection with a securitized mortgage financing. In September 2004, Ventas exercised this severance right with respect to Master Lease No. 1 to create a new lease of one hospital and seven nursing centers (“Master Lease No. 1A”). Effective May 10, 2006, the CMBS Lease and Master Lease No. 1A were recombined with Master Lease No. 1. At June 30, 2006, the Company leased from Ventas 39 LTAC hospitals and 186 nursing centers.

Ventas has a one-time option to reset the rent and the related rent escalators under each of its Master Leases with the Company to the “Fair Market Rental” of the leased properties. Fair Market Rental is determined through an appraisal procedure set forth in the Master Leases.

Generally, the Master Leases provide that Ventas can initiate the rent reset procedure under each Master Lease at any time between January 20, 2006 and July 19, 2007 by delivering a notice to the Company proposing the Fair Market Rental (as described below) for the balance of the lease term (the “Reset Proposal Notice”). If the Company and Ventas are unable to reach an agreement on the Fair Market Rental within 30 days following delivery of the Reset Proposal Notice, the Company and Ventas each must select an appraiser. These two appraisers then will have ten days to select a third independent final appraiser (the “Final Appraiser”). If the two appraisers cannot agree on a Final Appraiser, either the Company or Ventas can request that the American Arbitration Association select the Final Appraiser. The Final Appraiser will have 60 days to complete its determination of Fair Market Rental, which determination will be final and binding on the parties. Within 30 days following the Final Appraiser’s determination, Ventas may elect to exercise its right to reset Fair Market Rental by sending the Company a final exercise notice (the “Final Exercise Notice”).

Alternatively, Ventas may decide not to exercise its rental reset option, in which event the rent and the existing 3 1/2% contingent annual escalator would remain at their then current levels under the Master Leases. Provided that Ventas exercises its reset right in accordance with the Master Leases, the rent reset will become effective as of July 19, 2006.

As a condition to exercising its rent reset right, upon delivery of the Final Exercise Notice, Ventas is required to pay the Company a reset fee equal to a prorated portion of approximately $5 million based upon the proportion of base rent payable under the Master Lease(s) with respect to which rent is reset to the total base rent payable under all of the Master Leases.

“Fair Market Rental” is defined under each Master Lease as the annual amount per annum that a willing tenant would pay, and a willing landlord would accept, at arm’s length, for leasing of the leased properties (or, if applicable, any one or more, but less than all, of the leased properties) for the period of the term (including, without limitation, any extended terms) remaining from and after the date as of which the Fair Market Rental is being determined. The Fair Market Rental may include therein such escalations of rent as would be paid by such a tenant, and accepted by such a landlord, as part of an arm’s length transaction entered into as of the Fair Market Rental determination date; provided, however, that, in addition to such other market factors as may be applicable in determining the Fair Market Rental, the Fair Market Rental shall be determined on the basis, and on the assumptions, that (a) the Fair Market Rental may not include therein any rent, or method of rent calculation, that

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – LEASES (Continued)

 

would adversely affect any landlord by virtue of it being a real estate investment trust or the ability of any such landlord to satisfy the requirements for maintaining its status as a real estate investment trust (and, without limitation of the foregoing, the Fair Market Rental shall not include any rent that would fail to qualify as “rents from real property” for purposes of Section 856(d) of the Internal Revenue Code), (b) the Fair Market Rental amount is to be paid absolutely net to the landlord, without any rights of deduction, set-off or abatement, (c) all of the leased properties as to which the Fair Market Rental is being determined are in good condition and repair (given their respective ages and prevailing health care industry standards with respect to what is considered good condition and repair), without any deferred maintenance (but allowing for ordinary wear and tear), are in material compliance with any and all applicable laws, codes, ordinances and regulations and have in full force and effect, for the benefit of the tenant, the facilities and the leased properties, any and all necessary or appropriate material authorizations for use thereof in accordance with the respective primary intended uses applicable thereto, (d) the tenant has complied, and shall be required to comply, with the requirements of the Master Lease, (e) the respective replacement costs of the leased properties as to which Fair Market Rental is being determined are not determinative of the Fair Market Rental of such leased properties, and (f) the aforesaid tenant shall have available to it, with respect to each leased property as to which the Fair Market Rental is being determined, such remaining term as then remains, and such number of extended terms as then remain unexercised, with respect to such leased property under the terms of the Master Lease. Notwithstanding anything to the contrary contained in the Master Lease, “Fair Market Rental” shall take into account, for each of the applicable leased properties, the market conditions, market levels of earnings before interest, income taxes, depreciation, amortization, rent and management fees (“EBITDARM”), the ratio of market levels of EBITDARM to market levels of rent, and the actual levels of EBITDARM at the applicable leased properties, in each case that are prevailing or measured, as applicable, as of the date as of which the Fair Market Rental is being determined, as well as historical levels of EBITDARM at the applicable leased properties (including the EBITDARM of the leased properties measured as of April 20, 2001).

As discussed above, under the Master Leases, Ventas has a right to sever properties from the existing leases in order to create additional leases, a device adopted to facilitate its financing flexibility. For purposes of the reset right, the additional leases are disregarded and the Fair Market Rental is determined on the four original Master Leases.

On May 9, 2006, the Company received the Reset Proposal Notices from Ventas under each of the four Master Leases. In the Reset Proposal Notices, Ventas has asserted that the total aggregate annual rent under the four Master Leases should be reset to approximately $317 million and that the annual rent escalator for each Master Lease should be reset at 3%. The current total aggregate annual rent under the Master Leases is approximately $206 million. The current contingent annual rent escalator is 3 1/2% under each Master Lease.

Since receiving the Reset Proposal Notices, each of Ventas and the Company selected a third party appraiser in an effort to determine the Final Appraiser under each of the Master Leases. After significant negotiation, the two appraisers were unable to agree on the Final Appraiser for the Master Leases. Both Ventas and the Company have submitted formal requests to the American Arbitration Association to select appraisers to serve as the Final Appraiser under each of the Master Leases. Once the Final Appraisers are selected, they will have 60 days to complete the determination of the Fair Market Rental, including the annual rent escalator, under the Master Lease for which they are serving as the Final Appraiser. Within 30 days following the Final Appraiser’s determination, Ventas may elect to exercise its right to reset the Fair Market Rental by sending the Company the Final Exercise Notice. Ventas’ election can be made on a Master Lease by Master Lease basis. Alternatively, Ventas may decide not to exercise its rent reset option, in which event the rent and existing 3 1/2% contingent annual escalator would remain at their then current levels under the Master Leases. If Ventas exercises its rent reset right in accordance with the Master Leases, the rent reset will become effective as of July 19, 2006.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

NOTE 12 – STOCK-BASED COMPENSATION

The Company maintains plans under which up to ten million restricted stock awards and options to purchase common stock may be granted to officers, directors and key employees. Exercise provisions vary, but most stock options are exercisable in whole or in part beginning one to four years after grant and ending five to ten years after grant. Shares of common stock available for future grants were 2,030,369 at June 30, 2006.

