10-K 1 d10k.htm FORM 10-K Form 10-K
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Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

Commission File Number 000-14940

 


HealthSouth Corporation

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   63-0860407
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
One HealthSouth Parkway
Birmingham, Alabama
  35243
(Address of Principal Executive Offices)   (Zip Code)

(205) 967-7116

(Registrant’s telephone number)

 


Securities Registered Pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.01 Par Value

 


Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.    Yes  ¨     No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes   ¨    No  x

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  ¨    No  x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

Large accelerated filer  x            Accelerated filer  ¨            Non-Accelerated filer  ¨

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

The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $2.2 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates. There were 398,229,960 shares of common stock of the registrant outstanding, net of treasury shares, as of February 28, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

The definitive proxy statement relating to the registrant’s 2006 Annual Meeting of Stockholders is incorporated by reference in Part III to the extent described therein.

 



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TABLE OF CONTENTS

 

          Page

Cautionary Statement Regarding Forward-Looking Statements

   ii

PART I

     

Item 1.

  

Business

   1

Item 1A.

  

Risk Factors

   36

Item 1B.

  

Unresolved Staff Comments

   43

Item 2.

  

Properties

   43

Item 3.

  

Legal Proceedings

   45

Item 4.

  

Submission of Matters to a Vote of Security Holders

   57

PART II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   58

Item 6.

  

Selected Financial Data

   60

Item 7.

  

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

   64

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   122

Item 8.

  

Financial Statements and Supplementary Data

   122

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   122

Item 9A.

  

Controls and Procedures

   123

Item 9B.

  

Other Information

   128

PART III

     

Item 10.

  

Directors and Executive Officers of the Registrant

   129

Item 11.

  

Executive Compensation

   129

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   129

Item 13.

  

Certain Relationships and Related Transactions

   129

Item 14.

  

Principal Accountant Fees and Services

   129

PART IV

     

Item 15.

  

Exhibits and Financial Statement Schedules

   130

 

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to future events, our future financial performance, or our projected business results. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “targets,” “potential,” or “continue” or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:

 

    each of the factors discussed in Item 1A, Risk Factors;

 

    the outcome of continuing investigations by the United States Department of Justice and other governmental agencies regarding our financial reporting and related activity;

 

    the final resolution of pending litigation filed against us, including class action litigation alleging violations of federal securities laws by us, as discussed in Item 1, Business, “Securities Litigation Settlement;”

 

    our ability to successfully remediate our internal control weaknesses;

 

    changes or delays in or suspension of reimbursement for our services by governmental or private payors;

 

    changes in the regulations of the health care industry at either or both of the federal and state levels;

 

    changes in reimbursement for health care services we provide;

 

    competitive pressures in the health care industry and our response to those pressures;

 

    our ability to obtain and retain favorable arrangements with third-party payors;

 

    our ability to attract and retain nurses, therapists, and other health care professionals in a highly competitive environment with often severe staffing shortages; and

 

    general conditions in the economy and capital markets.

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.

 

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PART I

 

Item 1. Business

General

HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with 1,070 facilities and approximately 37,000 full- and part-time employees as of December 31, 2005. As used in this report, the terms “HealthSouth,” “we,” “us,” “our,” and the “company” refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context. In addition, we use the term “HealthSouth Corporation” to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing.

HealthSouth Corporation was organized as a Delaware corporation in February 1984. Our principal executive offices are located at One HealthSouth Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116.

Recent Significant Events

Over the past three years, we have focused substantial time and attention responding to various legal, financial, and operational challenges resulting from the financial fraud perpetrated by certain members of our prior management team. This fraud was uncovered as a result of a series of governmental investigations into our public reporting and related matters, which investigations we became aware of beginning in late 2002 and early 2003. In connection with these investigations, on March 19, 2003, the United States Securities and Exchange Commission (the “SEC”) filed a lawsuit against us and our then-Chairman and Chief Executive Officer, Richard M. Scrushy, alleging among other things that we overstated earnings by at least $1.4 billion since 1999.

Public disclosure of these investigations and the SEC’s lawsuit precipitated a number of events that had an immediate and substantial negative impact on our business, financial condition, results of operations, and cash flows. These events, which began within weeks of the SEC’s lawsuit, included the following:

 

    The SEC ordered a two-day halt in trading of our securities.

 

    The New York Stock Exchange (“NYSE”) delisted our common stock.

 

    Our lenders froze the line of credit under our $1.25 billion credit agreement, and instituted a payment blockage that, among other things, prohibited us from making an approximately $350 million payment due April 1, 2003. They subsequently claimed we were in default under that agreement, substantially impairing our liquidity.

 

    Certain bondholders delivered notices of technical default.

 

    A number of lawsuits were filed against us and some of our current and former employees, officers, and directors in the United States District Court for the Northern District of Alabama, generally purporting to be class actions under the federal securities laws, on behalf of those who purchased our common stock and other securities during a period beginning February 25, 1998 and ending March 19, 2003.

 

    Approximately 14 insurance companies, including the primary carriers for our director and officer liability policy, filed complaints against us in an attempt to rescind or deny coverage under various insurance policies.

As summarized below, we have made significant progress in addressing many of the more significant obstacles created by the March 2003 crisis, including the following:

 

    We have replaced our board of directors and senior management team and improved our corporate governance policies and practices. See this Item, “Our New Board of Directors and Senior Management Team.”

 

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    We have completed a substantive reconstruction of our accounting records and filed annual reports on Form 10-K for the fiscal years (including this filing) ended December 31, 2005, 2004, 2003, and 2002 (including a restatement of previously issued consolidated financial statements for the fiscal years ended December 31, 2001 and 2000). In December 2005, we held our first Annual Meeting of Stockholders since 2002.

 

    We have prepaid substantially all of our prior indebtedness with proceeds from a series of recapitalization transactions and replaced it with approximately $3 billion of new long-term debt, which we believe will produce enhanced operational flexibility, reduced refinancing risk, and an improved credit profile. See this Item, “Recapitalization Transactions.”

 

    We have reached a global, preliminary agreement in principle with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers, to settle claims filed against us, certain of our former directors and officers, and certain other parties. See this Item, “Securities Litigation Settlement.”

 

    We have settled with the Department of Justice’s (the “DOJ”) civil division and other parties regarding their allegations that we submitted various fraudulent Medicare cost reports and committed certain other violations of federal health care program requirements. Although this settlement does not cover all similar claims that have been or could be brought against us, it settles the primary known claims that have been pending against us relating to our participation in federal health care programs. The DOJ and the Office of Inspector General (the “HHS-OIG”) of the United States Department of Health and Human Services (“HHS”) continue to review certain other matters, including self-disclosures made by us to the HHS-OIG. See this Item, “Medicare Program Settlement.”

 

    We have settled with the SEC regarding its allegations that we violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. See this Item, “SEC Settlement.”

 

    We continue to cooperate with federal law enforcement officials and other federal investigators, including the DOJ and the SEC, as they work to conclude their investigations, which are still ongoing.

Although we have made significant progress since March 2003, we continue to face many challenges. We encourage you to read the discussions contained in Item 1A, Risk Factors, and in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth.

Our New Board of Directors and Senior Management Team

On April 4, 2003, we established the Special Committee of our board of directors (the “Special Committee”), which consisted of all of our then-current directors except Richard M. Scrushy and William T. Owens, our former chief financial officer. Our board of directors delegated to the Special Committee, to the fullest extent permitted by Delaware law, all authority that could have been delegated to the Special Committee, and authorized the Special Committee, to the fullest extent permitted by Delaware law, to exercise all of the powers and authority of the board of directors in the management of the business and affairs of HealthSouth when the board of directors was not in session. Mr. Owens resigned from the board of directors in October 2003. The Special Committee was disbanded effective December 29, 2005 following our 2005 Annual Meeting of Stockholders, at which meeting Mr. Scrushy was not elected as a member of the board of directors.

Of our current ten-person board of directors, nine members were added since March 2003: Steven R. Berrard (effective January 31, 2004), Edward A. Blechschmidt (effective January 31, 2004), Jay Grinney (effective May 10, 2004), Leo I. Higdon, Jr. (effective August 17, 2004), John E. Maupin, Jr. (effective August 17, 2004), Charles M. Elson (effective September 9, 2004), Yvonne Curl (effective November 18, 2004), L. Edward Shaw Jr. (effective June 29, 2005), and Donald L. Correll (effective June 29, 2005). Jon F. Hanson

 

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joined the board of directors on September 17, 2002, after the principal events previously under investigation by the SEC occurred. All members of our current board of directors other than Mr. Grinney, our CEO, qualify as “independent directors” under our Corporate Governance Guidelines. For more information about our directors, including the name of each independent director, see the section entitled “Directors and Executive Officers of the Registrant” in our 2006 proxy statement.

In addition to our new board of directors, since March 2003 we have recruited a new management team of experienced professionals, including the following new members of our senior management team:

 

    Jay Grinney—President and Chief Executive Officer

 

    Michael D. Snow—Executive Vice President and Chief Operating Officer

 

    John L. Workman—Executive Vice President and Chief Financial Officer

 

    John Markus—Executive Vice President and Chief Compliance Officer

 

    Gregory L. Doody—Executive Vice President, General Counsel and Secretary

 

    James C. Foxworthy—Executive Vice President and Chief Administrative Officer

 

    R. Gregory Brophy—President, Diagnostic Division

 

    Joseph T. Clark—President, Surgery Centers Division

 

    Diane L. Munson—President, Outpatient Division

 

    Mark J. Tarr—President, Inpatient Division

Except for Mr. Tarr, none of the members of our senior management team has been employed by HealthSouth in the past. In addition to our senior management team, we have substantially replaced and expanded the management of our accounting and finance, internal audit (including appointing an Inspector General), and compliance functions, and we have replaced or added key management personnel in each of our divisions.

In addition to replacing our board of directors and senior management team, we have made substantial changes to our corporate governance policies and practices. For example, we have developed internal governance devices including an annual calendar that specifies certain issues that must be reviewed by the board of directors and its committees, a decision protocol that defines the levels of expenditures above which approval must be sought from the board of directors, and comprehensive charters for the board of directors and each standing committee that detail their mission, organization, and principles of operation. We have also established a strong Code of Business Conduct as well as a set of implementing measures, including the designation of a chief compliance officer and extensive compliance training, to ensure that the standards are accepted and practiced by our employees. In addition, our directors are in regular contact with both our chief executive officer and our senior management team, and we believe we have established a governance culture that places a premium on informed director oversight of executive action and company behavior.

Recapitalization Transactions

On March 10, 2006, we completed the last of a series of recapitalization transactions (the “Recapitalization Transactions”) enabling us to prepay substantially all of our prior indebtedness and replace it with approximately $3 billion of new long-term debt. Although we remain highly leveraged, we believe these Recapitalization Transactions have eliminated significant uncertainty regarding our capital structure and have improved our financial condition in several important ways:

 

   

Reduced refinancing risk—The terms governing our prior indebtedness would have required us to refinance approximately $2.7 billion between 2006 and 2009, assuming all noteholders holding options to require us to repurchase their notes in 2007 and 2009 were to exercise those options. Under the terms

 

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governing our new indebtedness, we have minimal maturities until 2013 when our new term loans come due. The extension of our debt maturities has substantially reduced the risk and uncertainty associated with our near-term refinancing obligations under our prior debt.

 

    Improved operational flexibility—We have negotiated new loan covenants with higher leverage ratios and lower interest coverage ratios. In addition, our new loan agreements increase our ability to enter into certain transactions (e.g. acquisitions and sale-leaseback transactions).

 

    Increased liquidity—As a result of the Recapitalization Transactions, our revolving line of credit has increased by approximately $150 million. In addition, the increased flexibility provided by the covenants governing our new indebtedness will allow us greater access to our revolving credit facility than we had under our prior indebtedness.

 

    Improved credit profile—By issuing $400 million in convertible perpetual preferred stock and using the net proceeds from that offering to repay a portion of our outstanding indebtedness and to pay fees and expenses related to such prepayment, we were able to reduce the amount we ultimately borrowed under the interim loan agreement. Accordingly, we have improved our capital structure. In addition, by increasing the ratio of our secured debt to unsecured debt, our capital structure is now closer to industry norms. Further, a substantial amount of our new indebtedness is prepayable without penalty, which will enable us to reduce debt and interest expense as operating and non-operating cash flows allow without the substantial cost associated with the prepayment of our prior public indebtedness.

 

    Reduced interest rate exposure—By completing the Recapitalization Transactions we have taken advantage of current interest rates, which are relatively low compared to historical rates, and eliminated the need to refinance our debt over the next four years in what we perceive to be a rising interest-rate environment. In addition, we have entered into an interest rate swap to reduce our variable rate debt exposure.

The Recapitalization Transactions included (1) entering into credit facilities that provide for extensions of credit of up to $2.55 billion of senior secured financing, (2) entering into an interim loan agreement that provides us with $1.0 billion of senior unsecured financing, (3) completing a $400 million offering of convertible perpetual preferred stock, (4) completing cash tender offers to purchase $2.03 billion of our previously outstanding senior notes and $319 million of our previously outstanding senior subordinated notes and consent solicitations with respect to proposed amendments to the indentures governing each outstanding series of notes, and (5) prepaying and terminating our Senior Subordinated Credit Agreement, our Amended and Restated Credit Agreement, and our Term Loan Agreement. In order to complete the Recapitalization Transactions, we also entered into amendments, waivers, and consents to our prior senior secured credit facility, $200 million senior unsecured term loan agreement, and $355 million senior subordinated credit agreement.

We used a portion of the proceeds of the loans under the new senior secured credit facilities, the proceeds of the interim loans, and the proceeds of the $400 million offering of convertible perpetual preferred stock, along with cash on hand, to prepay substantially all of our prior indebtedness and to pay fees and expenses related to such prepayment and the Recapitalization Transactions. The remainder of the proceeds and availability under the senior secured credit facilities are expected to be used for general corporate purposes. In addition, the letters of credit issued under the revolving letter of credit subfacility and the synthetic letter of credit facility, each described below, will be used in the ordinary course of business to secure workers’ compensation and other insurance coverages and for general corporate purposes. We anticipate refinancing the $1 billion interim loans in the second quarter or third quarter of 2006 through an issuance of high-yield debt securities.

In addition, on March 10, 2006, we announced the results of our cash tender offers and consent solicitation. As of the expiration of the tender offers, approximately $2.0 billion in aggregate principal amount of our senior notes, representing 98.4% of the senior notes, and approximately $289.0 million in aggregate principal amount of our senior subordinated notes, representing 90.5% of the senior subordinated notes, were validly tendered for purchase and not withdrawn, and we accepted such notes for purchase. The aggregate purchase price, including accrued and unpaid interest and the consent payment, was approximately $2.5 billion.

 

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Credit Agreement

On March 10, 2006, we entered into a credit agreement (the “Credit Agreement”) with a consortium of financial institutions (collectively, the “Lenders”), JPMorgan Chase Bank, N.A., as the administrative agent and the collateral agent (“JPMorgan”), Citicorp North America, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as co-syndication agents, and Deutsche Bank Securities Inc., Goldman Sachs Credit Partners L.P. and Wachovia Bank, National Association, as co-documentation agents.

The Credit Agreement provides for extensions of credit of up to $2.55 billion of senior secured financing. The $2.55 billion available under the Credit Agreement includes (1) a six-year $400 million revolving credit facility (the “Revolving Loans”), with a revolving letter of credit subfacility and swingline loan subfacility, (2) a six-year $100 million synthetic letter of credit facility and (3) a seven-year $2.05 billion term loan facility (the “Term Loans”). The Term Loans amortize in quarterly installments, commencing with the quarter ending on September 30, 2006, equal to 0.25% of the original principal amount thereof, with the balance payable upon the final maturity. The Term Loans and, prior to the “Leverage Pricing Date” (as defined in the Credit Agreement), the Revolving Loans bear interest (1) if we have received an initial corporate credit rating after entering into the Credit Agreement of B+ or better by S&P and B1 or better by Moody’s (in each case with at least a stable outlook), at a rate of, at our option, (a) LIBOR, adjusted for statutory reserve requirements (“Adjusted LIBOR”), plus 2.50% or (b) 1.50% plus the higher of (i) the federal funds rate plus 0.50% and (ii) JPMorgan’s prime rate, (2) if we have received an initial corporate credit rating after entering into the Credit Agreement of B or better by S&P and B2 or better by Moody’s (in each case with at least a stable outlook), at a rate of, at our option, (a) Adjusted LIBOR plus 2.75% or (b) 1.75% plus the higher of (i) the federal funds rate plus 0.50% and (ii) JPMorgan’s prime rate or (3) if we have not received an initial corporate credit rating from either or both of S&P and Moody’s after entering into the Credit Agreement, or have not received an initial corporate credit rating of at least B by S&P and B2 by Moody’s (in each case with at least a stable outlook), at a rate of, at our option, (a) Adjusted LIBOR plus 3.25% or (b) 2.25% plus the higher of (i) the federal funds rate plus 0.50% and (ii) JPMorgan’s prime rate. After the Leverage Pricing Date, the revolving loans will bear interest at a rate of, at our option, (1) Adjusted LIBOR or (2) the higher of (a) the federal funds rate plus 0.50% and (b) JPMorgan’s prime rate, in each case, plus an applicable margin that varies depending upon our leverage ratio and our initial corporate credit rating after entering into the Credit Agreement.

The Credit Agreement contains customary representations, warranties, and affirmative and negative covenants. The Credit Agreement also includes customary events of default, including, without limitation, payment defaults, cross-defaults to other material indebtedness and bankruptcy-related defaults. If any “event of default” (as defined in the Credit Agreement) occurs and is continuing, JPMorgan may, and at the request of the required Lenders will, terminate the commitments and declare all of the amounts owed under the Credit Agreement to be immediately due and payable.

Pursuant to a Collateral and Guarantee Agreement (the “Collateral and Guarantee Agreement”), dated as of March 10, 2006, between us, our subsidiaries identified therein (collectively, the “Subsidiary Guarantors”) and JPMorgan, our obligations under the Credit Agreement are (1) secured by substantially all of our assets and the assets of the Subsidiary Guarantors and (2) guaranteed by the Subsidiary Guarantors. In addition to the Collateral and Guarantee Agreement, we and the Subsidiary Guarantors agreed to enter into mortgages with respect to certain of our material real property (excluding real property owned by the surgery centers division or otherwise subject to preexisting liens and/or mortgages) in connection with the Credit Agreement. Our obligations under the Credit Agreement will be secured by the real property subject to such mortgages.

Interim Loan Agreement

On March 10, 2006, we and the Subsidiary Guarantors also entered into the Interim Loan Agreement (the “Interim Loan Agreement”) with a consortium of financial institutions (collectively, the “Interim Lenders”), Merrill Lynch Capital Corporation, as administrative agent (“Merrill”), Citicorp North America, Inc. and

 

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JPMorgan, as co-syndication agents, and Deutsche Bank AG Cayman Islands Branch, Goldman Sachs Credit Partners L.P. and Wachovia Bank, National Association, as co-documentation agents. The Interim Loan Agreement provides us with $1 billion of senior unsecured interim financing. The loans under the Interim Loan Agreement will mature on March 10, 2007 (the “Initial Maturity Date”). Any Interim Lender who has not been repaid in full on or prior to the Initial Maturity Date will have the option to receive exchange notes (the “Exchange Notes”) issued under an indenture (the “Exchange Note Indenture”) in exchange for the outstanding loan. If any such Lender does not exchange its loans for Exchange Notes on the Initial Maturity Date, the maturity date of the loans will automatically extend to March 10, 2014, prior to which such Lender may exchange its loans for Exchange Notes at any time. The proceeds of the loans under the Interim Loan Agreement were used to refinance a portion of our prior indebtedness and to pay fees and expenses related to such refinancing. Our obligations under the Interim Loan Agreement are guaranteed by the Subsidiary Guarantors.

Prior to the Initial Maturity Date, subject to certain agreed upon minimum and maximum rates, the loans will bear interest at a rate per annum equal to: (1) Adjusted LIBOR, plus 4.50% for the period following the closing date on March 10, 2006 and ending prior to September 10, 2006 and (2) Adjusted LIBOR plus 5.50% as of September 10, 2006 and an additional 0.50% at the end of each three-month period commencing on September 10, 2006 until but excluding the Initial Maturity Date. After the Initial Maturity Date, subject to certain agreed upon minimum and maximum rates, the loans that have not been repaid or exchanged for Exchange Notes will bear interest at the rate borne by the loans on the day immediately preceding the Initial Maturity Date plus 0.50% during the three-month period commencing on the Initial Maturity Date and an additional 0.50% at the beginning of each subsequent three-month period.

The Interim Loan Agreement contains representations and warranties, affirmative and negative covenants, and default and acceleration provisions that are substantially similar to the provisions contained in the Credit Agreement. However, following the Initial Maturity Date, most of the affirmative covenants will cease to apply to us or the Subsidiary Guarantors and the negative covenants and the default and acceleration provisions will be replaced by those contained in the Exchange Note Indenture (such provisions are customary for high yield transactions).

As described above, a portion of our proceeds from the series of Recapitalization Transactions were used to prepay substantially all of our prior indebtedness. Our prepayment of indebtedness included loans under the following agreements: (1) Senior Subordinated Credit Agreement, dated as of January 16, 2004, by and among us, the lenders party thereto, and Credit Suisse, as administrative agent and syndication agent (the “Senior Subordinated Credit Agreement”); (2) Amended and Restated Credit Agreement, dated as of March 21, 2005, by and among us, the lenders party thereto, JPMorgan, as administrative agent and collateral agent, Wachovia Bank, National Association, as syndication agent, and Deutsche Bank Trust Company Americas, as documentation agent (the “Amended and Restated Credit Agreement”); and (3) Term Loan Agreement, dated as of June 15, 2005, by and among us, the lenders party thereto, JPMorgan, as administrative agent, Citicorp North America, Inc., as syndication agent, and J.P. Morgan Securities Inc. and Citigroup Global Markets Inc. as co-lead arrangers and joint bookrunners (the “Term Loan Agreement”).

Upon the closing of the Recapitalization Transactions on March 10, 2006, we prepaid and terminated the Senior Subordinated Credit Agreement, the Amended and Restated Credit Agreement, and the Term Loan Agreement. Descriptions of each of the terminated agreements follow.

Senior Subordinated Credit Agreement

On January 16, 2004, we entered into the $355 million Senior Subordinated Credit Agreement, which had an interest rate of 10.375% per annum, payable quarterly, with a 7-year maturity, callable after the third year with a premium.

On February 15, 2006, we entered into a consent and waiver (the “Consent”) to the Senior Subordinated Credit Agreement. Pursuant to the terms of the Consent, the “required lenders” (as defined in the Senior

 

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Subordinated Credit Agreement) consented to the prepayment of all outstanding loans in full (together with all accrued and unpaid interest) on or prior to March 20, 2006 and waived certain provisions of the Senior Subordinated Credit Agreement to the extent such provisions prohibited such prepayment. Pursuant to the Consent, along with the payment-in-full of all principal amount of loans and accrued and unpaid interest thereon owed under the Senior Subordinated Credit Agreement, we paid a prepayment premium equal to 15.00% of the principal amount of the loans.

Amended and Restated Credit Agreement

The Amended and Restated Credit Agreement amended and restated the Credit Agreement dated as of June 14, 2002, as amended on August 20, 2002 (the “2002 Credit Agreement”), among us, the lenders from time to time party thereto, JPMorgan, as administrative agent, Wachovia Bank, National Association, as syndication agent, UBS Warburg LLC, ScotiaBanc, Inc., and Deutsche Bank AG, New York Branch, as co-documentation agents, and Bank of America, N.A., as senior managing agent.

Pursuant to the Amended and Restated Credit Agreement, the lenders converted $315 million in aggregate principal amount of the loans outstanding under the 2002 Credit Agreement into a senior secured term facility which would have matured on June 14, 2007 (the “Senior Term Loans”). Such maturity date for the Senior Term Loans, however, would have automatically been extended to March 21, 2010 in the event that (1) such extension became permitted under our Senior Subordinated Credit Agreement or (2) the Senior Subordinated Credit Agreement ceased to be in effect. The Senior Term Loans amortized in quarterly installments, commencing with the quarter ended on September 30, 2005, equal to 0.25% of the original principal amount thereof, with the balance payable upon the final maturity. Until we had obtained ratings from Moody’s and S&P, the Senior Term Loans carried interest, at our option, at a rate of (1) Adjusted LIBOR plus 2.50% or (2) 1.50% plus the higher of (a) the Federal Funds Rate plus 0.50% and (b) JPMorgan’s prime rate. After we had obtained such ratings, the Senior Term Loans carried interest, at our option, (1) at a rate of Adjusted LIBOR plus a spread ranging from 2.00% to 2.50%, depending on our ratings with such institutions or (2) at a rate of a spread ranging from 1.00% to 1.50%, depending on our ratings with such institutions, plus the higher of (a) the Federal Funds Rate plus 0.50% and (b) JPMorgan’s prime rate.

In addition, the Amended and Restated Credit Agreement made available to us a senior secured revolving credit facility in an aggregate principal amount of $250 million (the “Revolving Facility”) and a senior secured revolving letter of credit facility in an aggregate principal amount of $150 million (the “LC Facility”). The commitments under the Revolving Facility and the LC Facility would have expired, and all borrowings under such facilities would have matured, on March 21, 2010.

Pursuant to the Collateral and Guarantee Agreement (the “2005 Collateral and Guarantee Agreement”), dated as of March 21, 2005, between us and JPMorgan, our obligations under the Amended and Restated Credit Agreement were secured (1) by substantially all of our assets and (2) from and after the date on which the Restrictive Indentures (as defined in the Amended and Restated Credit Agreement) and the Senior Subordinated Credit Agreement permitted the obligations (or an amount thereof) to be guaranteed by or secured by the assets of certain of our existing and subsequently acquired or organized material subsidiaries by substantially all of the assets of such subsidiaries. The 2005 Collateral and Guarantee Agreement, along with the guaranty obligation made and the security interests granted therein terminated automatically upon the termination of the Amended and Restated Credit Agreement.

On February 22, 2006, we entered into an amendment and waiver (the “Waiver”) to the Amended and Restated Credit Agreement. Pursuant to the terms of the Waiver, the “required lenders” (as defined in the Amended and Restated Credit Agreement) waived, in the event that all the transactions contemplated by the Recapitalization Transactions did not occur substantially simultaneously, certain provisions of the Amended and Restated Credit Agreement, to the extent such waiver was required to permit us to apply 100% of the net

 

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proceeds of the issuance of the convertible perpetual preferred stock to the prepayment or repayment of other prior indebtedness. In connection with the Waiver, we paid to each lender executing the Waiver on or prior to 5:00 p.m., February 22, 2006, a waiver fee equal to 0.05% of the principal amount of such lender’s loans.

Term Loan Agreement

On June 15, 2005, we obtained a senior unsecured term facility consisting of term loans (the “Term Loan Agreement”) in an aggregate principal amount of $200 million (the “Term Loans”). The Term Loans initially carried interest at a rate of Adjusted LIBOR plus 5.0% per year (the “Initial Rate”) and thereafter, at our option, at a rate of (1) the Initial Rate or (2) 4.0% per year plus the higher of (a) JPMorgan’s prime rate and (b) the Federal Funds Rate plus 0.50%. The Term Loans would have matured in full on June 15, 2010.

On February 15, 2006, we entered into an amendment and waiver (the “Amendment”) to the Term Loan Agreement. Pursuant to the terms of the Amendment, the “required lenders” (as defined in the Term Loan Agreement) amended certain provisions of the Term Loan Agreement to the extent such provisions prohibited a prepayment of the loans thereunder prior to June 15, 2006. In connection with the Amendment, we paid to each lender executing the Amendment on or prior to 5:00 p.m., February 15, 2006, an amendment fee equal to 1.00% of the principal amount of such lender’s loans. In connection with the prepayment-in-full of the principal amount of loans and accrued and unpaid interest thereon owed under the Term Loan Agreement, we paid a prepayment fee equal to 2.00% of the aggregate principal amount of the prepayment.

