10-Q 1 a20130331-10q.htm 10-Q 2013.03.31-10Q
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
R
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2013.
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: 001-33459
 
Skilled Healthcare Group, Inc.
(Exact name of registrant as specified in its charter)
  
 
Delaware
 
20-3934755
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
 
 
27442 Portola Parkway, Suite 200
 
 
Foothill Ranch, California
 
92610
(Address of principal executive offices)
 
(Zip Code)
(949) 282-5800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
£
 
Accelerated filer
þ
 
 
 
 
 
Non-accelerated filer
£
(do not check if smaller reporting company)
Smaller reporting company
£
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  £    No  þ
The number of shares outstanding of each of the issuer’s classes of common stock, as of the close of business on May 3, 2013, was:
Class A common stock, $0.001 par value – 23,673,866 shares
Class B common stock, $0.001 par value –15,576,096 shares
 



Skilled Healthcare Group, Inc.
Form 10-Q
For the Quarterly Period Ended March 31, 2013
Index
 
 
 
Page
Number
Part I.
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Part II.
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 




PART I — FINANCIAL INFORMATION
Item 1. Financial Statements.
Skilled Healthcare Group, Inc.
Condensed Consolidated Balance Sheets
(In thousands)
 
March 31, 2013
 
December 31, 2012
 
(Unaudited)
 
(Audited)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
5,149

 
$
2,003

Accounts receivable, less allowance for doubtful accounts of $15,534 and $15,646 at March 31, 2013 and December 31, 2012, respectively
112,505

 
107,245

Deferred income taxes
12,348

 
11,696

Prepaid expenses
7,335

 
7,569

Other current assets
10,594

 
10,312

Total current assets
147,931

 
138,825

Property and equipment, less accumulated depreciation of $124,068 and $118,141 at March 31, 2013 and December 31, 2012, respectively
367,219

 
370,745

Leased facility assets, less accumulated depreciation of $4,062 and $3,935 at March 31, 2013 and December 31, 2012, respectively
9,786

 
9,913

Other assets:
 
 
 
Notes receivable
1,531

 
2,055

Deferred financing costs, net
5,717

 
6,355

Goodwill
85,609

 
85,609

Intangible assets, less accumulated amortization of $4,300 and $4,218 at March 31, 2013 and December 31, 2012, respectively
21,953

 
22,035

Deferred income taxes
6,182

 
7,362

Other assets
38,588

 
39,737

Total other assets
159,580

 
163,153

Total assets
$
684,516

 
$
682,636

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued liabilities
$
51,967

 
$
48,780

Employee compensation and benefits
36,762

 
42,185

Current portion of long-term debt
13,460

 
13,338

Total current liabilities
102,189

 
104,303

Long-term liabilities:
 
 
 
Insurance liability risks
24,994

 
27,396

Other long-term liabilities
15,047

 
15,477

Long-term debt, less current portion
438,206

 
435,629

Total liabilities
580,436

 
582,805

Commitments and contingencies — Note 7
 
 
 
Stockholders’ equity:
 
 
 
Class A common stock, 175,000 shares authorized, $0.001 par value per share; Issued and outstanding - 23,674 and 22,967 at March 31, 2013 and December 31, 2012, respectively
24

 
23

Class B common stock, 30,000 shares authorized, $0.001 par value per share; Issued and outstanding - 15,576 at March 31, 2013 and December 31, 2012
16

 
16

Additional paid-in-capital
377,125

 
376,027

Accumulated deficit
(273,038
)
 
(276,108
)
Accumulated other comprehensive loss
(47
)
 
(127
)
Total stockholders’ equity
104,080

 
99,831

Total liabilities and stockholders’ equity
$
684,516

 
$
682,636

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

3


Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended March 31,
 
2013
 
2012
Revenue:
 
 
 
Net patient service revenue
$
218,114

 
$
218,659

Leased facility revenue
761

 
754

 
218,875

 
219,413

Expenses:
 
 
 
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)
190,137

 
183,131

Rent cost of revenue
4,812

 
4,556

General and administrative
6,455

 
6,100

Depreciation and amortization
6,219

 
6,275

 
207,623

 
200,062

Other (expenses) income:
 
 
 
Interest expense
(8,675
)
 
(9,565
)
Interest income
112

 
145

Other (expense) income, net
(30
)
 
(29
)
Equity in earnings of joint venture
489

 
471

Total other (expenses) income, net
(8,104
)
 
(8,978
)
Income before provision for income taxes
3,148

 
10,373

Provision for income taxes
78

 
4,036

Net income
$
3,070

 
$
6,337

 
 
 
 
Net income per share, basic
$
0.08

 
$
0.17

Net income per share, diluted
$
0.08

 
$
0.17

 
 
 
 
Weighted-average common shares outstanding, basic
37,557

 
37,285

Weighted-average common shares outstanding, diluted
38,034

 
37,407

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



4


Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Comprehensive Income
(In thousands)
(Unaudited)

 
Three Months Ended March 31,
 
2013
 
2012
 
 
 
 
Net income
$
3,070

 
$
6,337

Other comprehensive income:
 
 
 
Unrealized gain (loss) on interest rate swap, net of income tax expense of $0 for the three months ended March 31, 2012

 
(33
)
Unrealized gain (loss) on Investment available for sale, net of income tax (benefit) expense of ($1) and $41 for the three months ended March 31, 2013 and 2012, respectively
(3
)
 
21

Reclassification adjustments:
 
 
 
Interest expense on interest rate swap, net of income tax expense of $52 and $24 for the three months ended March 31, 2013 and 2012
83

 
114

Other comprehensive income, net of tax
80

 
102

Comprehensive income
$
3,150

 
$
6,439


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


5


Skilled Healthcare Group, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
 
Three Months Ended March 31,
 
2013
 
2012
Cash Flows from Operating Activities
 
 
 
Net income
$
3,070

 
$
6,337

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
6,219

 
6,275

Provision for doubtful accounts
2,983

 
1,775

Non-cash stock-based compensation
1,303

 
1,163

Excess tax benefits from stock-based payment arrangements

 
242

Amortization of deferred financing costs
638

 
825

Deferred income taxes
477

 
793

Amortization of discount on debt
238

 
144

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(8,149
)
 
(12,140
)
Payments on notes receivable
777

 
743

Other current and non-current assets
(1,611
)
 
(1,456
)
Accounts payable and accrued liabilities
1,973

 
(1,303
)
Employee compensation and benefits
(5,277
)
 
(5,609
)
Insurance liability risks
2,206

 
1,057

Other long-term liabilities
(366
)
 
132

Net cash provided by (used in) operating activities
4,481

 
(1,022
)
Cash Flows from Investing Activities
 
 
 
Additions to property and equipment
(2,401
)
 
(3,475
)
Net cash used in investing activities
(2,401
)
 
(3,475
)
Cash Flows from Financing Activities
 
 
 
Borrowings under line of credit
89,000

 
13,500

Repayments under line of credit
(84,000
)
 
(13,500
)
Repayments of long-term debt
(3,730
)
 
(1,187
)
Excess tax benefits from stock-based payment arrangements

 
(242
)
Taxes paid related to net share settlement of equity awards
(204
)
 
(210
)
Net cash provided by (used in) financing activities
1,066

 
(1,639
)
Increase (decrease) in cash and cash equivalents
3,146

 
(6,136
)
Cash and cash equivalents at beginning of period
2,003

 
16,017

Cash and cash equivalents at end of period
$
5,149

 
$
9,881

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

6


 
Three Months Ended March 31,
 
2013
 
2012
Supplemental cash flow information
 
 
 
Cash paid for:
 
 
 
Interest expense
$
7,763

 
$
12,203

Income taxes, net
$
(27
)
 
$
(32
)
Non-cash activities:
 
 
 
Insurance premium financed
$
1,187

 
$
1,107

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

7

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


1. Description of Business

Current Business
Skilled Healthcare Group, Inc. ("Skilled") is a holding company that owns subsidiary companies that in turn own and operate long-term care facilities and provide a wide range of post-acute care services, with a strategic emphasis on sub-acute specialty medical care. Skilled and its consolidated wholly-owned companies are collectively referred to as the "Company." As of March 31, 2013, the Company operated facilities in California, Iowa, Kansas, Missouri, Nevada, Nebraska, New Mexico and Texas, including 74 skilled nursing facilities ("SNFs"), which offer sub-acute care, rehabilitative, specialty healthcare, and skilled nursing care, and 22 assisted living facilities ("ALFs"), which provide room and board and assistance with activities of daily living. The Company leases five skilled nursing facilities in California to an unaffiliated third party operator. In addition, through its Hallmark Rehabilitation subsidiary ("Hallmark"), the Company provides a variety of rehabilitative services such as physical, occupational and speech therapy in Company-operated facilities and unaffiliated facilities. Furthermore, as of March 31, 2013, the Company provided hospice care and home health services in Arizona, California, Idaho, Montana, Nevada and New Mexico. The Company also provides private duty care services in Idaho, Montana, and Nevada. The Company has an administrative services company that provides a full complement of administrative and consultative services that allows affiliated operators and third-party operators with whom the Company contracts to better focus on delivery of healthcare services. The Company currently has one such service agreement with an unrelated skilled nursing facility operator. The Company is also a member in a joint venture located in Texas that provides institutional pharmacy services, which currently serves eight of the Company's SNFs and other facilities unaffiliated with the Company.

2. Summary of Significant Accounting Policies

Basis of Presentation
The accompanying condensed consolidated financial statements as of March 31, 2013 and for the three months ended March 31, 2013 and 2012 (collectively, the "Interim Financial Statements"), are unaudited. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted, as permitted under applicable rules and regulations. Readers of the Interim Financial Statements should refer to the Company's audited consolidated financial statements and notes thereto, updated for Note 3, "Summary of Significant Accounting Policies", to this filing, for the year ended December 31, 2012, which are included in the Company's 2012 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC"). Management believes that the Interim Financial Statements reflect all adjustments that are of a normal and recurring nature necessary to fairly present the Company's financial position and results of operations and cash flows in all material respects as of the dates and for the periods presented. The results of operations presented in the Interim Financial Statements are not necessarily representative of operations for the entire year or any other period.
The accompanying Interim Financial Statements include the accounts of Skilled and its consolidated wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation.
Estimates and Assumptions
The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"), which require the Company to consolidate company financial information and make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant estimates in the Company’s consolidated financial statements relate to revenue, allowance for doubtful accounts, self-insured liability risks, income taxes, valuation of contingent consideration and impairment of long-lived assets and goodwill. Actual results could differ materially from those estimates. There was a $3.2 million increase in insurance expense in the three months ended March 31, 2013 due to an increase in the reserves on professional liability claims from prior years.  While there can be no certainty regarding future emergence of reserves on professional liability claims, this is not expected to become a trend.
Revenue and Accounts Receivables
Revenue and accounts receivable are recorded on an accrual basis as services are performed at their estimated net realizable value. The Company derives a majority of its revenue from funds under federal Medicare and state Medicaid assistance programs, the continuation of which are dependent upon governmental policies and are subject to audit risk and potential recoupment.