Stock options

As discussed in Note 1, the Company adopted SFAS 123R as of January 1, 2006. The fair value of each stock option is estimated at the date of grant using a Black-Scholes option valuation model with the following weighted average assumptions for the six months ended June 30, 2006: risk-free interest rate of 4.62%; no dividend yield; expected term of five years; and volatility factors based upon the historical price of the Company’s common stock of 0.51. The expected term represents the period of time that stock options granted are expected to be outstanding. As required by SFAS 123R, an estimate of expected forfeitures was determined and compensation expense was recognized only for those stock options expected to vest. The weighted average fair value of stock options granted during the six months ended June 30, 2006 under a Black-Scholes valuation model was $10.93.

At June 30, 2006, unearned compensation costs related to non-vested stock options aggregated $9.3 million. These costs will be expensed over the remaining weighted average vesting period of approximately two years. Compensation expense related to stock options approximated $2.0 million ($1.7 million net of income taxes or $0.04 per diluted share) for the second quarter of 2006 and $3.6 million ($3.0 million net of income taxes or $0.07 per diluted share) for the six months ended June 30, 2006.

Activity in the various plans is summarized below:

 

     Shares
under
option
    Option price
per share
  

Weighted

average

exercise price

Balances, December 31, 2005

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

Granted

   511,943       21.99 to 28.89      22.42

Exercised

   (58,703 )     6.39 to 19.07      14.90

Canceled

   (86,121 )     6.39 to 29.72      17.67
           

Balances, June 30, 2006

   3,454,316     $  6.39 to $37.17    $ 22.27
           

The intrinsic value of the stock options exercised during the six months ended June 30, 2006 approximated $0.5 million.

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

 

     Options outstanding    Options exercisable

Range of exercise prices

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

$ 6.39 to $11.04

   567,465    7 years    $ 10.54    297,287    $ 10.41

$15.91 to $20.00

   729,923    6 years      17.64    577,673      17.71

$21.99 to $29.72

   1,325,720    7 years      24.25    398,446      26.27

$30.42 to $37.17

   831,208    6 years      31.18    831,208      31.18
                  
   3,454,316    7 years    $ 22.27    2,104,614    $ 23.62
                  

The intrinsic value of the stock options outstanding and stock options that are exercisable as of June 30, 2006 approximated $17.9 million and $9.8 million, respectively.

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12 – STOCK-BASED COMPENSATION (Continued)

 

Restricted stock

At June 30, 2006, unearned compensation costs related to non-vested restricted stock aggregated $13.9 million. These costs will be expensed over the remaining weighted average vesting period of approximately three years. Compensation expense related to these awards approximated $3.3 million ($2.0 million net of income taxes or $0.05 per diluted share) for the second quarter of 2006 and $6.4 million ($3.9 million net of income taxes or $0.09 per diluted share) for the six months ended June 30, 2006 and $2.0 million ($1.3 million net of income taxes or $0.03 per diluted share) for the second quarter of 2005 and $3.9 million ($2.4 million net of income taxes or $0.05 per diluted share) for the six months ended June 30, 2005.

A summary of non-vested restricted shares follows:

 

     Non-vested
restricted shares
   

Weighted average
fair value at

date of grant

Balances, December 31, 2005

   890,216     $ 26.05

Granted

   274,650       21.99

Vested

   (58,717 )     30.86
        

Balances, June 30, 2006

   1,106,149     $ 24.79
        

NOTE 13 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

Professional liability risks – The Company has provided for loss for professional liability risks based upon actuarially determined estimates. Ultimate claims costs may differ from the provisions for loss. See Notes 2 and 10.

Guarantees of indebtedness – Letters of credit and guarantees of indebtedness approximated $1.3 million at June 30, 2006.

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

 

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KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 13 – CONTINGENCIES (Continued)

 

Litigation – The Company is a party to certain material litigation as well as various suits and claims arising in the ordinary course of business. See Note 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 against employment-related matters, governmental regulations, environmental issues, and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally would be initiated by a breach of the terms of the contract or by a third party claim or event.

NOTE 14 – LITIGATION

A summary description of significant litigation follows.

A shareholder derivative suit entitled Thomas G. White on behalf of Vencor, Inc. and Ventas, Inc. v. W. Bruce Lunsford, et al., Case No. 98CI03669, was filed on July 2, 1998 in the Jefferson County, Kentucky, Circuit Court. The suit was brought on behalf of the Company and Ventas against certain former executive officers and directors of the Company and Ventas. The complaint alleges that the defendants damaged the Company and Ventas by engaging in violations of the securities laws, engaging in insider trading, fraud and securities fraud and damaging the reputation of the Company and Ventas. The plaintiff asserts that such actions were taken deliberately, in bad faith and constitute breaches of the defendants’ duties of loyalty and due care. The suit seeks unspecified damages, interest, punitive damages, reasonable attorneys’ fees, expert witness fees and other costs, and any extraordinary equitable and/or injunctive relief permitted by law or equity to assure that the Company and Ventas have an effective remedy. In October 2002, the defendants filed a motion to dismiss for failure to prosecute the case. The court granted the motion to dismiss but the plaintiff subsequently moved the court to vacate the dismissal. The defendants filed an opposition to the plaintiff’s motion to vacate the dismissal, but in August 2003 the court reinstated the lawsuit. In September 2003, the defendants filed a renewed motion to dismiss, as to all defendants, based upon the plaintiff’s failure to make a demand for remedy upon the appropriate board of directors. On July 26, 2005, the court granted the defendants’ motion to dismiss based upon the plaintiff’s failure to make a statutorily required demand for remedy upon the appropriate board of directors. On August 25, 2005, the plaintiff filed an appeal with the Court of Appeals of Kentucky, which is pending. The Company believes that the allegations in the complaint are without merit and intends to defend this action vigorously.