The foregoing descriptions of each of the agreements referenced above are qualified in their entirety by the complete text of the agreements, which are referenced in Item 15, Exhibits and Financial Statement Schedules, and are incorporated herein by reference.

Status of Long-Term Indebtedness and Liquidity

The face value of our long-term debt (excluding notes payable to banks and others, noncompete agreements, and capital lease obligations) before and after the Recapitalization Transactions is summarized in the following table:

 

     As of
December 31, 2005
   As of
March 10, 2006
     (In Thousands)

Revolving credit facility

   $ —      $ 50,000

Term loans

     513,425      3,050,000

Bonds payable

     2,720,907      80,101
             
   $ 3,234,332    $ 3,180,101
             

 

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The following charts show our scheduled payments on long-term debt (excluding notes payable to banks and others, noncompete agreements, and capital lease obligations) for the next five years and thereafter before and after the above described Recapitalization Transactions. The charts also exclude the convertible perpetual preferred stock, which is described in Item 5, Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

LOGO

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* Interim Loan Agreement maturity, which is subject to automatic extension

 

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As noted above, we have negotiated new debt covenants as part of the Recapitalization Transactions. These covenants include higher leverage ratios and lower interest coverage ratios. The following chart shows a comparison of these two restrictive covenants as of March 31, 2006 under our former Amended and Restated Credit Agreement and our new Credit Agreement:

 

             Required Ratios at March 31, 2006        
    

New

Credit
Agreement

   Former
Amended and
Restated Credit
Agreement

Minimum interest coverage ratio

   1.65 to 1.00    2.00 to 1.00

Maximum leverage ratio

   7.25 to 1.00    5.50 to 1.00

As of December 31, 2005, we had approximately $175.5 million in cash and cash equivalents and $23.8 million in marketable securities. We also had approximately $242.5 million in “restricted cash,” which is cash we cannot use because of various obligations we have under lending agreements, partnership agreements, and other arrangements primarily related to our captive insurance company. For more information about our liquidity, please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources,” Note 1, Summary of Significant Accounting Policies, Note 2, Liquidity, and Note 8, Long-term Debt, to our accompanying consolidated financial statements.

Securities Litigation Settlement

On June 24, 2003, the United States District Court for the Northern District of Alabama consolidated a number of separate securities lawsuits filed against us under the caption In re HealthSouth Corp. Securities Litigation, Master Consolidation File No. CV-03-BE-1500-S (the “Consolidated Securities Action”). The Consolidated Securities Action included two prior consolidated cases (In re HealthSouth Corp. Securities Litigation, CV-98-J-2634-S and In re HealthSouth Corp. 2002 Securities Litigation, Consolidated File No. CV-02-BE-2105-S) as well as six lawsuits filed in 2003. Including the cases previously consolidated, the Consolidated Securities Action comprised over 40 separate lawsuits. The court divided the Consolidated Securities Action into two subclasses:

 

    Complaints based on purchases of our common stock were grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S (the “Stockholder Securities Action”), which was further divided into complaints based on purchases of our common stock in the open market (grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S) and claims based on the receipt of our common stock in mergers (grouped under the caption HealthSouth Merger Cases, Consolidated Case No. CV-98-2777-S). Although the plaintiffs in the HealthSouth Merger Cases have separate counsel and have filed separate claims, the HealthSouth Merger Cases are otherwise consolidated with the Stockholder Securities Action for all purposes.

 

    Complaints based on purchases of our debt securities were grouped under the caption In re HealthSouth Corp. Bondholder Litigation, Consolidated Case No. CV-03-BE-1502-S (the “Bondholder Securities Action”).

On February 22, 2006, we announced that we had reached a global, preliminary agreement in principle with the lead plaintiffs in the Stockholder Securities Action, the Bondholder Securities Action, and the derivative litigation, as well as with our insurance carriers, to settle claims filed in those actions against us and many of our former directors and officers. Under the proposed settlement, claims brought against the settling defendants will be settled for consideration consisting of HealthSouth common stock and warrants valued at approximately $215 million and cash payments by our insurance carriers of $230 million. In addition, we have agreed to give the class 25% of our net recovery from any future judgments won by us or on our behalf against Richard M. Scrushy, our former Chairman and Chief Executive Officer, Ernst & Young LLP, our former auditor, and certain affiliates

 

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of UBS Group, our former lead investment banker, none of whom are included in the settlement. The proposed settlement is subject to a number of conditions, including the successful negotiation of definitive documentation and final court approval. The proposed settlement does not include Richard M. Scrushy or any director or officer who has agreed to plead guilty or otherwise been convicted in connection with our former financial reporting activities.

There can be no assurances that a final settlement agreement can be reached or that the proposed settlement will receive the required court approval. For additional information about the Consolidated Securities Action, see Item 3, Legal Proceedings, “Securities Litigation.”

Medicare Program Settlement

The Civil DOJ Settlement

On January 23, 2002, the United States intervened in four lawsuits filed against us under the federal civil False Claims Act. These so-called “qui tam” (i.e., whistleblower) lawsuits were transferred to the Western District of Texas and were consolidated under the caption United States ex rel. Devage v. HealthSouth Corp., et al., No. 98-CA-0372 (DWS) (W.D. Tex. San Antonio). On April 10, 2003, the United States informed us that it was expanding its investigation to review whether fraudulent accounting practices affected our previously submitted Medicare cost reports.

On December 30, 2004, we entered into a global settlement agreement (the “Settlement Agreement”) with the United States. This settlement was comprised of (1) the claims consolidated in the Devage case, which related to claims for reimbursement for outpatient physical therapy services rendered to Medicare, the TRICARE Management Activity (“TRICARE”), or United States Department of Labor (“DOL”) beneficiaries, (2) the submission of claims to Medicare for costs relating to our allegedly improper accounting practices, (3) the submission of other unallowable costs included in our Medicare Home Office Cost Statements and in our individual provider cost reports, and (4) certain other conduct (collectively, the “Covered Conduct”). The parties to this global settlement include us and the United States acting through the DOJ’s civil division, the HHS-OIG, the DOL through the Employment Standards Administration’s Office of Workers’ Compensation Programs, Division of Federal Employees’ Compensation (“OWCP-DFEC”), TRICARE, and certain other individuals and entities which had filed civil suits against us and/or our affiliates (those other individuals and entities, the “Relators”).

Pursuant to the Settlement Agreement, we agreed to make cash payments to the United States in the aggregate amount of $325 million, plus accrued interest from November 4, 2004 at an annual rate of 4.125%. The United States agreed, in turn, to pay the Relators the portion of the settlement amount due to the Relators pursuant to the terms of the Settlement Agreement. Through December 31, 2005, we have made payments of approximately $155 million (excluding interest), with the remaining balance of $170 million (plus interest) to be paid in quarterly installments ending in the fourth quarter of 2007.

The Settlement Agreement provides for our release by the United States from any civil or administrative monetary claim the United States had or may have had relating to Covered Conduct that occurred on or before December 31, 2002 (with the exception of Covered Conduct for certain outlier payments, for which the release date is extended to September 30, 2003). The Settlement Agreement also provides for our release by the Relators from all claims based upon any transaction or incident occurring prior to December 30, 2004, including all claims that have been or could have been asserted in each Relator’s civil action, and from any civil monetary claim the United States had or may have had for the Covered Conduct that is pled in each Relator’s civil action.

The Settlement Agreement also provides for the release of HealthSouth by the HHS-OIG and OWCP-DFEC, and the agreement by the HHS-OIG and OWCP-DFEC to refrain from instituting, directing, or maintaining any administrative action seeking exclusion from Medicare, Medicaid, the FECA Program, the TRICARE Program, and other federal health care programs, as applicable, for the Covered Conduct. The DOJ continues to review certain other matters, including self-disclosures made by us to the HHS-OIG.

 

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The Administrative Settlement Agreement

In connection with the Settlement Agreement, we entered into a separate settlement agreement (the “Administrative Settlement Agreement”) with the Centers for Medicare & Medicaid Services (“CMS”) acting on behalf of HHS, to resolve issues associated with various Medicare cost reporting practices.

Subject to certain exceptions and the terms and conditions of the Administrative Settlement Agreement, the Administrative Settlement Agreement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports that had or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The Administrative Settlement Agreement provides that all covered cost reports be closed and considered final and settled.

The December 2004 Corporate Integrity Agreement

On December 30, 2004, we entered into a new corporate integrity agreement (the “CIA”) with the HHS-OIG. This new CIA has an effective date of January 1, 2005 and a term of five years from that effective date. It incorporates a number of compliance program changes already implemented by us and requires, among other things, that not later than 90 days after the effective date we:

 

    form an executive compliance committee (made up of our chief compliance officer and other executive management members), which shall participate in the formulation and implementation of HealthSouth’s compliance program;

 

    require certain independent contractors to abide by our Standards of Business Conduct;

 

    provide general compliance training to all HealthSouth personnel as well as specialized training to personnel responsible for billing, coding, and cost reporting relating to federal health care programs;

 

    report and return overpayments received from federal health care programs;

 

    notify the HHS-OIG of any new investigations or legal proceedings initiated by a governmental entity involving an allegation of fraud or criminal conduct against HealthSouth;

 

    notify the HHS-OIG of the purchase, sale, closure, establishment, or relocation of any facility furnishing items or services that are reimbursed under federal health care programs; and

 

    submit regular reports to the HHS-OIG regarding our compliance with the CIA.

On April 28, 2005, we submitted an implementation report to the HHS-OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

The CIA also requires that we engage an Independent Review Organization (“IRO”) to assist us in assessing and evaluating: (1) our billing, coding, and cost reporting practices with respect to our inpatient rehabilitation facilities, (2) our billing and coding practices for outpatient items and services furnished by outpatient departments of our inpatient facilities and through other HealthSouth outpatient rehabilitation facilities; and (3) certain other obligations pursuant to the CIA and the Settlement Agreement. We have engaged PricewaterhouseCoopers LLP to serve as our IRO.

Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues.

SEC Settlement

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to the action filed by the SEC on March 19, 2003 captioned SEC v. HealthSouth Corporation and Richard M. Scrushy, No.

 

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CV-03-J-0615-S (N.D. Ala.) (the “SEC Litigation”). That lawsuit alleges that HealthSouth and our former Chairman and Chief Executive Officer, Richard M. Scrushy, violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. The civil claims against Mr. Scrushy are still pending.

Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to:

 

    pay a $100 million civil penalty and disgorgement of $100 to the SEC in the following installments: $12,500,100 by October 15, 2005, $12.5 million by April 15, 2006, $25 million by October 15, 2006; $25 million by April 15, 2007, and $25 million by October 15, 2007;

 

    retain a qualified governance consultant to perform a review of the adequacy and effectiveness of our corporate governance systems, policies, plans, and practices;

 

    either (1) retain a qualified accounting consultant to perform a review of the effectiveness of our material internal accounting control structure and policies, as well as the effectiveness and propriety of our processes, practices, and policies for ensuring our financial data is accurately reported in our filed consolidated financial statements, or (2) within 60 days of filing with the SEC audited consolidated financial statements for the fiscal year ended December 31, 2005, including our independent auditor’s attestation on internal control over financial reporting, provide to the SEC all communications between our independent auditor and our management and/or Audit Committee from the date of the judgment until such report concerning our internal accounting controls;

 

    provide reasonable training and education to certain of our officers and employees to minimize the possibility of future violations of the federal securities laws;

 

    continue to cooperate with the SEC and the DOJ in their respective ongoing investigations; and

 

    create, staff, and maintain the position of Inspector General within HealthSouth, which position shall have the responsibility of reporting any indications of violations of law or of HealthSouth’s procedures, insofar as they are relevant to the duties of the Audit Committee, to the Audit Committee.

We retained a qualified governance consultant to perform a review of the adequacy and effectiveness of our corporate governance systems, policies, plans, and practices, which review is now complete. The consultant’s report of that review concludes, among other things, that “[t]he company’s current practices, created by the new directors and executives, meet contemporary standards of corporate governance.” In addition, we have chosen to provide the SEC all communications between our independent auditor and our management and/or Audit Committee rather than retaining an accounting consultant to review the effectiveness of our internal controls. Further, we hired Shirley Yoshida, formerly Vice President, Internal Audit at Safeway Inc., to serve as our Inspector General and to lead our internal audit department. We continue to comply with the other terms of the SEC Settlement.

The SEC Settlement also provides that we must treat the amounts ordered to be paid as civil penalties as penalties paid to the government for all purposes, including all tax purposes, and that we will not be able to be reimbursed or indemnified for such payments through insurance or any other source, or use such payments to set off or reduce any award of compensatory damages to plaintiffs in related securities litigation pending against us.

In connection with the SEC Settlement, we consented to the entry of a final judgment in the SEC Litigation (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. However, Mr. Scrushy remains a defendant in the SEC Litigation.

For additional information about the SEC Settlement, see Note 22, SEC Settlement, to our accompanying consolidated financial statements.

 

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Our Business

We have spent more than three years responding to the various legal, financial, and operational challenges resulting from the financial fraud perpetrated by certain members of our prior management team. During that time we have also developed and begun implementation of a three-phase strategic plan to reposition HealthSouth as a leading provider of post-acute care and select ambulatory services. To achieve this goal we have established a multi-year operational plan that strives to improve our business in five key areas: revenue, cost, quality, people, and infrastructure.

In 2005, the first year of our strategic plan, we made improvements in each of the five key areas listed in our operational agenda:

 

    Revenue—We helped advocate a slower phase-in of the 75% Rule and, we believe, outperformed the industry in mitigating the impact of the 75% Rule. We consolidated outpatient revenue centers and overhauled our outpatient sales and marketing function. We also piloted various new programs to enhance our marketing and have hired a new senior vice president to improve our managed care contracting function.

 

    Cost—We substantially reduced unnecessary overhead expense and closed or sold under-performing facilities. We have also hired a new senior vice president to manage and streamline our supply chain. We will continue to work to reduce costs by reorganizing and flattening each operating division and implementing standardized labor management metrics and performance expectations. In addition, we are closely monitoring our business and will, when necessary, close or sell additional under-performing facilities.

 

    Quality—We began an inpatient clinical information assessment, increased production of our AutoAmbulator, and participated in various clinical research projects. We are also working to enhance strong quality assurance programs within our facilities and divisions. We plan to supplement these programs by improving our company-wide quality agenda that will include standardized division-specific quality metrics and improved clinical information through the use of technology.

 

    People—We completed our senior management team and hired a number of other management personnel. We also completed a human resources strategic plan and increased 401(k) contributions for our employees. Our goal is to build a culture of integrity, transparency, diversity, and excellence, while simplifying and flattening our organizational structure.

 

    Infrastructure—We invested significant resources to evaluate and improve our financial, reporting, and compliance infrastructure, and will continue to invest heavily in our infrastructure throughout this turnaround period. Although our infrastructure needs further improvement in many areas, we are specifically focused on implementing required internal controls (e.g., compliance with Section 404 of the Sarbanes-Oxley Act of 2002), enhancing our financial infrastructure (e.g., improving financial and operational reporting and establishing a formal capital expenditure process and formal budget process), enhancing our management reporting capabilities (e.g., standardizing our monthly reporting and analysis, standardizing our financial projections, and implementing a faster month-end close), developing regulatory compliance programs, enhancing our information systems (e.g. upgrading our patient accounting systems), and implementing an information technology strategic plan.

We are now in the second year of our strategic plan. In our inpatient division, we remain committed to growth in the inpatient rehabilitation market and anticipate exploring both consolidation and new development opportunities as they arise. In addition, we are planning to expand the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. We continue to evaluate which services to expand, and we are analyzing recent proposed reimbursement changes, such as those affecting long-term acute care hospitals, as part of our evaluation process. In our outpatient divisions (surgery, outpatient rehabilitation, and diagnostic) we are (1) focusing on key markets, and where necessary, divesting under-performing facilities, (2) standardizing operating performance and

 

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implementing best practices across our divisions, and (3) exploring growth opportunities in both core markets and new markets. We also have received inquiries from parties interested in acquiring our diagnostic division and have hired an investment bank to assist us in evaluating those opportunities. As we continue to implement our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company and add value for our stockholders.

Industry Trends

As a provider of rehabilitative health care, ambulatory surgery, and diagnostic services, our revenues and growth are affected by trends in health care spending. According to estimates published by CMS, the health care sector is growing faster than the overall economy. The United States’ estimated gross domestic product (“GDP”) was $12.5 trillion in 2005, representing a 6.1% increase since 2004, while national health care spending in 2005 was an estimated $2 trillion, representing a 7.4% increase over the prior year. Health care spending is expected to continue to grow as a percentage of GDP over the next ten years. CMS estimates that health care spending constituted 16.2% of GDP in 2005, up from 16% in 2004 and 13.8% in 2000. By 2015 health care spending is projected to reach $4 trillion, or 20% of GDP. The rate of health care spending growth is projected to remain relatively stable at an annual rate of 7.2% per year on average.

Demographic factors contribute to long-term growth projections in health care spending. According to the U.S. Census Bureau’s 2004 interim projections, there were approximately 35 million Americans aged 65 or older. The number of Americans aged 65 or older is expected to increase to approximately 40 million by 2010 and approximately 54 million by 2020. By 2030, the number of Americans aged 65 or older is expected to reach approximately 70 million, or 20% of the U.S. population.

We believe that the aging of the U.S. population and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—such as strokes and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care facilities out of the acute care environment. However, as discussed in this Item, “Sources of Revenues,” decreasing Medicare spending remains a major focus of the federal government and any reduction in reimbursement rates applicable to the services we provide will have a negative impact on our business.

Operating Divisions

We believe that demographics, regulation, payor pressures to reduce cost, technological advancements, and increased quality requirements will continue to fuel demand for our services because our post-acute and select ambulatory services are, on the whole, more cost effective. We believe we can take advantage of these health care trends in the markets we currently occupy as well as leverage our size and expertise to expand our services and increase our influence in new markets.

We currently provide various patient care services through four primary operating divisions and certain other services through a fifth division, which together correspond to our five reporting segments. Although we have no current plans to change our operating divisions, we are continually evaluating and looking to optimize our operational structure and the mix of services we provide, which may lead to future changes in our operating divisions. Our consolidated net operating revenues were $3.2 billion for the fiscal year ended December 31, 2005. We had a diversified payor mix across all our reporting segments, with Medicare representing the highest percentage of revenues.

For additional information regarding our business segments and related information, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Segment Results of Operations,” and Note 25, Segment Reporting, to our accompanying consolidated financial statements.

 

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Inpatient

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient division operates inpatient rehabilitation facilities (“IRFs”) and long-term acute care hospitals (“LTCHs”) and provides treatment on both an inpatient and outpatient basis. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.

As of December 31, 2005, our inpatient division operated 93 freestanding IRFs (65 of which are wholly owned and 28 of which are jointly owned). As of December 31, 2005, our inpatient division also operated 10 LTCHs (9 of which are wholly owned and 1 of which is jointly owned), 7 of which are freestanding and 3 of which are hospital-within-hospital facilities. As of December 31, 2005, our inpatient division also provided outpatient services through 101 facilities (81 of which are wholly owned and 20 of which are jointly owned) located within our IRFs or in satellite facilities near our IRFs. In addition to facilities in which we have an ownership interest, our inpatient division operated 14 inpatient rehabilitation units, 11 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts as of December 31, 2005.

Our IRFs provide services to patients who require intensive inpatient rehabilitative care. Inpatient rehabilitation patients typically experience significant physical disabilities due to various conditions, such as head injury, spinal cord injury, stroke, certain orthopedic problems, and neuromuscular disease. Our IRFs provide the medical, nursing, therapy, and ancillary services required to comply with local, state, and federal regulations, as well as accreditation standards of the Joint Commission on Accreditation of Healthcare Organizations (the “JCAHO”) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities.

Although the market for inpatient rehabilitation services is highly competitive, it is also highly fragmented. This fragmentation creates potential consolidation opportunities for us. In addition, because of our size, we believe we differentiate ourselves from our competitors in the following ways:

 

    Quality. Our IRFs provide a broad base of clinical experience from which we have developed clinical best practices and protocols. We believe these clinical best practices and protocols help ensure the delivery of consistently high quality rehabilitative services across all of our IRFs.

 

    Cost Effectiveness. Our size also helps us provide inpatient rehabilitative services on a very cost-effective basis. Specifically, because of our large number of inpatient facilities, we can utilize standardized staffing models and take advantage of certain supply chain efficiencies. We continue to try to reduce our costs by leveraging our size.

 

    Technology. As a market leader in inpatient rehabilitation, we have devoted substantial resources to creating and leveraging rehabilitative technology. For example, we have developed an innovative therapeutic device called the “AutoAmbulator,” which can help advance the rehabilitative process for patients who experience difficulty walking.

Our inpatient division’s payor mix is weighted toward government-funded sources, particularly Medicare. For the years ended December 31, 2005, 2004, and 2003, Medicare represented 71.2%, 70.6%, and 71.1%, respectively, of the inpatient division’s net operating revenues, which totaled $1.8 billion, $2.0 billion, and $2.0 billion, respectively.

As discussed later in this Item, “Sources of Revenues,” two recent changes in regulations governing IRF reimbursement have combined to create a very challenging operating environment for our inpatient division. The first change occurred on May 7, 2004, when CMS issued a final rule stipulating revised criteria for qualifying as an IRF under Medicare. This rule, known as the “75% Rule,” has created significant volume volatility in our inpatient division. The second change, which became effective on October 1, 2005, relates to reduced unit pricing applicable to IRFs.

 

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The volume volatility created by the 75% Rule has had a significantly negative impact on our inpatient division’s net operating revenues in 2005. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the following strategies:

 

    Refocus Marketing. The 75% Rule reduces the number of patients seeking treatment for orthopedic and other diagnostic conditions that we can accept at our IRFs. Consequently, we are focusing our marketing efforts on neurologists, neurosurgeons, and internists who can refer patients that require treatment for one of the 13 designated medical conditions identified by the 75% Rule, such as spinal cord injury, brain injury, and various neurological disorders.

 

    Broaden Services. To make up for a potentially reduced inpatient rehabilitation patient census, we are increasing the number of other post-acute care services performed at or complementary to our IRFs, such as long-term acute care, skilled nursing, and home health services.

 

    Reduce Costs. We are aggressively reducing our costs in proportion to patient census decline at our IRFs.

In addition to the specific mitigation strategies discussed above, we are participating with the rest of the inpatient rehabilitation industry to sponsor research evaluating the efficacy of inpatient rehabilitative care and to inform Members of Congress and other government officials of the adverse effect of the 75% Rule on patients and providers.

The combination of volume volatility created by the 75% Rule and lower unit pricing resulting from recent changes to the prospective payment system applicable to IRFs reduced our operating earnings in 2005 and will have a continuing negative impact on our operating earnings in 2006. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for additional information about the impact of these changes. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Based on recent industry data, we believe the impact of the 75% Rule on the inpatient rehabilitation industry will be significantly greater than CMS estimated when the rule was promulgated. However, Congress has approved a one-year extension of the phase-in period for the 75% Rule and delayed implementation of the 65% compliance threshold until July 1, 2007. In addition, we believe that we are doing better than the industry as a whole in mitigating the effects of the 75% Rule. We anticipate growth in our inpatient division once the 75% Rule is fully implemented and the division’s operations are re-based to maximize admission of higher acuity compliant cases. In addition, we believe continued phase-in of the 75% Rule will cause certain competitors to exit the market which will create consolidation opportunities for us.

Surgery Centers

We operate one of the largest networks of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2005, our surgery centers division provided ambulatory surgery services through 158 freestanding ASCs and 3 surgical hospitals in 35 states, with a concentration of centers in California, Texas, Florida, and North Carolina.

Our ASCs provide the facilities and medical support staff necessary for physicians to perform nonemergency surgical procedures. Our typical ASC is a freestanding facility with two to six fully equipped operating and procedure rooms and ancillary areas for reception, preparation, recovery, and administration. Each of our ASCs is licensed by the state and certified as a provider under federal programs, including Medicare and Medicaid. Our ASCs are available for use only by licensed physicians, oral surgeons, and podiatrists. To ensure consistent quality of care, each of our ASCs has a medical advisory committee that implements quality control procedures and reviews the professional credentials of physicians applying for medical staff privileges at the center. In addition, all but a few unique specialty centers are certified by the JCAHO.

 

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Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased ownership in ASCs. Consequently, we expect an increasing level of physician ownership in our ASCs, and thus our percentage ownership of centers within our ASC portfolio will decline over time. Currently, our ownership interest in centers within our ASC portfolio varies from 20% to 100%. Our average ownership is over 50%.

A critical component of this division’s performance depends upon our ability to periodically provide physicians who use our ASCs with the opportunity to purchase ownership interests in our ASCs. This so-called “resyndication” of ownership interests is important because it enables us to increase the ownership participation of physicians who use our ASCs as well as attract new physicians to our ASCs. Attracting new physician investors who intend to maintain an active practice promotes, we believe, partnership interest in and support for continuing investments in necessary facility improvements as well as a general focus on quality. Prior to 2005, we had difficulty resyndicating our ASCs primarily because we were unable to produce reliable financial statements for individual partnerships. We assembled a dedicated team of accountants, attorneys, and other specialists to expedite the resyndication effort and were able to achieve our resyndication objectives in 2005, although many of our resyndications were completed near the end of the year.

Our surgery centers division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2005, 2004, and 2003, managed care and other discount plans represented 59.2%, 55.5%, and 55.1%, respectively, of the division’s net operating revenues, which totaled $773.4 million, $817.7 million, and $871.3 million respectively.

The ASC market continues to grow, due in part to improved anesthesia, new instrumentation, payor pressure to reduce costs, and other factors. Because the market is highly fragmented, however, it is highly competitive. We plan to combat this competition (1) by increasing our concentration in specific markets, (2) by affiliating with acute care networks in selected markets, (3) by leveraging the size of our network to realize improved operating efficiencies, increased marketing opportunities, and better payor contracting, and (4) by using technology such as standardized e-coding to improve division performance.

Outpatient

We are one of the largest operators of outpatient rehabilitation facilities in the United States. As of December 31, 2005, our outpatient division provided outpatient therapy through 620 facilities (576 of which are wholly owned and 44 of which are jointly owned). These facilities are located in 40 states, with a concentration of centers in Florida, Texas, New Jersey, Missouri, and Connecticut. In 2005, in part to focus operations on core markets and in part to divest under-performing facilities, the outpatient division closed 157 facilities and sold 10 facilities. We plan to begin exploring selected development opportunities in core markets in 2006.

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

Our outpatient division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2005, 2004, and 2003, managed care and other discount plans represented 47.2%, 49.6%, and 44.6%, respectively, of the division’s net operating revenues, which totaled $379.4 million, $441.8 million, and $519.9 million, respectively.

 

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Diagnostic

We are one of the largest operators of freestanding diagnostic imaging centers in the United States. As of December 31, 2005, our diagnostic division operated 85 diagnostic centers (78 of which are wholly owned and 7 of which are jointly owned) in 27 states and the District of Columbia, with a concentration of centers in Texas, Georgia, Alabama, Florida, and the Washington, D.C. area. In addition to the locations that provide diagnostic scanning services, there are also five electro-shock wave lithotripter units that began operating under our diagnostic division in 2005.

Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services, and fluoroscopy. We do not provide all services at all sites, although approximately 71% of our diagnostic centers are multi-modality centers offering multiple types of service. Our diagnostic centers provide outpatient diagnostic procedures performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. Those radiologists prepare an interpretation which is then delivered to the referring physician.

Our diagnostic division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2005, 2004, and 2003, managed care and other discount plans represented 60.1%, 61.0%, and 63.5%, respectively, of the division’s net operating revenues, which totaled $226.5 million, $234.7 million, and $262.0 million, respectively.

Although the market for diagnostic services is highly competitive, we are expanding our focus on referring physicians outside of the orthopedic specialty to broaden our base of referrals. We also have received inquiries from parties interested in acquiring our diagnostic division and have hired an investment bank to assist us in evaluating those opportunities. As we continue to implement our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company and add value for our stockholders.