8

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Overall payments made by Medicare for hospice services are subject to an annual cap amount on a per hospice agency basis. Total Medicare payments received for services rendered during the applicable Medicare hospice cap year by each Medicare-certified agency during this period are compared to the cap amount for the relevant period. Payments in excess of the cap are subject to recoupment by Medicare. For the three months ended March 31, 2013 and 2012, the Company recorded hospice Medicare cap adjustments of $1.4 million and $0.6 million, respectively, as adjustments to revenue. Of the $1.4 million hospice cap reserves recorded in the three months ended March 31, 2013, $1.2 million was related to the 2012 cap year and $0.2 million was related to the 2011 cap year. As of March 31, 2013 there has been no accrual for hospice cap reserves for the 2013 cap year.
Information regarding the Company's significant accounting policies is contained in Note 3 - "Summary of Significant Accounting Policies" in the Company's 2012 Annual Report on Form 10-K filed with the SEC.
Notes Receivable
As of March 31, 2013 and December 31, 2012, net notes receivable were approximately $4.3 million and $5.2 million, respectively, of which $2.8 million and $3.1 million was reflected as current assets as of March 31, 2013 and December 31, 2012, with the remaining balances reflected as long-term assets. Interest rates on these notes approximated market rates as of the date the notes were originated.
As of March 31, 2013, two of the Company's rehabilitation therapy services business customers were responsible for $4.3 million, or 100%, of the net notes receivable balance. These notes receivable, as well as the trade receivables from these customers, are secured by the assets of the customers as well as a personal guaranty by the principal owners of the customers. As of March 31, 2013, these two customers represented $11.3 million, or 48.9% of the net accounts receivable for the Company's rehabilitation therapy services business and approximately $11.2 million, or 41.5%, of the external revenue of the rehabilitation therapy services business for the three months ended March 31, 2013.
As of March 31, 2013 and December 31, 2012, the Company also had a note receivable of $0.2 million which had an allowance for uncollectibility of $0.2 million and $0.1 million, respectively.
Recent Accounting Pronouncements
In November 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, ("ASU 2011-11"). This ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The adoption of ASU 2011-11 becomes effective for the Company's interim and annual periods beginning on or after January 1, 2013. The adoption of this guidance did not have a material impact on the Company's consolidated financial statements.
In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this update require an entity to provide information about the amounts reclassified from accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the income statement or in the notes, significant amounts reclassified from accumulated other comprehensive income by the net income line item. The adoption of this guidance did not have a material impact on the Company's consolidated financial statements.
3. Net Income Per Share of Class A Common Stock and Class B Common Stock
The Company computes net income per share of Class A common stock and Class B common stock using the two-class method. The Company's Class A common stock and Class B common stock are identical in all respects, except with respect to voting rights and except that each share of Class B common stock is convertible into one share of Class A common stock under certain circumstances. Net income is allocated on a proportionate basis to each class of common stock in the determination of income per share.
Basic net income per share was computed by dividing net income by the weighted-average number of outstanding shares for the period. Dilutive earnings per share is computed by dividing net income plus the effect of assumed conversions (if applicable) by the weighted-average number of outstanding shares after giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase and convertible preferred stock, if any. The following table sets forth the computation of basic and diluted net income per share of Class A common stock and Class B common stock for the three months ended March 31, 2013 and 2012 (amounts in thousands, except per share data):
 
Three months ended March 31, 2013
 
Three months ended March 31, 2012
 
Class A
 
Class B
 
Total
 
Class A
 
Class B
 
Total
Net Income per share, basic
 
 
 
 
 
 
 
 
 
 
 
Numerator:
 
 
 
 
 
 
 
 
 
 
 
Allocation of net income
$
1,797

 
$
1,273

 
$
3,070

 
$
3,458

 
$
2,879

 
$
6,337

Net Income per share, diluted
 
 
 
 
 
 
 
 
 
 
 
Numerator:
 
 
 
 
 
 
 
 
 
 
 
Allocation of net income
$
1,813

 
$
1,257

 
$
3,070

 
$
3,468

 
$
2,869

 
$
6,337

Denominator for basic and diluted net income per share:
 
 
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding, basic
21,981

 
15,576

 
37,557

 
20,348

 
16,937

 
37,285

Plus: incremental shares related to dilutive effect of stock options and restricted stock, if applicable
477

 

 
477

 
122

 

 
122

Adjusted weighted-average common shares outstanding, diluted
22,458

 
15,576

 
38,034

 
20,470

 
16,937

 
37,407

 
 
 
 
 
 
 
 
 
 
 
 
Net income per share, basic
$
0.08

 
$
0.08

 
$
0.08

 
$
0.17

 
$
0.17

 
$
0.17

 
 
 
 
 
 
 
 
 
 
 
 
Net income per share, diluted
$
0.08

 
$
0.08

 
$
0.08

 
$
0.17

 
$
0.17

 
$
0.17

The following were excluded from the weighted-average diluted shares computation for the three months ended March 31, 2013 and 2012, as their inclusion would have been anti-dilutive (shares in thousands):
 
 
Three Months Ended March 31,
 
2013
 
2012
Options to purchase common shares
584

 
464

Non-vested common shares
4

 
850

Total excluded
588

 
1,314

 

4. Business Segments
The Company has three reportable operating segments: (i) long-term care services ("LTC"), which includes the operation of SNFs and ALFs which is the most significant portion of the Company's business, the Company's administrative services provided to an unrelated SNF operator, and the facility lease revenue from a third-party operator; (ii) the Company's rehabilitation therapy services business; and (iii) the Company's hospice and home health businesses. The "other" column in the table below includes general and administrative items. The Company's reporting segments are business units that offer different services, and that are managed differently due to the nature of the services provided.
At March 31, 2013, LTC services included 74 wholly-owned SNF operating companies that offer post-acute, rehabilitative custodial and specialty skilled nursing care, as well as 22 wholly-owned ALF operating companies that provide room and board and social services. Therapy services included rehabilitative services such as physical, occupational and speech therapy provided in the Company's facilities and in unaffiliated facilities. Hospice and home health services were provided by the Company's wholly-owned subsidiaries to patients.
The Company evaluates performance and allocates capital resources to each segment based on an operating model that is designed to maximize the quality of care provided and profitability. Accordingly, earnings from operations before net interest, tax, depreciation and amortization, non-core expenses ("Adjusted EBITDA") and rent cost of revenue ("Adjusted EBITDAR") is used as the primary measure of each segment’s operating results because it does not include such costs as interest expense, income taxes, depreciation, amortization and rent cost of revenue which may vary from segment to segment depending upon various factors, including the method used to finance the original purchase of assets within a segment or the tax law of the states in which a segment operates. By excluding these items, the Company is better able to evaluate operating performance of the segment by focusing on more controllable measures. Adjusted EBITDA and Adjusted EBITDAR are non‑GAAP financial measures. For a full discussion of the definitions of these terms and the reasons why the Company utilizes such measures, see Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, of this filing. General and administrative expenses are not allocated to any segment for purposes of determining segment profit or loss, and are included

9

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

in the "other" category in the selected segment financial data that follows. Intersegment sales and transfers are recorded at cost plus standard mark-up; intersegment transactions have been eliminated in consolidation.
The following table sets forth selected financial data consolidated by business segment (dollars in thousands): 
 
Long-Term
Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Other
 
Elimination
 
Total
Three months ended March 31, 2013
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
164,946

 
$
27,074

 
$
26,094

 
$

 
$

 
$
218,114

Leased facility revenue
761

 

 

 

 

 
761

Intersegment revenue
508

 
15,205

 

 

 
(15,713
)
 

Total revenue
$
166,215

 
$
42,279

 
$
26,094

 
$

 
$
(15,713
)
 
$
218,875

Operating income (loss)
$
12,250

 
$
2,954

 
$
2,703

 
$
(6,655
)
 
$

 
$
11,252

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(8,563
)
Other expense
 
 
 
 
 
 
 
 
 
 
(30
)
Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
489

Income before provision for income taxes
 
 
 
 
 
 
 
 
 
 
$
3,148

Depreciation and amortization
$
5,611

 
$
177

 
$
239

 
$
192

 
$

 
$
6,219

Segment capital expenditures
$
2,197

 
$
23

 
$
130

 
$
51

 
$

 
$
2,401

Adjusted EBITDA
$
17,831

 
$
3,131

 
$
2,993

 
$
(6,025
)
 
$

 
$
17,930

Adjusted EBITDAR
$
22,183

 
$
3,131

 
$
3,445

 
$
(6,017
)
 
$

 
$
22,742

Three months ended March 31, 2012
 
 
 
 
 
 
 
 
 
 
 
Net patient service revenue from external customers
$
166,338

 
$
26,115

 
$
26,206

 
$

 
$

 
$
218,659

Leased facility revenue
754

 

 

 

 

 
754

Intersegment revenue
754

 
15,982

 

 

 
(16,736
)
 

Total revenue
$
167,846

 
$
42,097

 
$
26,206

 
$

 
$
(16,736
)
 
$
219,413

Operating (loss) income
$
18,138

 
$
2,948

 
$
4,531

 
$
(6,266
)
 
$

 
$
19,351

Interest expense, net of interest income
 
 
 
 
 
 
 
 
 
 
(9,420
)
Other expense
 
 
 
 
 
 
 
 
 
 
(29
)
Equity in earnings of joint venture
 
 
 
 
 
 
 
 
 
 
471

Income before provision for income taxes
 
 
 
 
 
 
 
 
 
 
$
10,373

Depreciation and amortization
$
5,671

 
$
168

 
$
277

 
$
159

 
$

 
$
6,275

Segment capital expenditures
$
2,405

 
$
277

 
$
203

 
$
590

 
$

 
$
3,475

Adjusted EBITDA
$
23,780

 
$
3,116

 
$
4,868

 
$
(5,696
)
 
$

 
$
26,068

Adjusted EBITDAR
$
28,014

 
$
3,116

 
$
5,182

 
$
(5,688
)
 
$

 
$
30,624

    

10

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

A reconciliation of Adjusted EBITDA and Adjusted EBITDAR to net income is as follows (dollars in thousands):
 
Three Months Ended March 31,
 
2013
 
2012
Adjusted EBITDAR
$
22,742

 
$
30,624

Rent cost of revenue
(4,812
)
 
(4,556
)
Adjusted EBITDA
17,930

 
26,068

Depreciation and amortization
(6,219
)
 
(6,275
)
Interest expense
(8,675
)
 
(9,565
)
Interest income
112

 
145

Provision for income taxes
(78
)
 
(4,036
)
Net income
$
3,070

 
$
6,337

The following table presents the segment assets as of March 31, 2013 compared to December 31, 2012 (dollars in thousands): 
 
Long-Term
Care  Services
 
Therapy Services
 
Hospice & Home Health Services
 
Other
 
Total
March 31, 2013:
 
 
 
 
 
 
 
 
 
Segment total assets
$
468,457

 
$
54,224

 
$
102,461

 
$
59,374

 
$
684,516

Goodwill and intangibles included in total assets
$
1,601

 
$
23,693

 
$
82,268

 
$

 
$
107,562

December 31, 2012:
 
 
 
 
 
 
 
 
 
Segment total assets
$
471,129

 
$
52,559

 
$
103,800

 
$
55,148

 
$
682,636

Goodwill and intangibles included in total assets
$
1,670

 
$
23,693

 
$
82,281

 
$

 
$
107,644


5. Property and Equipment
Property and equipment consisted of the following as of March 31, 2013 and December 31, 2012 (in thousands):

 
March 31, 2013
 
December 31, 2012
Land and land improvements
$
64,983

 
$
64,983

Buildings and leasehold improvements
333,314

 
331,316

Furniture and equipment
85,169

 
83,949

Construction in progress
7,821

 
8,638

 
491,287

 
488,886

Less accumulated depreciation
(124,068
)
 
(118,141
)
 
$
367,219

 
$
370,745


Leased facility assets consisted of the following as of March 31, 2013 and December 31, 2012 (in thousands):
 
March 31, 2013
 
December 31, 2012
Leased facility assets
13,848

 
13,848

Less accumulated depreciation
(4,062
)
 
(3,935
)
 
9,786

 
9,913


The Company began leasing five skilled nursing facilities in California to an unaffiliated third party operator in April 2011 and signed a 10-year lease with two 10-year extension options exercisable by the lessee.