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

 

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

Cautionary Statement

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

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

 

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

 

    the risks and uncertainties arising from and related to the rent reset process, including the appraisal process, pursuant to the Master Leases,

 

    the risks and uncertainties associated with the court action presently pending between the Company and Ventas related to the production of the Company’s third party appraisals prepared for the rent reset process,

 

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

 

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

 

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

 

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

 

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

 

    changes in the reimbursement rates or methods of payment from third party payors, including the Medicare and Medicaid programs, changes arising from and related to the Medicare prospective payment system for LTAC hospitals (“LTAC PPS”), including the final Medicare payment rules issued on May 2, 2006, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“Medicare Part D”), and changes in Medicare and Medicaid reimbursements for the Company’s nursing centers,

 

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

 

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

 

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

 

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

Cautionary Statement (Continued)

 

    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,

 

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

 

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

 

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

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

General

The business segment data in Note 9 of the accompanying Notes to Condensed Consolidated Financial Statements should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing centers, a contract rehabilitation services business and institutional pharmacies across the United States. At June 30, 2006, the Company’s hospital division operated 80 LTAC hospitals (6,363 licensed beds) in 24 states. The Company’s health services division operated 253 nursing centers (32,433 licensed beds) in 28 states. The Company operated a contract rehabilitation services business which provides rehabilitative services primarily in long-term care settings. The Company’s pharmacy division operated an institutional pharmacy business with 39 pharmacies in 24 states and a pharmacy management business servicing substantially all of the Company’s hospitals.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals, nursing centers and other healthcare businesses to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains or losses associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2006 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 2 of the accompanying Notes to Condensed Consolidated Financial Statements.

In April 2001, the Company and its subsidiaries emerged from proceedings under the Bankruptcy Code pursuant to the terms of the Plan of Reorganization.

Critical Accounting Policies

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

 

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

Critical Accounting Policies (Continued)

 

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

Revenue recognition

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

Operating results included income related to the favorable settlement of prior year hospital Medicare cost reports that aggregated $4 million and $55 million for the second quarter of 2006 and 2005, respectively, and $6 million and $58 million for the six months ended June 30, 2006 and 2005, respectively.

Operating results for the second quarter of 2005 included pretax income of $16 million ($32 million of revenues net of $16 million of provider taxes classified as operating expenses) related to retroactive nursing center Medicaid rate increases in the state of Indiana, of which approximately $2 million related to the first quarter of 2005 and approximately $14 million related to prior years.

See Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $10 million and $4 million for the second quarter of 2006 and 2005, respectively, and totaled $18 million and $8 million for the six months ended June 30, 2006 and 2005, respectively.

Allowances for insurance risks

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

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

 

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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 (Continued)

 

Provisions for loss for professional liability risks retained by the limited purpose insurance subsidiary have been discounted based upon management’s estimate of long-term investment yields and independent actuarial estimates of claim payment patterns. The interest rate used to discount funded professional liability risks in each period presented was 5%. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $258 million at June 30, 2006 and $252 million at December 31, 2005. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $271 million at June 30, 2006 and $266 million at December 31, 2005.

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

Changes in the number of professional liability claims and the increasing cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at June 30, 2006 would impact the Company’s operating income by approximately $3 million. The Company recorded favorable pretax adjustments of $10 million and $23 million for the second quarter of 2006 and 2005, respectively, and $17 million and $33 million for the six months ended June 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas (included in discontinued operations).

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $20 million and $19 million for the second quarter of 2006 and 2005, respectively, and $42 million and $39 million for the six months ended June 30, 2006 and 2005, respectively.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $85 million at June 30, 2006 and $78 million at December 31, 2005. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $11 million and $12 million for the second quarter of 2006 and 2005, respectively, and $24 million and $25 million for the six months ended June 30, 2006 and 2005, respectively.

See Note 10 of the accompanying Notes to Condensed Consolidated Financial Statements.

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the

 

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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 (Continued)

 

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.

There are significant uncertainties with respect to professional liability costs, future government payments to both the Company’s hospitals and nursing centers and the outcome of income tax examinations which, among other things, could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent the realizability of the deferred tax assets is unlikely. The Company recognized deferred tax assets totaling $147 million at June 30, 2006 and $135 million at December 31, 2005.

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

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

Valuation of long-lived assets and goodwill

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

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

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

 

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

 

Recent Developments

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

On August 1, 2006, CMS issued the final rule to reweight LTAC hospital diagnosis related groups (“DRGs”), among other things, beginning October 1, 2006 for the Company. CMS estimates that the effect of the proposal would decrease Medicare reimbursements to LTAC hospitals by an additional 1.3%.

Results of Operations – Continuing Operations

Hospital Division

Revenues increased 1% to $439 million in the second quarter of 2006 from $435 million in the same period a year ago and 5% to $870 million for the six months ended June 30, 2006 from $828 million in the same period a year ago. As previously discussed in Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements, revenues in both periods included certain Medicare cost report settlements. Excluding these settlements, revenues increased 15% in the second quarter of 2006 and 12% for the six months ended June 30, 2006 compared to the same periods a year ago. Revenue growth was primarily a result of growth in admissions, new hospital development and the Commonwealth Acquisition. On a same-store basis, revenues increased 6% in both the second quarter and six months ended June 30, 2006 compared to the same periods a year ago. Revenues associated with the Commonwealth Acquisition approximated $30 million and $40 million in the second quarter and six months ended June 30, 2006, respectively.

Admissions rose 9% in the second quarter of 2006 and 10% for the six months ended June 30, 2006 compared to the respective prior year periods, while non-government admissions grew 28% in the second quarter of 2006 and 25% for the six months ended June 30, 2006 compared to the respective prior year periods. On a same-store basis, admissions increased 1% in the second quarter of 2006 and 3% for the six months ended June 30, 2006 compared to the respective prior year periods.

Hospital wage and benefit costs increased 9% to $191 million in the second quarter of 2006 from $175 million in the same period a year ago and 10% to $378 million for the six months ended June 30, 2006 from $343 million in the same period last year. Average hourly wage rates grew 3% in both the second quarter and six months ended June 30, 2006 compared to the same periods a year ago, while employee benefit costs increased 11% in the second quarter of 2006 and 10% for the six months ended June 30, 2006 compared to the same periods a year ago.

Professional liability costs were $5 million in the second quarter of both 2006 and 2005 and $11 million for both six-month periods ended June 30, 2006 and 2005.