Corporate and Other

This division comprises all revenue producing activities that do not fall within one of the four operating divisions discussed above, including other patient care services and certain non-patient care services.

 

    Medical Centers. This category formerly included our acute care business which, for all practical purposes, we have now exited. Specifically, as described later in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Results of Discontinued Operations,” we have signed an agreement to sell our acute care hospital located in Birmingham, Alabama. In addition, on January 4, 2006, we executed a letter of intent with an undisclosed party regarding the sale of the property and equipment which were to have comprised our Digital Hospital in Birmingham, Alabama. Any sale of the Digital Hospital will not involve conveyance of our interest in any certificate of need from our acute care hospital. The letter of intent expires, subject to certain conditions, on March 31, 2006 unless otherwise extended in accordance with the terms of the letter of intent. As of December 31, 2005, we had invested approximately $210 million in the Digital Hospital project. We have not signed a definitive agreement with respect to the Digital Hospital, and there can be no assurance any sale will take place. See Note 5, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the impairment charge we recognized in 2005 relating to the Digital Hospital. As of December 31, 2005, this “Medical Centers” category continues to include a physician practice located at the University of Miami Sports Center.

 

    Other Patient Care Services. In some markets, we provide other limited patient care services. We evaluate market opportunities on a case-by-case basis in determining whether to provide additional services of these types. We may provide these services as a complement to our facility-based businesses or as stand-alone businesses.

 

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    Non-Patient Care Services. We also provide certain services that do not involve the provision of patient care, including the operation of the conference center located at our corporate campus, operation of medical office buildings, various corporate marketing activities, our clinical research activities, and other services that are generally intended to complement our patient care activities.

 

    Corporate Functions. All our corporate departments and related overhead are contained within this division. These departments, which include among others accounting, communications, compliance, human resources, information technology, internal audit, legal, payor strategies, reimbursement, tax, and treasury, provide support functions to our operating divisions.

For the years ended December 31, 2005, 2004, and 2003, respectively, the division’s net operating revenues totaled $79.1 million, $85.5 million, and $80.2 million, respectively.

Competition

Inpatient

Our IRFs and LTCHs compete primarily with rehabilitation units and skilled nursing units, many of which are within acute care hospitals in the markets we serve. In addition, we face competition from large privately and publicly held companies such as Rehabcare Group, Inc., Select Medical Corporation, and Kindred Healthcare, Inc.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our size, reputation for quality, competitive prices, and positive rehabilitation outcomes.

Surgery Centers

We face competition from other providers of ambulatory surgical care in developing ASC joint ventures, acquiring existing centers, attracting patients, and negotiating managed care contracts in each of our markets. There are several publicly held companies, divisions or subsidiaries of publicly held companies, and several private companies that operate ASCs. Further, many physician groups develop ASCs without a corporate partner, utilizing consultants who typically perform management services for a fee and who may not require an ownership interest in the ongoing operations of the center. We believe that we compete effectively in this market because of our size, experience, and reputation for providing quality care.

Outpatient

Our outpatient rehabilitation facilities compete directly or indirectly with the physical and occupational therapy departments of hospitals, physician-owned therapy clinics, other private therapy clinics, and chiropractors. We also face competition from large privately held and publicly held physical therapy companies such as U.S. Physical Therapy, Inc. and Benchmark Medical, Inc., as well as mid-sized regional companies. It is particularly difficult to compete with physician-owned therapy clinics because physicians have traditionally been our customers, rather than our competitors. Consequently, in addition to competing with those physicians who offer physical therapy services as in-office ancillary services, we lose them as a referral source.

Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our reputation for quality, competitive prices, positive rehabilitation outcomes, and innovative programs.

Diagnostic

The market for diagnostic services is highly fragmented and highly competitive. Many physicians and physician groups have opened diagnostic facilities as an in-office ancillary service. Our diagnostic centers also

 

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compete with local hospitals, other multi-center imaging companies, and local independent diagnostic centers. Because of the age of equipment at many of our facilities, competition will become increasingly intense if we do not make substantial capital expenditures in future periods for the purchase of new equipment or the upgrading of existing equipment.

Other Competition

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a “certificate of need” program. Certificate of need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of need laws generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. We potentially face competition any time we initiate a certificate of need project or seek to acquire an existing facility or certificate of need. This competition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed certificate of need project. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition. We have generally been successful in obtaining certificates of need or similar approvals when required, although there can be no assurance that we will achieve similar success in the future.

We rely significantly on our ability to attract, develop, and retain physicians, therapists, and other clinical personnel for our facilities. We compete for these professionals with other health care companies, hospitals, and potential clients and partners. In addition, changes in health care regulations have enabled physicians to open facilities in direct competition with us, which has increased the choices for such professionals and therefore made it more difficult and/or expensive for us to hire the necessary personnel for our facilities.

Sources of Revenues

We receive payment for patient care services from the federal government (primarily under the Medicare program), state governments (under their respective Medicaid or similar programs), managed care plans, private insurers, and directly from patients. In addition, we receive payment for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated:

 

     Year Ended December 31,  

Source

   2005     2004     2003  

Medicare

   47.5 %   47.4 %   44.6 %

Medicaid

   2.3 %   2.4 %   2.6 %

Workers’ compensation

   7.4 %   8.1 %   9.5 %

Managed care and other discount plans

   33.1 %   31.8 %   31.8 %

Other third-party payors

   5.4 %   5.1 %   6.5 %

Patients

   1.8 %   3.0 %   2.6 %

Other income

   2.5 %   2.2 %   2.4 %
                  
   100.0 %   100.0 %   100.0 %
                  

Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a jointly administered federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford health care.

Our facilities generally offer discounts from established charges to certain group purchasers of health care services, including Blue Cross and Blue Shield (“BCBS”), other private insurance companies, employers, health

 

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maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”), and other managed care plans. These discount programs, which are often negotiated for multi-year terms, limit our ability to increase revenues in response to increasing costs.

Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, BCBS plans, HMOs, or PPOs, but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. The amount of such exclusions, deductibles, copayments, and coinsurance has been increasing each year. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors.

Medicare Reimbursement

Medicare, through statutes and regulations, establishes reimbursement methodologies for various types of health care facilities and services. These methodologies have historically been subject to periodic revisions that can have a substantial impact on existing health care providers. In accordance with authorization from Congress, CMS makes annual upward or downward adjustments to Medicare payment rates in most areas. Frequently, these adjustments can result in decreases in actual dollars per procedure or a freeze in reimbursement despite increases in costs.

We expect that Congress and CMS will address reimbursement rates for a variety of health care settings over the next several years. Any downward adjustment to rates for the types of facilities that we operate could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

A basic summary of current Medicare reimbursement in our service areas follows:

Acute Care. As a result of the Social Security Act Amendments of 1983, Congress adopted a prospective payment system (“PPS”) to cover the routine and ancillary operating and capital costs of most Medicare inpatient acute care hospital services. Under this system, the Secretary of HHS has established fixed payment amounts per discharge based on diagnosis-related groups (“DRGs”). With limited exceptions, reimbursement received for inpatient acute care hospital services is limited to the DRG payment rate, regardless of the number of services provided to the patient or the length of the patient’s hospital stay. Under Medicare’s acute care PPS, a hospital may retain the difference, if any, between its DRG payment rate and its operating costs incurred in furnishing inpatient services, and is at risk for any operating costs that exceed its DRG payment rate.

On August 12, 2005, CMS published its final rule for fiscal year 2006 acute care inpatient PPS payments. Acute care hospitals that report selected quality data will receive a 3.7% increase in payment rates under the inpatient PPS. Acute care hospitals that do not participate in the quality reporting initiative will receive only a 3.3% increase in payments. Because we receive very limited revenues from the acute care PPS, these changes are not material to us. The final rule also expands the number of DRGs that are subject to the post-acute transfer policy in order to reduce payment to acute care hospitals when the patient is prematurely transferred to a post-acute care setting. This transfer policy applies to 182 DRGs. This transfer policy has a direct impact on acute care hospital payments. In addition, the transfer policy indirectly affects our IRFs by changing the timing of when patients may be referred to our hospitals. At this time, we cannot determine whether the transfer policy will have a material adverse effect on net operating revenues in any of our facilities.

Inpatient Rehabilitation and the 75% Rule. Historically, freestanding and hospital-based IRF units received cost-based reimbursement from Medicare under an exemption from the acute care PPS. The Balanced Budget Act of 1997 and its implementing regulations replaced the traditional IRF cost-based methodology, however, with a PPS system that recognizes 21 “Rehabilitation Impairment Categories.” This IRF-PPS became effective on January 1, 2002.

 

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To qualify as an IRF under Medicare, a facility must show that a certain percentage of its patients are treated for at least one of a specified list of medical conditions. Under a May 7, 2004 CMS regulation, the “75% Rule” identifies the following 13 qualifying conditions:

 

    stroke

 

    spinal cord injury

 

    congenital deformity

 

    amputation

 

    major multiple trauma

 

    fracture of the femur (hip fracture)

 

    brain injury

 

    neurological disorders

 

    burns

 

    active, polyarthricular rheumatoid arthritis, psoriatic arthritis, and seronegative arthropathies

 

    systemic vasculidities with joint inflammation

 

    severe/advanced osteoarthritis involving two or more major weight-bearing joints (not counting joints with a prosthesis) with joint deformity, substantial loss of range of motion, and atrophy of muscles surrounding the joint

 

    knee or hip joint replacement, with at least one of three specific circumstances

CMS established an initial phase-in period for compliance with the 75% Rule, as follows:

 

Cost Reporting Period

   Minimum Qualifying
Patient Mix
    Patient Mix Affected

July 1, 2004—June 30, 2005

   50 %   Medicare or Total

July 1, 2005—June 30, 2006

   60 %   Medicare or Total

July 1, 2006—June 30, 2007

   65 %   Medicare or Total

July 1, 2007 and Thereafter

   75 %   Total

On February 8, 2006, the Deficit Reduction Act of 2005 was signed into law as Public Law 109-171. The legislation redefined the phase-in period for compliance with the 75% Rule. The following phase-in schedule is now applicable:

 

Cost Reporting Period

   Minimum Qualifying
Patient Mix
    Patient Mix Affected

July 1, 2006—June 30, 2007

   60 %   Medicare or Total

July 1, 2007—June 30, 2008

   65 %   Medicare or Total

July 1, 2008 and Thereafter

   75 %   Total

Any IRF that fails to meet the requirements of the 75% Rule is subject to prospective reclassification as an acute care hospital. The effect of such reclassification would be to revert Medicare IRF-PPS payment rates to lower acute care payment rates for rehabilitative services (assuming that state certificate of need and licensing rules permit the use of the beds for acute care services).

Our inpatient division has begun to reduce or refocus admissions at most locations in response to the phase-in schedule for the 75% Rule. This has resulted in volume volatility that has had a significantly negative impact on our inpatient division’s net operating revenues in 2005. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed earlier in this Item, “Our Business—Operating Divisions.”

 

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On August 15, 2005, CMS published a final rule, as amended by the subsequent correction notice published on September 30, 2005, that updates the IRF-PPS for the federal fiscal year 2006 (which covers discharges occurring on or after October 1, 2005 and on or before September 30, 2006). Although the final rule includes an overall market basket update of 3.6%, it makes several other adjustments that we estimate will result in a net reduction in reimbursement to us. For example, the final rule (1) reduces the standard payment rates by 1.9%, (2) implements changes to Case-Mix Groups, comorbidity tiers, and relative weights, (3) updates the formula for the low income patient payment adjustment, (4) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, (5) implements new and revised payment adjustments on a budget-neutral basis, (6) implements a new indirect medical education teaching adjustment, (7) increases the rural add-on to 21.3%, and (8) incorporates several other modifications to Medicare reimbursement for IRFs. Although CMS predicted that overall payments to IRFs nationwide would increase by 3.4%, we estimate that the revised IRF-PPS will reduce Medicare reimbursement to our IRFs by 3.5% to 4%, primarily owing to the changes to Case-Mix Groups, comorbidity tiers, and relative weights. We estimate this net impact on reimbursement will reduce our inpatient division’s net operating revenues by approximately $10 million per quarter for the first three quarters of 2006 as compared to 2005. These estimates do not take into account potential changes in our case-mix resulting from our compliance with the 75% Rule, which could have the effect of increasing the acuity of our case-mix and therefore reducing the overall net impact of the IRF-PPS changes.

The combination of volume volatility created by the 75% Rule and lower unit pricing resulting from recent IRF-PPS changes reduced our operating earnings in 2005 and will have a continuing negative impact on our operating earnings in 2006. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for additional information about the impact of these changes. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Although the 75% Rule and changes to IRF-PPS represent the most significant operating challenge to our inpatient division, other coverage policies can affect our operations. For example, Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria for determining the medical appropriateness of services provided by IRFs. Other Medicare fiscal intermediaries also have implemented local coverage rules. We cannot predict how these local coverage rules will affect us.

Long-Term Acute Care Hospitals. LTCHs provide medical treatment to patients with chronic diseases and/or complex medical conditions. In order for a facility to qualify as an LTCH, patients discharged from the facility in any given cost reporting year must have an average length-of-stay in excess of 25 days. Historically, LTCHs have been exempt from the acute care PPS and have received Medicare reimbursement on the basis of reasonable costs subject to certain limits. However, this cost-based reimbursement has been transitioning to a PPS system over a 5-year period which began for twelve-month periods beginning on or after October 1, 2002. Providers were given the option to transition into the full LTCH-PPS by receiving 100% of the federal payment rate at any time through the transition period. We have elected to receive the full federal payment rate for all of our LTCHs. Under the new LTCH-PPS system, Medicare classifies patients into distinct diagnostic groups (“LTC-DRGs”) based upon specific clinical characteristics and expected resource needs. The LTCH-PPS also provides for an adjustment for differences in area wages as well as a cost of living adjustment for LTCHs located in Alaska or Hawaii.

Effective July 1, 2004, CMS expanded its interrupted stay policy to include a discharge and readmission to the LTCH within three days, regardless of where the patient is transferred upon discharge. Accordingly, if a

 

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patient is readmitted to an LTCH within three days of discharge, Medicare will pay only one LTC-DRG. This expanded, but did not replace, the prior interrupted stay policy which provides that if an LTCH patient is discharged to an acute care hospital, an IRF, or a skilled nursing facility and then is readmitted to the LTCH within a fixed period of time, the entire hospitalization, both before and after the interruption, will be considered one episode of care and thus generate one LTC-DRG payment.

Effective October 1, 2004, CMS promulgated regulations altering the separateness and control requirements pertaining to LTCHs which are located within a hospital. Such hospitals within hospitals (“HIHs”) must meet more stringent requirements as to their independence from the host hospital and further must follow additional HIH requirements based upon the percentage of admittances from the host hospital. These HIH policies are to be phased in over a four-year period which began on October 1, 2004. See this Item, “Regulation—Hospital Within Hospital Rules.”

On May 6, 2005, CMS published a final rule regarding LTCH-PPS rate updates and policy changes effective for discharges on or after July 1, 2005. The final rule increases LTCH-PPS standard payment rates by 3.4% and adopts revised labor market area definitions based on the Core-Based Statistical Areas designated by the Office of Management and Budget using 2000 census data. The final rule also lowers the eligibility threshold for hospitals to qualify for outlier payments. On August 12, 2005, CMS published its final fiscal year 2006 acute care inpatient PPS update rule, which impacts LTCH relative weights and LTC-DRG assignments for the period October 1, 2005 through September 30, 2006. This final rule reduces total Medicare payments to us as a result of the impact of the relative weight calculations on our LTCH reimbursement. We estimate that both final rule revisions will cause a reduction in net operating revenues of approximately $2.5 million for the period affected.

On January 27, 2006, CMS issued proposed regulations that would update the annual payment rates under the LTCH-PPS for rate year 2007, which is effective for discharges occurring on or after July 1, 2006 through June 30, 2007. The proposal would (1) provide no market basket increase for rate year 2007, (2) substantially reduce Short Stay Outlier payments, (3) increase the High Cost Outlier threshold, reducing outlier payments, (4) phase-out the Surgical DRG exception for interrupted stays, (5) implements a new method to determine future market basket increases, (6) increase the labor-related share, and (7) make certain other payment policy changes that would impact the LTCH-PPS. CMS has predicted that overall payments to LTCHs nationwide would be decreased by 11.1%, or $362 million, under the proposed rule. We estimate that the impact on reimbursement would be a reduction in our inpatient division’s net operating revenues of approximately $5.3 million in the third and fourth quarters of 2006 combined and of approximately $10.6 million on an annualized basis.

CMS has contracted with the Research Triangle Institute, International (“RTI”) to analyze the feasibility of further defining “facility and patient criteria to ensure patients admitted to LTCHs are medically complex and have a good chance of improvement.” This study has the potential to develop new admission criteria that may create tighter restrictions on LTCH admissions similar to the “75% Rule.” While difficult to predict, these changes could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Ambulatory Surgery Centers. ASC services are reimbursed by Medicare based on prospectively determined rates. Surgical procedures approved by CMS for ASC reimbursement are classified into nine payment groups based on cost for facility reimbursement purposes. All approved surgical procedures within the same payment group are reimbursed at a single rate, adjusted by the location of the facility and applicable wage index. On May 4, 2005, CMS published an interim final rule updating the list of approved surgical procedures. The interim final rule, which became effective on July 1, 2005, deletes five approved procedures and adds 65 new procedures to the list of approved surgical procedures.

Other significant changes in ASC reimbursement have been adopted in recent years, and more are being contemplated. The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“MMA”)

 

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reduced the payment update for ASC services for fiscal year 2004, changed the update cycle from a fiscal year to a calendar year, and eliminated the updates for fiscal year 2005 through calendar year 2009. The MMA also directed HHS to implement a new payment system by 2008, taking into account a Government Accountability Office (“GAO”) report of ASCs to be completed by December 31, 2004. The report, which has not yet been issued, will examine the costs of providing the same services in ASCs versus hospital outpatient departments, the accuracy of ASC payment categories, and whether it would be appropriate to base a new ASC payment system upon the hospital outpatient system.

Both the Medicare Payment Advisory Commission (“Med PAC”) and the HHS-OIG have recommended greater coordination of payments for services performed in hospital outpatient departments (“HOPDs”) and those performed in ASCs. Such coordination could result in lower payments for certain procedures that receive higher reimbursement in ASCs than in a HOPD, but could result in higher reimbursement for those services currently priced lower in ASCs than in HOPDs. The Deficit Reduction Act of 2005 placed a cap on ASC payments paid above HOPD rates. The cap limits all ASC reimbursement that would otherwise exceed the HOPD payment to the amount of the HOPD price, effective for services furnished on or after January 1, 2007.

Further reductions in ASC Medicare reimbursement are possible. Any significant reductions in Medicare reimbursement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Outpatient Rehabilitation. Most of our outpatient rehabilitation facilities are certified by Medicare. Therapy services are reimbursed by Medicare under the Physician Fee Schedule. A fixed fee is paid per reimbursable procedure performed. This fee is adjusted by the geographical area in which the facility is located. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee schedule payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services. Both of these amounts were indexed for inflation. The therapy caps do not apply to therapy services provided in hospital outpatient departments. Subsequent legislation suspended implementation of these caps through 2002. CMS began enforcing the therapy caps on September 1, 2003 (the inflation-adjusted amounts for 2003 were $1,590). The MMA suspended application of the therapy cap from the date of enactment (December 8, 2003) through calendar year 2005. Effective January 1, 2006, the therapy caps are effective and set at $1,740 per beneficiary per year. However, the Deficit Reduction Act of 2005 established an exception to the caps for medically necessary services for calendar year 2006. On February 15, 2006, CMS published procedures to implement the exception process. The process provides for two groups of exceptions, automatic and manual. Automatic exceptions, which do not require advance approval, apply to certain conditions or complexities that have a direct and significant effect on the need for additional therapy. CMS established a list of the diagnoses as well as certain clinically complex situations that qualify for automatic exceptions. Providers are required to document the basis for qualification for an exception. Manual exceptions require submission of a written request to the appropriate Medicare payment contractor (i.e., fiscal intermediary or carrier). If the patient has a condition or complexity that does not qualify for an automatic exception, but the treatment is considered to be medically necessary, the provider or beneficiary may request up to 15 treatment days of service beyond the cap. If, at the end of 10 business days after the request, the Medicare payment contractor has not responded, the exception is deemed approved. We anticipate these therapy caps will have a negative impact on net operating revenues in our outpatient division. The extent of that impact will depend on both the administration of the medical necessity exception process by CMS and the response of possible deferral of therapy treatment by Medicare patients subject to the cap.

Outpatient rehabilitation professional services are reimbursed under the Medicare Physician Fee Schedule. Under a final rule published November 21, 2005, CMS proposed a 4.4% across-the-board reduction in Medicare reimbursement for physician fee schedule services in calendar year 2006. The Deficit Reduction Act of 2005 blocks the fee reduction for 2006 and instead provides for a payment freeze for 2006. In the absence of further legislative action, however, additional reductions in Medicare reimbursement for services provided under the physician fee schedule are expected beginning in 2007 and beyond.

 

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Diagnostic Facilities. Medicare allows diagnostic facilities that are independent of physician practices or hospitals to bill for approved diagnostic procedures as Independent Diagnostic Testing Facilities (“IDTFs”). Such procedures must be performed by licensed or certified nonphysician personnel under appropriate physician supervision or by physicians in accordance with detailed guidelines. IDTFs are reimbursed for approved tests with required physician orders on the basis of appropriate Current Procedural Terminology (“CPT”) codes under Medicare Part B. CPT reimbursement is geographically adjusted by CMS. Medicare uses the Physician Fee Schedule to pay for services provided in freestanding imaging centers. Each CPT code is assigned a set of relative value units (“RVUs”) that reflects the average time, effort, and practice costs (including a geographic adjustment) involved in performing a given procedure. Medicare payment amounts are based on a procedure’s total RVUs multiplied by a dollar conversion factor. Medicare makes payment determinations for diagnostic radiology procedures and imaging agents based on where the procedure is performed. More specifically, Medicare uses different payment methodologies for procedures performed in a hospital outpatient department versus an IDTF.

On November 21, 2005, CMS issued a final Physician Fee Schedule rule that reduces payment for the technical component of subsequent diagnostic imaging procedures performed in the same session on contiguous body areas. This reduction will be phased in over two years with a 25% reduction for the 2006 calendar year and a 50% reduction for the 2007 calendar year. Certain diagnostic tests conducted in IDTFs require multiple imaging procedures. Accordingly, this reduction could result in a significant reduction in IDTF Medicare reimbursement and may negatively affect our diagnostic division. The rule also called for a 4.4% across-the-board reduction in Medicare reimbursement for Physician Fee Schedule services in calendar year 2006. The Deficit Reduction Act of 2005 blocks the fee reduction for 2006 and instead provides for a payment freeze for 2006. In the absence of further legislative reforms, however, additional reductions in Medicare reimbursement for services provided under the Physician Fee Schedule are expected beginning in 2007 and beyond. The Deficit Reduction Act of 2005 also provides that payment rates for imaging services delivered in physician offices and independent diagnostic testing facilities may not exceed payment rates for identical imaging services delivered in hospital outpatient departments, effective for services furnished on or after January 1, 2007. Specifically, the technical component (including the technical component of the global fee) of a radiology service under the Physician Fee Schedule will be reduced if it exceeds (without regard to the geographic wage adjustment factor) the ambulatory payment classification reimbursement amount under the hospital outpatient prospective payment system (“OPPS”). Imaging services affected by this provision are: imaging and computer-assisted imaging services, including X-ray, ultrasound (including echocardiography), nuclear medicine (including positron emission tomography), magnetic resonance imaging, computed tomography, and fluoroscopy, but excluding diagnostic and screening mammography.

Hospital Outpatient Surgical Services. The Balanced Budget Act of 1997 authorized CMS to implement OPPS on July 1, 2000 for certain hospital outpatient services (excluding diagnostic laboratory services, ambulance services, orthotics, prosthetics, chronic dialysis, screening mammographies, and outpatient rehabilitation services). All services and items paid under the OPPS are classified into groups called Ambulatory Payment Classifications (“APCs”), with a per-service payment rate established for each APC. Our three surgical hospitals, which provide mostly outpatient surgical services, as well as our acute care hospital located in Birmingham, Alabama, are paid under the OPPS for outpatient surgical services.

On November 15, 2004, CMS published the 2005 OPPS final rule. The rule affected Medicare outpatient services furnished on or after January 1, 2005 and before January 1, 2006. The rate adjustments to the OPPS mainly affected the Birmingham Medical Center and our three surgical hospitals. The changes were expected to increase Medicare outpatient net operating revenues for these facilities.

On November 10, 2005, CMS published a final rule to update OPPS payment rates for calendar year 2006. CMS projects that the update will increase OPPS payments by 2.2% after taking into account changes in drug reimbursement. At this time, we are unable to quantify the impact this rule will have on our business.

 

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Fiscal Year 2007 Proposed Budget. On February 6, 2006, President Bush proposed a federal budget for fiscal year 2007. Among other things, the budget would eliminate Medicare payment increases for IRFs, LTCHs, SNFs, and home health services for the 2007 fiscal year. In 2008 and 2009, the budget proposes that IRFs and certain other providers receive a Medicare payment update of market basket minus 0.4%. These provisions are expected to reduce Medicare IRF spending by $1.59 billion in fiscal years 2007 through 2011. The President’s budget also calls for reductions in Medicare payments to IRFs for hip and knee replacements to decrease variances in payments based on site of care. Specifically, for services provided to hip and knee replacement patients, the proposal would pay IRFs the average amount paid to skilled nursing facilities (“SNFs”), plus one third of the difference between the average IRF payment amount and the average SNF payment rate. Each of these budget recommendations requires Congressional approval, with the exception of those relating to LTCH reimbursement which can be implemented administratively. Any of these budget recommendations, if approved, could have an adverse effect on our future operating results and financial condition.

The proposed budget also proposes to phase out all Medicare bad debt reimbursement to providers between 2007 and 2011. If enacted, we estimate that this phase out would reduce our Medicare reimbursement by approximately $1.8 million. The President’s budget also proposes the enactment of legislation that would impose across-the-board spending reductions of 0.4% for all Medicare payment systems if: (1) general revenues are projected to exceed 45% of total Medicare financing and (2) Congress fails to act upon recommendations to reduce that percentage below 45%. The 0.4% reduction would grow annually as long as general revenues exceed 45% of total Medicare financing. Legislation would be necessary to enact both of these changes.

Medicaid Reimbursement

Medicaid programs are jointly funded by the federal and state governments. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodologies and coverage policies from state to state. Many states have experienced shortfalls in their Medicaid budgets and are implementing significant cuts in Medicaid reimbursement rates. Additionally, certain states control Medicaid expenditures through restricting or eliminating coverage of certain services. Continuing downward pressure on Medicaid payment rates could cause a decline in revenues.

Cost Reports

Because of our participation in the Medicare, Medicaid, and TRICARE programs, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient and certain surgery center hospitals to Medicare beneficiaries and Medicaid recipients.

Annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due HealthSouth under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to these programs and to set payment levels for future years. In addition, as a result of the reconstruction of our accounting records we are reviewing previously submitted cost reports to ensure that they accurately reflect the revenue, costs, and expenses associated with services provided at our facilities. The majority of our revenues are derived from prospective payment system payments, and even if we amend previously filed cost reports we do not expect the impact of those amendments to materially affect our inpatient division or surgery centers division results of operations.

On December 30, 2004, we announced that HealthSouth had signed an agreement with CMS to resolve issues associated with various Medicare cost reporting practices. Subject to certain exceptions, the settlement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports which had, or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost

 

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reporting periods ended on or before December 31, 2003. The settlement provides that all covered federal cost reports be closed and considered final and settled. Open state Medicaid cost reports still are subject to potential audits as described above. See this Item, “Medicare Program Settlement.”

Managed Care and Other Discounted Plans

Most of our facilities offer discounts from established charges to certain large group purchasers of health care services, including managed care plans, BCBS, other private insurance companies, and employers. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent, we cannot provide any assurance that we will continue to receive increases.

Regulation

The health care industry is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our facilities, regulating the use of our properties, and controlling our growth.