6. Income Taxes


11

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

For the three months ended March 31, 2013, the Company recorded an income tax expense of $0.1 million representing an effective tax rate of 2.48%. The effective tax rate was less than the statutory rate primarily due to a $1.2 million benefit from the resolution and ultimate disposition of remaining funds related to the 2010 settlement of the Humboldt County Action, see Note 7, "Commitments and Contingencies - Legal Matters," for additional detail, and $0.4 million benefit related to increased Work Opportunity Tax Credits as a result of retroactive reinstatement of that program with the enactment of the American Taxpayer Relief Act of 2012, partially offset by additional tax expense in the amount of $0.3 million related to stock based compensation.

7. Commitments and Contingencies
Legal Matters
Humboldt County Litigation
In connection with the September 2010 settlement of the class action litigation against Skilled and certain of its subsidiaries related to, among other matters, alleged understaffing at certain California skilled nursing facilities operated by Skilled's subsidiaries (the "Humboldt County Action"), Skilled and its defendant subsidiaries (collectively, the "Defendants”) entered into settlement agreements with the plaintiffs and intervenor and agreed to an injunction. The settlement was approved by the Superior Court of California, Humboldt County on November 30, 2010. Under the terms of the settlement agreements, the defendant entities deposited a total of $50.0 million into escrow accounts to cover settlement payments to class members, notice and claims administration costs, reasonable attorneys' fees and costs and certain other payments, including $5.0 million to settle certain government agency claims and potential government claims that may arise. Of the $5.0 million provided for such government claims, $1.0 million was initially released by the court to the Humboldt County Treasurer-Tax Collector on behalf of the People of the State of California for their release of the Defendants. The remaining $4.0 million was available for the settlement and releases by the California Attorney General and certain other District Attorneys. However, in the event that any of these government authorities were to instead file certain actions against the Defendants by the second anniversary of the effective date of the settlement agreement, which occurred in February 2013, the entire $4.0 million would have reverted to the Defendants upon their request to the Settlement Administrator. No such actions were filed, however, resulting in an additional $1.0 million distribution to the Humboldt County District Attorney's Office and the remaining $3.0 million will be distributed to the class settlement fund, as required by the settlement agreement.
In addition to the payments to the Humboldt County Treasurer-Tax Collector on behalf of the People of the State of California, the court also approved payments from the escrow of up to approximately $24.8 million for attorneys' fees and costs and $10,000 to each of the three named plaintiffs.  Pursuant to the injunction, the twenty-two Defendants that operated California nursing facilities were required to provide specified nurse staffing levels, comply with specified state and federal laws governing staffing levels and posting requirements, and provide reports and information to a court-appointed auditor. The injunction was to remain in effect for a period of twenty-four months unless extended for additional three-month periods as to those Defendants that may be found in violation. Defendants demonstrating compliance for an eighteen-month period that ended September 30, 2012 were permitted to petition for early termination of the injunction. The Defendants were required to demonstrate over the term of the injunction that the costs of the injunction met a minimum threshold level pursuant to the settlement agreement, which level, initially $9.6 million, was reduced by the portion attributable to any Defendant in the case that no longer operated a skilled nursing facility during the injunction period.
In April 2011, five of the subsidiary Defendants transferred their operations to an unaffiliated third party skilled nursing facility operator (the “Former Humboldt County Facilities”). On November 14, 2012, the Defendants filed a motion to terminate the injunction and vacate the final judgment in the Humboldt County Action. Based upon compliance with the injunction through the requisite eighteen-month period, on December 21, 2012, the Superior Court of California, Humboldt County granted the Defendants' motion for early termination of the injunction, and the injunction has now ended with respect to the 17 California nursing facilities that the subsidiary Defendants still operate. In its order, the court determined that the injunction termination did not apply to the Former Humboldt County Facilities. However, the 2010 court-approved stipulation and order establishing the injunction provides that the injunction applies to the named defendants and any successor licensees of the applicable nursing facilities, but only if those successor licensees are affiliates of the named defendants. As noted above, the Former Humboldt County Facilities have been operated by an unaffiliated third party since April 2011. Therefore, under the terms of the injunction it does not apply to the Former Humboldt County Facilities unless an affiliate of the Defendants operates them. Pursuant to the BMFEA matter discussed below the California theories in this context were released in February 2013.
In the course of ongoing communications with the California Attorney General's Bureau of Medi-Cal Fraud & Elder Abuse ("BMFEA") related to the BMFEA matter discussed below, representatives of the California Attorney General and the U.S. Department of Justice indicated an interest in pursuing an action under the False Claims Act ("FCA") and certain other legal theories based upon the jury findings of understaffing in the Humboldt County Action. While the Company continues to

12

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

cooperate with the government's evaluation of the matter, the Company views the government's apparent legal theories, including the False Claims Act theories, as lacking support in the established case law and intends to vigorously defend any such action if brought.
BMFEA Matter
On April 15, 2009, two of Skilled's wholly-owned companies, Eureka Healthcare and Rehabilitation Center, LLC (“EHRC”), which at the time operated Eureka Healthcare and Rehabilitation Center (the "Facility"), and Skilled Healthcare, LLC (“SHC”), the administrative services provider for the Facility, were served with a search warrant that related to an investigation of the Facility by the BMFEA. The search warrant related to, among other things, records, property and information regarding certain enumerated patients of the Facility and covered the period from January 1, 2007 through the date of the search. On October 31, 2012, the BMFEA filed a criminal complaint (the “BMFEA Action”) in California Superior Court, Humboldt County against EHRC, SHC and Skilled alleging elder endangerment in nine misdemeanor counts under Penal Code Section 368(c) and two felony counts under Penal Code Section 368(b)(1) related to the care of certain patients at the Facility in 2008. No individuals were named as defendants in the complaint. The Company disputed the BMFEA's theories of alleged criminal liability and vigorously defended the action. The charges filed by the BMFEA, if proven, would have carried fines of up to $6,000 for each of the two felony counts and $2,000 for each of the nine misdemeanor counts. Convictions could also lead to exclusion from participation in federal healthcare programs under federal laws such as the Federal False Claims Act and the Civil Monetary Penalty Law, which could be materially adverse to Skilled's business. EHRC transferred its operations in April 2011 to an unaffiliated third party skilled nursing facility operator, and has not had any ongoing operations since that time.
On February 15, 2013, the parties reached a mutually satisfactory settlement of the BMFEA Action. Pursuant to the settlement: (i) Skilled and SHC were dismissed from the case with prejudice; (ii) EHRC pled no contest to a single misdemeanor count of elder endangerment under Penal Code Section 368(c) and agreed to pay a statutory fine of $680, pay $145,000 to the California Attorney General for its costs of investigation, and to serve two (2) years of summary probation; and (iii) the California Attorney General granted Skilled, SHC, and twenty-five (25) of their affiliates who currently or formerly operated skilled nursing facilities in California, a release of any potential liability to the California Attorney General under certain civil statutes based upon conduct occurring through the effective date of the settlement (including the FCA theories discussed under Humboldt County Litigation above). The court accepted EHRC's misdemeanor plea and the other relevant terms of the settlement on February 15, 2013. Notwithstanding EHRC's no contest plea to the single misdemeanor charge, the Company, SHC and EHRC continue to deny any liability for the allegations in the BMFEA Action.

Pursuant to the settlement, Skilled, SHC and their twenty (20) affiliated current California skilled nursing facility operators also agreed to a 2-year staffing agreement (the “2013 Staffing Agreement”) with the California Attorney General that essentially continues the requirements of the staffing-related injunction that was in effect until December 2012 as a result of the September 2010 settlement of the Humboldt County Action. Similar to the former staffing-related injunction, the 2013 Staffing Agreement requires the applicable nursing facility operators to provide a minimum of 3.2 nursing hours per patient day as required by applicable California law and to adhere to related legal requirements, as well as to submit to periodic compliance audits of the same. Unlike the former staffing-related injunction, however, the 2013 Staffing Agreement does not provide for early termination based on demonstrated compliance and does not contain a minimum spend requirement. The Company does not believe that the 2013 Staffing Agreement will require it or its affected affiliates to incur any material staffing or other costs beyond what they would otherwise incur in the ordinary course of business.
Insurance
The Company maintains insurance for workers' compensation, general and professional liability, employee benefits liability, property, casualty, directors’ and officers’ liability, inland marine, crime, boiler and machinery, automobile, employment practices liability and earthquake and flood. The Company believes that its insurance programs are adequate and appropriate, and where there has been a direct transfer of risk to the insurance carrier, the Company does not recognize a liability in the consolidated financial statements.
Workers' Compensation. The Company has maintained workers' compensation insurance as statutorily required. Most of its commercial workers' compensation insurance purchased is loss sensitive in nature, except as noted below. As a result, the Company is responsible for adverse loss development. Additionally, the Company self-insures the first unaggregated $1.0 million per workers' compensation claim for all California, New Mexico and Nevada skilled nursing and assisted living businesses. The Company has elected not to carry workers' compensation insurance in Texas and it may be liable for negligence claims that are asserted against it by its Texas-based employees. For the policy periods up to December 31, 2011, the Company has purchased guaranteed cost policies for its Kansas, Missouri, Iowa and Nebraska skilled nursing and assisted living businesses, as well as all of its hospice and home health businesses. There are no deductibles associated with these