 

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

Results of Operations – Continuing Operations (Continued)

Hospital Division (Continued)

 

Hospital operating income declined 22% to $105 million in the second quarter of 2006 from $134 million a year ago and declined 11% to $209 million for the six months ended June 30, 2006 from $236 million a year ago. As previously discussed in Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements, hospital operating income in both periods included certain adjustments. Excluding these adjustments, operating income grew 21% in the second quarter of 2006 and 11% for the six months ended June 30, 2006 and operating margins were 23.2% and 23.5% in the second quarter and six months ended June 30, 2006, respectively, compared to 22.0% and 23.7% in the same prior year periods. Excluding the adjustments, growth in hospital operating income in both periods was primarily attributable to growth in admissions, operating efficiencies associated with growth in volumes and the Commonwealth Acquisition. Aggregate operating costs per admission increased 2% in both the second quarter and six months ended June 30, 2006 compared to the corresponding prior year periods. Operating income associated with the Commonwealth Acquisition approximated $3 million and $4 million in the second quarter and six months ended June 30, 2006, respectively.

The adoption of the Hospital Medicare Rule for the Company’s in-house Medicare patients at June 30, 2006 reduced second quarter hospital revenues and operating income by approximately $5 million.

Health Services Division

Revenues increased 6% to $515 million in the second quarter of 2006 from $484 million in the same period a year ago and 7% to $995 million for the six months ended June 30, 2006 from $927 million in the same period a year ago. Excluding the retroactive Medicaid rate increases discussed in Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements, revenues increased 14% in the second quarter of 2006 and 10% for the six months ended June 30, 2006 compared to the same periods a year ago. Revenue growth was primarily a result of generally favorable reimbursement rates and an increase in patient days. Aggregate patient days increased 7% in the second quarter of 2006 and 5% for the six months ended June 30, 2006 compared to the respective prior year periods. On a same-store basis, aggregate patient days increased 1% in both the second quarter and six months ended June 30, 2006 compared to the same prior year periods. Revenues associated with the Commonwealth Acquisition approximated $31 million and $41 million in the second quarter and six months ended June 30, 2006, respectively.

Nursing center wage and benefit costs increased 8% to $270 million in the second quarter of 2006 from $250 million in the same period a year ago and 8% to $528 million for the six months ended June 30, 2006 from $487 million in the same period a year ago. Average hourly wage rates increased 5% in the second quarter of 2006 and 4% for the six months ended June 30, 2006 compared to the respective prior year periods, while employee benefit costs increased 6% for both the second quarter and six months ended June 30, 2006 compared to the respective prior year periods.

Professional liability costs were $14 million in the second quarter of both 2006 and 2005, and $30 million and $28 million for the six months ended June 30, 2006 and 2005, respectively.

Nursing center operating income increased 2% to $67 million in the second quarter of 2006 from $66 million in the same period a year ago and declined 3% to $115 million for the six months ended June 30, 2006 from $119 million in the same period a year ago. As previously discussed in Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements, nursing center operating income in the second quarter of 2005 included certain adjustments. Excluding these adjustments, operating income grew 14% in the second quarter of 2006 and 1% for the six months ended June 30, 2006 while operating margins were 13.0% and 11.6% in the second quarter and six months ended June 30, 2006, respectively, compared to 13.0% and 12.7% in the

 

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

Results of Operations – Continuing Operations (Continued)

Health Services Division (Continued)

 

same prior year periods. Excluding these adjustments, aggregate operating costs per patient day increased 6% in the second quarter of 2006 and 7% for the six months ended June 30, 2006 compared to the respective prior year periods. Nursing center operating income in the second quarter and six months ended June 30, 2006 increased primarily due to improved reimbursement rates and increases in patient days (particularly Medicare, private and other patient days). Operating income associated with the Commonwealth Acquisition approximated $3 million and $4 million in the second quarter and six months ended June 30, 2006, respectively.

Rehabilitation Division

Revenues increased 14% to $74 million in the second quarter of 2006 from $65 million in the same period a year ago and 12% to $145 million for the six months ended June 30, 2006 from $130 million in the same period a year ago. The increase in revenues in both periods was primarily attributable to price increases and growth in the volume of services provided to existing customers.

Operating income increased 21% to $9 million in the second quarter of 2006 from $7 million in the same period a year ago and declined 24% to $13 million for the six months ended June 30, 2006 from $17 million in the same period a year ago. Operating income for the six months ended June 30, 2006 included a pretax charge of approximately $3 million related primarily to revisions to prior estimates for accrued contract labor costs. Operating income in 2006 also was negatively impacted by increased costs associated with wage rate pressures resulting from an increasingly competitive marketplace for therapists. Operating income for the second quarter of 2005 included a $1 million charge related to a special recognition payment to the Company’s non-executive caregivers and employees.

Pharmacy Division

Revenues increased 21% to $160 million in the second quarter of 2006 from $132 million in the same period a year ago and 32% to $317 million for the six months ended June 30, 2006 from $240 million in the same period a year ago due primarily to acquisitions, price increases and higher drug utilization. Revenues associated with three pharmacy acquisitions completed during 2005 approximated $38 million and $77 million in the second quarter and six months ended June 30, 2006, respectively, compared to $25 million and $28 million for the respective prior year periods. At June 30, 2006, the Company provided pharmacy services to nursing centers containing 95,300 licensed beds, including 30,300 licensed beds that it operates. At June 30, 2005, the Company provided pharmacy services to nursing centers containing 84,800 licensed beds, including 28,700 licensed beds that it operates.

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

Pharmacy operating income increased 14% to $15 million in the second quarter of 2006 from $14 million in the same period a year ago and 29% to $32 million for the six months ended June 30, 2006 from $25 million in the same period a year ago. Pharmacy operating income for the six months ended June 30, 2006 included a $1 million gain from a joint venture transaction. Pharmacy operating income for the second quarter of 2005

 

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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)

Pharmacy Division (Continued)

 

included a $1 million charge related to a special recognition payment to the Company’s non-executive caregivers and employees. Operating income associated with three pharmacy acquisitions completed in 2005 approximated $2 million and $6 million in the second quarter and six months ended June 30, 2006, respectively, compared to $3 million for both respective prior year periods. Operating margins were 9.5% and 10.0% in the second quarter and six months ended June 30, 2006, respectively, compared to 10.1% and 10.3% in the same prior year periods. The cost of goods sold as a percentage of institutional pharmacy revenues were 64.9% and 65.2% in the second quarter and six months ended June 30, 2006, respectively, compared to 65.1% and 64.9% in the same prior year periods. Excluding acquisitions, pharmacy operating income in both periods increased from the same period last year primarily due to volume growth.