Licensure and Certification

Health care facility construction and operation are subject to numerous federal, state, and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, fire prevention, and compliance with building codes and environmental protection laws. Our facilities are subject to periodic inspection by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient facilities and substantially all of our ASCs are currently required to be licensed. Only a relatively small number of states require licensure for outpatient rehabilitation facilities. Many states do not require diagnostic facilities to be licensed.

In addition, facilities must be “certified” by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. All of our inpatient facilities participate in (or are awaiting the assignment of a provider number to participate in) the Medicare program. As of December 31, 2005, approximately 92% of our outpatient therapy facilities (including outpatient rehabilitation facilities and other outpatient facilities) participate in, or are awaiting the assignment of a provider number to participate in, the Medicare program. Substantially all of our ASCs and diagnostic centers are certified (or are awaiting certification) under the Medicare program. Our Medicare-certified facilities undergo periodic on-site surveys in order to maintain their certification.

Failure to comply with applicable certification requirements may make our facilities ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing quality assurance activities; however, given the complex nature of governmental health care regulations, there can be no assurance that Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance.

Certificates of Need

In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state

 

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regulatory agencies under “certificate of need” laws. Certificate of need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of need laws generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. Most states do not require such approvals for outpatient rehabilitation, occupational health, or diagnostic facilities and services. However, any time a certificate of need is required, we must obtain it before acquiring, opening, reclassifying, or expanding a health care facility or starting a new health care program.

False Claims Act

Over the past several years, an increasing number of health care providers have been accused of violating the federal False Claims Act. That act prohibits the knowing presentation of a false claim to the United States government, and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as “relators,” to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because of the sealing provisions of the False Claims Act, it is possible for health care providers to be subject to False Claims Act suits for extended periods of time without notice of such suits or an opportunity to respond to them. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act or other laws. We have recently entered into a substantial settlement of claims under the False Claims Act. See this Item, “Medicare Program Settlement.” We remain a named defendant in certain unsealed suits under the False Claims Act where the United States did not intervene. See Item 3, Legal Proceedings, “Certain Regulatory Actions.”

Corporate Integrity Agreement

As described in this Item, “Medicare Program Settlement,” we entered into a new corporate integrity agreement (“CIA”) in December 2004, which is effective for five years beginning January 1, 2005. Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. See Note 21, Medicare Program Settlement, in the accompanying consolidated financial statements for a description of the accounting treatment of the settlement relating to this CIA. On April 28, 2005, we submitted an implementation report to the HHS-OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.

Relationships with Physicians and Other Providers

The Anti-Kickback Law. Various state and federal laws regulate relationships between providers of health care services, including employment or service contracts and investment relationships. Among the most important of these restrictions is a federal criminal law prohibiting (1) the offer, payment, solicitation, or receipt of remuneration by individuals or entities to induce referrals of patients for services reimbursed under the Medicare or Medicaid programs or (2) the leasing, purchasing, ordering, arranging for, or recommending the lease, purchase, or order of any item, good, facility, or service covered by such programs (the “Anti-Kickback Law”). In addition to federal criminal sanctions, including penalties of up to $50,000 for each violation plus tripled damages for improper claims, violators of the Anti-Kickback Law may be subject to exclusion from the Medicare and/or Medicaid programs. In 1991, the HHS-OIG issued regulations describing compensation arrangements that are not viewed as illegal remuneration under the Anti-Kickback Law (the “1991 Safe Harbor Rules”). The 1991 Safe Harbor Rules create certain standards (“Safe Harbors”) for identified types of compensation arrangements that, if fully complied with, assure participants in the particular arrangement that the HHS-OIG will not treat that participation as a criminal offense under the Anti-Kickback Law or as the basis for an exclusion from the Medicare and Medicaid programs or the imposition of civil sanctions.

 

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The HHS-OIG closely scrutinizes health care joint ventures involving physicians and other referral sources for compliance with the Anti-Kickback Law. In 1989, the HHS-OIG published a Fraud Alert that outlined questionable features of “suspect” joint ventures, and has continued to rely on such Fraud Alert in later pronouncements. We currently operate some of our rehabilitation hospitals and outpatient rehabilitation facilities as general partnerships, limited partnerships, or limited liability companies (collectively, “partnerships”) with third-party investors, including other institutional health care providers but also including, in a number of cases, physician investors. Some of these partners may be deemed to be in a position to make or influence referrals to our facilities. Those partnerships that are providers of services under the Medicare program, and their owners, are subject to the Anti-Kickback Law. A number of the relationships we have established with physicians and other health care providers do not fit within any of the Safe Harbors. The 1991 Safe Harbor Rules do not expand the scope of activities that the Anti-Kickback Law prohibits, nor do they provide that failure to fall within a Safe Harbor constitutes a violation of the Anti-Kickback Law; however, the HHS-OIG has indicated that failure to fall within a Safe Harbor may subject an arrangement to increased scrutiny. While we do not believe that our rehabilitation facility partnerships engage in activities that violate the Anti-Kickback Law, there can be no assurance that such violations may not be asserted in the future, nor can there be any assurance that our defense against any such assertion would be successful.

Most of our ASCs are owned by partnerships, which include as partners physicians who perform surgical or other procedures at such centers. HHS has promulgated four categories of safe harbors under the Anti-Kickback Law for ASCs (the “ASC Safe Harbors”). Under the ASC Safe Harbors, ownership by a referring physician in a freestanding ASC will be protected if a number of conditions are satisfied. The conditions include the following:

 

    The center must be ASC certified to participate in the Medicare program and its operating and recovery room space must be dedicated exclusively to the ASC and not a part of a hospital (although such space may be leased from a hospital if such lease meets the requirements of the safe harbor for space rental).

 

    Each investor must be either (1) a physician who derived at least one-third of his or her medical practice income for the previous fiscal year or 12-month period from performing procedures on the list of Medicare-covered procedures for ASCs, (2) a hospital, or (3) a person or entity not in a position to make or influence referrals to the center, nor to provide items or services to the center, nor employed by the center or any investor.

 

    Unless all physician-investors are members of a single specialty, each physician-investor must perform at least one-third of his or her procedures at the center each year. (This requirement is in addition to the requirement that the physician-investor has derived at least one-third of his or her medical practice income for the past year from performing procedures.)

 

    Physician-investors must have fully informed their referred patients of the physician’s investment interest.

 

    The terms on which an investment interest is offered to an investor are not related to the previous or expected volume of referrals, services furnished, or the amount of business otherwise generated from that investor to the entity.

 

    Neither the center nor any other investor may loan funds to or guarantee a loan for an investor if the investor uses any part of such loan to obtain the investment interest.

 

    The amount of payment to an investor in return for the investment interest is directly proportional to the amount of the capital investment (including the fair market value of any pre-operational services rendered) of that investor.

 

    All physician-investors, any hospital-investor, and the center agree to treat patients receiving medical benefits or assistance under the Medicare or Medicaid programs.

 

    All ancillary services performed at the center for beneficiaries of federal health care programs must be directly and integrally related to primary procedures performed at the center and may not be billed separately.

 

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    No hospital-investor may include on its cost report or any claim for payment from a federal health care program any costs associated with the center.

 

    The center may not use equipment owned by or services provided by a hospital-investor unless such equipment is leased in accordance with an agreement that complies with the equipment rental safe harbor and such services are provided in accordance with a contract that complies with the personal services and management contracts safe harbor.

 

    No hospital-investor may be in a position to make or influence referrals directly or indirectly to any other investor or the center.

Because we invest in each partnership that owns an ASC and often provide management and other services to the ASC, our arrangements with physician investors do not fit within the terms of the ASC Safe Harbors. In addition, because we do not control the medical practices of our physician investors or control where they perform surgical procedures, in some of our ASCs, the quantitative tests described above have not been met and/or will not be met in the future, and certain other conditions of the ASC Safe Harbors have not been or will not be satisfied. We cannot ensure that all physician-investors will perform, or have performed, one-third of their procedures at the ASC or have informed or will inform their referred patients of their investment interests. Accordingly, there can be no assurance that the ownership interests in some of our ASCs will not be challenged under the Anti-Kickback Law.

Some of our diagnostic centers are also owned or operated by partnerships that include radiologists as partners. While those ownership interests are not directly covered by the Safe Harbor Rules, we do not believe that the structure of such arrangements violate the Anti-Kickback Law because radiologists are typically not in a position to make referrals to diagnostic centers. In addition, our mobile lithotripsy operations are conducted by partnerships in which urologists are limited partners. Because such urologists are in a position to, and do, perform lithotripsy procedures utilizing our lithotripsy equipment, we believe that the same analysis underlying the ASC Safe Harbor should apply to ownership interests in lithotripsy equipment held by urologists. There can be no assurance, however, that the Anti-Kickback Law will not be interpreted in a manner contrary to our beliefs with respect to diagnostic and lithotripsy services.

We have entered into agreements to manage many of our facilities that are owned by partnerships in which physicians have invested. A number of these agreements incorporate a percentage-based management fee. Although there is a safe harbor for personal services and management contracts, this safe harbor requires, among other things, that the aggregate compensation paid to the manager over the term of the agreement be set in advance. Because our management fee may be based on a percentage of revenues, the fee arrangement may not meet this requirement. However, we believe that our management arrangements satisfy the other requirements of the safe harbor for personal services and management contracts and that they comply with the Anti-Kickback Law. The HHS-OIG has taken the position that percentage-based management agreements are not protected by a safe harbor, and consequently, may violate the Anti-Kickback Law. On April 15, 1998, the HHS-OIG issued Advisory Opinion 98-4 which reiterates this proposition. This opinion focused on areas the HHS-OIG considers problematic in a physician practice management context, including financial incentives to increase patient referrals, no safeguards against overutilization, and incentives to increase the risk of abusive billing. The opinion reiterated that proof of intent to violate the Anti-Kickback Law is the central focus of the HHS-OIG. We have implemented programs designed to safeguard against overbilling and otherwise achieve compliance with the Anti-Kickback Law and other laws, but we cannot assure you that the HHS-OIG would find our compliance programs to be adequate.

While several federal court decisions have aggressively applied the restrictions of the Anti-Kickback Law, they provide little guidance as to the application of the Anti-Kickback Law to our partnerships, and we cannot provide any assurances that a federal or state agency charged with enforcement of the Anti-Kickback Law and similar laws might not claim that some of our partnerships have violated or are violating the Anti-Kickback Law. Such a claim could adversely affect relationships we have established with physicians or other health care

 

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providers or result in the imposition of penalties on us or on particular HealthSouth facilities. Any conviction of a partnership for violations of the Anti-Kickback Law would have severe consequences on that partnership’s ability to be a viable entity and our ability to attract physician investors to other partnerships and could result in substantial fines as well as our exclusion from Medicare and Medicaid. Moreover, even the assertion of a violation of the Anti-Kickback Law by one or more of our partnerships could have a material adverse effect upon our business, financial condition, results of operations, or cash flows.

Stark Prohibitions. The so-called “Stark II” provisions of the Omnibus Budget Reconciliation Act of 1993 amend the federal Medicare statute to prohibit the making by a physician of referrals for “designated health services” including physical therapy, occupational therapy, radiology services, or radiation therapy, to an entity in which the physician has an investment interest or other financial relationship, subject to certain exceptions. Such prohibition took effect on January 1, 1995 and applies to all of our partnerships with physician partners and to our other financial relationships with physicians. Final Phase II Stark Regulations were published in the Federal Register on March 26, 2004 and had an effective date of July 26, 2004. The final regulations substantially clarified recruitment arrangements among health care facilities, individual physicians, and group practices and addressed compensation arrangements with physicians.

Ambulatory surgery is not identified as a “designated health service” under Stark II, and we do not believe the statute is intended to cover ambulatory surgery services. The Phase I Final Stark Regulations expressly clarify that the provision of designated health services in an ASC is excepted from the referral prohibition of Stark II if payment for such designated health services is included in the ambulatory surgery center payment rate. Likewise, the Stark Regulations expressly provide that a referral for designated health services does not include a request by a radiologist for diagnostic radiology services if the request results from a consultation initiated by another physician and the tests or services are furnished by or under the supervision of a radiologist. As a result, we believe that radiologists may enter into joint ventures for diagnostic imaging centers without violating Stark II in most circumstances.

Our lithotripsy units frequently operate on hospital campuses. CMS has indicated that lithotripsy services provided at a hospital would constitute “inpatient and outpatient hospital services” and thus would be subject to Stark II. However, a federal court decision does not support this interpretation. On January 3, 2003, CMS withdrew its appeal of Judge Henry Kennedy’s decision in American Lithotripsy Society and Urology Society of America v. Thompson, made in the Federal District Court for the District of Columbia. The Court of Appeals accepted the withdrawal, and, accordingly, the District Court decision is final. This order permanently enjoined CMS from implementing and enforcing its Stark II Regulations declaring lithotripsy a “designated health service.” However, according to CMS, even if lithotripsy provided under arrangement with a hospital is not a designated health service, this arrangement would result in an “indirect compensation relationship” between the urologist and the hospital with which the lithotripsy entity has an arrangement. Under that theory, referrals by the physician for designated health service other than lithotripsy (e.g. radiology, radiation oncology, etc.) are still prohibited unless the lithotripsy facility/hospital arrangement meets a Stark II exception. If Congress passes revised legislation on this topic, CMS adopts additional regulations or is otherwise successful in re-asserting its position on lithotripsy services and Stark, we would be forced to restructure many of our relationships for lithotripsy services at substantial cost.

While we do not believe that our financial relationships with physicians violate the Stark II statute or the associated regulations, no assurances can be given that a federal or state agency charged with enforcement of the Stark II statute and regulations or similar state laws might not assert a contrary position or that new federal or state laws governing physician relationships, or new interpretations of existing laws governing such relationships, might not adversely affect relationships we have established with physicians or result in the imposition of penalties on us or on particular HealthSouth facilities. Even the assertion of a violation could have a material adverse effect upon our business, financial condition, or results of operations. In addition, a number of states have passed or are considering statutes which prohibit or limit physician referrals of patients to facilities in which they have an investment interest. Any actual or perceived violation of these state statutes could have a material adverse effect on business, financial condition, results of operations, and cash flows.

 

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HIPAA

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain fraud and abuse laws by adding several criminal provisions for health care fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program, and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers, and managing employees associated with business entities that have committed health care fraud, even if the officer or managing employee had no knowledge of the fraud.

HIPAA also contains certain administrative simplification provisions that require the use of uniform electronic data transmission standards for certain health care claims and payment transactions submitted or received electronically. HHS has issued regulations implementing the HIPAA administrative simplification provisions and compliance with these regulations became mandatory for our facilities on October 16, 2003. Although HHS temporarily agreed to accept noncompliant Medicare claims, CMS stopped processing non-HIPAA-compliant Medicare claims beginning October 1, 2005. We believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial condition, results of operations, and cash flows.

HIPAA also requires HHS to adopt standards to protect the privacy and security of individually identifiable health-related information. HHS released regulations containing privacy standards in December 2000 and published revisions to the regulations in August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations regulate the use and disclosure of individually identifiable health-related information, whether communicated electronically, on paper, or orally. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed. HHS released security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require health care providers to implement administrative, physical, and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The privacy regulations and security regulations could impose significant costs on our facilities in order to comply with these standards.

Penalties for violations of HIPAA include civil and criminal monetary penalties. In addition, there are numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy concerns. Facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These statutes vary and could impose additional penalties.

EMTALA

Our acute care hospital in Birmingham, Alabama and two of our surgical hospitals are subject to the Emergency Medical Treatment and Active Labor Act (“EMTALA”). This federal law requires any hospital that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospital’s emergency room for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patient’s ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patient’s ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patient’s family, or a medical facility that suffers a financial loss as a direct result of another hospital’s violation of the law can bring a civil suit against the hospital.

 

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Hospital Within Hospital Rules

Effective October 1, 2004, CMS enacted final regulations that provide if a long-term acute care “hospital within hospital” has Medicare admissions from its host hospital that exceed 25% (or an adjusted percentage for certain rural or Metropolitan Statistical Area dominant hospitals) of its Medicare discharges for its cost-reporting period, the LTCH will receive an adjusted payment for its Medicare patients of the lesser of (1) the otherwise full payment under the LTCH-PPS or (2) a comparable payment that Medicare would pay under the acute care inpatient PPS. In determining whether an LTCH meets the 25% criterion, patients transferred from the host hospital that have already qualified for outlier payments at the acute host facility would not count as part of the host hospital’s allowable percentage. Cases admitted from the host hospital before the LTCH crosses the 25% threshold will be paid under the LTCH-PPS. Under the final regulation, this “25% Rule” is being phased in over a four year period which began on October 1, 2004.

Additionally, other excluded hospitals or units of a host hospital, such as inpatient rehabilitation facilities and/or units, must meet certain HIH requirements in order to maintain their excluded status and not be subject to Medicare’s acute care inpatient PPS.

The majority of our IRFs and LTCHs are freestanding facilities. As such, many of HealthSouth’s facilities are not subject to these rules. However, HIH rules are complex and there can be no assurance that future CMS interpretations will not adversely affect our facilities. HealthSouth’s “hospital within hospital” LTCH or inpatient competitors or their referral sources could refer a certain number of patients to free-standing facilities for LTCH or inpatient rehabilitation services in order to comply with this policy, and thus HealthSouth facilities may benefit from increased referrals.

Patient Safety and Quality Improvement Act of 2005

On July 29, 2005, the President signed the Patient Safety and Quality Improvement Act of 2005 which has the goal of reducing medical errors and increasing patient safety. This legislation establishes a confidential reporting structure in which providers can voluntarily report “Patient Safety Work Product” (“PSWP”) to “Patient Safety Organizations.” Under the system, PSWP is made privileged, confidential, and legally protected from disclosure. PSWP does not include medical, discharge, or billing records or any other original patient or provider records but does include information gathered specifically in connection with the reporting of medical errors and improving patient safety. This legislation does not preempt state or federal mandatory disclosure laws concerning information that does not constitute PSWP. Patient Safety Organizations will be certified by the Secretary of HHS for three year periods after the Secretary develops applicable certification criteria. Patient Safety Organizations will analyze PSWP, provide feedback to providers and may report non-identifiable PSWP to a database. In addition, these organizations are expected to generate patient safety improvement strategies. We are presently evaluating our participation in this voluntary reporting process.

Risk Management and Insurance

We insure a substantial portion of our professional, general liability, and workers’ compensation risks through a self-insured retention program implemented through HCS, Ltd., which is our wholly-owned offshore captive insurance subsidiary. HCS provides our first layer of insurance coverage for professional and general liability risks (up to $6 million per claim and $60 million in the aggregate per year) and workers’ compensation claims (between $250,000 and $1 million per claim, depending upon the state). We maintain professional and general liability insurance with unrelated commercial carriers for losses in excess of amounts insured by HCS. HealthSouth and HCS maintained reserves for professional, general liability, and workers’ compensation risks that totaled $214.9 million at December 31, 2005. Management considers such reserves, which are based on actuarially determined estimates, to be adequate for those liability risks. However, there can be no assurance that the ultimate liability will not exceed management’s estimates.

We also maintain director and officer, property, and other typical insurance coverages with unrelated commercial carriers. Our director and officer liability insurance coverage for our current officers and directors is in the amount of $200 million, which includes $50 million in coverage for individual directors and officers in

 

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circumstances where we are legally or financially unable to indemnify these individuals. Examples of a company’s inability to indemnify would include derivative suits, bankruptcy/financial restraints, and claims that are against public policy. Of the $200 million coverage, we have a self-insured retention of $10 million for claims against us.

In addition to the standard industry exclusions, our director and officer liability policy also includes exclusions of coverage for (1) our former Chairman and Chief Executive Officer, Richard M. Scrushy, and our former Chief Financial Officer, William T. Owens and (2) a prior acts exclusion and a pending and prior litigation exclusion as of July 31, 2003. See Item 3, Legal Proceedings, “Insurance Coverage Litigation,” for a description of various lawsuits that have been filed to contest coverage under certain directors and officers insurance policies.

While to date we have not had difficulty in obtaining director and officer liability insurance coverage for our current directors and officers, the premium costs associated with this coverage have been dramatically higher than in the years prior to March 2003. We believe we will be able to continue to secure comparable coverage for the coming insurance year. We anticipate that, although the premium costs associated with our director and officer liability insurance coverage will be reduced during the coming insurance year, such premium costs will remain higher than in the years prior to March 2003. Despite these increased premium costs, we do not believe these costs are material to our results of operation or financial condition.

Employees

As of December 31, 2005, we employed approximately 37,000 individuals, of whom approximately 24,000 were full-time employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 96 employees at one IRF (about 20% of that facility’s workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other facilities. We believe our relationship with our employees is satisfactory. Like most health care providers, our labor costs are rising faster than the general inflation rate. In some markets, the availability of nurses and other medical support personnel has become a significant operating issue to health care providers. To address this challenge, we are implementing initiatives to improve retention, recruiting, compensation programs, and productivity. The shortage of nurses and other medical support personnel, including physical therapists, may require us to increase utilization of more expensive temporary personnel.

Available Information

Our website address is www.healthsouth.com. We make available through our website the following documents, free of charge: our annual reports (Form 10-K), our quarterly reports (Form 10-Q), our current reports (Form 8-K), and any amendments we file with respect to any such reports promptly after we electronically file such material with, or furnish it to, the SEC. Please note, however, that we have not filed any quarterly reports for periods after September 30, 2002. In addition to the information that is available on our website, you may read and copy any materials we file with or furnish to the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website, www.sec.gov, which includes reports, proxy, and information statements, and other information regarding us and other issuers that file electronically at the SEC.

 

Item 1A. Risk Factors

Our business, operations, and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating HealthSouth or any investment decision involving HealthSouth. This section does not describe all risks that may be applicable to our company, our industry, or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this annual report.

 

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Risks Related to Pending Governmental Investigations and Litigation

Any adverse outcome of continuing investigations being conducted by the DOJ and other governmental agencies could have a material adverse effect on us.

While we are fully cooperating with the DOJ and other governmental authorities in their investigations, we cannot predict the outcome of those investigations. Such investigations could have a material adverse effect on us, the trading prices of our securities, and our ability to raise additional capital. If we are convicted of a crime, certain contracts and licenses that are material to our operations could be revoked which would materially and adversely affect our business, financial condition, results of operations, and cash flows.

Several lawsuits have been filed against us involving our accounting practices and other related matters and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

A number of class action, derivative, and individual lawsuits have been filed against us, as well as certain of our past and present officers and directors, relating to, among other things, allegations of numerous violations of securities laws. Although we have reached a preliminary agreement in principle to settle these cases, there can be no assurances that a final settlement can be reached or that the proposed settlement will receive court approval. Substantial damages or other monetary remedies assessed against us could have a material adverse effect on our business, financial condition, results of operations, and cash flows. See Item 3, Legal Proceedings, for a discussion of these lawsuits.

Although we have entered into a settlement with various government agencies and other parties regarding our participation in federal health care programs, we remain a defendant in litigation relating to our participation in federal health care programs, and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Qui tam actions brought under the False Claims Act are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the court. Therefore, it is possible that additional qui tam actions have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Thus, it is possible that we are subject to liability exposure under the False Claims Act based on qui tam actions other than those discussed in this report.

CMS has been granted authority to suspend payments, in whole or in part, to Medicare providers if CMS possesses reliable information that an overpayment, fraud, or willful misrepresentation exists. If CMS suspects that payments are being or have been made as the result of fraud or misrepresentation, CMS may suspend payment at any time without providing us with prior notice. The initial suspension period is limited to 180 days. However, the payment suspension period can be extended almost indefinitely if the matter is under investigation by the HHS-OIG or the DOJ. Therefore, we are unable to predict if or when we may be subject to a suspension of payments by the Medicare and/or Medicaid programs, the possible length of the suspension period or the potential cash flow impact of a payment suspension. Any such suspension would adversely impact our business, financial condition, results of operations, and cash flows.

If the HHS-OIG determines we have violated federal laws governing kickbacks and self-referrals, it could impose substantial civil monetary penalties on us and could seek to exclude our provider entities from participation in the federal health care programs which would severely impact our financial condition and ability to continue operations.

If the HHS-OIG determines that we have violated the Anti-Kickback Law, the HHS-OIG may commence administrative proceedings to impose penalties under the Civil Monetary Penalties Law of up to three times the amount of damages and $11,000 per claim for each false or fraudulent claim allegedly submitted by us. If the

 

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HHS-OIG determines that we have violated the federal Stark statute’s general prohibition on physician self-referrals (42 U.S.C. § 1395nn), it may impose a civil monetary penalty of up to $15,000 per service billed in violation of the statute.

The HHS-OIG has been granted the authority to exclude persons or entities from participation in the federal health care programs for a variety of reasons, including: (1) committing an act in violation of the Anti-Kickback Law, (2) submitting a false or fraudulent claim, (3) submitting a claim for services rendered in violation of the physician self-referral statute, or (4) violating any other provision of the Civil Monetary Penalties Law. Thus, if the HHS-OIG believes that we have submitted false or fraudulent claims, paid or received kickbacks, submitted claims in violation of the physician self-referral law, or committed any other act in violation of the Civil Monetary Penalties Law, the HHS-OIG could move to exclude our provider entities from participation in the federal health care programs.

Limitations of our director and officer liability insurance and potential indemnification obligations could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Our director and officer liability insurance coverage for our current officers and directors is in the amount of $200 million, which includes $50 million in coverage for individual directors and officers in circumstances where we are legally or financially unable to indemnify these individuals. Examples of a company’s inability to indemnify would include derivative suits, bankruptcy/financial restraints, and claims that are against public policy. Of the $200 million coverage, we have a self-insured retention of $10 million for claims against us.

As discussed in Item 3, Legal Proceedings, several of our current and former directors and officers have been sued based on allegations that they participated in accounting fraud and other illegal activities during periods ended March 18, 2003. Several of our insurance carriers have filed lawsuits against us and are attempting to have our director and officer liability policies that provide coverage for those claims voided or cancelled or have advised us that they do not intend to provide coverage with respect to those pending actions. We have reached a preliminary agreement in principle with our insurance carriers to resolve our claims against each other. In the proposed settlement, the carriers for three of our prior policy periods will contribute $230 million in cash toward the settlement of certain federal securities and derivative litigation. In our settlement discussions, our insurance carriers for these periods are demanding a full policy release of any future claims against the policies, in which event, we will not be able to rely on any additional insurance proceeds to fund any settlements, judgments, or indemnification claims relating to actions occurring on or prior to July 31, 2003. See Item 1, Business, “Securities Litigation Settlement.”

Under our bylaws and certain indemnification agreements, we may have an obligation to indemnify our current and former officers and directors. Although we contest the validity of his claim, Richard M. Scrushy recently requested that we reimburse him for costs relating to his criminal defense, which he estimates exceed $31 million. If the settlement described in Item 3, Legal Proceedings, “Insurance Coverage Litigation” is approved on the terms contained in the preliminary settlement, we will not have insurance to cover expenses incurred or liabilities imposed in connection with the pending actions against certain of our past and present directors and officers who we may be required to indemnify.

Risks Related to Our Financial Condition

We are highly leveraged. As a consequence, a substantial down-turn in earnings could jeopardize our ability to make our interest payments and could impair our ability to obtain additional financing, if necessary.

We are highly leveraged. As of December 31, 2005 we had approximately $3.4 billion of long-term debt outstanding. As discussed in Item 1, Business, “Recapitalization Transactions,” we have prepaid substantially all of our prior indebtedness with proceeds from a series of recapitalization transactions and replaced it with approximately $3 billion of new long-term debt. Although we remain highly leveraged, we believe these

 

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recapitalization transactions have eliminated significant uncertainty regarding our capital structure and have improved our financial condition by reducing our refinancing risk, increasing our liquidity, improving our operational flexibility, improving our credit profile, and reducing our interest rate exposure.