13

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

programs. Since January 1, 2013, the Company self-insures the first $0.5 million for these businesses. The Company recognizes a liability in its interim consolidated financial statements for its estimated self-insured workers' compensation risks. Historically, estimated liabilities have been sufficient to cover actual claims.
General and Professional Liability. The Company's services subject it to certain liability risks. Malpractice and similar claims may be asserted against the Company if its services are alleged to have resulted in patient injury or other adverse effects. The Company is subject to malpractice and similar claims and other litigation in the ordinary course of business.
Effective September 1, 2008, the Company's California-based skilled nursing facility companies purchased individual general and professional liability insurance policies for claims reported through August 31, 2011, with a per occurrence and annual aggregate coverage limit of $1.0 million and $3.0 million, respectively, and an unaggregated $0.1 million per claim self-insured retention. Effective September 1, 2008, the Company also had an excess liability policy for claims reported through August 31, 2011, with a $14.0 million per loss limit and an $18.0 million annual aggregate limit for losses arising from claims in excess of $1.1 million for the California skilled nursing facilities and in excess of $1.0 million for all other businesses.
Effective September 1, 2011, the Company purchased excess liability policies with $25.0 million per loss and annual aggregate limits for claims in excess of $1.0 million per loss for all businesses. Effective September 1, 2011, the Company also self-insures professional liability claims at its California based SNF subsidiaries through its wholly-owned offshore captive insurance company, Fountain View Reinsurance, Ltd., for claims up to $1.0 million. Effective September 1, 2012, the Company self-insures professional liability claims for all of its SNF and ALF subsidiaries through its wholly-owned off shore captive company for claims up to $1.0 million.
The Company retains an unaggregated self-insured retention of $1.0 million per claim for all of its businesses other than its hospice and home health businesses, which are insured under a separate general and professional liability insurance policy with a $1.0 million per loss limit. The excess liability policy referenced above is also applicable to this policy.
Employee Medical Insurance. Medical preferred provider option programs are offered as a component of the Company's employee benefits. The Company retains a self-insured amount up to a contractual stop loss amount of $0.25 million deductible for most participants on its preferred provider organization plan. All other employee medical plans are guaranteed cost plans.
A summary of the liabilities related to insurance risks are as follows (dollars in thousands):
 
As of March 31, 2013:
 
As of December 31, 2012
 
General and
Professional
 
Employee
Medical
 
Workers’
Compensation
 
Total
 
General and
Professional
 
Employee
Medical
 
Workers’
Compensation
 
Total
Current
$
6,828

(1) 
$
2,318

(2) 
$
5,299

(2) 
$
14,445

 
$
5,622

(1) 
$
2,143

(2) 
$
5,328

(2) 
$
13,093

Non-current
13,302

  

 
11,692

  
24,994

 
15,587

  

  
11,809

  
27,396

 
$
20,130

  
$
2,318

  
$
16,991

  
$
39,439

 
$
21,209

  
$
2,143

  
$
17,137

  
$
40,489


(1)
Included in accounts payable and accrued liabilities.
(2)
Included in employee compensation and benefits.
Hallmark Indemnification
Hallmark, the Company's rehabilitation services subsidiary, provides physical, occupational and speech therapy services to various unaffiliated skilled nursing facilities. These unaffiliated skilled nursing facilities are reimbursed for these services from the Medicare Program and other third-party payors. Hallmark has indemnified these unaffiliated skilled nursing facilities from a portion of certain disallowances of these services. Additionally, to the extent a Recovery Audit Contractor ("RAC") or other regulatory authority or contractor is successful in making a claim for recoupment of revenue from any of these skilled nursing facilities, Hallmark will typically be required to indemnify them against their charges associated with this loss. No material indemnification payments were required to be made in three months ended March 31, 2013 or 2012.
Financial Guarantees
Substantially of all Skilled's wholly-owned subsidiaries guarantee the Company's first lien senior secured credit facility. These guarantees are full and unconditional and joint and several. Other subsidiaries of Skilled that are not guarantors are considered minor. On May 12, 2012, the Company redeemed the entire $130.0 million of its then outstanding 11.0% senior subordinated notes due 2014 (the "2014 Notes"). The 2014 Notes were guaranteed by substantially all of Skilled's wholly-owned subsidiaries on terms similar to their guarantees of the Company's first lien senior secured credit facility.

14

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


8. Stockholders' Equity
Accumulated Other Comprehensive Income
Accumulated other comprehensive income refers to gains and losses that are recorded as an element of stockholders' equity but are excluded from net income. The Company's other comprehensive income consists of net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and gains and losses from investments available for sale. Details of other comprehensive income are included in the Company's Statement of Comprehensive Income.
 
2007 Incentive Award Plan
There were no new stock options granted in the three months ended March 31, 2013. There were 106,748 new stock options granted in the three months ended March 31, 2012.
The fair value of the stock option grants for the three months ended March 31, 2012 was estimated on the dates of the grants using the Black-Scholes option pricing model with the following assumptions:
 
 
Three Months Ended March 31,
 
2013
 
2012
Risk-free interest rate
n/a
 
1.75
%
Expected Life
n/a
 
6.25 years

Dividend yield
n/a
 
%
Volatility
n/a
 
70.81
%
Weighted-average fair value
n/a
 
$
5.44

There were no options exercised during the three months ended March 31, 2013 or 2012. As of March 31, 2013, there was $0.8 million of unrecognized compensation cost related to outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted-average period of 1.6 years. To the extent the forfeiture rate is different than the Company has anticipated, stock-based compensation related to these awards will be different from the Company's expectations.
The following table summarizes stock option activity during the three months ended March 31, 2013 under the Skilled Healthcare Group, Inc. Amended and Restated 2007 Incentive Award Plan:
 
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term
(in years)
 
Aggregate
Intrinsic
Value
(in thousands)
Outstanding at January 1, 2013
1,122,195

 
$
8.83

 
 
 
 
Granted

 
$

 
 
 
 
Exercised

 
$

 
 
 
 
Forfeited or cancelled

 
$

 
 
 
 
Outstanding at March 31, 2013
1,122,195

 
$
8.83

 
6.49
 
$
293

Fully vested and expected to vest at March 31, 2013
1,106,696

 
$
8.86

 
6.47
 
$
290

Exercisable at March 31, 2013
857,259

 
$
9.37

 
6.13
 
$
220

Aggregate intrinsic value represents the value of Skilled's closing stock price on the New York Stock Exchange on the last trading day of the fiscal period in excess of the exercise price, multiplied by the number of options outstanding or exercisable.
 
Compensation related to stock option grants and stock awards included in general and administrative expenses was $0.8 million for the three months ended March 31, 2013 and 2012. The amount of compensation included in cost of services was $0.5 million and $0.4 million for the three months ended March 31, 2013 and 2012.

9. Fair Value Measurements

15

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions. The following table summarizes the valuation of the Company’s interest rate hedge transaction and contingent consideration as of March 31, 2013 (dollars in thousands):
 
March 31, 2013
 
December 31, 2012
 
Level 1
 
Level 2
 
Level 3
 
Level 1
 
Level 2
 
Level 3
Interest rate hedges
$

 
$
(143
)
 
$

 
$

 
$
(277
)
 
$

Available for sale securities
$

 
$
1,067

 
$

 
$

 
$
1,070

 
$

Contingent consideration – acquisitions
$

 
$

 
$
6,021

 
$

 
$

 
$
6,238

In June 2010, the Company entered into an interest rate cap agreement (which expired December 31, 2011) and an interest rate swap agreement in order to manage fluctuations in cash flows resulting from interest rate risk. The interest rate swap agreement is for a notional amount of $70.0 million with a LIBOR rate not to exceed 2.3% from January 2012 to June 2013. The Company continues to assess its exposure to interest rate risk on an ongoing basis.
The interest rate swap is required to be measured at fair value on a recurring basis. The fair value of the interest rate swap contract is determined by calculating the value of the discounted cash flows of the difference between the fixed interest rate of the interest rate swap and the counterparty’s forward LIBOR curve, which is the input used in the valuation. The forward LIBOR curve is readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized the interest rate swap as Level 2. The Company obtained the counterparty’s calculation of the valuation of the interest rate swap as well as a forward LIBOR curve from another investment bank and independently recalculated the valuation of the interest rate swap, which agreed with the counterparty’s calculation.
The Company's wholly-owned offshore captive insurance company is required by regulatory agencies to set aside assets to comply with the laws of the jurisdiction in which it operates. These assets consist of restricted cash and available for sale securities, which are included in other assets in the Company's consolidated March 31, 2013 balance sheet. The Company's available for sale securities are U.S. government securities with an amortized cost basis and aggregate fair value of $1.0 million and $1.1 million, respectively, as of March 31, 2013. Net unrealized loss included in other comprehensive income on the Company's available for sale securities was negligible for the three months ended March 31, 2013.
On May 1, 2010, the Company acquired substantially all of the assets of five Medicare-certified hospice companies and four Medicare-certified home health companies located in Arizona, Idaho, Montana and Nevada (which is sometimes referred to herein as the "Hospice/Home Health Acquisition"). As part of the purchase agreement, the purchase consideration included cash, promissory notes, contingent consideration, and deferred cash payments. The contingent consideration arrangement requires the Company to pay contingent payments should the acquired operations achieve certain financial targets based on EBITDA of the acquired businesses, as defined in the acquisition agreement, which was filed as Exhibit 2.1 to the Company’s Report on Form 10-Q filed with the SEC on May 4, 2010. The contingent consideration is up to $7.0 million over a period of 5 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The contingent consideration was recorded at the date of acquisition in the amount of $4.9 million. As of March 31, 2013, the contingent consideration had a fair value of $3.9 million. The change represents amounts accreted less a $2.8 million payment to the seller. This is included in the Company’s accounts payable and accrued liabilities and other long-term liabilities on the balance sheet. The change in fair value related to the contingent consideration is included in the Company's depreciation and amortization on the statements of operations. There has been no change in the valuation technique of the contingent consideration from December 31, 2012 to March 31, 2013.
On July 1, 2011, a wholly-owned subsidiary of the Company acquired Altura Homecare & Rehab ("Altura"). The acquisition includes contingent earn-out consideration which can be earned based on the acquired business's achievement of an EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 3 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value of the earn-out at the acquisition date and at March 31, 2013 was $0.9 million which reflects payments of $0.5 million to the seller.
On October 24, 2011, wholly-owned subsidiaries of the Company acquired substantially all of the assets of Cornerstone Hospice, Inc. ("Cornerstone"). The acquisition includes contingent earn-out consideration which can be earned based on the

16

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

acquired business's achievement of an EBITDA threshold. The contingent consideration is up to $1.5 million over a period of 5 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value of the earn-out at the acquisition date and at March 31, 2013 was $1.1 million which reflects a $0.3 million payment to the seller.
On May 13, 2012, a wholly-owned subsidiary of the Company acquired substantially all of the assets of A Better Care Home Health, Inc. ("ABC"). The acquisition includes contingent earn-out consideration which can be earned based on the acquired operations' achievement of an EBITDA threshold. The contingent consideration spans 3 years following the closing. The fair value of the contingent consideration was estimated using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value of the earn-out at the acquisition date and at March 31, 2013 was $0.1 million.
As discussed above, EBITDA is the basis for calculating the contingent consideration. The unobservable inputs to the determination of the fair value of the contingent consideration include assumptions as to the ability of the acquired businesses to meet their EBITDA targets and discount rates used in the calculation. Should the actual EBITDA generated by the acquired businesses increase or decrease as compared to our assumptions, the fair value of the contingent consideration obligations would increase or decrease, up to the contracted limit, as applicable. As the timing of contingent payments go further into the future, discount rate assumptions increase due to the increased uncertainty of the EBITDA that may be generated in those periods.
The Company's assumptions range from the acquired businesses achieving none, a portion, or all of the consideration, and discount rates range from 4%- 7%.
Below is a table listing the Level 3 rollforward as of March 31, 2013 (in thousands):
Level 3 Rollforward
 
Value at January 1, 2013
$
6,238

Change in fair value
83

Payout
(300
)
Value at March 31, 2013
$
6,021

Long Term Debt
At March 31, 2013 and December 31, 2012, the fair value of the Company's term loan, due in 2016 and the revolving credit facility, due in 2015, using the Level 2 inputs, was approximately $460.6 million and $456.1 million, respectively. The carrying value of the debt at March 31, 2013 and December 31, 2012 was $451.7 million and $449.0 million, respectively. Fair value was estimated based on current yield rates plus the Company's estimated credit spread available for loan products with similar terms and maturities.