Corporate Overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $43 million and $80 million in the second quarter and six months ended June 30, 2006, respectively, compared to $38 million and $67 million for the respective prior year periods. As previously discussed in Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements, corporate overhead included certain adjustments. Excluding these adjustments, corporate overhead as a percentage of consolidated revenues totaled 3.6% and 3.5% in the second quarter and six months ended June 30, 2006, respectively, compared to 3.5% and 3.3% in the same prior year periods. The increase in corporate overhead in the second quarter and six months ended June 30, 2006 compared to the same periods last year was primarily attributable to increases in stock-based compensation and certain incentive compensation costs.

Corporate expenses included the operating losses of the Company’s limited purpose insurance subsidiary of $2 million and $4 million in the second quarter and six months ended June 30, 2006, respectively, compared to $3 million and $5 million for the respective prior year periods.

Reorganization Items

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

Capital Costs

Rent expense increased 12% to $77 million in the second quarter of 2006 from $69 million in the same period a year ago and 10% to $149 million for the six months ended June 30, 2006 from $136 million in the same period a year ago. A substantial portion of the increase resulted from acquisition and development activities, and contractual inflation increases, including those associated with the Master Leases.

Depreciation and amortization expense increased 21% to $31 million in the second quarter of 2006 from $25 million in the same period a year ago and 20% to $59 million for the six months ended June 30, 2006 from $49 million in the same period a year ago. The increase was primarily a result of the Company’s ongoing capital expenditure program and acquisition and development activities.

Interest expense increased to $3 million in the second quarter of 2006 from $2 million in the same period a year ago and to $6 million for the six months ended June 30, 2006 from $4 million in the same period a year ago. The increase was primarily a result of increased borrowings under the Company’s revolving credit facility as a result of the Commonwealth Acquisition.

 

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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)

Capital Costs (Continued)

 

Investment income, related primarily to the Company’s excess cash balances and insurance subsidiary investments, approximated $3 million and $7 million in the second quarter and six months ended June 30, 2006, respectively, compared to $2 million and $5 million for the respective prior year periods.

Consolidated Results

Income from continuing operations before income taxes declined 50% to $43 million in the second quarter of 2006 from $86 million in the same period a year ago and 45% to $78 million for the six months ended June 30, 2006 from $142 million in the same period a year ago. Net income from continuing operations declined 52% to $25 million in the second quarter of 2006 from $52 million in the same period a year ago and 47% to $45 million for the six months ended June 30, 2006 from $85 million in the same period a year ago. See Note 3 of the accompanying Notes to Condensed Consolidated Financial Statements.

Discontinued Operations

Net income from discontinued operations aggregated $5 million in the second quarter of 2006 compared to $11 million for the same period a year ago. Net income from discontinued operations aggregated $9 million for the six months ended June 30, 2006 compared to $15 million for the same period a year ago. Net income from discontinued operations included favorable pretax adjustments of $10 million and $23 million for the second quarter of 2006 and 2005, respectively, and $17 million and $33 million for the six months ended June 30, 2006 and 2005, respectively, resulting from a change in estimate for professional liability reserves related primarily to the Company’s former nursing centers in Florida and Texas. See Notes 2 and 10 of the accompanying Notes to Condensed Consolidated Financial Statements.

Liquidity

Cash flows from operations (including discontinued operations) aggregated $18 million for the six months ended June 30, 2006 compared to $57 million for the same period a year ago. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance acquisitions.

Cash and cash equivalents totaled $15 million at June 30, 2006 compared to $83 million at December 31, 2005. Based upon the Company’s existing cash levels, expected operating cash flows and capital spending (including planned acquisitions), and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

Long-term debt at June 30, 2006 aggregated $165 million (including $143 million of borrowings under the Company’s revolving credit facility). The Company was in compliance with the terms of its $400 million revolving credit facility at June 30, 2006. The Company expects to continue to utilize its revolving credit facility in 2006 to fund working capital and development needs.

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

 

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

Liquidity (Continued)

 

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

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

During the past several years, the Company’s federal income tax payments have been significantly reduced primarily as a result of certain income tax benefits arising in connection with the Company’s reorganization, including the utilization of NOLs. Beginning in 2006, the Company expects that cash payments of federal income taxes will more closely reflect the Company’s provision for income taxes. Accordingly, the Company’s operating cash flows in 2006 may decline from the levels reported in 2005. Operating cash flows for the six months ended June 30, 2006 included $28 million of federal income tax payments, compared to $1 million in the same period a year ago.

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

On May 9, 2006, the Company received the Reset Proposal Notices from Ventas under each of the four Master Leases. In the Reset Proposal Notices, Ventas has asserted that the total aggregate annual rent under the four Master Leases should be reset to approximately $317 million and that the annual rent escalator for each Master Lease should be reset at 3%. The current total aggregate annual rent under the Master Leases is approximately $206 million. The current contingent annual rent escalator is 3 1/2% under each Master Lease.

Since receiving the Reset Proposal Notices, each of Ventas and the Company selected a third party appraiser in an effort to determine the Final Appraiser under each of the Master Leases. After significant negotiation, the two appraisers were unable to agree on the Final Appraiser for the Master Leases. Both Ventas and the Company have submitted formal requests to the American Arbitration Association to select appraisers to serve as the Final Appraiser under each of the Master Leases. Once the Final Appraisers are selected, they will have 60 days to complete the determination of the Fair Market Rental, including the annual rent escalator, under the Master Lease for which they are serving as the Final Appraiser. Within 30 days following the Final Appraiser’s determination, Ventas may elect to exercise its right to reset the Fair Market Rental by sending the Company the Final Exercise Notice. Ventas’ election can be made on a Master Lease by Master Lease basis. Alternatively, Ventas may decide not to exercise its rent reset option, in which event the rent and existing 3 1/2% contingent annual escalator would remain at their then current levels under the Master Leases. If Ventas exercises its rent reset right in accordance with the Master Leases, the rent reset will become effective as of July 19, 2006.

The Company has performed substantial analysis of the potential rent reset, including internal analysis, and has had each Ventas facility appraised by one or more independent appraisers taking into account the terms of the Master Leases. Based upon this analysis, the Company has a significant disagreement with Ventas on the asserted rent reset, both with respect to the annual aggregate base rent and the level of the annual rent escalator. Based upon the independent appraisals of the Ventas facilities, the Company believes that both the existing aggregate rents and the 3 1/2% annual rent escalator under each Master Lease are already well above market.