We are required to use a substantial portion of our cash flow to service our debt. A substantial down-turn in earnings could jeopardize our ability to make our interest payments and could impair our ability to obtain additional financing, if necessary. Certain trends in our business, including declining revenues resulting from the 75% Rule, acute care volume weakness, recent IRF-PPS changes, and continued weakness in our surgery centers division, have created a challenging operating environment, and future changes could place additional pressure on our revenues and cash flow. In addition, we are subject to numerous contingent liabilities and are subject to prevailing economic conditions and to financial, business, and other factors beyond our control. Although we expect to make scheduled interest payments and principal reductions, we cannot assure you that changes in our business or other factors will not occur that may have the effect of preventing us from satisfying obligations under our debt.

We have significant cash obligations relating to government settlements that, in addition to our indebtedness, may limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.

In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we are obligated to pay $170 million (plus interest) in quarterly installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Item 1, Business, “Medicare Program Settlement.” Furthermore, we are obligated to pay $87.5 million to the SEC in four installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Item 1, Business, “SEC Settlement.”

We likely will not apply to relist our common stock on a major securities exchange until the middle of 2006, and do not expect to be able to meet the registration requirements of the Securities Act until the first quarter of 2007, at the earliest. Until we are relisted on a major securities exchange, the prices at which our common stock trades in the over-the-counter market may be much more volatile than if it traded on a major securities exchange. Until we can meet the registration requirements of the Securities Act, our access to capital will be limited.

We do not expect to apply for relisting on a major securities exchange until the middle of 2006. While our common stock is quoted on the OTC Bulletin Board and in the Pink Sheets, there is currently only a limited trading market for our shares and the market price of these shares may be volatile for the foreseeable future. The limited trading market for our common stock may cause fluctuations in the price and volume of our shares to be more exaggerated than would occur on a major securities exchange. We cannot assure you that prior to relisting our shares on a major securities exchange, you will be able to sell shares of our common stock without a considerable delay or significant impact on the sale price.

In addition, it will likely be the first quarter of 2007, at the earliest, before we can meet the registration requirements of the Securities Act and thereby have access to public capital markets. Because our internal controls are still ineffective, it may be difficult to file our annual report on Form 10-K and quarterly reports on Form 10-Q for 2006 on a timely basis, which could extend the time it will take for us to satisfy the registration requirements of the Securities Act. Consequently, we will not have access to public capital markets until the first quarter of 2007, at the earliest, which will make it more difficult to grow our business.

We have determined that our internal controls are currently ineffective. The lack of effective internal controls could adversely affect our financial condition and ability to carry out our strategic business plan.

As discussed in Item 9A, Controls and Procedures, our new management team, under the supervision and with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the

 

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effectiveness of the design and operation of HealthSouth’s internal controls. As of December 31, 2005, they concluded that HealthSouth’s disclosure controls and procedures, including HealthSouth’s internal control over financial reporting, were not effective. Although we have made improvements in our internal controls, if we are unsuccessful in our focused effort to permanently and effectively remediate the weaknesses in our internal control over financial reporting and to establish and maintain effective corporate governance practices, our financial condition and ability to carry out our strategic business plan, our ability to report our financial condition and results of operations accurately and in a timely manner, and our ability to earn and retain the trust of our patients, physician partners, employees, and security holders, could be adversely affected.

Risks Related to Our Business

The continuing time, effort, and expense relating to investigations and implementation of improved internal controls and procedures, may have an adverse effect on our business, financial condition, results of operations, and cash flows.

In addition to the challenges of the various government investigations and extensive litigation we face, our new management team has spent considerable time and effort dealing with internal and external investigations involving our historical accounting and internal controls, and in developing and implementing accounting policies and procedures, disclosure controls and procedures, and corporate governance policies and procedures. The significant time and effort spent may have adversely affected our operations and may continue to do so in the future.

Current and prospective investors, patients, physician partners, and employees may react adversely to the continuing negative effects of the March 2003 crisis and the financial reporting and operational issues that were uncovered as a result of that crisis.

Our future success depends in large part on the support of our current and future investors, patients, physician partners, and employees. The various legal, financial, and operational challenges resulting from the financial fraud perpetrated by certain members of our prior management team has caused negative publicity, the delisting of our common stock from the NYSE, and has, and may continue to have, a negative impact on the market price of our securities. In addition, the reconstruction of our historical financial records has caused us to restate the financial statements of certain of our partnerships. While the process of communicating the effect of these restatement activities to our partners has begun, we anticipate the process of resolving issues arising from these restatements will continue at least through 2006, which may have a negative impact on our relationships with our current partners and may create an environment that is not conducive to attracting new partners. Finally, employees and prospective employees may factor in these considerations relating to our stability and the value of any equity incentives in their decision-making regarding employment opportunities.

If we fail to comply with the extensive laws and government regulations applicable to us, we could suffer penalties or be required to make significant changes to our operations.

We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These laws and regulations relate to, among other things:

 

    licensure, certification, and accreditation,

 

    coding and billing for services,

 

    relationships with physicians and other referral sources, including physician self-referral and anti-kickback laws,

 

    quality of medical care,

 

    use and maintenance of medical supplies and equipment,

 

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    maintenance and security of medical records,

 

    accuracy of billing operations, and

 

    disposal of medical and hazardous waste.

In the future, changes in these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our investment structure, facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.

If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including (1) criminal penalties, (2) civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and (3) exclusion or suspension of one or more of our facilities from participation in the Medicare, Medicaid, and other federal and state health care programs.

If we fail to comply with our new Corporate Integrity Agreement, we could be subject to severe sanctions.

In December 2004, we entered into a new corporate integrity agreement with the HHS-OIG to promote our compliance with the requirements of Medicare, Medicaid, and all other federal health care programs. Under that agreement, which is effective for five years from January 1, 2005, we are subject to certain administrative requirements and are subject to review of certain Medicare cost reports and reimbursement claims by an Independent Review Organization. Our failure to comply with the material terms of the corporate integrity agreement could lead to suspension or exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Any of these sanctions would have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Reductions or changes in reimbursement from government or third-party payors could adversely affect our operating results.

We derive a substantial portion of our net operating revenues from the Medicare and Medicaid programs. In 2005, 47.5% of our consolidated net operating revenues was derived from Medicare, 2.3% was derived from Medicaid, 7.4% was derived from workers’ compensation plans, 33.1% was derived from managed care and other discount plans, 5.4% was derived from other third-party payors, 1.8% was derived from patients, and 2.5% was derived from other income. There are increasing pressures from many payors to control health care costs and to reduce or limit increases in reimbursement rates for medical services. Our operating results could be adversely affected by changes in laws or regulations governing the Medicare and Medicaid programs. See Item 1, Business, “Sources of Revenue.”

Historically, Congress and some state legislatures have periodically proposed significant changes in the health care system. Many of these changes have resulted in limitations on and, in some cases, significant reductions in the levels of, payments to health care providers for services under many government reimbursement programs. See Item 1, Business, “Regulation” for a discussion of potential changes to the health care system that could materially and adversely affect our business, financial condition, results of operations, and cash flows.

In particular, as discussed in Item 1, Business, “Sources of Revenues,” changes to the 75% Rule and IRF-PPS have combined to create a very challenging operating environment for our inpatient division. The volume volatility created by the 75% Rule has had a significantly negative impact on our inpatient division’s net operating revenues in 2005. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed in Item 1, Business, “Our Business—Operating Divisions.” However, the combination of volume volatility created by the 75% Rule and lower unit pricing resulting from IRF-PPS changes reduced our operating earnings in 2005 and will have a continuing negative impact on our operating earnings in 2006. See Item 7, Management’s Discussion and

 

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Analysis of Financial Condition and Results of Operations, for additional information about the impact of these changes. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Our relationships with third-party payors, such as HMOs and PPOs, are generally governed by negotiated agreements. These agreements set forth the amounts we are entitled to receive for our services. We could be adversely affected in some of the markets where we operate if we are unable to negotiate and maintain favorable agreements with third-party payors. In addition, our third-party payors may, from time to time, request audits of the amounts paid to us under our agreements with them. We could be adversely affected in some of the markets where we operate and within certain of our operating divisions if the audits uncover substantial overpayments made to us. As part of the reconstruction of accounting records, we discovered the existence of substantial credit balances, which could represent posting errors, misapplied payments or overpayments due to patients and third-party payors, including the Medicare and Medicaid programs. We have reviewed these accounts to determine whether and to what extent we may be required to repay any of these credit balances to patients or third-party payors, including the Medicare and Medicaid programs. We could be adversely affected if the amount we are required to repay exceeds our current estimates.

The adoption of more restrictive Medicare coverage policies at the national and/or local levels could have an adverse impact on our ability to obtain Medicare reimbursement for inpatient rehabilitation services.

Medicare providers also can be negatively affected by the adoption of coverage policies, either at the national or local levels, describing whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria for determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.

Downward pressure on pricing from commercial and government payors may adversely affect the revenues and profitability of certain of our operations.

We have experienced downward pressure on prices in our markets, from both commercial and government payors, and we anticipate continuing price pressure in all our divisions. There can be no assurances that we will be able to maintain current prices in the face of continuing pricing pressures. We may be required to implement additional measures to mitigate these pressures and further enhance the efficiency of our operations or, in the alternative, dispose of inefficient operations. These pricing pressures have had, and if we are not successful in mitigating such pressures in the future, may continue to have, an adverse effect on the revenues and profitability of our surgery centers and our outpatient and diagnostic divisions, including certain operations which we are currently considering divesting. In the event that we decide to divest certain inefficient operations, we cannot assure you that we will be able to successfully do so at all, or on a timely basis or on terms acceptable to us. As discussed elsewhere in this report, we have signed an agreement to sell our acute care facility located in Birmingham, Alabama. That operation reported an approximate $35 million loss from operations, before provision for income tax expense, in 2005. This loss is included in our loss from discontinued operations (See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations) for the year ended December 31, 2005. In addition, we have received inquiries from parties interested in acquiring our diagnostic division. That operation represented approximately 7.1% of our consolidated net operating revenues for the year ended December 31, 2005. The diagnostic division’s operating loss for 2005 was approximately $1.0 million (See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations). No final decision has been made with respect to the divestiture of our diagnostic division at this time.

 

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Our facilities face national, regional, and local competition for patients from other health care providers.

We operate in a highly competitive industry. Although we are the largest provider of rehabilitative health care services, and one of the largest providers of ambulatory surgery and outpatient diagnostic services in the United States, in any particular market we may encounter competition from local or national entities with longer operating histories or other competitive advantages. There can be no assurance that this competition, or other competition which we may encounter in the future, will not adversely affect our business, financial condition, results of operations, or cash flows. In addition, weakening certificate of need laws in some states could potentially increase competition in those states.

Competition for staffing may increase our labor costs and reduce profitability.

Our operations are dependent on the efforts, abilities, and experience of our management and medical support personnel, such as physical therapists, nurses, and other health care professionals. We compete with other health care providers in recruiting and retaining qualified management and support personnel responsible for the daily operations of each of our facilities. In some markets, the availability of physical therapists, nurses, and other medical support personnel has become a significant operating issue to health care providers. This shortage may require us to continue to enhance wages and benefits to recruit and retain qualified personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues consists of fixed, prospective payments, our ability to pass along increased labor costs is limited. Our failure to recruit and retain qualified management, physical therapists, nurses, and other medical support personnel, or to control our labor costs, could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

We depend on our relationships with the physicians who use our facilities.

Our business depends upon the efforts of the physicians who provide health care services at our facilities and/or refer their patients to our facilities and the strength of our relationships with these physicians. Each physician referring or treating patients at one of our facilities may also practice at other facilities not owned by us.

At each of our facilities, our business could be adversely affected if a significant number of key physicians or a group of physicians:

 

    terminate their relationship with, or reduced their use of, our facilities,

 

    fail to maintain the quality of care provided or otherwise adhere to professional standards at our facilities, or

 

    exit the market entirely.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

Our principal executive offices are located in Birmingham, Alabama, where we own and maintain a headquarters building of approximately 200,000 square feet located on an 85-acre corporate campus. In addition to our headquarters building, as of December 31, 2005 we leased or owned nearly 1,100 facilities through various consolidated entities to support our operations. Our leases generally have initial terms of 5 years, but range from 1 to 99 years. Most of our leases contain options to extend the lease period for up to 5 additional years. Our

 

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consolidated entities are sometimes responsible for property taxes, property and casualty insurance, and routine maintenance expenses. Other than our headquarters campus, our acute care hospital located in Birmingham, Alabama, and our Digital Hospital described below, none of our other properties is materially important. Each of our material properties is used by our corporate and other segment, except our Digital Hospital, which is not in use but is held by our corporate and other segment. We and our Subsidiary Guarantors have pledged substantially all of our property as collateral to secure the performance of our obligations under our Credit Agreement. . In addition, we and the Subsidiary Guarantors agreed to enter into mortgages with respect to certain of our material real property (excluding real property owned by the surgery centers division or otherwise subject to preexisting liens and/or mortgages) in connection with the Credit Agreement. Our obligations under the Credit Agreement will be secured by the real property subject to such mortgages. For additional information about our Credit Agreement, see Note 8, Long-term Debt, to our accompanying consolidated financial statements.

We also currently own, and from time to time may acquire, certain other improved and unimproved real properties in connection with our business. See Note 5, Property and Equipment, to our accompanying consolidated financial statements for more information about the properties we own and certain related indebtedness.

In 2005 we sold approximately $8.4 million in land and buildings, not including properties sold in connection with the sale of operating facilities. On July 20, 2005, we executed an asset purchase agreement with The Board of Trustees of the University of Alabama (the “University of Alabama”) for the sale of the real property, furniture, fixtures, equipment and certain related assets associated with our 219 licensed-bed acute care hospital located in Birmingham, Alabama. Simultaneously with the execution of this purchase agreement with the University of Alabama, we executed an agreement with an affiliate of the University of Alabama whereby this entity currently provides certain management services to our acute care hospital in Birmingham. On December 31, 2005, we executed an amended and restated asset purchase agreement with the University of Alabama. This amended and restated agreement provides that the University of Alabama will purchase our Birmingham acute care hospital and associated real and personal property as well as our interest in the gamma knife partnership associated with this hospital. We anticipate closing this transaction by the end of the first quarter of 2006. We will transfer the hospital and associated real and personal property at that time, but will transfer our interest in the gamma knife partnership at a later date. The proposed transaction also requires that we acquire and convey title to the University of Alabama for certain professional office buildings that we are currently leasing. Both the certificate of need under which the hospital currently operates, and the licensed beds operated by us at the hospital, will be transferred as part of the sale of the hospital under the amended and restated agreement. Upon consummation of the agreement with the University of Alabama, we would no longer have the ability to operate or sell the Digital Hospital project as an acute care hospital without obtaining an additional certificate of need or specific exception. On January 4, 2006, we executed a letter of intent with an undisclosed party regarding the sale of the property and equipment which were to have comprised our Digital Hospital in Birmingham, Alabama. Any sale of the Digital Hospital will not involve conveyance of our interest in any certificate of need from our acute care hospital located in Birmingham, Alabama. The letter of intent expires, subject to certain conditions, on March 31, 2006 unless otherwise extended in accordance with the terms of the letter of intent. As of December 31, 2005, we had invested approximately $210 million in the Digital Hospital project. We have not signed a definitive agreement with respect to the Digital Hospital, and there can be no assurance any sale will take place. See Note 5, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the impairment charge we recognized in 2005 relating to the Digital Hospital.

Our headquarters, facilities, and other properties are suitable for their respective uses and are, in general, adequate for our present needs. Our properties are subject to various federal, state, and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our business, financial condition, or results from operations.

 

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Item 3. Legal Proceedings

Investigations and Proceedings Commenced by the SEC, the United States Department of Justice, and Other Governmental Authorities

In September 2002, the Securities and Exchange Commission (the “SEC”) notified us that it was conducting an investigation of trading in our securities that occurred prior to an August 27, 2002 press release concerning the impact of new Medicare billing guidance on our expected earnings. On February 5, 2003, the United States District Court for the Northern District of Alabama issued a subpoena requiring us to provide various documents in connection with a criminal investigation of us and certain of our directors, officers, and employees being conducted by the United States Attorney for the Northern District of Alabama. On March 18, 2003, agents from the Federal Bureau of Investigation (the “FBI”) executed a search warrant at our headquarters in connection with the United States Attorney’s investigation and were provided access to a number of financial records and other materials. The agents simultaneously served a grand jury subpoena on us on behalf of the criminal division of the United States Department of Justice (the “DOJ”). Some of our employees also received subpoenas.

On March 19, 2003, the SEC filed a lawsuit captioned Securities and Exchange Commission v. HealthSouth Corp., et al., CV-03-J-0615-S, in the United States District Court for the Northern District of Alabama. The complaint alleges that we overstated earnings by at least $1.4 billion since 1999, and that this overstatement occurred because our then-Chairman and Chief Executive Officer, Richard M. Scrushy, insisted that we meet or exceed earnings expectations established by Wall Street analysts.

The SEC states in its complaint that our actions and those of Mr. Scrushy violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. Specifically, the SEC charged us with violations of Section 17(a) of the Securities Act of 1933 (the “Securities Act”) and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (the “1934 Act”), and 1934 Act Rules 10b-5, 12b-20, 13a-1, and 13a-13. The SEC sought a permanent injunction against us, civil money penalties, disgorgement of ill-gotten gains and losses avoided, as well as prejudgment interest. On March 19, 2003, we consented to the entry of an order by the court that (1) required us to place in escrow all extraordinary payments (whether compensation or otherwise) to our directors, officers, partners, controlling persons, agents, and employees, (2) prohibited us and our employees from destroying documents relating to our financial activities and/or the allegations in the SEC’s lawsuit against us and Mr. Scrushy, and (3) provided for expedited discovery in the lawsuit brought by the SEC.

On June 6, 2005, the SEC approved a settlement (the “SEC Settlement”) with us relating to this lawsuit. Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to pay a $100 million civil penalty and disgorgement of $100 to the SEC in installments over two years, beginning in the fourth quarter of 2005. We consented to the entry of a final judgment (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. See Item 1, Business, “SEC Settlement,” for additional information about the SEC Settlement. Mr. Scrushy remains a defendant in the lawsuit.

On November 4, 2003, Mr. Scrushy was charged in federal court on 85 counts of wrongdoing in connection with his actions while employed by us. A superseding indictment of 58 counts, released on September 29, 2004, added charges of obstruction of justice and perjury while consolidating and eliminating some of the 85 counts of conspiracy, mail fraud, wire fraud, securities fraud, false statements, false certifications, and money laundering that were previously charged. The superseding indictment sought the forfeiture of $278 million in property from Mr. Scrushy allegedly derived from his offenses. Mr. Scrushy was acquitted on June 28, 2005.

On April 10, 2003, the DOJ’s civil division notified us that it was expanding its investigation (which began with the lawsuit United States ex rel. Devage v. HealthSouth Corp., et al., C.A. No. SA-98-EA-0372-FV, filed in the United States District Court for the Western District of Texas, as discussed in Item 1, Business, “Medicare

 

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Program Settlement”) into allegations of fraud associated with Medicare cost reports submitted by us for fiscal years 1995 through 2002. We subsequently received subpoenas from the Office of Inspector General (the “HHS-OIG”) of the United States Department of Health and Human Services (“HHS”) and requests from the DOJ’s civil division for documents and other information regarding this investigation. As described in Item 1, Business, “Medicare Program Settlement,” on December 30, 2004, we announced that we had entered into a global settlement agreement with the DOJ’s civil division and other parties to resolve the primary claims made in the Devage litigation, although the DOJ continues to review certain other matters, including self-disclosures made by us to the HHS-OIG.

In the summer of 2003, we discovered certain irregular payments made to a foreign official under a consulting agreement entered into in connection with an October 2000 agreement between us and the Sultan Bin Abdul Aziz Foundation to manage an inpatient rehabilitation hospital in Riyadh, Saudi Arabia. We notified the DOJ immediately, and we cooperated fully with the investigation. One former executive pled guilty to charges of wire fraud in connection with the irregular payments, and another former executive pled guilty to charges of making a false statement to government investigators in connection with the investigation. Two additional former executives were acquitted by a jury of charges that they participated in the fraud. We terminated the October 2000 agreement and entered into a new agreement, effective January 1, 2004, to manage the Riyadh facility. Effective October 2004, we terminated our relationship with the Sultan Bin Abdul Aziz Foundation and the Riyadh facility entirely.

Many of our former officers, including all five of our former chief financial officers, have pleaded guilty to federal criminal charges filed in connection with the investigations described above. These individuals pled guilty to a variety of charges, including securities fraud, accounting fraud, filing false tax returns, making a false statement to governmental authorities, falsifying books and accounts, wire fraud, conspiracy, and falsely certifying financial information to the SEC. One former executive was convicted on November 18, 2005 of criminal charges filed in connection with the accounting fraud investigation.

On October 26, 2005, a federal grand jury issued a superseding indictment against Richard M. Scrushy, former Alabama Governor Don Siegelman, and others, in which Mr. Scrushy is charged with three counts of bribery and mail fraud. We are cooperating with the Office of the United States Attorney on that matter.

Securities Litigation

On June 24, 2003, the United States District Court for the Northern District of Alabama consolidated a number of separate securities lawsuits filed against us under the caption In re HealthSouth Corp. Securities Litigation, Master Consolidation File No. CV-03-BE-1500-S (the “Consolidated Securities Action”). The Consolidated Securities Action included two prior consolidated cases (In re HealthSouth Corp. Securities Litigation, CV-98-J-2634-S and In re HealthSouth Corp. 2002 Securities Litigation, Consolidated File No. CV-02-BE-2105-S) as well as six lawsuits filed in 2003. Including the cases previously consolidated, the Consolidated Securities Action comprised over 40 separate lawsuits. The court divided the Consolidated Securities Action into two subclasses:

 

    Complaints based on purchases of our common stock were grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S (the “Stockholder Securities Action”), which was further divided into complaints based on purchases of our common stock in the open market (grouped under the caption In re HealthSouth Corp. Stockholder Litigation, Consolidated Case No. CV-03-BE-1501-S) and claims based on the receipt of our common stock in mergers (grouped under the caption HealthSouth Merger Cases, Consolidated Case No. CV-98-2777-S). Although the plaintiffs in the HealthSouth Merger Cases have separate counsel and have filed separate claims, the HealthSouth Merger Cases are otherwise consolidated with the Stockholder Securities Action for all purposes.

 

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    Complaints based on purchases of our debt securities were grouped under the caption In re HealthSouth Corp. Bondholder Litigation, Consolidated Case No. CV-03-BE-1502-S (the “Bondholder Securities Action”).

On January 8, 2004, the plaintiffs in the Consolidated Securities Action filed a consolidated class action complaint. The complaint names us as a defendant, as well as more than 30 of our current and former employees, officers and directors, the underwriters of our debt securities, and our former auditor. The complaint alleges, among other things, (1) that we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the Balanced Budget Act of 1997 on our operations in order to artificially inflate the price of our common stock, (2) that from January 14, 2002 through August 27, 2002, we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the changes in Medicare reimbursement for outpatient therapy services on our operations in order to artificially inflate the price of our common stock, and that some of the individual defendants sold shares of such stock during the purported class period, and (3) that Richard M. Scrushy instructed certain former senior officers and accounting personnel to materially inflate our earnings to match Wall Street analysts’ expectations, and that senior officers of HealthSouth and other members of a self-described “family” held meetings to discuss the means by which our earnings could be inflated and that some of the individual defendants sold shares of our common stock during the purported class period. The consolidated class action complaint asserts claims under Sections 11, 12(a)(2) and 15 of the Securities Act, and claims under Sections 10(b), 14(a), 20(a) and 20A of the 1934 Act.

On February 22, 2006, we announced that we had reached a global, preliminary settlement with the lead plaintiffs in the Stockholder Securities Action, the Bondholder Securities Action, and the derivative litigation, as well as with our insurance carriers, to settle claims filed in those actions against us and many of our former directors and officers. Under the proposed settlement, claims brought against the settling defendants will be settled for consideration consisting of HealthSouth common stock and warrants valued at approximately $215 million and cash payments by our insurance carriers of $230 million. In addition, we have agreed to give the class 25% of our net recovery from any future judgments won by us or on our behalf against Richard M. Scrushy, our former Chairman and Chief Executive Officer, Ernst & Young LLP, our former auditor, and certain affiliates of UBS Group, our former lead investment banker, none of whom are included in the settlement. The proposed settlement is subject to a number of conditions, including the successful negotiation of definitive documentation and final court approval. The proposed settlement does not include Richard Scrushy or any director or officer who has agreed to plead guilty or otherwise been convicted in connection with our former financial reporting activities.

There can be no assurances that a final settlement agreement can be reached or that the proposed settlement will receive the required court approval.

On March 17, 2004, an individual securities fraud action captioned Amalgamated Gadget, L.P. v. HealthSouth Corp., 4-04CV-198-A, was filed in the United States District Court for the Northern District of Texas. The complaint made allegations similar to those in the Consolidated Securities Action and asserted claims under the federal securities laws and Texas state law based on the plaintiff’s purchase of $24 million in face amount of 3.25% convertible debentures. The court denied our motion to transfer the action to the United States District Court for the Northern District of Alabama, and also denied our motion to dismiss. This action has been settled by the agreement of the parties and dismissed with prejudice.

On November 24, 2004, an individual securities fraud action captioned Burke v. HealthSouth Corp., et al., 04-B-2451 (OES), was filed in the United States District Court of Colorado against us, some of our former directors and officers, and our former auditor. The complaint makes allegations similar to those in the Consolidated Securities Action and asserts claims under the federal securities laws and Colorado state law based on plaintiff’s alleged receipt of unexercised options and his open-market purchases of our stock. By order dated May 3, 2005, the action was transferred to the United States District Court for the Northern District of Alabama, where it remains pending.

 

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Derivative Litigation

Between 1998 and 2004, a number of lawsuits purporting to be derivative actions (i.e., lawsuits filed by shareholder plaintiffs on our behalf) were filed in several jurisdictions, including the Circuit Court for Jefferson County, Alabama, the Delaware Court of Chancery, and the United States District Court for the Northern District of Alabama. Most of these lawsuits have been consolidated as described below:

 

    All derivative complaints filed in the Circuit Court of Jefferson County, Alabama since 2002 have been consolidated and stayed in favor of the first-filed action captioned Tucker v. Scrushy, No. CV-02-5212, filed August 28, 2002. The Tucker complaint names as defendants a number of former HealthSouth officers and directors. Tucker also asserts claims on our behalf against Ernst & Young LLP, UBS Group, UBS Investment Bank, and UBS Securities, LLC, as well as against MedCenterDirect.com, Source Medical Solutions, Inc., Capstone Capital Corp., Healthcare Realty Trust, and G.G. Enterprises.

 

    Two derivative lawsuits filed in the United States District Court for the Northern District of Alabama were consolidated under the caption In re HealthSouth Corp. Derivative Litigation, CV-02-BE-2565. The court stayed further action in this federal consolidated action in deference to litigation filed in state courts in Alabama and Delaware.

 

    Two derivative lawsuits filed in the Delaware Court of Chancery were consolidated under the caption In re HealthSouth Corp. Shareholders Litigation, Consolidated Case No. 19896. Plaintiffs’ counsel in this litigation and in Tucker agreed to litigate all claims asserted in those lawsuits in the Tucker litigation, except for claims relating to an agreement to retire a HealthSouth loan to Richard M. Scrushy with shares of our stock (the “Buyback Claim”). On November 24, 2003, the court granted the plaintiffs’ motion for summary judgment on the Buyback Claim and rescinded the retirement of Scrushy’s loan. The court’s judgment was affirmed on appeal. We have collected a judgment of $12.5 million, net of attorneys’ fees awarded by the court. The plaintiffs’ remaining claims are being litigated in Tucker.

When originally filed, the primary allegations in the Tucker case involved self-dealing by Richard M. Scrushy and other insiders through transactions with various entities allegedly controlled by Mr. Scrushy. The complaint was amended four times to add additional defendants and include claims of accounting fraud, improper Medicare billing practices, and additional self-dealing transactions. On September 7, 2005, the Alabama Circuit Court ordered the parties to participate in mediation.