10. Debt
The Company’s long-term debt is summarized as follows (dollars in thousands):

17

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

 
 
As of March 31, 2013
 
As of December 31, 2012
Revolving Credit Facility due 2015, interest rate comprised of LIBOR plus 4.50% or 4.74% at March 31, 2013
$
33,000

 
$
25,000

Revolving Credit Facility due 2015, interest rate comprised of the Prime rate of 3.25% plus 3.50%, or 6.75% at March 31, 2013
7,000

 
10,000

Term Loan, due 2016, interest rate based on LIBOR (subject to a 1.50% floor) plus 5.25%, or 6.75% at March 31, 2013; collateralized by substantially all assets of the Company
408,979

 
411,600

Term Loan original issue discount
(2,775
)
 
(3,013
)
Note payable due December 2018, interest rate fixed at 6.50%, payable in monthly installments, collateralized by a first priority deed of trust
1,079

 
1,118

Hospice/Home Health Acquisition note, interest rate fixed at 6.00%, due November 1, 2014
1,486

 
1,483

Insurance premiums financed
2,237

 
2,119

Other
660

 
660

Total long-term debt
451,666

 
448,967

Less amounts due within one year
(13,460
)
 
(13,338
)
Long-term debt, net of current portion
$
438,206

 
$
435,629


Term Loan and Revolving Loan
On April 9, 2010, the Company entered into an up to $360.0 million senior secured term loan and a $100.0 million revolving credit facility (the "Prior Credit Agreement") that amended and restated the senior secured term loan and revolving credit facility that were set to mature in June 2012. On April 12, 2012, the Company entered into an Amendment and Restatement and Additional Term Loan Assumption Agreement (“Restated Credit Agreement”) that amended and restated the Prior Credit Agreement and pursuant to which, among other things, the size of the Company's existing senior secured term loan was increased by $100.0 million (hereinafter referred to as the incremental senior secured term loan). The credit arrangements provided under the Restated Credit Agreement are collectively referred to herein as the Company's senior secured credit facility.
The incremental senior secured term loan bears interest, at our option, at the London Interbank Offered Rate ("LIBOR") (subject to a floor of 1.50%) plus a margin of 5.25% or the prime rate (subject to a floor of 2.50%) plus a margin of 4.25%. As part of the refinancing, the interest rate on the existing senior secured term loan was amended to match the interest rate of the incremental senior secured term loan. The interest rate on the existing revolving credit facility was also amended to be, at the Company's option, LIBOR plus a margin of between 4.25% and 4.50% (based upon consolidated senior leverage) or the prime rate plus a margin of between 3.25% and 3.50% (based upon consolidated senior leverage). There is no longer a LIBOR or prime rate floor with respect to the revolving credit facility. Pursuant to the Restated Credit Agreement, the quarterly term loan amortization payments increased to $2.6 million beginning June 30, 2012 compared to $0.9 million under the Prior Credit Agreement. Additionally, the maximum portion of the annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement) to be applied to term debt reductions increased to 75% from 50%, subject to stepdowns to 50% and 25% based on consolidated leverage. The Company also increased its ability to refinance a portion of its credit facility with U.S. Department of Housing and Urban Development ("HUD") insured debt up to $250 million, subject to certain credit facility covenants. The Company has received the formal portfolio conditional credit approval from HUD for up to an aggregate of $460 million in HUD insured loans secured by up to 78 facilities under HUD's Section 232 loan program, which provides loans for nursing homes, assisted living and related facilities. Any HUD insured borrowings beyond $250 million would necessitate either refinancing the senior secured credit facility in full or otherwise seeking a waiver or amendment from the senior secured lenders. The Company has not yet determined the amount of borrowings it will ultimately seek under the HUD insured loan program, and all loan applications will be subject to further review and approval by HUD. Furthermore, there can be no assurance that the Company will ultimately be approved for and close any HUD insured loans, what the timing of any approvals or closings would be, or what the interest rates on any HUD insured loans would be. The HUD approval process is subject to a number of contingencies, many of which are out of the Company's control. The Restated Credit Agreement requires that all of the net proceeds from any HUD insured loans be used to pay down the term portion of the Company's senior secured credit facility.
The Company expensed fees paid in connection with the refinancing of the Prior Credit Agreement in the amount of $2.0 million in conjunction with the amended senior secured credit facility. Substantially all of the Company's assets are pledged as collateral under the senior secured credit facility. Amounts borrowed under the senior secured term loan may be prepaid at any

18

SKILLED HEALTHCARE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

time without penalty, except for LIBOR breakage costs. Commitments under the revolving credit facility terminate on April 9, 2015. The senior secured term loan matures on April 9, 2016.
The Company has the right to increase its borrowings under the revolving credit facility up to an aggregate amount of $150 million provided that the Company is in compliance with the Restated Credit Agreement, that the additional debt would not cause any covenant violation of the Restated Credit Agreement, and that existing or new lenders within the Restated Credit Agreement agree to increase their commitments. To reduce the risk related to interest rate fluctuations, the Prior Credit Agreement required the Company to enter into, and the Restated Credit Agreement requires us to continue to maintain, an interest rate swap, cap or similar agreement to effectively fix or cap the interest rate on 40% of its funded long-term debt within three months of the April 2010 commencement of the senior secured credit facility. The Company entered into two interest rate hedge transactions, as described in Note 9 - "Fair Value Measurements," in order to comply with this requirement.
Under the senior secured credit facility, the Company must maintain compliance with specified financial covenants measured on a quarterly basis. The senior secured credit facility also includes certain additional affirmative and negative covenants, including limitations on the incurrence of additional indebtedness, liens, investments in other businesses and capital expenditures. Also under the senior secured credit facility, subject to certain exceptions and minimum thresholds, the Company is required to apply all of the proceeds from any issuance of debt, as much as half of the proceeds from any issuance of equity, as much as 75% of the Company's annual Consolidated Excess Cash Flow (as defined in the Restated Credit Agreement), and amounts received in connection with any sale of the Company's assets to repay the outstanding amounts under the Restated Credit Agreement. The Company believes that it is in compliance with its debt covenants as of March 31, 2013. As of March 31, 2013, the fixed charge coverage ratio was 2.5, which compares to a minimum requirement of 1.75 and the leverage ratio was 4.5, as compared to an allowed maximum of 4.75.
Senior Subordinated Notes
On May 12, 2012, the Company redeemed the entire $130.0 million outstanding principal amount plus all accrued but unpaid interest, of the 2014 Notes. The proceeds from the incremental senior secured term loan (as well as a draw on the revolving portion of the senior secured credit facility) were used to fund the redemption of the outstanding 2014 Notes at par plus accrued interest. In addition, the Company expensed unamortized deferred financing fees and original issue discount ("OID") in the amount of $1.9 million in conjunction with the redemption of the 2014 Notes.
The 2014 Notes were issued in December 2005 in the aggregate principal amount of $200.0 million, with an interest rate of 11.0% and a discount of $1.3 million. Interest was payable semiannually in January and July of each year. The 2014 Notes were to mature on January 15, 2014. The 2014 Notes were unsecured senior subordinated obligations and ranked junior to all of the Company's existing and future senior indebtedness, including indebtedness under the senior secured credit facility. The 2014 Notes were guaranteed on a senior subordinated basis by certain of the Company's subsidiaries.
Other Debt
The Company issued $10.0 million of promissory notes as part of the purchase consideration for the Hospice/Home Health Acquisition. The notes bear interest at 6.0% with $2.0 million of principal due annually beginning November 1, 2010. During 2012, the notes were substantially paid down leaving a remaining balance of $1.5 million at December 31, 2012. The promissory notes are payable to the selling entities, of which the President and Chief Operating Officer, and the Senior Vice President, of Signature Hospice & Home Health, LLC are significant shareholders. Signature Hospice & Home Health, LLC is a consolidated subsidiary of Skilled holding 100% interests in the operating companies for the Hospice/Home Health Acquisition. The promissory notes were retired in April 2013.


19


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition as of the dates and for the periods presented. Historical results may not indicate future performance. Our forward-looking statements, which reflect our current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2012 and our subsequent reports on Form 10-Q and Form 8-K filed with the Securities and Exchange Commission (the “SEC”). As used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the words, “we,” “our,” and “us” refer to Skilled Healthcare Group, Inc. and its wholly-owned subsidiaries. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes included in this report.
Business Overview
Skilled Healthcare Group, Inc. ("Skilled") is a holding company that owns subsidiary companies that in turn own and operate skilled nursing facilities, assisted living facilities, hospices, home health providers and a rehabilitation therapy business. As used in this report, the terms "we," "us," "our" and the "Company," and similar terms, refer collectively to Skilled and its consolidated wholly-owned subsidiaries, unless the context requires otherwise. We have an administrative service company that provides a full complement of administrative and consultative services that allows our affiliated operators and third-party operators with whom we contract to better focus on delivery of healthcare services. We currently also have one such service agreement with an unaffiliated skilled nursing facility operator. All of our subsidiaries focus on providing high-quality care to the people we serve, and our skilled nursing facility subsidiaries, which comprise the largest portion of our consolidated business, have a strong commitment to treating patients who require a high level of skilled nursing care and extensive rehabilitation therapy, whom we refer to as high-acuity patients. As of March 31, 2013, we owned or leased 74 skilled nursing facilities and 22 assisted living facilities, together comprising 10,413 licensed beds. We also lease five skilled nursing facilities in California to an unaffiliated third party operator. Our skilled nursing and assisted living facilities are located in California, Texas, Iowa, Kansas, Missouri, Nebraska, Nevada and New Mexico, and are generally clustered in large urban or suburban markets. We owned 77% of these facilities as of March 31, 2013. As of March 31, 2013 we provided hospice and home health services in Arizona, California, Idaho, Montana, Nevada, and New Mexico. We also provided private duty care services in Idaho, Montana, and Nevada. For the three months ended March 31, 2013, we generated approximately 72% of our revenue from our skilled nursing facilities, including our integrated rehabilitation therapy services at these facilities. The remainder of our revenue is generated from our assisted living services, rehabilitation therapy services provided to third-party facilities, hospice care and home health services.