The Company’s analysis is based upon a number of factors, some of which are subject to change, including, without limitation, reimbursement rates and regulatory changes affecting the leased properties, the historical and projected financial results of the individual leased properties, the condition, age and capital requirements of the

 

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

Liquidity (Continued)

 

leased properties, the method of calculating market rents, current market rents and industry market rents for LTAC hospitals and nursing centers, the terms of the Master Leases that limit operational and malpractice insurance restructuring flexibility, the aggregate rental value of the portfolio of LTAC hospitals and nursing centers contained within each Master Lease, and the inherent risks involved in any third party appraisal process. The average ages of the hospitals and nursing centers in the Ventas portfolio are approximately 38 years and 36 years, respectively.

Given the significant difference of opinion with Ventas, the Company believes investors should consider that this issue may be resolved through the appraisal process set forth in the Master Leases.

Capital Resources

Excluding acquisitions, capital expenditures totaled $62 million in the six months ended June 30, 2006 compared to $47 million for the same period a year ago. Excluding acquisitions, capital expenditures could approximate $150 million to $175 million in 2006. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds. At June 30, 2006, the estimated cost to complete and equip construction in progress approximated $60 million.

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

During the first six months of 2005, the Company acquired a hospital and completed both the PPI Acquisition and the SCP Acquisition. The Company financed these acquisitions through the use of operating cash flows and borrowings under the revolving credit facility.

The revolving credit facility includes certain covenants which limit the Company’s acquisitions and annual capital expenditures. At June 30, 2006, the Company’s remaining permitted acquisition amount under its revolving credit facility aggregated $230 million.

Other Information

Effects of Inflation and Changing Prices

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

CMS issued final regulatory changes regarding the Hospital Medicare Rule on May 2, 2006. Based upon the Company’s historical Medicare patient volumes, the Company expects that the Hospital Medicare Rule will reduce Medicare revenues to the Company’s hospitals associated with short stay outliers and high cost outliers by approximately $46 million on an annual basis. This estimate does not include the negative impact resulting from the elimination of the annual market basket adjustment to the Medicare payment rates that also is contained in the Hospital Medicare Rule. The annual market basket adjustment has typically ranged between 3% and 4%, or approximately $25 million to $30 million annually. The Hospital Medicare Rule is effective for discharges

 

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

Other Information (Continued)

Effects of Inflation and Changing Prices (Continued)

 

occurring after June 30, 2006. The adoption of the Hospital Medicare Rule for the Company’s in-house Medicare patients at June 30, 2006 reduced second quarter hospital revenues by approximately $5 million. The Hospital Medicare Rule also extends until July 1, 2008 CMS’s authority to impose a one-time prospective budget neutrality adjustment to LTAC hospital rates. This authority was scheduled to expire on October 1, 2006.

On August 1, 2006, CMS issued the final rule to reweight LTAC hospital DRGs, among other things, beginning October 1, 2006 for the Company. CMS estimates that the effect of the proposal would decrease Medicare reimbursements to LTAC hospitals by an additional 1.3%.

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

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

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.

On August 1, 2005, CMS published the final rules related to the DRG weights and the geometric length-of-stay thresholds that took effect for hospital Medicare discharges occurring on or after October 1, 2005. The Company expects these changes to reduce Medicare revenues to its hospitals between $35 million to $40 million on an annual basis based upon the Company’s historical Medicare patient volumes.

Medicare payments to the Company’s nursing centers are based upon certain resource utilization grouping (“RUG”) payment rates developed by CMS that provide various levels of reimbursement based upon patient acuity. On July 28, 2005, CMS published the final rules related to revised payment rates to nursing centers. Among other things, the final rules provide for a 3.1% inflation update to all RUGs categories effective October 1, 2005.

In addition, beginning January 1, 2006, the final rules increased the indexing of RUG categories, expanded the total RUG categories from 44 to 53 and eliminated the 20% payment add-on for the care of higher acuity patients that had been in effect since 2000 under the Balanced Budget Refinement Act of 2000.

 

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

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

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

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

Litigation

The Company is a party to certain material litigation. See Note 14 of the accompanying Notes to Condensed Consolidated Financial Statements.

 

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

 

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)

 

    2005 Quarters     2006 Quarters  
    First     Second     Third     Fourth     First     Second  

Revenues

  $ 930,473     $ 1,035,865     $ 968,619     $ 989,042     $ 1,048,157     $ 1,093,999  
                                               

Salaries, wages and benefits

    508,680       535,605       531,322       537,129       572,892       592,762  

Supplies

    127,615       145,329       146,112       155,855       164,733       168,798  

Rent

    67,184       68,783       68,961       69,596       71,785       77,379  

Other operating expenses

    149,000       175,603       163,484       160,409       176,118       181,516  

Depreciation and amortization

    23,768       25,213       26,466       27,709       28,454       30,439  

Interest expense

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

Investment income

    (2,347 )     (3,031 )     (2,472 )     (3,210 )     (3,691 )     (3,444 )
                                               
    875,900       949,941       935,804       949,216       1,012,940       1,050,984  
                                               

Income from continuing operations before reorganization items and income taxes

    54,573       85,924       32,815       39,826       35,217       43,015  

Reorganization items

    (1,371 )                 (268 )            
                                               

Income from continuing operations before income taxes

    55,944       85,924       32,815       40,094       35,217       43,015  

Provision for income taxes

    22,567       34,533       13,266       15,781       14,795       18,399  
                                               

Income from continuing operations

    33,377       51,391       19,549       24,313       20,422       24,616  

Discontinued operations, net of income taxes:

           

Income (loss) from operations

    3,513       12,029       (48 )     2,166       3,380       5,365  

Gain (loss) on divestiture of operations

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

Net income

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

Earnings per common share:

           

Basic:

           

Income from continuing operations

  $ 0.92     $ 1.37     $ 0.51     $ 0.65     $ 0.56     $ 0.59  

Discontinued operations:

           

Income (loss) from operations

    0.10       0.32             0.06       0.09       0.13  

Gain (loss) on divestiture of operations

          0.07       (0.08 )     (0.03 )           (0.01 )
                                               

Net income

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

Diluted:

           

Income from continuing operations

  $ 0.75     $ 1.11     $ 0.43     $ 0.56     $ 0.50     $ 0.57  

Discontinued operations:

           

Income (loss) from operations

    0.08       0.26             0.05       0.08       0.13  

Gain (loss) on divestiture of operations

          0.06       (0.07 )     (0.02 )           (0.01 )
                                               

Net income

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

Shares used in computing earnings per common share:

           