On January 3, 2006, the Alabama Circuit Court in the Tucker case granted the plaintiff’s motion for summary judgment against Mr. Scrushy on a claim for the restitution of incentive bonuses Scrushy received for years 1996 through 2002. Including pre-judgment interest, the court’s total award was approximately $48 million. The judgment does not resolve other claims brought by the plaintiff against Scrushy, which remain pending. On February 8, 2006, the Alabama Supreme Court stayed execution on the judgment and ordered briefing on whether or not the Alabama Circuit Court’s order was appropriate for certification as a final appealable order pursuant to Rule 54(b).

The plaintiffs in the Tucker action have reached a preliminary agreement in principle to settle their claims against many of our former directors and officers for $100 million in cash. This settlement amount is to be paid by our insurance carriers, and will be included in the aggregate cash payment of $230 million that is part of the proposed settlement of the Consolidated Securities Action. We are continuing to negotiate the other terms of a settlement with the other parties to this agreement; however, there can be no assurance that a final settlement agreement will be reached or that the proposed settlement will receive the required court approval.

On September 8, 2003, a derivative lawsuit captioned Teachers Retirement Sys. of Louisiana v. Scrushy, C.A. No. 20529-NC, was filed in the Delaware Court of Chancery. The complaint contains allegations similar to

 

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those made in the Tucker case, class claims, as well as a request for relief seeking an order compelling us to hold an annual meeting of stockholders. On December 2, 2003, we announced a settlement of the plaintiff’s claims seeking an annual meeting of stockholders. The Court of Chancery has stayed the remaining claims in favor of earlier-filed litigation in Alabama. This case was not consolidated with In re HealthSouth Corp. Shareholders Litigation.

On November 19, 2004, a derivative lawsuit captioned Campbell v. HealthSouth Corp., Scrushy, et al., CV-04-6985, was filed in Circuit Court of Jefferson County, Alabama, alleging that we wrongfully refused to file with the Internal Revenue Service refund requests for overpayment of taxes and seeking an order allowing the plaintiff to file claims for refund of excess tax paid by us. This suit was filed just prior to the voluntary dismissal of a similar suit brought by the same plaintiff in the United States District Court for the Northern District of Alabama. On August 23, 2005, the court granted our motion to dismiss without prejudice.

Litigation by and Against Former Independent Auditors

On March 18, 2005, Ernst & Young LLP filed a lawsuit captioned Ernst & Young LLP v. HealthSouth Corp., CV-05-1618, in the Circuit Court of Jefferson County, Alabama. The complaint asserts that the filing of the claims against us was for the purpose of suspending any statute of limitations applicable to those claims. The complaint alleges that we provided Ernst & Young LLP with fraudulent management representation letters, financial statements, invoices, bank reconciliations, and journal entries in an effort to conceal accounting fraud. Ernst & Young LLP claims that as a result of our actions, Ernst & Young LLP’s reputation has been injured and it has and will incur damages, expense, and legal fees. Ernst & Young LLP seeks recoupment and setoff of any recovery against Ernst & Young LLP in the Tucker case, as well as litigation fees and expenses, damages for loss of business and injury to reputation, and such other relief to which it may be entitled. On April 1, 2005, we answered Ernst & Young LLP’s claims and asserted counterclaims alleging, among other things, that from 1996 through 2002, when Ernst & Young LLP served as our independent auditors, Ernst & Young LLP acted recklessly and with gross negligence in performing its duties, and specifically that Ernst & Young LLP failed to perform reviews and audits of our financial statements with due professional care as required by law and by its contractual agreements with us. Our counterclaims further allege that Ernst & Young LLP either knew of or, in the exercise of due care, should have discovered and investigated the fraudulent and improper accounting practices being directed by Richard M. Scrushy and certain other officers and employees, and should have reported them to our board of directors and the Audit Committee. The counterclaims seek compensatory and punitive damages, disgorgement of fees received from us by Ernst & Young LLP, and attorneys’ fees and costs.

ERISA Litigation

In 2003, six lawsuits were filed in the United States District Court for the Northern District of Alabama against us and some of our current and former officers and directors alleging breaches of fiduciary duties in connection with the administration of our Employee Stock Benefit Plan (the “ESOP”). These lawsuits have been consolidated under the caption In re HealthSouth Corp. ERISA Litigation, Consolidated Case No. CV-03-BE-1700-S (the “ERISA Action”). The plaintiffs filed a consolidated complaint on December 19, 2003 that alleges, generally, that fiduciaries to the ESOP breached their duties to loyally and prudently manage and administer the ESOP and its assets in violation of sections 404 and 405 of the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et seq. (“ERISA”), by failing to monitor the administration of the ESOP, failing to diversify the portfolio held by the ESOP, and failing to provide other fiduciaries with material information about the ESOP. The plaintiffs seek actual damages including losses suffered by the plan, imposition of a constructive trust, equitable and injunctive relief against further alleged violations of ERISA, costs pursuant to 29 U.S.C. § 1132(g), and attorneys’ fees. The plaintiffs also seek damages related to losses under the plan as a result of alleged imprudent investment of plan assets, restoration of any profits made by the defendants through use of plan assets, and restoration of profits that the plan would have made if the defendants had fulfilled their fiduciary obligations. Pursuant to an Amended Class Action Settlement Agreement entered into on March 6, 2006, all parties have agreed to a global settlement of the claims in the ERISA Action. Under the terms of this

 

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settlement, Michael Martin, a former chief financial officer of the company, will contribute $350,000 to resolve claims against him, Richard Scrushy, former chief executive officer of the company, and our insurance carriers, will contribute $3.5 million to resolve claims against him, and HealthSouth and its insurance carriers will contribute $25 million to settle claims against all remaining defendants, including HealthSouth. In addition, if we recover any or all of the judgment against Mr. Scrushy for the restitution of incentive bonuses paid to him during 1996 through 2002, we will contribute the first $1 million recovered to the class in the ERISA Action. There can be no assurance that the settlement will be approved by an independent fiduciary appointed to review the settlement on behalf of the ESOP or that the settlement will receive the required court approval.

Insurance Coverage Litigation

In 2003, approximately 14 insurance companies filed complaints in state and federal courts in Alabama, Delaware, and Georgia alleging that the insurance policies issued by those companies to us and/or some of our directors and officers should be rescinded on grounds of fraudulent inducement. The complaints also seek a declaration that we and/or some of our current and former directors and officers are not covered under various insurance policies. These lawsuits challenge the majority of our director and officer liability policies, including our primary director and officer liability policy in effect for the claims at issue. Actions filed by insurance companies in the United States District Court for the Northern District of Alabama were consolidated for pretrial and discovery purposes under the caption In re HealthSouth Corp. Insurance Litigation, Consolidated Case No. CV-03-BE-1139-S. Four lawsuits filed by insurance companies in the Circuit Court of Jefferson County, Alabama have been consolidated with the Tucker case for discovery and other pretrial purposes. Cases related to insurance coverage that were filed in Georgia and Delaware have been dismissed. We have filed counterclaims against a number of the plaintiffs in these cases alleging, among other things, bad faith for wrongful failure to provide coverage. On February 22, 2006, we announced that we had reached a preliminary agreement in principle with our insurance carriers to resolve our claims against each other. In the proposed settlement, the carriers will contribute $230 million in cash toward the settlement of both the Consolidated Securities Action and the Tucker derivative litigation. However, there can be no assurances that a final settlement agreement can be reached.

Litigation by and Against Richard M. Scrushy

Richard M. Scrushy filed two lawsuits against us in the Delaware Court of Chancery. One lawsuit, captioned Scrushy v. HealthSouth Corp., C.A. No. 20357-NC, filed on June 10, 2003, sought indemnification and advancement of Mr. Scrushy’s legal fees. The other lawsuit, captioned Scrushy v. Gordon, et al., C.A. No. 20375, filed June 16, 2003, named us and our then-current directors as defendants and petitioned the court to enjoin the defendants from excluding Mr. Scrushy from board meetings and from conducting the business of HealthSouth exclusively through the meetings of the Special Committee. The second lawsuit also sought access to certain information, including meetings of the Special Committee. Both lawsuits were voluntarily dismissed without prejudice.

On December 9, 2005, Richard M. Scrushy filed a new complaint in the Circuit Court of Jefferson County, Alabama, captioned Scrushy v. HealthSouth, CV-05-7364. The complaint alleges that, as a result of Mr. Scrushy’s removal from the position of CEO in March 2003, we owe him “in excess of $70 million” pursuant to an employment agreement dated as of September 17, 2002. We have answered the complaint and filed counterclaims against Mr. Scrushy.

In addition, on or about December 19, 2005, Mr. Scrushy filed a demand for arbitration with the American Arbitration Association, supposedly pursuant to an indemnity agreement with us. The arbitration demand seeks to require us to pay expenses which he estimates exceed $31 million incurred by Mr. Scrushy, including attorneys’ fees, in connection with the defense of criminal fraud claims against him and in connection with a preliminary hearing in the SEC litigation.

In our counterclaim filed in the Alabama Circuit Court action, we have asked the court to prohibit Mr. Scrushy from having his claims resolved in arbitration, as opposed to a jury trial. After hearings on

 

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January 4, 2006 and January 23, 2006, the Alabama Circuit Court denied our motion to stay and enjoin the arbitration. However, the court ordered Mr. Scrushy to terminate the arbitration and withdraw his demand for arbitration, but left him the option of beginning arbitration at a later date on further order of the court. The court also granted Scrushy the right to petition the court to lift the stay after pre-trial discovery had occurred in the court proceeding between us and Mr. Scrushy.

On or about February 6, 2006, Mr. Scrushy filed a motion with the Alabama Supreme Court asking it to direct the Alabama Circuit Court to vacate its order requiring Scrushy to withdraw his arbitration demand, and to direct the Alabama Circuit Court to dismiss our counterclaim for a declaratory judgment and end “any further exercise of jurisdiction over this arbitration matter.” Mr. Scrushy’s motion is still pending.

Litigation by Other Former Officers

On August 22, 2003, Anthony Tanner, our former Secretary and Executive Vice President—Administration, filed a petition in the Circuit Court of Jefferson County, Alabama, captioned In re Tanner, CV-03-5378, seeking permission to obtain certain information through the discovery process prior to filing a lawsuit. That petition was voluntarily dismissed with prejudice on August 11, 2004. On December 29, 2004, Mr. Tanner filed a lawsuit in the Circuit Court of Jefferson County, Alabama, captioned Tanner v. HealthSouth Corp., CV-04-7715, alleging that we breached his employment contract by failing to pay certain retirement benefits. The complaint requests damages, a declaratory judgment, and a preliminary injunction to require payment of past due amounts under the contract and reinstatement of the claimed retirement benefits. The parties have agreed to settle this case.

On December 23, 2003, Jason Hervey, one of our former officers, filed a lawsuit captioned Hervey v. HealthSouth Corp., et al., CV-03-8031, in the Circuit Court of Jefferson County, Alabama. The complaint sought compensatory and punitive damages in connection with our alleged breach of his employment contract. We settled this lawsuit in 2005.

Litigation Against Former Officers

On June 10, 2004, we filed a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Corp. v. James Goodreau, CV-04-3619, to collect unpaid loans in the original principal amount of $55,500 that we made to James A. Goodreau, our former Director of Corporate Security, while he was a HealthSouth employee. Mr. Goodreau has asserted counterclaims against us seeking monetary damages in an unspecified amount and equitable relief based upon his contention that he was promised lifetime employment with us by Mr. Scrushy. This case is still pending.

On August 30, 2004, we filed a collection action in the United States District Court for the Northern District of Alabama, captioned HealthSouth Corp. v. Daniel J. Riviere, CV-04-CO-2592-S, to collect unpaid loans in the original principal amount of $3,163,421 that we made to Daniel J. Riviere, our former President—Ambulatory Services Division, while he was a HealthSouth employee. Mr. Riviere filed a six-count counterclaim against us on April 5, 2005 seeking (1) severance benefits exceeding $2 million under a written employment agreement dated March 18, 2003, (2) a declaratory judgment that the noncompete clause in his employment agreement is void, (3) damages in an unspecified amount based on stock allegedly purchased and held by him in reliance on misrepresentations made by Richard M. Scrushy, (4) $500,000 in lost profits based allegedly on us forcing him to sell shares of our common stock after he was terminated, (5) damages in an unspecified amount based on our alleged conversion of the cash value of certain insurance policies after his termination, and (6) set off of any award from his counterclaim against unpaid loans we made to him. On April 5, 2005, Mr. Riviere commenced a Chapter 7 bankruptcy case in the U.S. Bankruptcy Court for the Northern District of Florida, Case No. 05-30718-LMK, and this lawsuit is stayed pending resolution of the bankruptcy proceedings. We entered into a settlement agreement with Mr. Riviere and his bankruptcy trustee settling the disputes made the subject of the lawsuit. Pursuant to the settlement agreement, Mr. Riviere has agreed to pay us $1.5 million, plus accrued interest at 6% per annum, within three years. The settlement was approved by the bankruptcy court on November 8, 2005.

 

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On July 28, 2005, we filed a collection action in the Circuit Court of Jefferson County, Alabama captioned HealthSouth Corp. v. William T. Owens, CV-05-4420, to collect unpaid loans in the original principal amount of approximately $1.0 million that we made to William T. Owens, our former Chief Financial Officer, while he was a HealthSouth employee. On March 16, 2006, the trial court granted from the bench our motion for summary judgment against Mr. Owens for the balance of the outstanding company loans, plus attorneys’ fees, and a written order to that effect should be issued shortly.

Litigation by Former Medical Director

On April 5, 2001, Helen M. Schilling, one of our former medical directors, filed a lawsuit captioned Helen M. Schilling, M.D. v. North Houston Rehabilitation Associates d/b/a HealthSouth Houston Rehabilitation Institute, Romano Rehabilitation Hospital, Inc. and Anne Leon, Cause No. 01-04-02243-CV, in the 410th Judicial District Court of Montgomery County, Texas. The plaintiff claimed, among other things, that we wrongfully terminated her medical director agreement. On November 5, 2003, after a jury trial, the court entered a final judgment awarding the plaintiff $465,000 in compensatory damages and $865,000 in exemplary damages. We appealed the judgment and settled the case while on appeal in 2005.

Certain Regulatory Actions

The False Claims Act, 18 U.S.C. § 287, allows private citizens, called “relators,” to institute civil proceedings alleging violations of the False Claims Act. These so-called qui tam, or “whistleblower,” cases are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the federal government, and the presiding court. We recently settled one qui tam lawsuit, Devage, which is discussed in Item 1, Business, “Medicare Program Settlement.” We are aware of one other qui tam lawsuit, Mathews, which is discussed below. It is possible that additional qui tam lawsuits have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. Thus, we may be subject to liability exposure under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.

On April 1, 1999, a plaintiff relator filed a lawsuit captioned United States ex rel. Mathews v. Alexandria Rehabilitation Hospital, CV-99-0604, in the United States District Court for the Western District of Louisiana. On February 29, 2000, the United States elected not to intervene in the lawsuit. The complaint alleged, among other things, that we filed fraudulent reimbursement claims under the Medicare program on a nationwide basis. The district court dismissed the False Claims Act allegations of two successive amended complaints. However, the district court’s dismissal of the third amended complaint with prejudice was partially reversed by the United States Court of Appeals for the Fifth Circuit on October 22, 2002. The case was remanded to the district court, and our subsequent motion to dismiss was denied on February 21, 2004. The case is currently in the discovery stage on False Claims Act allegations concerning one HealthSouth facility during a specific timeframe.

Americans with Disabilities Act Litigation

On April 19, 2001 a nationwide class action now captioned Michael Yelapi, et al. v. St. Petersburg Surgery Center, et al., Case No: 8:01-CV-787-T-17EAJ, was filed in the United States District Court for the Middle District of Florida alleging violations of the Americans with Disabilities Act, 42 U.S.C. § 12181, et seq. (the “ADA”) and the Rehabilitation Act of 1973, 92 U.S.C. § 792 et seq. (the “Rehabilitation Act”) at our facilities. The complaint alleges violations of the ADA and Rehabilitation Act for the purported failure to remove barriers and provide accessibility to our facilities, including reception and admitting areas, signage, restrooms, phones, paths of access, elevators, treatment and changing rooms, parking, and door hardware. As a result of these alleged violations, the plaintiffs sought an injunction ordering that we make necessary modifications to achieve compliance with the ADA and the Rehabilitation Act, as well as attorneys’ fees. We have entered into a settlement agreement with the plaintiffs that provides for inspection of our facilities and requires us to correct any deficiencies under the ADA and the Rehabilitation Act. The settlement agreement was approved by the court on December 29, 2005.

 

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General Medicine, P.C. and Meadowbrook Actions

Pursuant to a Plan and Agreement of Merger dated February 17, 1997, Horizon/CMS Healthcare Corporation (“Horizon/CMS”) became a wholly owned subsidiary of HealthSouth Corporation. At the time of the merger, there was pending against Horizon/CMS in the United States District Court for the Eastern District of Michigan a lawsuit captioned General Medicine, P.C. v. Horizon/CMS Healthcare Corporation, CV-96-72624 (the “Michigan Action”). The complaint in the Michigan Action alleged that Horizon/CMS wrongfully terminated a contract with General Medicine, P.C. (“General Medicine”) for the provision of medical directorship services to long-term care facilities owned and/or operated by Horizon/CMS. Effective December 31, 2001, while the Michigan Action was pending, we sold all of our stock in Horizon/CMS to Meadowbrook Healthcare Corporation (“Meadowbrook”) pursuant to a Stock Purchase Agreement dated November 2, 2001. Pursuant to the Stock Purchase Agreement, Meadowbrook agreed to indemnify us against losses arising out of the historic and ongoing operations of Horizon/CMS. The Michigan Action was disclosed to Meadowbrook in the Stock Purchase Agreement.

On April 21, 2004, Meadowbrook and Horizon/CMS entered into a settlement agreement with General Medicine in connection with the Michigan Action. Pursuant to the settlement agreement, Horizon/CMS consented to the entry of a final judgment in the amount of $376 million in favor of General Medicine in the Michigan Action on May 3, 2004 (the “Consent Judgment”). The settlement agreement between the parties provides that, with the exception of $300,000 paid by Meadowbrook, the Consent Judgment may only be collected from us. At the time of the Consent Judgment, we had no ownership or other interest in Horizon/CMS.

On August 16, 2004, General Medicine filed a lawsuit captioned General Medicine, P.C. v. HealthSouth Corp., CV-04-958, in the Circuit Court of Shelby County, Alabama, seeking to recover the unpaid amount of the Consent Judgment from us. The complaint alleges that while Horizon/CMS was a wholly-owned subsidiary of HealthSouth Corporation and General Medicine was an existing creditor of Horizon/CMS, we caused Horizon/CMS to transfer assets to us thereby rendering Horizon/CMS insolvent and unable to pay its creditors. The complaint asserts that these transfers were made for less than a reasonably equivalent value and/or with the actual intent to defraud creditors of Horizon/CMS, including General Medicine, in violation of the Alabama Uniform Fraudulent Transfer Act. General Medicine’s complaint requests relief including the avoidance of the subject transfers of assets, attachment of the assets transferred to us, appointment of a receiver over the transferred properties, and a monetary judgment for the value of properties transferred. We have filed an answer denying that we have any liability to General Medicine.

On October 6, 2004, Meadowbrook filed a declaratory judgment action against us in the Circuit Court of Shelby County, Alabama, captioned Meadowbrook Healthcare Corporation v. HealthSouth Corp., CV-04-1131, seeking a declaration that it is not contractually obligated to indemnify us against General Medicine’s complaint.

On February 28, 2005, the General Medicine case was transferred to the Circuit Court of Jefferson County, Alabama, and assigned case number CV-05-1483. On May 9, 2005, the Meadowbrook case was transferred to the Circuit Court of Jefferson County, Alabama, and assigned case number CV-05-3042.

On July 26, 2005, we filed an Answer and Verified Counterclaim for Injunctive and Other Relief in the Meadowbrook case seeking a judgment requiring Meadowbrook to indemnify us against the claims asserted by General Medicine in its complaint and other relief based upon legal and equitable theories. In August of 2005, both sides filed motions for summary judgment in the Meadowbrook case based upon the express language of the indemnification provision in the Stock Purchase Agreement. On November 15, 2005, the court entered a final order determining that Meadowbrook is not contractually obligated under the Stock Purchase Agreement to indemnify us against the claims asserted by General Medicine in its complaint. The final order did not adjudicate our equitable claims against Meadowbrook which, if successful, would require Meadowbrook to pay our liability, if any, to General Medicine. On December 21, 2005, we filed an appeal of the court’s ruling that Meadowbrook has no contractual obligation to indemnify us under the Stock Purchase Agreement, captioned HealthSouth Corporation vs. Meadowbrook Healthcare, Inc., appeal no. 1050406 in the Supreme Court of Alabama.

 

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On December 9, 2005, we filed a Motion to Consolidate the Meadowbrook case and the General Medicine case. On January 26, 2006, the court entered an order consolidating the two cases for purposes of discovery and pre-trial matters.

On December 9, 2005, we filed a First Amended Counterclaim asserting counterclaims against Meadowbrook, General Medicine and Horizon/CMS for fraud, injurious falsehood, tortious interference with business relations, bad faith, conspiracy, unjust enrichment, and other causes of action. The First Amended Counterclaim alleges that the Consent Judgment is the product of fraud, collusion and bad faith by Meadowbrook, General Medicine and Horizon/CMS and, further, that these parties are guilty of a conspiracy to manufacture a lawsuit against HealthSouth in favor of General Medicine and to divert the assets of Horizon/CMS to Meadowbrook and away from creditors, including HealthSouth.

For additional information about Meadowbrook, see Note 20, Related Party Transactions, to the accompanying consolidated financial statements.

Massachusetts Real Estate Actions

On February 3, 2003, HRPT Properties Trust (“HRPT”) filed a lawsuit against Senior Residential Care/North Andover, Limited Partnership (“SRC”) in the Land Court for the Commonwealth of Massachusetts captioned HRPT Properties Trust v. Senior Residential Care/North Andover, Limited Partnership, Misc. Case No. 287313, in which it claimed an ownership interest in certain parcels of real estate in North Andover, Massachusetts and alleged that SRC unlawfully occupied and made use of those properties. On March 17, 2003, we (and our subsidiary, Greenery Securities Corp.) moved to intervene in this case claiming ownership of the disputed property pursuant to an agreement that involved the conveyance of five nursing homes. We seek to effect a transfer of title to the disputed property by HRPT to us or our nominee.

On April 16, 2003, Senior Housing Properties Trust (“SNH”) and its wholly owned subsidiary, HRES1 Properties Trust (“HRES1”), filed a lawsuit against us in Land Court for the Commonwealth of Massachusetts captioned Senior Housing Properties Trust and HRES1 Properties Trust v. HealthSouth Corporation, Misc. Case No 289182, seeking reformation of a lease pursuant to which we, through subsidiaries, operate the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts. HRES1 and SNH allege that certain of our representatives made false statements regarding our financial condition, thereby inducing HRES1 to enter into lease terms and other arrangements to which it would not have otherwise agreed. HRES1 and SNH have since amended their complaint to add claims for rescission and damages for fraud. HRES1 and SNH seek to reform the lease to increase the annual rent from $8.7 million to $10.3 million, to increase the repurchase option price at the end of the lease term to $80.3 million from $40 million, and to change the lease term to expire on January 1, 2006 instead of December 31, 2011. We filed an answer to the complaint and amended complaint denying the allegations, and we asserted claims against HRPT and counterclaims against SNH and HRES1 for breach of contract, reformation, and fraud based on the failure to convey title to the property in North Andover. We also seek damages incurred as a result of that failure to convey. The two actions in the Land Court have been consolidated for all purposes.

On May 13, 2005, the Land Court ruled that we are entitled to a jury trial in the consolidated cases. SNH, HRES1, and HRPT have taken an interlocutory appeal from this order, and argument before the Massachusetts Supreme Judicial Court was held on March 7, 2006. The Supreme Judicial Court has not issued its order as of the date of this report. The consolidated Land Court cases have been stayed pending disposition of the appeal. The parties were still in the discovery phase of the proceedings at the time the stay came into effect.

In a related action, on November 2, 2004, we filed a lawsuit in the Commonwealth of Massachusetts, Middlesex County Superior Court, captioned HealthSouth Corporation v. HRES1 Properties Trust, Case No 04-4345, in response to our receipt of a notice from HRES1 purporting to terminate our lease governing the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in

 

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Woburn, Massachusetts due to our alleged failure to furnish quarterly and annual financial information pursuant to the terms of the lease. In the lawsuit, we seek a declaration that we are not in default of our obligations under the lease, as well as an injunction preventing HRES1 from terminating the lease, taking possession of the property on which the hospitals and facilities are located, and assuming or acquiring the hospital businesses and any licenses related thereto. We filed an amended complaint asserting violations of the Massachusetts unfair and deceptive business practices statute and adding HRPT as a party. On November 8, 2004, HRES1 and SNH, its parent, filed a counterclaim seeking a declaration that it lawfully terminated the lease and an order requiring us to use our best efforts to transfer the licenses for the hospitals and to continue to manage the hospitals during the time necessary to effect such transfer.

On September 25, 2005, the Superior Court granted SNH and HRES1’s motion for summary judgment on our requests for declaratory and injunctive relief, ruling that their termination of the lease was valid, and the Court granted HRPT’s motion to dismiss. On September 29, 2005, the Court, at SNH and HRES1’s request, appointed a receiver to hold the “net cash proceeds of operations” of the facilities during the pendency of the litigation.

On November 30 and December 9, 2005, the Court conducted a bench trial on the issues relating to the parties’ relationship post-termination. On January 12, 2006, the Court issued an order accepting HRES1’s construction that: (1) the lease requires us to use our best efforts to accomplish the license transfer while managing the facilities for HRES1’s account; and (2) since October 26, 2004 and until a successor operator assumes control over the facilities, HRES1 is entitled to the net cash proceeds of the hospitals after deducting direct operating expenses and a management fee equal to 5% of net patient revenues. A judgment reflecting this order was entered on January 18, 2006. The judgment required us to pay these amounts for the period from October 26, 2004 through January 18, 2006, within 15 days of the entry of judgment, or February 2, 2006. For future monthly periods, HealthSouth is obligated to pay the net cash proceeds to HRES1 within 15 days of the end of each month. We do not anticipate that these payments will be material to our results of operations or financial condition.

On January 24, 2006, we filed a Notice of Appeal from the judgment and all orders encompassed therein, including the order granting SNH and HRES1’s motion for summary judgment on the lease termination issue and their request for the appointment of a receiver. A hearing on the appeal has not yet been scheduled.

On January 31, 2006, the Superior Court denied our request to stay the judgment during the appeal, and, on February 2, 2006, a Single Justice of the Appeals Court also denied our request for a stay. Accordingly, we are cooperating with HRES1 regarding transfer of the licenses. In addition, through December 31, 2005, we have paid HRES1 a total of approximately $4.6 million for the net cash proceeds of the hospitals for the period between October 26, 2004 and December 31, 2005.

SNH, HRES1, and HRPT have recently filed motions seeking to require HealthSouth to pay their attorneys’ fees incurred in the Superior Court litigation. We have opposed these requests. A hearing on these motions is currently scheduled for April 11, 2006.

Other Litigation

On September 17, 1998, John Darling, who was one of the federal False Claims Act relators in the now-settled Devage case (see discussion in Item 1), filed a lawsuit captioned Darling v. HealthSouth Sports Medicine & Rehabilitation, et al., 98-6110-CI-20, in the Circuit Court for Pinellas County, Florida. The complaint alleges that Mr. Darling was injured while receiving physical therapy during a 1996 visit to a HealthSouth outpatient rehabilitation facility in Clearwater, Florida. The complaint was amended in December 2004 to add a punitive damages claim. This amended complaint alleges that fraudulent misrepresentations and omissions by us resulted in the injury to Mr. Darling. The court recently ordered the parties to participate in non-binding arbitration.