Industry Trends
Medicare and Medicaid Reimbursement
Rising healthcare costs due to a variety of factors, including an aging population and increasing life expectancies, has in recent years increased demand for post-acute healthcare services, such as skilled nursing, assisted living, home health care, hospice care and rehabilitation therapy. In an effort to mitigate the cost of providing healthcare benefits, third party payors including Medicare, Medicaid, managed care providers, insurance companies and others have increasingly encouraged the treatment of patients in lower-cost care settings. As a result, in recent years skilled nursing facilities, which typically have significantly lower cost structures than acute care hospitals and certain other post-acute care settings, have generally been serving larger populations of higher-acuity patients than in the past. Despite this growth in demand, uncertainty over Medicare and Medicaid reimbursement rates persists. Medicare and Medicaid reimbursement rates are subject to change from time to time and, because revenue derived directly or indirectly from Medicare and Medicaid reimbursement has historically comprised the most significant portion of our consolidated revenue, a reduction in rates could materially and adversely impact our revenue.
Medicare reimburses our skilled nursing facilities under a prospective payment system ("PPS") for certain inpatient covered services. Under the PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into a resource utilization group ("RUG") category that is based upon each patient's acuity level. In October 2010, the number of RUG categories was expanded from 53 to 66 as part of the implementation of the RUGs IV system and the introduction of a revised and substantially expanded patient assessment tool called the minimum data set (MDS) version 3.0.
On July 29, 2011, the Centers for Medicare & Medicaid Services ("CMS") issued a final rule providing for, among other things, a net 11.1% reduction in PPS payments to skilled nursing facilities for CMS's fiscal year 2012 (which began October 1, 2011) as compared to PPS payments in CMS's fiscal year 2011 (which ended September 30, 2011). The 11.1% reduction was

20


on a net basis, after the application of a 2.7% market basket increase, and reduced by a 1.0% multi-factor productivity adjustment required by the Patient Protection and Affordable Care Act of 2010 ("PPACA"). The final CMS rule also adjusted the method by which group therapy is counted for reimbursement purposes, and changed the timing in which patients who are receiving therapy must be reassessed for purposes of determining their RUG category.
The Budget Control Act of 2011, enacted on August 2, 2011, increased the United States debt ceiling in connection with deficit reductions over the next ten years. Under the Budget Control Act of 2011, $1.2 trillion in domestic and defense spending reductions were automatically set to begin February 1, 2013, split evenly between domestic and defense spending. Payments to Medicare providers are subject to these automatic spending reductions, subject to a 2% cap. As discussed below, the American Taxpayer Relief Act of 2012 (the “Taxpayer Relief Act”) subsequently delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The automatic 2% reduction on each claim submitted to Medicare will begin on April 1, 2013. Reductions to Medicare and Medicaid reimbursement resulting from the Budget Control Act of 2011 could have a material adverse effect on the Company's business, financial position, results of operations and liquidity.
The Middle Class Tax Relief and Job Creation Act of 2012 was signed into law on February 22, 2012, extending the Medicare Part B outpatient therapy cap exceptions process through December 31, 2012. The statutory Medicare Part B outpatient therapy cap for occupational therapy (OT) was $1,880 for 2012, and the combined cap for physical therapy (PT) and speech-language pathology services (SLP) was also $1,880 for 2012.  This is the annual per beneficiary therapy cap amount determined for each calendar year. Similar to the therapy cap, Congress established a threshold of $3,700 for PT and SLP services combined and another threshold of $3,700 for OT services. All therapy services rendered above the $3,700 are subject to manual medical review and may be denied unless pre-approved by the provider's Medicare Administrative Contractor (or "MAC"). The law requires an exceptions process to the therapy cap that allows providers to receive payment from Medicare for medically necessary therapy services above the therapy cap amount.  Beginning October 1, 2012 some therapy providers may submit requests for exceptions (pre-approval for up to 20 therapy treatment days for beneficiaries at or above the $3,700 threshold) to avoid denial of claims for services above the threshold amount. The $3,700 figure is the defined threshold that triggers the provision for an exception request. Prior to October 1, 2012 there was no provision for an exception request when the threshold was exceeded.
July 27, 2012, CMS issued a final rule providing for, among other things, a net 1.8% increase in PPS payments to skilled nursing facilities for CMS's fiscal year 2013 (which began October 1, 2012 and runs through September 30, 2013) as compared to PPS payments in CMS's fiscal year 2012 (which ended September 30, 2012). The 1.8% increase was on a net basis, after the application of a 2.5% market basket increase, and reduced by a 0.7% multi-factor productivity adjustment required by PPACA. After our wage index adjustment, our net increase was 1.7%.
In July 2012, CMS issued its final rule for hospice services for its 2013 fiscal year. The rule includes a market basket increase of 2.6% less a 0.3% reduction in the market basket as a result of the PPACA and a 0.7% reduction due to productivity adjustment. After our wage index adjustment, our net increase was 0.9%.
On May 1, 2013, the Centers for Medicare & Medicaid Services ("CMS") proposed an increase of 1.4% in PPS payments to skilled nursing facilities for CMS's fiscal year 2014 (which begins October 1, 2013) as compared to the PPS payments in CMS's fiscal year 2013 (which ends September 30, 2013). The proposed 1.4% increase is on a net basis, after the application of a 2.3% market basket increase reduced by a 0.5% forecast error correction and further reduced by 0.4% multi-factor productivity adjustment required by the Patient Protection and Affordable Care Act of 2010 ("PPACA").
The American Taxpayer Relief Act of 2012 (the “ATRA”) was enacted on January 2, 2013. As noted above, the ATRA delayed by two months the automatic budget sequestration cuts established by the Budget Control Act of 2011. The ATRA also extended the therapy cap exception process for one year. The ATRA also made additional changes to the Multiple Procedure Payment Reduction ("MPPR") previously implemented in 2010. The existing discount to multiple therapy procedures performed in an outpatient environment during a single day was 25%. Effective April 1, 2013, ATRA increased the discount by an additional 25% to 50%. We believe that the new rules related to MPPR will reduce our revenue by $3 million to $4 million on an annual basis.
Should future changes in PPS include further reduced rates or increased standards for reaching certain reimbursement levels (including as a result of automatic cuts tied to federal deficit cut efforts or otherwise), our Medicare revenues derived from our skilled nursing facilities (including rehabilitation therapy services provided at our skilled nursing facilities) could be reduced, with a corresponding adverse impact on our financial condition and results of operation. Our rehabilitation therapy, hospice and home health care businesses are also to a large degree directly or indirectly dependent on (and therefore affected by changes in) Medicare and Medicaid reimbursement rates. For example, our rehabilitation therapy business may have difficulty increasing or maintaining the rates it has negotiated with third party nursing facilities in light of the reduced PPS reimbursement rates that took effect on October 1, 2011 as discussed above or future reductions in reimbursement rates.
We also derive a substantial portion of our consolidated revenue from Medicaid reimbursement, primarily through our skilled nursing business. Medicaid programs are administered by the applicable states and financed by both state and federal

21


funds. Medicaid spending nationally has increased substantially in recent years, becoming an increasingly significant component of state budgets. This, combined with slower state revenue growth and other state budget demands, has led both the federal government and many states, including California and other states in which we operate, to institute measures aimed at controlling the growth of Medicaid spending (and in some instances reducing it).
Historically, adjustments to reimbursement under Medicare and Medicaid have had a significant effect on our revenue and results of operations. Recently enacted, pending and proposed legislation and administrative rulemaking at the federal and state levels could have similar effects on our business. Efforts to impose reduced reimbursement rates, greater discounts and more stringent cost controls by government and other payors are expected to continue for the foreseeable future and could adversely affect our business, financial condition and results of operations. Additionally, any delay or default by the federal or state governments in making Medicare and/or Medicaid reimbursement payments could materially and adversely affect our business, financial condition and results of operations.

Federal Health Care Reform
In addition to the matters described above affecting Medicare and Medicaid participating providers, PPACA enacted several reforms with respect to skilled nursing facilities, home health agencies and hospices, including payment measures to realize significant savings of federal and state funds by deterring and prosecuting fraud and abuse in both the Medicare and Medicaid programs. While many of the provisions of PPACA will not take effect for several years or are subject to further refinement through the promulgation of regulations, some key provisions of PPACA are presently effective.
Enhanced CMPs and Escrow Provisions. PPACA includes expanded civil monetary penalty ("CMP") and related provisions applicable to all Medicare and Medicaid providers. CMS rules adopted to implement applicable provisions of PPACA also provide that assessed CMPs may be collected and placed in whole or in part into an escrow pending final disposition of the applicable administrative and judicial appeals processes. To the extent our businesses are assessed large CMPs that are collected and placed into an escrow account pending lengthy appeals, such actions could adversely affect our liquidity and results of operations.
Nursing Home Transparency Requirements. In addition to expanded CMP provisions, PPACA imposes new transparency requirements for Medicare-participating nursing facilities. In addition to previously required disclosures regarding a facility's owners, management and secured creditors, PPACA expanded the required disclosures to include information regarding the facility's organizational structure, additional information on officers, directors, trustees and "managing employees" of the facility (including their names, titles, and start dates of services), and information regarding certain parties affiliated with the facility. The transparency provisions could result in the potential for greater government scrutiny and oversight of the ownership and investment structure for skilled nursing facilities, as well as more extensive disclosure of entities and individuals that comprise part of skilled nursing facilities' ownership and management structure.
Face-to-Face Encounter Requirements. PPACA imposes new patient face-to-face encounter requirements on home health agencies and hospices to establish a patient's ongoing eligibility for Medicare home health services or hospice services, as applicable. A certifying physician or other designated health care professional must conduct the face-to-face encounters within specified timeframes, and failure of the face-to-face encounter to occur and be properly documented during the applicable timeframes could render the patient's care ineligible for reimbursement under Medicare.
Suspension of Payments During Pending Fraud Investigations. PPACA provides the federal government with expanded authority to suspend Medicare and Medicaid payments if a provider is investigated for allegations or issues of fraud. This suspension authority creates a new mechanism for the federal government to suspend both Medicare and Medicaid payments for allegations of fraud, independent of whether a state exercises its authority to suspend Medicaid payments pending a fraud investigation. To the extent the suspension of payments provision is applied to one of our businesses for allegations of fraud, such a suspension could adversely affect our liquidity and results of operations.
Overpayment Reporting and Repayment; Expanded False Claims Act Liability. PPACA enacted several important changes that expand potential liability under the federal False Claims Act. Overpayments related to services provided to both Medicare and Medicaid beneficiaries must be reported and returned to the applicable payor within specified deadlines, or else they are considered obligations of the provider for purposes of the federal False Claims Act. This new provision substantially tightens the repayment and reporting requirements generally associated with operations of health care providers to avoid False Claims Act exposure.
Home and Community Based Services. PPACA provides that states can provide home and community-based attendant services and supports through the Community First Choice State plan option. States choosing to provide home and community based services under this option must make them available to assist with