Basic

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

Diluted

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

 

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

 

Operating Data

(Unaudited)

(In thousands)

 

    2005 Quarters     2006 Quarters  
    First     Second     Third     Fourth     First     Second  

Revenues:

           

Hospital division

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

Health services division

    443,144       484,581       461,272       470,501       479,572       515,028  

Rehabilitation division

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

Pharmacy division

    107,957       131,849       135,165       147,254       157,214       159,926  
                                               
    1,009,088       1,116,357       1,051,766       1,075,405       1,138,762       1,188,638  

Eliminations:

           

Rehabilitation

    (48,497 )     (49,139 )     (50,932 )     (51,619 )     (55,164 )     (58,155 )

Pharmacy

    (30,118 )     (31,353 )     (32,215 )     (34,744 )     (35,441 )     (36,484 )
                                               
    (78,615 )     (80,492 )     (83,147 )     (86,363 )     (90,605 )     (94,639 )
                                               
  $ 930,473     $ 1,035,865     $ 968,619     $ 989,042     $ 1,048,157     $ 1,093,999  
                                               

Income from continuing operations:

           

Operating income (loss):

           

Hospital division

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

Health services division

    53,680       65,447       49,928       55,035       48,563       66,978  

Rehabilitation division

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

Pharmacy division

    11,454       13,298       14,455       17,630       16,729       15,139  

Corporate:

           

Overhead

    (29,115 )     (38,052 )     (32,631 )     (34,716 )     (37,334 )     (43,257 ) (b)

Insurance subsidiary

    (2,353 )     (2,617 )     (2,692 )     (2,493 )     (1,847 )     (1,697 )
                                               
    (31,468 )     (40,669 )     (35,323 )     (37,209 )     (39,181 )     (44,954 )
                                               
    145,178       179,328       127,701       135,649       134,414       150,923  

Reorganization items

    1,371                   268              
                                               

Operating income

    146,549       179,328       127,701       135,917       134,414       150,923  

Rent

    (67,184 )     (68,783 )     (68,961 )     (69,596 )     (71,785 )     (77,379 )

Depreciation and amortization

    (23,768 )     (25,213 )     (26,466 )     (27,709 )     (28,454 )     (30,439 )

Interest, net

    347       592       541       1,482       1,042       (90 )
                                               

Income from continuing operations before income taxes

    55,944       85,924       32,815       40,094       35,217       43,015  

Provision for income taxes

    22,567       34,533       13,266       15,781       14,795       18,399  
                                               
  $ 33,377     $ 51,391     $ 19,549     $ 24,313     $ 20,422     $ 24,616  
                                               

(a) Includes income of $4.3 million related to the favorable settlement of prior year hospital Medicare cost reports.
(b) Includes a charge of $3.3 million in connection with the settlement of a prior year tax dispute and a charge of $1.0 million for investment banking services and costs related to the rent reset issue with Ventas.

 

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

 

Operating Data (Continued)

(Unaudited)

(In thousands)

 

     2005 Quarters    2006 Quarters
     First    Second    Third    Fourth    First    Second

Rent:

                 

Hospital division

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

Health services division

     40,674      41,429      41,473      41,555      42,939      45,506

Rehabilitation division

     800      817      817      809      869      897

Pharmacy division

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

Corporate

     67      124      79      89      78      72
                                         
   $ 67,184    $ 68,783    $ 68,961    $ 69,596    $ 71,785    $ 77,379
                                         

Depreciation and amortization:

                 

Hospital division

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

Health services division

     7,476      7,914      8,271      8,975      9,895      10,871

Rehabilitation division

     54      56      57      64      80      115

Pharmacy division

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

Corporate

     5,758      5,886      6,034      5,912      5,575      5,938
                                         
   $ 23,768    $ 25,213    $ 26,466    $ 27,709    $ 28,454    $ 30,439
                                         

Capital expenditures, excluding acquisitions (including discontinued operations):

                 

Hospital division

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

Health services division

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

Rehabilitation division

     2      96      17      538      19      130

Pharmacy division

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

Corporate:

                 

Information systems

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

Other

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

 

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

 

Operating Data (Continued)

(Unaudited)

 

     2005 Quarters    2006 Quarters
     First    Second    Third    Fourth    First    Second

Hospital data:

                 

End of period data:

                 

Number of hospitals

     73      73      73      74      80      80

Number of licensed beds

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

Revenue mix % (a):

                 

Medicare

     65      71      65      65      64      62

Medicaid

     6      6      7      6      7      9

Private and other

     29      23      28      29      29      29

Admissions:

                 

Medicare

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

Medicaid

     727      823      845      827      913      1,018

Private and other

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

Admissions mix %:

                 

Medicare

     76      75      75      76      73      71

Medicaid

     8      9      9      8      9      10

Private and other

     16      16      16      16      18      19

Patient days:

                 

Medicare

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

Medicaid

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

Private and other

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

Average length of stay:

                 

Medicare

     28.1      29.6      27.8      27.4      27.2      28.8

Medicaid

     36.7      34.5      36.1      36.1      41.2      49.3

Private and other

     39.0      36.4      35.8      38.3      34.6      36.2

Weighted average

     30.5      31.1      29.8      29.9      29.7      32.3

Revenues per admission (a):

                 

Medicare

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

Medicaid

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

Private and other

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

Weighted average

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

Revenues per patient day (a):

                 

Medicare

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

Medicaid

     826      896      898      803      830      815

Private and other

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

Weighted average

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

Medicare case mix index
(discharged patients only)

     1.22      1.25      1.20      1.11      1.12      1.12

Average daily census

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

Occupancy %

     61.2      59.9      56.9      58.5      65.3      63.3

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

 

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

 

Operating Data (Continued)

(Unaudited)

 

    2005 Quarters   2006 Quarters
    First   Second     Third   Fourth   First   Second

Nursing center data:

           

End of period data:

           

Number of nursing centers:

           

Owned or leased

    236     237       237     237     248     248

Managed

    7     5       5     5     5     5
                                     
    243     242       242     242     253     253
                                     

Number of licensed beds:

           

Owned or leased

    30,161     30,266       30,264     30,264     31,818     31,828

Managed

    803     605       605     605     605     605
                                     
    30,964     30,871       30,869     30,869     32,423     32,433
                                     

Revenue mix %:

           

Medicare

    35     32       32     33     35     34

Medicaid

    47     51 (a)     50     49     47     47

Private and other

    18     17       18     18     18     19

Patient days (excludes managed facilities):

           