 

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We have been named as a defendant in two lawsuits brought by individuals in the Circuit Court of Jefferson County, Alabama, Nichols v. HealthSouth Corp., CV-03-2023, filed March 28, 2003, and Hilsman v. Ernst & Young, HealthSouth Corp., et al., CV-03-7790, filed December 12, 2003. The plaintiffs allege that we, some of our former officers, and our former auditor engaged in a scheme to overstate and misrepresent our earnings and financial condition. The plaintiffs seek compensatory and punitive damages. On March 24, 2003, a lawsuit captioned Warren v. HealthSouth Corp., et al., CV-03-5967, was filed in the Circuit Court of Montgomery County, Alabama. The lawsuit, which claims damages for the defendants’ alleged negligence, wantonness, fraud and breach of fiduciary duty, was transferred to the Circuit Court of Jefferson County, Alabama. Each of the lawsuits described in this paragraph has been consolidated with the Tucker case for discovery and other pretrial purposes.

On June 30, 2004, two physical therapy providers in New Jersey filed a class action lawsuit captioned William Weiss Physical Therapy, et al., v. HealthSouth Corporation, et al., Docket No. BER-L-10218-04 (N.J. Super.) in the Superior Court of New Jersey. The nine count complaint alleges certain unfair trade practices in offering physical therapy services in violation of the New Jersey Physical Therapy Licensing Act of 1983. This case has been dismissed with prejudice.

On May 13, 2003, Plano Hospital Investors, Inc. (“Plano”) filed a complaint captioned Plano Hospital Investors, Inc., et al., v. HealthSouth Corp., et al., Cause No. 219-1416-03, in the 219th Judicial District Court of Collin County, Texas. Plano was a limited partner in Collin County Rehab Associates Limited Partnership, a partnership in which we, through wholly owned subsidiaries, are the general partner and hold limited partner interests. Plano alleged that we conducted unauthorized and improper sweeps of partnership funds into a HealthSouth centralized cash management account instead of a partnership account, that we improperly received late partnership distributions, and that the predecessor general partner took a negative capital contribution improperly increasing its interest, and upon the sale of that interest to us, our interest, in the partnership. Effective on or about May 31, 2005, we settled this case and obtained a full and final release of all claims.

On December 28, 2004, we commenced a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Medical Center, Inc. v. Neurological Surgery Associates, P.C., CV-04-7700, to collect unpaid loans in the original principal amount of $275,000 made to Neurological Surgery Associates, P.C. (“NSA”), pursuant to a written Practice Guaranty Agreement. The purpose of the loans was to enable NSA to employ a physician who would bring necessary specialty skills to patients served by both NSA and our acute-care hospital in Birmingham, Alabama. NSA has asserted counterclaims that we breached verbal promises to lease space and employees from NSA, to pay NSA for billing and coding services performed by NSA on behalf of the subject physician-employee, and to pay NSA to manage the subject physician-employee. This case is currently in the discovery phase.

On April 15, 2004, Klemett L. Belt, Jr. filed a complaint captioned Belt v. HealthSouth Corp., CV-2004-02517, in the Second Judicial District Court of Bernalillo County, New Mexico. Mr. Belt, a former executive officer and director of Horizon/CMS Healthcare Corporation, entered into a Non-Competition and Retirement Agreement with Horizon/CMS that we subsequently assumed in our acquisition of Horizon/CMS pursuant. Mr. Belt alleged in his complaint that he was entitled to retirement benefits, life insurance and, in the event of certain events of default, liquidated damages pursuant to a contractual provision requiring that the life insurance policies be fully paid and permitting Mr. Belt to receive a lump sum cash payment in lieu of certain unpaid retirement benefits. Mr. Belt alleges that we defaulted under the terms of the agreement due to our nonpayment of insurance policy premium payments beginning on December 31, 2003. As a result of our alleged default under the agreement, Mr. Belt sought liquidated damages in lieu of retirement benefits, payment of insurance policy premiums, amounts sufficient to compensate Mr. Belt for excess income taxes, interest, expenses, attorneys’ fees, and such other relief as may be determined by the court. We entered into a settlement agreement with Mr. Belt pursuant to which we must pay certain damages and relinquish our right to receive returned insurance premiums, if any, under a split dollar arrangement.

 

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On June 2, 2003, Vanderbilt Health Services, Inc. and Vanderbilt University filed a lawsuit captioned Vanderbilt Health Services, Inc. and Vanderbilt University v. HealthSouth Corporation, Case No. 03-1544-III, in the Chancery Court for Davidson County, Tennessee. We are partners with the plaintiffs in a partnership that operates a rehabilitation hospital in Nashville, Tennessee. In the complaint, the plaintiffs allege that we violated the terms of a non-competition provision in the partnership agreement in connection with our purchase of a number of rehabilitation clinics in the Nashville area. Effective as of January 20, 2006, we settled this case and obtained a full and final release of all claims.

On July 19, 2005, Gary Bellinger filed a pro se complaint captioned Gary Bellinger v. Eric Hanson, d/b/a U.S. Strategies, Inc., Medika Group, Ltd., Laserlife, Inc., & Relife, Inc.; and Richard Scrushy, d/b/a HealthSouth, Case No. 05-06898-B, In the District Court, Dallas County, Texas, 44th Judicial District. Mr. Bellinger claims the defendants violated the terms of a distribution agreement with his company, Laser Bio Therapy, Inc., resulting in that company’s bankruptcy. He has sued for breach of contract, breach of fiduciary duty, and fraud, and claims compensatory damages of $270 million and punitive damages of $10 million. We filed a Motion to Quash Service of Process because we were not properly named or served. That motion is currently pending before the court.

 

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

We held our first Annual Meeting of Stockholders since 2002 on December 29, 2005. At the annual meeting, the stockholders voted on the election of all ten directors and on a stockholder submitted proposal recommending the amendment of our bylaws to require the chairman of our board of directors to be an independent director, as defined in the proposal. The voting results at the annual meeting were as follows:

Proposal One, election of directors, which passed:

 

Name of Nominee

   Votes For    Votes Withheld

Steven R. Berrard

   347,667,377    11,072,428

Edward A. Blechschmidt

   353,190,740    5,549,065

Donald L. Correll

   353,070,714    5,669,091

Yvonne M. Curl

   346,349,152    12,390,653

Charles M. Elson

   354,027,434    4,712,371

Jay Grinney

   353,397,813    5,341,992

Jon F. Hanson

   347,389,459    11,350,346

Leo I. Higdon, Jr.  

   347,574,800    11,165,005

John E. Maupin, Jr.  

   353,374,009    5,365,796

L. Edward Shaw, Jr.  

   347,935,809    10,803,996

Proposal Two, stockholder proposal, which did not pass:

 

Votes For

   Votes Against    Abstain    Broker Non-Votes

140,021,612

   27,665,012    12,774,407    178,278,774

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

On March 19, 2003, after the Securities and Exchange Commission issued an Order of Suspension of Trading, the New York Stock Exchange (“NYSE”) suspended trading in our common stock, which was then listed under the symbol HRC. That same day, Standard & Poor’s announced that it removed our common stock from the S&P 500 Index. The NYSE continued the trading halt and eventually delisted our common stock. On March 25, 2003, immediately following the delisting from the NYSE, our stock began trading in the over-the-counter “Pink Sheets” market under the symbol HLSH.

The following table sets forth the high and low bid quotations per share of HealthSouth common stock as reported on the over-the-counter market from January 1, 2004 through December 31, 2005. The stock price information is based on published financial sources. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions.

 

     Market    High    Low

2004

        

First Quarter

   OTC    $ 6.18    $ 3.76

Second Quarter

   OTC      6.07      4.10

Third Quarter

   OTC      6.41      5.02

Fourth Quarter

   OTC      6.46      4.88

2005

        

First Quarter

   OTC    $ 6.16    $ 5.18

Second Quarter

   OTC      6.03      4.82

Third Quarter

   OTC      5.69      4.02

Fourth Quarter

   OTC      4.85      3.65

Holders

As of February 28, 2006, there were 398,229,960 shares of HealthSouth common stock issued and outstanding, net of treasury shares, held by approximately 8,581 holders of record.

Dividends

We have never paid cash dividends on our common stock, and we do not anticipate paying cash dividends on our common stock in the foreseeable future. In addition, the terms of our new credit agreement and interim loan agreement restrict us from declaring or paying cash dividends on our common stock unless: (1) all term loans made to us under our interim loan agreement have been repaid or such dividend occurs after the first anniversary of the effective date of our credit agreement and interim loan agreement, (2) we are not in default under our credit agreement or interim loan agreement, and (3) the amount of the dividend, when added to the aggregate amount of certain other defined payments made during the same fiscal year, does not exceed certain maximum thresholds. We currently anticipate that any future earnings will be retained to finance our operations and reduce debt. However, as described below, our recently issued 6.50% Series A Convertible Perpetual Preferred Stock generally provides for the payment of cash dividends subject to certain limitations.

Recent Sales of Unregistered Securities

In 2005, we sold an aggregate of 50,000 shares of common stock to Joel C. Gordon, a former director, pursuant to the exercise of outstanding stock options in reliance on Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”). The aggregate consideration for this sale was $247,000. In 2005 we issued 1,232,827 shares of restricted stock to various directors and executive officers in reliance on Section 4(2) of the Securities Act. There was no monetary consideration for the issuances of restricted stock.

 

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In addition, on February 28, 2006, we entered into a Securities Purchase Agreement (the “Purchase Agreement”) with several investors, pursuant to which we sold 400,000 shares of 6.50% Series A Convertible Perpetual Preferred Stock (the “Series A Preferred Stock”) at a price per share of $1,000, for an aggregate purchase price of $400 million. We received approximately $388 million in net proceeds from this offering (after deducting the placement agents’ fees of $12 million paid to Citigroup Global Markets Inc., J.P. Morgan Securities Inc., Merrill Lynch, Pierce, Fenner and Smith Incorporated, Deutsche Bank Securities Inc., Goldman Sachs & Co., and Wachovia Capital Markets, LLC and before deducting our estimated offering expenses). The offers and sales of the Series A Preferred Stock were made only to Qualified Institutional Buyers as such term is defined under Rule 144A promulgated by the SEC under the Securities Act and were deemed exempt from registration under the Securities Act, in reliance on Section 4(2) of the Securities Act and Rule 506 promulgated by the SEC under the Securities Act, as transactions not involving a public offering. As of February 28, 2006 there were 47 holders of record of the Series A Preferred Stock.

The Series A Preferred Stock is convertible, at the option of the holder, at any time into shares of our common stock at an initial conversion price of $6.10 per share, which is equal to an approximate conversion rate of 163.9344 shares of common stock per share of Series A Preferred Stock, subject to specified adjustments. On or after July 20, 2011, we may cause the shares of Series A Preferred Stock to be automatically converted into shares of our common stock at the conversion rate then in effect if the closing sale price of our common stock for 20 trading days within a period of 30 consecutive trading days ending on the trading day before the date we give the notice of forced conversion exceeds 150% of the conversion price of the Series A Preferred Stock.

Holders of Series A Preferred Stock are entitled to receive, when and if declared by our board of directors, cash dividends at the rate of 6.50% per annum on the accreted liquidation preference per share, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on July 15, 2006. If we are prohibited by the terms of our credit facilities, debt indentures or other debt instruments from paying cash dividends on the Series A Preferred Stock, we may pay dividends in shares of our common stock, or a combination of cash and shares of our common stock, if the shares of our common stock delivered as payment are freely transferable by the recipient thereof (other than by reason of the fact that the recipient is a HealthSouth affiliate) or if a shelf registration statement relating to that common stock is effective to permit the resale thereof. Shares of our common stock delivered as dividends will be valued at 95% of their market value. Unpaid dividends will accrete at an annual rate of 8.0% per year for the relevant dividend period and will be reflected as an accretion to the liquidation preference of the Series A Preferred Stock.

We applied the net proceeds from the issuance of the Series A Preferred Stock to prepay certain existing indebtedness and to pay associated transaction costs in connection with our recapitalization transactions.

The foregoing descriptions of the Series A Preferred Stock is qualified in its entirety by the complete text of the Certificate of Designation of 6.50% Series A Convertible Perpetual Preferred Stock, which is referenced in Item 15, Exhibits and Financial Statement Schedules, and is incorporated herein by reference.

Securities Authorized for Issuance Under Equity Compensation Plans

The information required by Item 201(d) of Regulation S-K is provided under Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters, “Securities Authorized for Issuance Under Equity Compensation Plans,” which is incorporated herein by reference.

Purchases of Equity Securities

None.

 

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Item 6. Selected Financial Data

We derived the selected historical consolidated financial data presented below for the years ended December 31, 2005, 2004, and 2003 from our audited consolidated financial statements and related notes included elsewhere in this filing. We derived the selected historical consolidated financial data presented below for the years ended December 31, 2002 and 2001 from our audited consolidated financial statements and related notes included in our Form 10-K for the year ended December 31, 2003. You should refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the notes to our accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial condition or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.

 

    Certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications primarily relate to facilities closed in 2005 that qualify under Financial Accounting Standards Board (“FASB”) Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to be reported as discontinued operations. We reclassified our consolidated financial statements for the years ended December 31, 2004, 2003, 2002, and 2001 to show the results of those qualifying facilities in 2005 as discontinued operations.

 

    As discussed in more detail in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, a judgment was entered against us in 2005 that upheld the landlord’s termination of the lease at two of our inpatient rehabilitation facilities and placed us as the manager, rather than the owner, of these two facilities. Accordingly, our 2005 results of operations include only the $5.4 million management fee we earned for operating these facilities on behalf of the landlord during the year. In 2004 and 2003, the results of operations of these two facilities were included in our consolidated statements of operations on a gross basis. Our consolidated net operating revenues and consolidated operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, in 2005 as a result of the change in classification of these two facilities.

 

    In 2001 and 2002, we reserved approximately $38.0 million related to amounts due from Meadowbrook Healthcare, Inc. (“Meadowbrook”), an entity formed by one of our former chief financial officers, Michael D. Martin, related to net working capital advances made to Meadowbrook in 2001 and 2002. In August 2005, we received a payment of $37.9 million from Meadowbrook. This cash payment is included as Amounts due from Meadowbrook in our 2005 income statement data. For more information regarding Meadowbrook, see Note 20, Related Party Transactions, to our accompanying consolidated financial statements.

 

    Included in our net loss for 2005, 2004, 2003, 2002, and 2001 are property and equipment and goodwill and other intangible assets impairment charges of $45.2 million, $37.3 million, $468.3 million, $83.3 million, and $0.1 million, respectively. These charges were recorded as a result of experiencing continued significant decreases in projected revenue and operating profit at numerous facilities and significant changes in the business climate over this five-year period. We performed impairment analyses and calculated the fair value of our long-lived assets with the assistance of a third-party valuation specialist using a combination of discounted cash flows and market valuation models based on competitors’ multiples of revenue, gross profit, and other financial ratios. These impairment charges are shown separately as a component of operating loss within the consolidated statements of operations, excluding $6.8 million, $19.3 million, $38.4 million, and $1.7 million of impairment charges in 2005, 2004, 2002, and 2001, respectively, related to certain closed facilities which are included in discontinued operations.

 

   

In 2005, our net loss includes a $215.0 million charge as Government, class action, and related settlements expense under a proposed settlement with the lead plaintiffs in the Stockholder Securities Action and the Bondholder Securities Action. In 2003, our net loss includes the cost related to our settlement with the United States Securities and Exchange Commission (the “SEC”) and certain

 

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additional settlements, as well as legal fees related to this litigation and certain other actions brought against us. Also, as a result of the Medicare Program Settlement, our 2002 net loss includes a $347.7 million charge as Government, class action, and related settlements expense. For additional information, see Note 21, Medicare Program Settlement, Note 22, SEC Settlement, Note 23, Securities Litigation Settlement, and Note 24, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

 

    As noted throughout this filing, significant changes have occurred at HealthSouth since the events leading up to March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. Our net loss includes professional fees associated with the reconstruction and restatement of our previously issued consolidated financial statements of approximately $169.8 million in 2005, $206.2 million in 2004, and $70.6 million in 2003.

 

    We recorded the cumulative effect of an accounting change in both 2003 and 2002. Effective January 1, 2003, we adopted the provisions of FASB Statement No. 143, Accounting for Asset Retirement Obligations, and recorded a related charge of approximately $2.5 million. On January 1, 2002, we recorded a charge of approximately $48.2 million as a result of the adoption of FASB Statement No. 142, Goodwill and Other Intangible Assets, related to an impairment of goodwill of our diagnostic segment.

 

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    Year ended December 31,  
    2005     2004     2003     2002     2001  
    (In Thousands, Except Per Share Data)  

Income Statement Data:

 

Net operating revenues

  $ 3,207,728     $ 3,512,632     $ 3,657,892     $ 3,641,816     $ 3,247,749  
                                       

Salaries and benefits

    1,429,867       1,619,834       1,595,534       1,630,565       1,510,590  

Professional and medical director fees

    76,373       78,118       87,673       95,271       78,523  

Supplies

    305,585       331,339       317,220       312,983       286,930  

Other operating expenses

    679,626       611,401       750,001       823,056       739,118  

Provision for doubtful accounts

    98,417       113,783       128,296       83,235       84,427  

Depreciation and amortization

    167,112       176,959       185,552       216,450       328,783  

Amounts due from Meadowbrook

    (37,902 )     —         —         36,902       1,000  

Loss (gain) on disposal of assets

    14,776       9,539       (14,967 )     84,510       34,438  

Impairment of goodwill

    —         —         335,623       —         —    

Impairment of intangible assets

    —         1,030       —         16,388       —    

Impairment of long-lived assets

    45,203       36,260       132,722       66,901       58  

Government, class action, and related settlements expense

    215,000       —         170,949       347,716       —    

Professional fees—reconstruction and restatement

    169,804       206,244       70,558       —         —    

Loss (gain) on early extinguishment of debt

    33       (45 )     (2,259 )     (9,644 )     5,136  

Interest expense and amortization of debt discounts and fees

    338,701       302,635       265,327       251,776       308,199  

Interest income

    (17,141 )     (13,090 )     (7,273 )     (6,709 )     (7,380 )

(Gain) loss on sale of investments

    (229 )     (3,601 )     15,811       (12,464 )     (140 )

Equity in net income of nonconsolidated affiliates

    (29,432 )     (9,949 )     (15,769 )     (15,320 )     (16,909 )

Minority interests in earnings of consolidated entities

    96,728       94,389       98,196       90,978       59,537  
                                       
    3,552,521       3,554,846       4,113,194       4,012,594       3,412,310  
                                       

Loss from continuing operations

    (344,793 )     (42,214 )     (455,302 )     (370,778 )     (164,561 )

Provision for income tax expense (benefit)

    39,792       11,914       (28,382 )     20,338       (44,911 )

Loss from discontinued operations, net of income tax expense

    (61,409 )     (120,342 )     (5,181 )     (27,519 )     (71,575 )

Cumulative effect of accounting change, net of income tax expense

    —         —         (2,456 )     (48,189 )     —    
                                       

Net loss

  $ (445,994 )   $ (174,470 )   $ (434,557 )   $ (466,824 )   $ (191,225 )
                                       

Weighted average common shares outstanding:

         

Basic

    396,563       396,423       396,132       395,520       390,485  
                                       

Diluted*

    398,021       397,625       405,831       408,321       415,163  
                                       

Basic and diluted loss per share:

         

Loss from continuing operations, net of tax

  $ (0.97 )   $ (0.14 )   $ (1.08 )   $ (0.99 )   $ (0.31 )

Discontinued operations, net of tax

    (0.15 )     (0.30 )     (0.01 )     (0.07 )     (0.18 )

Cumulative effect of accounting change, net of tax

    —         —         (0.01 )     (0.12 )     —    
                                       

Net loss per common share

  $ (1.12 )   $ (0.44 )   $ (1.10 )   $ (1.18 )   $ (0.49 )
                                       

* Per share diluted amounts are treated the same as basic per share amounts, because the effect of including potentially dilutive shares is antidilutive.

 

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     December 31,  
     2005     2004     2003     2002     2001  
     (In Thousands)  

Balance Sheet Data:

  

Cash and marketable securities

   $ 199,336     $ 449,125     $ 463,952     $ 88,642     $ 62,681  

Restricted cash

     242,450       241,375       173,737       24,031       31,694  

Working capital (deficit)

     (235,569 )     (3,752 )     167,036       (490,477 )     (83,601 )

Total assets

     3,592,213       4,082,993       4,209,703       4,536,700       4,578,267  

Long-term debt, including current portion

     3,404,043       3,497,191       3,503,836       3,487,094       3,533,996  

Shareholders’ deficit

     (1,540,721 )     (1,109,420 )     (963,837 )     (528,759 )     (111,507 )

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of HealthSouth as a whole.

Forward Looking Information

This MD&A should be read in conjunction with our accompanying consolidated financial statements and related notes. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors.

Executive Overview

As described in detail in Item 1, Business, the past several years have been marked by profound turmoil and change. During this period, a significant portion of our time and attention has been devoted to matters primarily outside the ordinary course of business such as replacing our senior management team, cooperating with federal investigators, restructuring our finances, and reconstructing our accounting records. We have also devoted substantial resources to improving fundamental business systems including our corporate governance functions, financial controls, and operational infrastructure.

Despite these difficulties, our board of directors, senior management team, and employees worked diligently throughout 2005 and into 2006 and have made significant progress in addressing many of the more significant obstacles created by the March 2003 crisis, including the following:

 

    We have replaced our board of directors and senior management team and improved our corporate governance policies and practices. See Item 1, Business, “Our New Board of Directors and Senior Management Team.”

 

    We have completed a substantive reconstruction of our accounting records and filed annual reports on Form 10-K for the fiscal years (including this filing) ended December 31, 2005, 2004, 2003, and 2002 (including a restatement of previously issued consolidated financial statements for the fiscal years ended December 31, 2001 and 2000). In December 2005, we held our first Annual Meeting of Stockholders since 2002.

 

    We have prepaid substantially all of our existing indebtedness with proceeds from a series of recapitalization transactions and replaced it with approximately $3 billion of new long-term debt, which we believe will produce enhanced operational flexibility, reduced refinancing risk, and an improved credit profile. See Item 1, Business, “Recapitalization Transactions” and Note 8, Long-term Debt, to our accompanying consolidated financial statements.

 

    We have reached a global, preliminary agreement in principle with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers, to settle claims filed against us, certain of our former directors and officers, and certain other parties. See Item 1, Business, “Securities Litigation Settlement.”

 

   

We have settled with the Department of Justice’s (the “DOJ”) civil division and other parties regarding their allegations that we submitted various fraudulent Medicare cost reports and committed certain other violations of federal health care program requirements. Although this settlement does not cover all similar claims that have been or could be brought against us, it settles the primary known claims that

 

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have been pending against us relating to our participation in federal health care programs. The DOJ and the Office of Inspector General (the “HHS-OIG”) of the United States Department of Health and Human Services (“HHS”) continue to review certain other matters, including self-disclosures made by us to the HHS-OIG. See Item 1, Business, “Medicare Program Settlement.”

 

    We have settled with the United States Securities and Exchange Commission (the “SEC”) regarding its allegations that we violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. See Item 1, Business, “SEC Settlement.”

 

    We continue to cooperate with federal law enforcement officials and other federal investigators, including the DOJ and the SEC, as they work to conclude their investigations, which are still ongoing.

We have also made significant progress implementing our multi-year operational agenda, which strives to improve our business in five key areas: revenue, cost, quality, people, and infrastructure. In 2005, we made improvements in each of the five key areas listed in that agenda:

 

    Revenue—We helped advocate a slower phase-in of the 75% Rule and, we believe, outperformed the industry in mitigating the impact of the 75% Rule. We consolidated outpatient revenue centers and overhauled our outpatient sales and marketing function. We also piloted various new programs to enhance our marketing and have hired a new senior vice president to improve our managed care contracting function.

 

    Cost—We substantially reduced unnecessary overhead expense and closed or sold under-performing facilities. We have also hired a new senior vice president to manage and streamline our supply chain. We will continue to work to reduce costs by reorganizing and flattening each operating division and implementing standardized labor management metrics and performance expectations. In addition, we are closely monitoring our business and will, when necessary, close or sell additional under-performing facilities.

 

    Quality—We began an inpatient clinical information assessment, increased production of our AutoAmbulator, and participated in various clinical research projects. We are also working to enhance strong quality assurance programs within our facilities and divisions. We plan to supplement these programs by improving our company-wide quality agenda that will include standardized division-specific quality metrics and improved clinical information through the use of technology.

 

    People—We completed our senior management team and hired a number of other management personnel. We also completed a human resources strategic plan and increased 401(k) contributions for our employees. Our goal is to build a culture of integrity, transparency, diversity, and excellence, while simplifying and flattening our organizational structure.

 

    Infrastructure—We invested significant resources to evaluate and improve our financial, reporting, and compliance infrastructure, and will continue to invest heavily in our infrastructure throughout this turnaround period. Although our infrastructure needs further improvement in many areas, we are specifically focused on implementing required internal controls (e.g., compliance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”)), enhancing our financial infrastructure (e.g., improving financial and operational reporting and establishing a formal capital expenditure process and formal budget process), enhancing our management reporting capabilities (e.g., standardizing our monthly reporting and analysis, standardizing our financial projections, and implementing a faster month-end close), developing regulatory compliance programs, enhancing our information systems (e.g. upgrading our patient accounting systems), and implementing an information technology strategic plan.

Our business, and the health care market in general, continued to evolve throughout 2005. On the positive side, health care sector growth continues to outpace the economy in response to an aging U.S. population and other factors. In addition, the delivery of health care services is migrating to outpatient and post-acute care

 

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environments, which suits our business model. On the other hand, we anticipate pricing pressure in the markets we serve, as well as increased competition. Most importantly, recent changes to the 75% Rule and the prospective payment system applicable to our inpatient rehabilitation facilities (“IRF-PPS”) have combined to create a very challenging operating environment for us.

On the whole, our core businesses remain sound. We continue to be the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with (as of December 31, 2005) 1,070 facilities and approximately 37,000 full- and part-time employees. We believe that we are responding to challenges in the inpatient market as well as or better than our competitors, which may lead to potential consolidation opportunities in the future.

We continue to face operational challenges, but we believe our accomplishments in 2005 and the 2006 recapitalization transactions have positioned us to capitalize on our competencies and move forward with implementing our strategic growth plan.

Our Business

Our business is currently divided into four primary operating divisions—inpatient, surgery centers, outpatient, and diagnostic—and a fifth division that manages certain other revenue producing activities and corporate functions. These five divisions correspond to our five reporting segments discussed later in this Item and throughout this annual report.

Inpatient. Our inpatient division, which comprises the majority of our net operating revenues, provides treatment at (as of December 31, 2005) 93 freestanding inpatient rehabilitation facilities (“IRFs”), 10 long-term acute care hospitals (“LTCHs”), and 101 satellites of inpatient facilities providing primarily outpatient care. In addition to the facilities in which we have an ownership interest, our inpatient division operated 14 inpatient rehabilitation units, 11 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts as of December 31, 2005. This division continues to be the market leader in inpatient rehabilitation services in terms of revenues, number of IRFs, and patients served. In 2004, operating earnings of this division remained stable due largely to treating higher acuity patients and stricter expense controls. In 2005, net operating revenues decreased due to the continued phase-in of the 75% Rule, but operating earnings increased slightly because of the division’s efforts to manage expenses in relation to declining patient volume. We expect this division to continue to show positive results; however, as discussed below, the 75% Rule and recent IRF-PPS changes are likely to have a materially negative impact on future results of operations.

Surgery Centers. Our surgery centers division, which is our second largest division in terms of net operating revenues, operates (as of December 31, 2005) 158 freestanding ambulatory surgery centers (“ASCs”) and 3 surgical hospitals. Our surgery centers segment’s net operating revenues declined from 2003 to 2005. Since March 2003, the division has struggled due in large part to an inability to efficiently resyndicate (i.e., sell ownership interests in) its partnership portfolio and its inability to control supply costs. During 2005, resyndication activity improved, and we enhanced our portfolio of ASCs through the closure of under-performing facilities. We expect this division to benefit as outpatient procedures continue to migrate to the more efficient ASC environment. However, potential benefits from industry growth may be offset by physician partners who are demanding a higher ownership interest in our partnerships, thereby lowering our share of partnership earnings.