22


activities of daily living, instrumental activities of daily living and health related tasks under a plan of care agreed upon by the individual and his/her representative. For states that elect to make coverage of home and community-based services available through the Community First Choice State plan option, the percentage of the state's Medicaid expenses paid by the federal government will increase by 6 percentage points. PPACA also includes additional measures related to the expansion of community and home based services and authorizes states to expand coverage of community and home-based services to individuals who would not otherwise be eligible for them. The expansion of home-and-community based services could reduce the demand for the facility based services that we provide.
Health Care-Acquired Conditions. PPACA provides that the Secretary of Health and Human Services must prohibit payments to states for any amounts expended for providing medical assistance for certain medical conditions acquired during the patient's receipt of health care services. The CMS regulation implementing this provision of PPACA prohibits states from making payments to providers under the Medicaid program for conditions that are deemed to be reasonably preventable. It uses Medicare's list of preventable conditions in inpatient hospital settings as the base (adjusted for the differences in the Medicare and Medicaid populations) and provides states the flexibility to identify additional preventable conditions and settings for which Medicaid payment will be denied.
Value-Based Purchasing. PPACA requires the Secretary of Health and Human Services to develop a plan to implement a value-based purchasing (“VBP”) program for payments under the Medicare program for skilled nursing facilities and to submit a report containing the plan to Congress. The intent of the provision is to potentially reconfigure how Medicare pays for health care services, moving the program towards rewarding better value, outcomes, and innovations, instead of volume. According to the plan submitted to Congress in June 2012, the funding for the VBP program could come from payment withholds from poor-performing skilled nursing facilities or by holding back a portion of the base payment rate or the annual update for all skilled nursing facilities. If a VBP program is ultimately implemented, it is uncertain what effect it would have upon skilled nursing facilities, but its funding or other provisions could negatively affect skilled nursing facilities.
Anti-Kickback Statute Amendments. PPACA amended the Anti-Kickback Statute so that (i) a claim that includes items or services violating the Anti-Kickback Statute also would constitute a false or fraudulent claim under the federal False Claims Act and (ii) the intent required to violate the Anti-Kickback Statute is lowered such that a person need not have actual knowledge or specific intent to violate the Anti-Kickback Statute in order for a violation to be deemed to have occurred. These modifications of the Anti-Kickback Statute could expose us to greater risk of inadvertent violations of the statute and to related liability under the federal False Claims Act.
The provisions of PPACA discussed above are examples of recently enacted federal health reform provisions that we believe may have a material impact on the long-term care profession generally and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of PPACA. It is possible that other provisions of PPACA may be interpreted, clarified, or applied to our businesses in a way that could have a material adverse impact on our business, financial condition and results of operations. Similar federal and/or state legislation that may be adopted in the future could have similar effects.
Revenue
Revenue by Service Offering

We operate our business in three reportable operating segments: (i) long-term care services, which includes the operation of skilled nursing and assisted living facilities and is the most significant portion of our business; (ii) our rehabilitation therapy services business; and (iii) our hospice and home health businesses. Our reporting segments are business units that offer different services, and that are managed separately due to the nature of services provided.
In our long-term care services segment, we derive the majority of our revenue by providing skilled nursing care and integrated rehabilitation therapy services to residents in our affiliated skilled nursing facilities. The remainder of our long-term care segment revenue is generated by our assisted living facilities, by our administration of an unaffiliated third party skilled nursing facility, and from our leasing of five skilled nursing facilities to an unaffiliated third party operator. In our therapy services segment, we derive revenue by providing rehabilitation therapy services to third-party facilities. In our hospice and home health services segment, we provide hospice and home health services.
The following table shows the revenue and percentage of our total revenue generated by each of these segments for the periods presented (dollars in thousands):


23


 
Three Months Ended March 31,
 
 
 
2013
 
2012
 
 
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Increase/(Decrease)
Dollars
 
Percentage
Long-term care services:
 
 
 
 
 
 
 
 
 
 
 
Skilled nursing facilities
$
157,661

 
72.0
%
 
$
158,983

 
72.5
%
 
$
(1,322
)
 
(0.8
)%
Assisted living facilities
7,126

 
3.3

 
6,914

 
3.2

 
212

 
3.1

Administration of third party facility
159

 
0.1

 
441

 
0.2

 
(282
)
 
(63.9
)
Facility lease revenue
761

 
0.3

 
754

 
0.3

 
7

 
0.9

Total long-term care services
165,707

 
75.7

 
167,092

 
76.2

 
(1,385
)
 
(0.8
)
Therapy services:
 
 
 
 
 
 
 
 
 
 
 
Third-party rehabilitation therapy services
27,074

 
12.4

 
26,115

 
11.9

 
959

 
3.7

Total therapy services
27,074

 
12.4

 
26,115

 
11.9

 
959

 
3.7

Hospice & home health services:
 
 
 
 
 
 
 
 
 
 
 
Hospice
18,983

 
8.7

 
19,754

 
9.0

 
(771
)
 
(3.9
)
Home Health
7,111

 
3.2

 
6,452

 
2.9

 
659

 
10.2

Total hospice & home health services
26,094

 
11.9

 
26,206

 
11.9

 
(112
)
 
(0.4
)
Total
$
218,875

 
100.0
%
 
$
219,413

 
100.0
%
 
$
(538
)
 
(0.2
)%
Sources of Revenue
The following table sets forth revenue consolidated by state in dollars and as a percentage of total revenue for the periods presented (dollars in thousands):
 
Three Months Ended March 31,
 
2013
 
2012
 
Revenue Dollars
 
Percentage of
Revenue
 
Revenue Dollars
 
Percentage of
Revenue
California
$
88,969

 
40.7
%
 
$
88,228

 
40.2
%
Texas
45,012

 
20.6

 
45,660

 
20.8

New Mexico
24,273

 
11.1

 
24,601

 
11.2

Kansas
15,405

 
7.0

 
15,703

 
7.2

Missouri
15,083

 
6.9

 
15,120

 
6.9

Nevada
14,946

 
6.8

 
15,348

 
7.0

Arizona
4,388

 
2.0

 
3,998

 
1.8

Montana
3,552

 
1.6

 
3,641

 
1.7

Idaho
2,732

 
1.2

 
2,423

 
1.1

Iowa
2,554

 
1.2

 
2,927

 
1.3

Nebraska
1,481

 
0.7

 
859

 
0.4

Other
480

 
0.2

 
905

 
0.4

Total
$
218,875

 
100.0
%
 
$
219,413

 
100.0
%
Long-Term Care Services Segment
Skilled Nursing Facilities. Within our skilled nursing facilities, we generate our revenue from Medicare, Medicaid, managed care providers, insurers, private pay and other sources. We believe that our skilled mix, which we define as the number of Medicare and non-Medicaid managed care patient days at our skilled nursing facilities divided by the total number of patient days at our skilled nursing facilities for any given period, is an important indicator of our success in attracting high-acuity patients because it represents the percentage of our patients who are reimbursed by Medicare and managed care payors, for whom we receive higher reimbursement rates. Most of our skilled nursing facilities include our Express RecoveryTM program. This program uses a dedicated unit within a skilled nursing facility to deliver a comprehensive rehabilitation and recovery regimen in accommodations specifically designed to serve high-acuity patients.

24


Assisted Living Facilities. Within our assisted living facilities, which are mostly in Kansas, we generate our revenue primarily from private pay sources, with a small portion earned from Medicaid or other state-specific programs.
Leased Facility Revenue. We lease five skilled nursing facilities in California to an unaffiliated third party operator. For additional information on the lease arrangement, see Note 5 - "Property and Equipment" to the interim consolidated financial statements.
Therapy Services Segment
As of March 31, 2013, we provided rehabilitation therapy services to a total of 193 healthcare facilities, including 64 of our facilities, as compared to 188 facilities, including 64 of our facilities, as of March 31, 2012. In addition, we have contracts to manage the rehabilitation therapy services for our 10 healthcare facilities in New Mexico. The net increase of 5 facilities serviced was comprised of 19 new facilities serviced, net of 14 cancellations. Rehabilitation therapy revenue derived from servicing our own facilities is included in our revenue from skilled nursing facilities. Our rehabilitation therapy business receives payment for services from the third-party facilities that it serves based on negotiated patient per diem rates or a negotiated fee schedule based on the type of service rendered. As of March 31, 2013, we provided rehabilitation therapy services to facilities in California, Nevada, New Mexico, Texas, Missouri, Nebraska, Iowa, and Indiana.
Hospice and Home Health Services Segment
Hospice. As of March 31, 2013, we provided hospice care in Arizona, California, Idaho, Montana, Nevada and New Mexico. We derive substantially all of the revenue from our hospice business from Medicare and managed care reimbursement.
Federal law imposes a Medicare payment cap on hospice service programs. We monitor the impact of the Medicare cap on our hospice business by attempting to address our average length-of-stay on an agency-by-agency basis. A key component of this strategy is to analyze each hospice agency's mix of patients and referral sources to achieve a desirable mix of the types of patients and referral sources that we serve in each of our agencies.
Home Health. We provided home health care in Arizona, California, Idaho, Montana, Nevada and New Mexico as of March 31, 2013. We derive the majority of the revenue from our home health business from Medicare. Net service revenue is recorded under the Medicare payment program based on a 60-day episodic payment rate that is subject to downward adjustment based on certain variables.
Regulatory and Other Governmental Actions Affecting Revenue

We derive a substantial portion of our revenue from government Medicare and Medicaid programs. In addition, our rehabilitation therapy services, for which we receive payment from private payors, is significantly dependent on Medicare and Medicaid funding, as those private payors are primarily funded or reimbursed by these programs. The following table summarizes the amount of revenue that we received from each of our payor classes by segment in the periods presented (dollars in thousands):


25


 
Three Months Ended March 31,
 
2013
 
2012
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
 
Long-Term Care Services
 
Therapy Services
 
Hospice & Home Health Services
 
Total Revenue
 
Revenue Percentage
Medicare Part A
$
44,395

 
$

 
$
22,666

 
$
67,061

 
30.6
%
 
$
47,307

 
$

 
$
23,242

 
$
70,549

 
32.2
%
Medicare Part B
4,366

 

 

 
4,366

 
2.0

 
6,150

 

 

 
6,150

 
2.8

Medicaid
65,232

 

 
657

 
65,889

 
30.1

 
64,844

 

 
419

 
65,263

 
29.7

Subtotal Medicare and Medicaid
113,993

 

 
23,323

 
137,316

 
62.7

 
118,301

 

 
23,661

 
141,962

 
64.7

Managed Care Part A
25,623

 

 
1,361

 
26,984

 
12.3

 
22,904

 

 
1,105

 
24,009

 
11.0

Managed Care Part B
568

 

 

 
568

 
0.3

 
469

 

 