Medicare

    394,310     396,230       378,714     381,430     407,214     426,618

Medicaid

    1,564,779     1,568,306       1,601,714     1,591,713     1,574,699     1,645,022

Private and other

    385,093     383,986       396,053     414,738     413,123     447,916
                                     
    2,344,182     2,348,522       2,376,481     2,387,881     2,395,036     2,519,556
                                     

Patient day mix %:

           

Medicare

    17     17       16     16     17     17

Medicaid

    67     67       67     67     66     65

Private and other

    16     16       17     17     17     18

Revenues per patient day:

           

Medicare Part A

  $ 347   $ 346     $ 349   $ 364   $ 374   $ 375

Total Medicare (including Part B)

    388     389       395     404     410     409

Medicaid

    134     159 (a)     144     144     142     147

Private and other

    207     211       206     211     216     219

Weighted average

    189     206       194     197     200     204

Average daily census

    26,046     25,808       25,831     25,955     26,612     27,687

Occupancy %

    86.0     85.3       85.3     85.8     86.5     87.3

Rehabilitation data:

           

Revenue mix %:

           

Company-operated

    76     77       78     77     78     78

Non-affiliated

    24     23       22     23     22     22

Pharmacy data:

           

Number of customer licensed beds at end of period:

           

Company-operated

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

Non-affiliated

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

(a) Includes income of $31.8 million for periods prior to April 1, 2005 related to retroactive Medicaid rate increases in the state of Indiana. Related provider tax expense of $16.0 million under this program was recorded in other operating expenses.

 

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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

Interest Rate Sensitivity

Principal (Notional) Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)

 

    Expected maturities  

Fair

value

6/30/06

    2006     2007     2008     2009     2010     Thereafter     Total  

Liabilities:

               

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

               

Fixed rate:

               

Ventas debt obligation:

               

Principal

  $ 3,214     $ 7,209     $ 5,510     $ 4,889     $ 2,889     $ 4,864     $ 28,575   $ 28,575

Interest

    1,456       2,350       1,612       1,096       631       632       7,777    
                                                           
    4,670       9,559       7,122       5,985       3,520       5,496       36,352     28,575

Other

    34       71       76       81       86       648       996     955
                                                           
  $ 4,704     $ 9,630     $ 7,198     $ 6,066     $ 3,606     $ 6,144     $ 37,348   $ 29,530
                                                           

Average interest rate

    10.9 %     11.0 %     10.9 %     10.9 %     10.9 %     10.4 %    

Variable rate (a)

  $     $     $     $ 142,600     $     $     $ 142,600   $ 142,600

(a) Interest on borrowings under the Company’s revolving credit facility is payable, at the Company’s option, at (1) the London Interbank Offered Rate plus an applicable margin ranging from 2.00% to 2.75% or (2) prime plus an applicable margin ranging from 1.00% to 1.75%. The applicable margin is based upon the Company’s adjusted leverage ratio as defined in the Company’s revolving credit facility.

 

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ITEM 4.    CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures and Changes in Internal Control Over Financial Reporting

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2006, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended June 30, 2006, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II.    OTHER INFORMATION

 

Item 1. Legal Proceedings

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

 

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

Issuer Purchases of Equity Securities

 

     (a)    (b)    (c)    (d)

Period

   Total number of
shares (or units)
purchased
   Average price
paid per share
(or unit)
   Total number of
shares (or units)
purchased as part of
publicly announced
plans or programs
   Maximum number (or
approximate dollar value) of
shares (or units) that may yet
be purchased under the plans or
programs (1)

Month #1

(April 1-April 30)

   747,100    $ 24.73    747,100    $ 175,811,764

Month #2

(May 1-May 31)

   4,478,120      24.42    4,478,120      66,323,070

Month #3

(June 1-June 30)

   2,603,335      25.45    2,603,335     
               

Total

   7,828,555    $ 24.79    7,828,555    $
               

(1) On August 2, 2005, the Company announced that its Board of Directors had authorized up to $100 million in repurchases of its common stock and Series A and Series B warrants. The Company purchased only common stock under this repurchase program.

 

   In addition, the Company also announced on February 27, 2006 that its Board of Directors had authorized the use of the proceeds from the exercise of the Company’s formerly outstanding warrants to repurchase common stock issued in connection with the exercise of the warrants. After giving effect to warrants that were exercised using a cashless exercise procedure, the Company received approximately $142 million in net proceeds from the exercise of these warrants. During the second quarter of 2006, these proceeds were used to purchase approximately 5.8 million shares of common stock under this program.

 

   The amounts set forth in the table reflect repurchases under both of the repurchase programs discussed in this footnote.

 

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PART II.    OTHER INFORMATION (Continued)

 

Item 4. Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 25, 2006 in Louisville, Kentucky. At the meeting, shareholders elected a board of eight directors pursuant to the following votes:

 

Director

   Votes in Favor    Votes Withheld

Thomas P. Cooper, M.D.

   36,996,454    214,427

Paul J. Diaz

   37,021,421    189,460

Michael J. Embler

   33,864,890    3,345,991

Garry N. Garrison

   37,030,926    179,955

Isaac Kaufman

   37,032,021    178,860

John H. Klein

   37,028,976    181,905

Edward L. Kuntz

   36,886,683    324,198

Eddy J. Rogers, Jr.

   37,051,158    159,723

In addition to electing directors, shareholders of the Company ratified the appointment of PricewaterhouseCoopers LLP as the Company’s independent auditor for fiscal year 2006 by the vote of 37,186,991 in favor, 16,729 against, 7,159 abstentions and no non-votes.

Also at the Annual Meeting, the Company’s shareholders rejected a shareholder proposal to urge the Board of Directors to arrange for the spin-off of the Company’s pharmacy division to its shareholders by the vote of 4,176,786 in favor, 30,134,263 against, 26,278 abstentions and no non-votes.

 

Item 6. Exhibits

 

10.1    Master Lease Combination Amendment and Agreement by and among Kindred Healthcare, Inc. (f/k/a Vencor, Inc.), Kindred Healthcare Operating, Inc. (f/k/a Vencor Operating, Inc.), and Ventas Realty, Limited Partnership dated as of May 10, 2006. Exhibit 10.1 to the Company’s Current Report on Form 8-K dated May 10, 2006 (Comm. File No. 001-14057) is hereby incorporated by reference.
31    Rule 13a-14(a)/15d-14(a) Certifications.
32    Section 1350 Certifications.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    KINDRED HEALTHCARE, INC.
Date: August 4, 2006   &