 
469

 
0.2

Private pay and other
25,523

 
27,074

 
1,410

 
54,007

 
24.7

 
25,418

 
26,115

 
1,440

 
52,973

 
24.1

Total
$
165,707

 
$
27,074

 
$
26,094

 
$
218,875

 
100.0
%
 
$
167,092

 
$
26,115

 
$
26,206

 
$
219,413

 
100.0
%

Medicare. Medicare is a federal program that provides certain healthcare benefits to beneficiaries who are 65 years of age or older, blind, disabled or qualify for Medicare’s End Stage Renal Disease program. Medicare provides health insurance benefits in two primary parts for services that we provide:
Part A. Medicare Part A is hospital insurance, which provides reimbursement for inpatient services for hospitals, skilled nursing facilities, hospices, home health and certain other healthcare providers and patients requiring daily professional skilled nursing and other rehabilitative care. Coverage in a skilled nursing facility is limited for a period of up to 100 days, if medically necessary, after the individual has qualified for Medicare coverage as a result of a three-day or longer hospital stay. Medicare pays for the first 20 days of stay in a skilled nursing facility in full and the next 80 days, to the extent above a daily coinsurance amount. Covered services include supervised nursing care, room and board, social services, pharmaceuticals and supplies as well as physical, speech and occupational therapies and other necessary services provided by nursing facilities. Medicare Part A also covers hospice care and some home health care. Skilled nursing facilities are paid under Medicare Part A on the basis of a prospective payment system, or PPS. The PPS payment rates are adjusted for case mix and geographic variation in wages and cover all costs of furnishing covered skilled nursing facilities services (routine, ancillary, and capital-related costs). The amount to be paid is determined by classifying each patient into a resource utilization group ("RUG"), category, which is based upon the patient's acuity level. CMS generally evaluates and adjusts payment rates on an annual basis.
Part B. Medicare Part B is supplemental medical insurance, which requires the beneficiary to pay monthly premiums, covers physician services, limited drug coverage and other outpatient services, such as physical, occupational and speech therapy services, enteral nutrition, certain medical items and X-ray services received outside of a Part A covered inpatient stay.
Medicaid. Medicaid is a state-administered medical assistance program for the indigent, operated by the individual states with the financial participation of the federal government. Each state has relatively broad discretion in establishing its Medicaid reimbursement formulas and coverage of service, which must be approved by the federal government in accordance with federal guidelines. All states in which we operate cover long-term care services for individuals who are Medicaid eligible and qualify for institutional care. Providers must accept the Medicaid reimbursement level as payment in full for services rendered. Medicaid programs generally make payments directly to providers, except in cases where the state has implemented a Medicaid managed care program, under which providers receive Medicaid payments from managed care organizations ("MCOs") that have subcontracted with the Medicaid program. PPACA provides for increased financial participation by the federal government in a state's Medicaid program if the state chooses to expand its Medicaid program as contemplated by PPACA. However, states are not required to expand their Medicaid programs and it is uncertain as to which states, including states in which we operate, will ultimately expand their programs.
Managed Care. Our managed care patients consist of individuals who are insured by a third-party entity, typically called a senior Health Maintenance Organization, ("HMO") plan, or are Medicare beneficiaries who assign their Medicare benefits to a senior HMO plan.

26


Private Pay and Other. Private pay and other sources consist primarily of individuals or parties who directly pay for their services or are beneficiaries of the Department of Veterans Affairs.
Critical Accounting Estimates
There has been no change in our critical accounting policies and estimates as included under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, which we filed with the SEC on February 11, 2013.

27


Results of Operations
The following table summarizes some of our key performance indicators, along with other statistics, for each of the periods indicated:
 
Three Months Ended March 31,
 
2013
 
2012
Occupancy statistics (skilled nursing facilities):
 
 
 
     Available beds in service at end of period
8,815

 
8,813

     Available patient days
793,232

 
801,526

     Actual patient days
658,646

 
668,193

     Occupancy percentage
83.0
%
 
83.4
%
     Average daily number of patients
7,318

 
7,343

 
 
 
 
Hospice average daily census
1,336

 
1,375

Home health episodic-based admissions
2,242

 
1,985

Home health episodic-based recertifications
490

 
333

 
 
 
 
Revenue per patient day (skilled nursing facilities prior to intercompany eliminations)
 
 
 
     LTC only Medicare (Part A)
$
521

 
$
508

     Medicare blended rate (Part A & B)
572

 
575

     Managed care (Part A)
381

 
382

     Managed care blended rate (Part A & B)
390

 
389

     Medicaid
161

 
158

     Private and other
176

 
173

     Weighted-average for all
$
240

 
$
239

 
 
 
 
Patient days by payor (skilled nursing facilities):
 
 
 
Medicare
85,228

 
93,034

Managed care
67,206

 
60,022

Total skilled mix days
152,434

 
153,056

Private pay and other
102,551

 
104,200

Medicaid
403,661

 
410,937

Total days
658,646

 
668,193

 
 
 
 
Patient days as a percentage of total patient days (skilled nursing facilities):
 
 
 
Medicare
12.9
%
 
13.9
%
Managed care
10.2

 
9.0

Skilled Mix
23.1

 
22.9

Private pay and other
15.6

 
15.6

Medicaid
61.3

 
61.5

Total
100.0
%
 
100.0
%
 
 
 
 
Revenue for total company:
 
 
 
Medicare
32.6
%
 
35.0
%
Managed care, private pay, and other
37.3

 
35.3

Quality mix
69.9

 
70.3

Medicaid
30.1

 
29.7

Total
100.0
%
 
100.0
%
 
 
 
 


28


The following table sets forth details of our revenue, expenses, and net income and other items as a percentage of total revenue for the periods indicated:

 
Three Months Ended March 31,
 
2013
 
2012
Revenue
100.0
 %
 
100.0
 %
Expenses:
 
 
 
Cost of services (exclusive of rent cost of revenue and depreciation and amortization shown below)
86.9

 
83.5

Rent cost of revenue
2.2

 
2.1

General and administrative
3.0

 
2.8

Depreciation and amortization
2.8

 
2.8

 
94.9

 
91.2

Other income (expenses):
 
 
 
Interest expense
(4.0
)
 
(4.4
)
Interest income
0.1

 
0.1

Other income (expense)

 

Equity in earnings of joint venture
0.2

 
0.2

Total other (expenses) income, net
(3.7
)
 
(4.1
)
Income before provision for income taxes
1.4

 
4.7

Provision for income taxes

 
1.8

Net income
1.4
 %
 
2.9
 %
 
 
 
 
Adjusted EBITDA(1)
8.2
 %
 
11.9
 %
Adjusted EBITDAR(2)
10.4
 %
 
14.0
 %
 
 
 
 
 
Three Months Ended March 31,
 
2013
 
2012
Reconciliation from net income to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR (in thousands):
 
 
 
Net income
$
3,070

 
$
6,337

Interest expense, net of interest income
8,563

 
9,420

Provision for income taxes
78

 
4,036

Depreciation and amortization expense
6,219

 
6,275

EBITDA(1)
17,930

 
26,068

Rent cost of revenue
4,812

 
4,556

EBITDAR(2)
22,742

 
30,624

EBITDA(1)
17,930

 
26,068

Adjusted EBITDA(1)
17,930

 
26,068

Rent cost of revenue
4,812

 
4,556

Adjusted EBITDAR(2)
$
22,742

 
$
30,624


(1)
We define EBITDA as net income (loss) before depreciation, amortization and interest expense (net of interest income) and the provision for income taxes. Adjusted EBITDA is EBITDA adjusted for non-core business items, such as gains or losses on debt retirement costs or the disposal of property and equipment.
(2)
We define EBITDAR as net income (loss) before depreciation, amortization, interest expense (net of interest income), the provision for income taxes and rent cost of revenue. Adjusted EBITDAR is EBITDAR adjusted for the non-core business items listed above for the definition of Adjusted EBITDA (each to the extent applicable in the appropriate period.)

29


We believe that the presentation of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.
Specifically, we believe that a report of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods. EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are primary indicators management uses for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of expenses, revenues and gains (losses) that we believe are unrelated to the day-to-day performance of our business but are required to be reported in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). We also use EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.
Management, including operating company based management, uses EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated and segment level. Segment management uses these metrics to measure performance on a business unit by business unit basis. We typically use Adjusted EBITDA and Adjusted EBITDAR for these purposes on a consolidated basis as the adjustments to EBITDA and EBITDAR are not generally allocable to any individual business unit and we typically use EBITDA and EBITDAR to compare the operating performance of each skilled nursing facility, assisted living facility, or other business unit as well as to assess the performance of our operating segments. EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes, depreciation and amortization expense, rent cost of revenue (in the case of EBITDAR and Adjusted EBITDAR) and special charges, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a facility is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. We believe these types of charges are dependent on factors unrelated to the underlying business unit performance. As a result, we believe that the use of EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business units between periods by eliminating certain items required by U.S. GAAP which have little or no significance to their day-to-day operations.
Finally, we use Adjusted EBITDA to determine compliance with our debt covenants and assess our ability to borrow additional funds and to finance or expand operations. Our senior secured credit facility uses a measure substantially similar to Adjusted EBITDA as the basis for determining compliance with our financial covenants, specifically our minimum interest coverage ratio and our maximum total leverage ratio, and for determining the interest rate of our first lien term loan. For example, the senior secured credit facility includes adjustments to EBITDA for (i) gain or losses on sale of assets, (ii) the write-off of deferred financing costs of extinguished debt, (iii) pro forma adjustments for acquisitions to show a full year of EBITDA and interest expense, (iv) sponsorship fees paid to Onex which totals $0.5 million annually, (v) non-cash stock compensation and (vi) impairment of long-lived assets. Our noncompliance with these financial covenants could lead to acceleration of amounts due under our senior secured credit facility.
Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and individual business level basis, EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by U.S. GAAP. Therefore, our EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under U.S. GAAP. Some of these limitations are:
they do not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments;
they do not reflect changes in, or cash requirements for, our working capital needs;
they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;
they do not reflect any income tax payments we may be required to make;
although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements;
they are not adjusted for all non-cash income or expense items that are reflected in our consolidated statements of cash flows;

30


they do not reflect the impact on earnings of charges resulting from certain matters we consider not to be indicative of our ongoing operations; and
other companies in our industry may calculate these measures differently than we do, which may limit their usefulness as comparative measures.
We compensate for these limitations by using EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with U.S. GAAP in order to provide a more complete understanding of the factors and trends affecting our business. Furthermore, the non-GAAP financial measures that we present may be different from the presentation of similar measures by other companies, so the comparability of the measures among companies may be limited. We strongly encourage investors to consider net income determined under U.S. GAAP as compared to EBITDA, EBITDAR, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.
Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012
Revenue. Revenue decreased by $0.5 million, or 0.2%, to $218.9 million in the three months ended March 31, 2013 from $219.4 million in the three months ended March 31, 2012.
Long term care services
 
 
Three Months Ended March 31,
 
 
 
2013
 
2012
 
Increase/(Decrease)
 
Revenue
Dollars
 
Revenue
Percentage
 
Revenue
Dollars
 
Revenue
Percentage
 
Dollars
 
Percentage
 
(dollars in millions)
   Skilled nursing facilities
$
157.7

 
72.0
%
 
$
159.0

 
72.5
%
 
$
(1.3
)
 
(0.8
)%
   Assisted living facilities
7.1

 
3.3

 
6.9

 
3.2

 
0.2

 
2.9

   Administration of third party facility
0.1

 
0.1