Outpatient. Our outpatient division currently provides outpatient therapy services (as of December 31, 2005) at 620 facilities. This division’s performance declined between 2003 and 2005 due primarily to poor operational processes and increased competition from physician-owned physical therapy sites. During 2005, we continued the rationalization of our outpatient facilities and formulated a sales and marketing team with the primary purpose to diversify our referral sources and minimize our exposure to physician-owned physical therapy sites. We believe these initiatives will begin to produce positive results for this division in 2006.

 

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Diagnostic. Our diagnostic division operates (as of December 31, 2005) 85 diagnostic imaging centers. This division’s performance suffered from 2003 to 2005 due to poor margins for the diagnostic market in general and strong competition from physician-owned diagnostic service centers. We are beginning to see stabilization of both net operating revenues and operating earnings, which we believe is due in part to payor pressures to decrease perceived over-utilization of diagnostic services by physician-owned diagnostic service centers. We continue to focus on operational improvements to increase our margins. In 2006, we hired R. Gregory Brophy to serve as president of the diagnostic division. In addition, we have received inquiries from parties interested in acquiring our diagnostic division and have hired an investment bank to assist us in evaluating those opportunities. However, no final decision has been made with respect to the divestiture of our diagnostic division at this time.

As shown by the following charts, our inpatient and surgery centers divisions made up more than 80% of 2005 net operating revenues and over 85% of 2005 Consolidated Adjusted EBITDA (as defined in this Item, “Consolidated Results of Operations,”) from our four primary operating divisions. For a reconciliation of loss from continuing operations to Consolidated Adjusted EBITDA, see this Item, “Consolidated Results of Operations—Consolidated Adjusted EBITDA.”

 

LOGO   LOGO

We believe that the aging of the U.S. population, changes in technology, and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aging—like stroke and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and joints—will increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care hospitals out of the acute care environment. We believe these market factors align with our strengths. We plan to prioritize investment of time and capital based on where realistic growth prospects are strongest, which we currently believe are our inpatient and surgery centers divisions.

Key Challenges

Although our business is continuing to generate substantial revenues, and market factors appear to favor our outpatient and post-acute care business model, we still have several immediate internal and external challenges to overcome before we can realize significant improvements in our business, including:

 

    Operational Improvements. We need to improve our operational efficiency, particularly in our surgery centers, outpatient, and diagnostic divisions. This includes streamlining our division management structure, continuing to consolidate or divest under-performing facilities, implementing standardized performance metrics and practices, and ensuring high quality care. We also will strive to reduce operational variation within each division.

 

    Price Pressure. We are seeing downward pressure on prices in our markets, from both commercial and government payors. We anticipate continuing price pressure in all our divisions. For example, recent IRF-PPS changes are likely to have a materially negative impact on inpatient revenues. In addition, Medicare has frozen ASC pricing through 2009, and beginning in 2007, the Deficit Reduction Act of 2005 will cap ASC and imaging service payments at hospital outpatient department reimbursement levels. Other pricing changes may have a negative impact on our operating results.

 

   

Single-Payor Exposure. Medicare comprises approximately 48% of our consolidated net operating revenues and approximately 71% of our largest division’s revenues. Consequently, single-payor exposure presents a serious risk. In particular, as discussed in Item 1, Business, “Sources of Revenues,” changes to the 75% Rule and IRF-PPS have combined to create a very challenging operating environment for our inpatient division. The volume volatility created by the 75% Rule has had a

 

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significantly negative impact on our inpatient division’s net operating revenues in 2005. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed in Item 1, Business, “Our Business—Operating Divisions.” However, the combination of volume volatility created by the 75% Rule and lower unit pricing resulting from IRF-PPS changes reduced our operating earnings in 2005 and will have a continuing negative impact on our operating earnings in 2006. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

 

    Competition. Competition is increasing as physicians look for new revenue sources to offset declining incomes. In our outpatient and diagnostic divisions, physician practices are the natural owners of most patient volume. Any physician group that generates a substantial portion of facility volume for us may have reached sufficient critical mass to insource their referrals, and is therefore a potential competitor. In addition, the low barriers to entry in the outpatient physical therapy sector, and decreasing barriers to entry in the diagnostic sector, make competition from physician practices a particular problem in those markets.

 

    Declining Ownership Share of Surgery Centers. Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased equity participation in ASCs. Consequently, we expect to see our percentage ownership of centers within our ASC portfolio decline over time, thereby reducing our share of partnership earnings from our ASCs.

 

    Leverage. Although we have completed a series of recapitalization transactions that have eliminated significant uncertainty regarding our capital structure and have improved our financial condition, we remain highly leveraged. Our high leverage increases our cost of capital, decreases our net income, and may prevent us from taking advantage of potential growth opportunities.

 

    Settlement Costs. We have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we are required to pay the remaining balance of our $325 million settlement to the United States in quarterly installments ending in the fourth quarter of 2007 to satisfy our obligations under a settlement described in Item 1, Business, “Medicare Program Settlement.” Furthermore, we are required to pay the remaining balance of our $100 million settlement to the SEC in four installments ending in the fourth quarter of 2007, as described in Item 1, Business, “SEC Settlement.” Payments due under these settlement agreements are as follows as of December 31, 2005:

 

     Medicare
Program
Settlement
   SEC
Settlement
   Total
     (In Thousands)

2006

   $ 83,300    $ 37,500    $ 120,800

2007

     86,666      50,000      136,666
                    
   $ 169,966    $ 87,500    $ 257,466
                    

 

    Continuing Investigations and Litigation. We face continuing government investigations, as well as numerous class action and individual lawsuits, all of which will consume considerable management attention and company resources and could result in substantial additional payments and fines. Although we have reached a global, preliminary agreement in principle with the lead plaintiffs in the federal securities class actions and the derivative litigation, as well as with our insurance carriers, to settle claims filed against us, certain of our former directors and officers, and certain other parties, there can be no assurance that a final settlement can be reached or that the proposed settlement will receive the required court approval. For additional information, see Item 1, Business, “Securities Litigation Settlement.”

 

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    Reconstruction, Restatement, and Sarbanes-Oxley Related Costs. We paid approximately $208 million in 2005 in connection with the restructuring of our financial reporting processes, internal control over financial reporting, and managerial operations, and the reconstruction and/or restatement of our consolidated financial statements for the years ended December 31, 2004, 2003, 2002, 2001, and 2000. We anticipate incurring additional related costs in the future, although we expect these costs to decline over time.

Strategic Plan

Although management’s attention recently has been focused on a range of tactical issues critical to HealthSouth’s survival, our new senior management team has spent considerable time developing a comprehensive strategic plan for the next three to five years that is focused on HealthSouth’s future, not its past. The plan, which has been approved by our board of directors, is divided into the following three phases:

 

    Phase 1—Operational Focus. Because of our highly leveraged balance sheet, we must generate additional cash flow from operating activities by improving operational performance in all our operating divisions. In the first phase, we plan to focus on key operational initiatives such as mitigating the impact of the 75% Rule, realizing significant operating performance improvements in each division through standardization of labor and supply chain practices and reduction of fixed costs, completing additional surgery center resyndications, and improving our company-wide quality agenda. In addition, we plan to establish an appropriate internal control environment, strengthen regulatory compliance programs, pilot new post-acute care services, and establish our business development capabilities. Phase 1 has already begun.

 

    Phase 2—Operational/Growth Focus. In this phase, we will continue establishing an appropriate internal control environment. We will also continue making operational improvements by developing ways to use our size to create supply chain efficiencies and to identify and disseminate operational best practices in patient care, sales, and payor contracting. Assuming we are successful in achieving our targeted operational improvements in Phase 1 and mitigating the impact of the 75% Rule, we anticipate we will generate sufficient additional cash flow from operating activities to enable us to take advantage of selected development opportunities in the post-acute and surgery markets. Specifically, we plan to explore consolidation opportunities as they arise and build new IRFs and surgery centers in target markets. During this phase, we also plan to grow promising new post-acute services that are complementary to our existing services.

 

    Phase 3—Growth Focus. The third phase will be more outward looking. We plan to continue to acquire or build IRFs in target markets, develop new ASCs, grow new post-acute care businesses, and evaluate potential consolidation opportunities.

We are into the first phase of our strategic plan, and we are already making significant strides. For example, as described in Item 1, Business, “Recapitalization Transactions,” we have recently completed several recapitalization transactions resulting in reduced refinancing risk, enhanced operational flexibility, and increased liquidity. We have also entered into key settlements with the government and various private parties, reconstructed our accounting records, filed annual reports on Form 10-K for 2002 – 2005, and held our first Annual Meeting of Stockholders since 2002. Operationally, we have replaced the presidents of each of our primary operating divisions, reorganized these divisions by eliminating unnecessary management layers, increased productivity, divested under-performing facilities, and worked to improve operational systems. We are also continuing to implement mitigation strategies for the 75% Rule in our inpatient facilities, enhance the resyndication process for our ASCs, and implement new information systems to improve cash collections in our diagnostic division.

We believe our strategic plan capitalizes on our strengths, market direction, and legitimate growth opportunities. We are implementing a realistic operational plan and creating the appropriate infrastructure—organization, policies, protocols, systems, and reports—to support it. Finally, we are setting priorities based on resources and with our long-range goals of quality, profitability, and shareholder value at the forefront of our minds.

 

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Consolidated Results of Operations

HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with 1,070 facilities and approximately 37,000 full- and part-time employees. We provide these services through a national network of inpatient and outpatient rehabilitation facilities, outpatient surgery centers, diagnostic centers, and other health care facilities.

During 2005, 2004, and 2003, we derived consolidated net operating revenues from the following payor sources:

 

     For the year ended
December 31,
 
     2005     2004     2003  

Medicare

   47.5 %   47.4 %   44.6 %

Medicaid

   2.3 %   2.4 %   2.6 %

Workers’ compensation

   7.4 %   8.1 %   9.5 %

Managed care and other discount plans

   33.1 %   31.8 %   31.8 %

Other third-party payors

   5.4 %   5.1 %   6.5 %

Patients

   1.8 %   3.0 %   2.6 %

Other income

   2.5 %   2.2 %   2.4 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

We provide our patient care services through four primary operating divisions and certain other services through a fifth division. These five divisions correspond to our five reporting segments discussed in this Item, “Segment Results of Operations,” and throughout this annual report.

When reading our consolidated statements of operations, it is important to recognize the following items included within our results of operations:

 

    Restructuring charges. In our continuing efforts to streamline operations, we closed numerous under-performing facilities or consolidated similar facilities within the same market in 2005, 2004, and 2003. As a result of these facility closures or consolidations, we recorded certain restructuring charges approximating $8.2 million, $4.0 million, and $2.6 million in 2005, 2004, and 2003, respectively, for one-time termination benefits and contract termination costs under the guidance in Financial Accounting Standards Board (“FASB”) Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. See Note 10, Restructuring Charges, to our accompanying consolidated financial statements for additional information.

 

    Change in ownership of certain inpatient rehabilitation facilities. As discussed in more detail in this Item, “Segment Results of Operations—Inpatient,” a judgment was entered against us in 2005 that upheld the landlord’s termination of the lease at two of our inpatient rehabilitation facilities and placed us as the manager, rather than the owner, of these two facilities. Accordingly, our 2005 results of operations include only the $5.4 million management fee we earned for operating these facilities on behalf of the landlord during the year. In 2004 and 2003, the results of operations of these two facilities were included in our consolidated statements of operations on a gross basis. Our consolidated net operating revenues and consolidated operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, in 2005 as a result of the change in classification of these two facilities.

 

   

Recovery of amounts due from Meadowbrook. In 2001, we sold four inpatient rehabilitation facilities to Meadowbrook Healthcare, Inc. (“Meadowbrook”), an entity formed by one of our former chief financial officers, Michael D. Martin, for a $9.7 million note receivable. Meadowbrook paid no cash in connection with the sale of these facilities. The transaction was closed effective January 1, 2002, but remained in escrow until July 2002. We recognized a loss on this sale of approximately $37.4 million

 

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during 2001. In addition, during 2001, we advanced approximately $1.0 million in working capital loans to Meadowbrook. During 2002, we made a net advance of approximately $37.0 million to Meadowbrook. We reserved these amounts in 2001 and 2002, respectively.

In March 2005, we obtained a security interest in the real properties previously sold to Meadowbrook, evidenced by a mortgage that was recorded in June 2005. In July 2005, we received a payoff letter from Meadowbrook’s attorneys informing us that a payment of $37.9 million would be made by Meadowbrook to us. This repayment was effected by the purchase of Meadowbrook by Rehabcare Group, Inc. in August 2005. We received a cash payment of $37.9 million in August 2005 and recorded this bad debt recovery at that time.

See Note 20, Related Party Transactions, and Note 24, Contingencies and Other Commitments, to our accompanying consolidated financial statements for additional information regarding Meadowbrook.

 

    Impairments. During 2005, we recorded an impairment charge of approximately $45.2 million to reduce the carrying value of long-lived assets to their estimated fair market value. During 2004, we recorded an impairment charge of approximately $36.3 million to reduce the carrying value of property and equipment and an impairment charge of $1.0 million to reduce the carrying value of amortizable intangibles of certain operating facilities to their estimated fair market value. During 2003, we recorded a charge of approximately $335.6 million for the impairment of goodwill and an additional charge of approximately $132.7 million for the impairment of certain long-lived assets. These charges are discussed in more detail in this Item, “Segment Results of Operations,” Note 5, Property and Equipment, and Note 6, Goodwill and Other Intangible Assets, to our accompanying consolidated financial statements.

 

    Government, class action, and related settlements expense. In 2005, our net loss includes a $215.0 million charge as Government, class action, and related settlements expense under a proposed settlement with the lead plaintiffs in the Stockholder Securities Action and the Bondholder Securities Action. In 2003, our net loss includes the cost related to our settlement with the SEC and certain additional settlements, as well as legal fees related to this litigation and certain other actions brought against us. For additional information, see Note 22, SEC Settlement, Note 23, Securities Litigation Settlement, and Note 24, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

 

    Professional fees—reconstruction and restatement. As noted throughout this annual report, significant changes have occurred at HealthSouth since the events leading up to March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. During 2005, 2004, and 2003, professional fees associated with the reconstruction of our financial records and restatement of our previously issued 2001 and 2000 consolidated financial statements approximated $169.8 million, $206.2 million, and $70.6 million, respectively.

 

    Loss (gain) on early extinguishment of debt. In each year, we recorded a loss or gain on early extinguishment of debt due to our termination of certain capital leases or various credit agreements, or the repurchase of various bonds. For more information regarding these transactions, please see Note 8, Long-term Debt, to our accompanying consolidated financial statements.

 

    Cumulative effect of an accounting change, net of tax. We recorded the cumulative effect of an accounting change in 2003. Effective January, 1, 2003, we adopted the provisions of FASB Statement No. 143, Accounting for Asset Retirement Obligations, and recorded a related charge of approximately $2.5 million.

 

    Reclassifications. Certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications primarily relate to facilities we closed or sold in 2005 that qualify under FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to be reported as discontinued operations.

 

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From 2003 through 2005, our consolidated results of operations were as follows:

 

     For the year ended December 31,     Percentage Change  
     2005     2004     2003    

2005 vs.

2004

    2004 vs.
2003
 
     (In Thousands)              

Net operating revenues

   $ 3,207,728     $ 3,512,632     $ 3,657,892     (8.7 )%   (4.0 )%

Operating expenses:

          

Salaries and benefits

     1,429,867       1,619,834       1,595,534     (11.7 )%   1.5 %

Professional and medical director fees

     76,373       78,118       87,673     (2.2 )%   (10.9 )%

Supplies

     305,585       331,339       317,220     (7.8 )%   4.5 %

Other operating expenses

     679,626       611,401       750,001     11.2 %   (18.5 )%

Provision for doubtful accounts

     98,417       113,783       128,296     (13.5 )%   (11.3 )%

Depreciation and amortization

     167,112       176,959       185,552     (5.6 )%   (4.6 )%

Recovery of amounts due from Meadowbrook

     (37,902 )     —         —       N/A     N/A  

Loss (gain) on disposal of assets

     14,776       9,539       (14,967 )   54.9 %   (163.7 )%

Impairment of goodwill, intangible assets, and long-lived assets

     45,203       37,290       468,345     21.2 %   (92.0 )%

Government, class action, and related settlements expense

     215,000       —         170,949     N/A     (100.0 )%

Professional fees—reconstruction and restatement

     169,804       206,244       70,558     (17.7 )%   192.3 %
                                    

Total operating expenses

     3,163,861       3,184,507       3,759,161     (0.6 )%   (15.3 )%

Loss (gain) on early extinguishment of debt

     33       (45 )     (2,259 )   (173.3 )%   (98.0 )%

Interest expense and amortization of debt discounts and fees

     338,701       302,635       265,327     11.9 %   14.1 %

Interest income

     (17,141 )     (13,090 )     (7,273 )   30.9 %   80.0 %

(Gain) loss on sale of investments

     (229 )     (3,601 )     15,811     (93.6 )%   (122.8 )%

Equity in net income of nonconsolidated affiliates

     (29,432 )     (9,949 )     (15,769 )   195.8 %   (36.9 )%

Minority interests in earnings of consolidated affiliates

     96,728       94,389       98,196     2.5 %   (3.9 )%
                                    

Loss from continuing operations before income tax expense (benefit) and cumulative effect of accounting change

     (344,793 )     (42,214 )     (455,302 )   716.8 %   (90.7 )%

Provision for income tax expense (benefit)

     39,792       11,914       (28,382 )   234.0 %   (142.0 )%
                                    

Loss from continuing operations before cumulative effect of accounting change

     (384,585 )     (54,128 )     (426,920 )   610.5 %   (87.3 )%

Loss from discontinued operations, net of income tax expense

     (61,409 )     (120,342 )     (5,181 )   (49.0 )%   2222.8 %
                                    

Loss before cumulative effect of accounting change

     (445,994 )     (174,470 )     (432,101 )   155.6 %   (59.6 )%

Cumulative effect of accounting change, net of income tax expense

     —         —         (2,456 )   N/A     (100.0 )%
                                    

Net loss

   $ (445,994 )   $ (174,470 )   $ (434,557 )   155.6 %   (59.9 )%
                                    

 

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Operating Expenses as a % of Net Operating Revenues

 

     For the year ended
December 31,
 
     2005     2004     2003  

Salaries and benefits

   44.6 %   46.1 %   43.6 %

Professional and medical director fees

   2.4 %   2.2 %   2.4 %

Supplies

   9.5 %   9.4 %   8.7 %

Other operating expenses

   21.2 %   17.4 %   20.5 %

Provision for doubtful accounts

   3.1 %   3.2 %   3.5 %

Depreciation and amortization

   5.2 %   5.0 %   5.1 %

Recovery of amounts due from Meadowbrook

   (1.2 )%   0.0 %   0.0 %

Loss (gain) on disposal of assets

   0.5 %   0.3 %   (0.4 )%

Impairment of goodwill, intangible assets, and long-lived assets

   1.4 %   1.1 %   12.8 %

Government, class action, and related settlements expense

   6.7 %   0.0 %   4.7 %

Professional fees—reconstruction and restatement

   5.3 %   5.9 %   1.9 %
                  

Total operating expenses as a % of net operating revenues

   98.6 %   90.7 %   102.8 %
                  

Net Operating Revenues

Our consolidated net operating revenues primarily include revenues derived from patient care services provided by one of our four primary operating segments. It also includes other revenues generated from management and administrative fees, trainer income, operation of the conference center located on our corporate campus, and other non-patient care services.

Volume decreases in each of our operating segments and the change in ownership of certain facilities within our inpatient segment were the primary factors that contributed to the declining net operating revenues in 2005. Our inpatient segment experienced volume decreases due to the continued phase-in of the 75% Rule. Although resyndication activity increased in 2005, volumes in our surgery centers segment continued to decline based on the timing of these resyndications. Competition from physician-owned similar sites continued to negatively impact volumes in our outpatient and diagnostic segments. The change in ownership of these two inpatient facilities contributed approximately $106.3 million to the decline in net operating revenues. See this Item, “Segment Results of Operations—Inpatient.”

The decrease in our consolidated net operating revenues from 2003 to 2004 was due primarily to volume decreases within our surgery centers, outpatient, and diagnostic segments. The volume decline within our surgery centers segment was due to the limited resyndication activity which occurred in 2004. Volume decreases within both our outpatient and diagnostic segments were due to competition from physician-owned similar sites.

Salaries and Benefits

Salaries and benefits represents the most significant cost to us and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor.

In 2005, our segments demonstrated their ability to manage employee-related costs during periods of declining volumes, with salaries and benefits decreasing from 46.1% of net operating revenues in 2004 to 44.6% of net operating revenues in 2005. From 2004 to 2005, salaries and benefits decreased by 11.7%, primarily in our inpatient, surgery centers, and outpatient segments. Approximately $66.1 million of the decrease is due to the change in classification of two inpatient facilities, as discussed later in this Item. In addition, our inpatient and surgery centers segments reduced their full-time equivalents as their volumes declined throughout the year, and our outpatient segment reduced its full-time equivalents through the closure of under-performing facilities that did not qualify for discontinued operations treatment.

 

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Salaries and benefits grew as a percent of net operating revenues during 2004. This was due to rising costs associated with group medical and workers’ compensation across all of our segments, increased use of contract labor within our inpatient segment, and an inability to further adjust minimum staffing levels within our diagnostic segment. Due to staffing shortages for therapists and nurses, our inpatient segment was forced to increase its use of higher-priced contract labor to properly care for its patients during 2004. As discussed further in this Item, “Segment Results of Operations—Diagnostic,” our diagnostic segment reached minimum staffing levels and could not further adjust its staffing levels with the declining volumes experienced in 2004. All of the above contributed to the increase in salaries and benefits as a percent of net operating revenues during the year.

Professional and Medical Director Fees

Professional and medical director fees include fees paid under contracts with radiologists, medical directors, and other clinical professionals at our centers for services provided. It also includes professional consulting fees associated with operational initiatives, such as strategic planning and revenue enhancement projects.

The change in professional and medical director fees from 2004 to 2005 was not material in the aggregate. However, it is important to note that these fees decreased in our diagnostic segment due to declining volumes, but increased in our corporate and other segment due to fees paid to consulting firms for corporate strategy and other projects. From 2003 to 2004, these fees decreased primarily in our diagnostic division due to declining volumes. For more information regarding these fees and their relation to volumes in our diagnostic segment, see this Item, “Segment Results of Operations—Diagnostic.”

Supplies

Supplies include costs associated with supplies used while providing patient care at our facilities. Examples include pharmaceuticals, implants, bandages, food, and other similar items. In each year, our inpatient and surgery centers segments comprise over 94% of our supplies expense.

From 2004 to 2005, supplies expense decreased by 7.8% due primarily to the decline in volumes in our inpatient and surgery centers segments combined with the change in classification of two of our inpatient facilities, as discussed below. Supplies expense as a percent of net operating revenues remained relatively flat year-over-year.

The increase in supplies expense from 2003 to 2004 was due to an increase in supplies expense in our inpatient segment due to increasing costs associated with supplies and the higher acuity of our patients in 2004. Higher acuity results in increased costs associated with supplies, especially in drug costs.

Other Operating Expenses

Other operating expenses include costs associated with managing and maintaining our operating facilities as well as the general and administrative costs related to the operation of our corporate office. These expenses include such items as repairs and maintenance, utilities, contract services, rent, professional fees, and insurance.

The increase in other operating expenses from 2004 to 2005 primarily related to increased professional fees associated with projects related to our compliance with Sarbanes-Oxley, strategic consulting, and other similar services from accounting and consulting firms offset by an approximate $17.2 million decrease in other operating expenses due to the change in classification of certain facilities discussed below within our inpatient segment.

The decrease in other operating expenses from 2003 to 2004 primarily related to decreased operating expenses within our inpatient segment. Continuing a trend seen in 2003, our inpatient segment’s operating expenses decreased in 2004 as the segment continued to digest the change to the Prospective Payment System (“PPS”) and faced the challenge of mitigating the 75% Rule impact on its net operating revenues.

 

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Provision for Doubtful Accounts

In 2005, our provision for doubtful accounts decreased by $15.4 million due to the decrease in net operating revenues year-over-year in each of our operating segments and the continued implementation of new information systems to improve cash collections in our diagnostic segment.

Our provision for doubtful accounts decreased from 3.5% of net operating revenues in 2003 to 3.2% of net operating revenues in 2004 as we made progress collecting aged receivables and implementing improved cash collections procedures within our diagnostic and surgery centers segments.

For more information, please see this Item, “Segment Results of Operations.”

Depreciation and Amortization

The decrease in depreciation and amortization expense in each year is due to impairment charges and an increase in fully depreciated assets within our operating segments.

Loss (gain) on Disposal of Assets

The net loss on disposal of assets in 2005 resulted from numerous individually immaterial asset sales and disposals in our inpatient and outpatient segments. The net loss on disposal of assets in 2004 primarily resulted from facility closures in our outpatient and diagnostic segments. Continuing volume declines and competition in these segments forced us to close additional under-performing facilities in 2004. The net gain on disposal of assets in 2003 primarily resulted from the sale of our inpatient facility in Reno, Nevada.

Interest Expense and Amortization of Debt Discounts and Fees

Interest expense and amortization of debt discounts and fees increased by $36.1 million, or 11.9%, from 2004 to 2005 primarily due to the amortization of consent fees and bond issue costs associated with the 2004 consent solicitation and 2005 refinancings. During 2004, consent fees paid for all of our debt issues approximated $80.2 million, and we paid approximately $11.1 million in debt issuance costs. We amortize these fees to interest expense over the remaining term of the debt. In 2004, we amortized these costs for approximately six months, as compared to a full year of amortization in 2005. We also paid approximately $17.9 million in debt issuance costs in 2005. These costs are also amortized to interest expense over the life of the related debt. As a result of the above amortization charges, interest expense increased by approximately $17.2 million in 2005. An additional $11.2 million of interest expense was recorded in 2005 related to payments under our Medicare Program Settlement (see Note 21, Medicare Program Settlement, to our accompanying consolidated financial statements). The remaining $7.7 million of the increase in interest expense is primarily the result of higher average borrowing rates in 2005. In 2005, our average borrowing rate was 9.4% compared to an average rate of 8.5% in 2004.

The increase in interest expense from 2003 to 2004 was the result of higher average borrowing rates in 2004. In 2003, our average borrowing rate was 7.5% compared to an average rate of 8.5% in 2004. The average borrowing rate increased due to the repayment of our 3.25% convertible debentures with proceeds from a 10.375% senior subordinated term loan.

For more information regarding the above changes in debt, see Note 8, Long-term Debt, to our accompanying consolidated financial statements.

(Gain) loss on Sale of Investments

In each year presented in our consolidated statements of operations, the net gain or loss on sale of investments was primarily comprised of numerous individually insignificant transactions related to less than

 

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100% owned entities, including investments in nonconsolidated affiliates. In 2004, the net gain on sale of investments was solely comprised of these types of transactions. In 2005 and 2003, the net gain or loss on sale of investments also includes the realized gains and losses recorded on the sale of marketable securities. For additional information regarding our marketable securities, please see Note 4, Cash and Marketable Securities, to our accompanying consolidated financial statements.

Equity in Net Income of Nonconsolidated Affiliates

The increase in Equity in Net Income of Nonconsolidated Affiliates from 2004 to 2005 is primarily due to the reclassification of five surgery centers that became equity method investments rather than consolidated entities in 2005 as a result of changes in control of these entities. The decrease in Equity in Net Income of Nonconsolidated Affiliates from 2003 to 2004 is primarily due to higher year-over-year operating expenses at three of our nonconsolidated surgery centers.

Minority Interests in Earnings of Consolidated Affiliates

Minority interests in earnings of consolidated affiliates represent the share of net income or loss allocated to members or partners in our consolidated entities. For 2003 through 2005, the number and average external ownership interest in these consolidated entities were as follows:

 

     As of and for the year ended
December 31,
 
     2005      2004      2003  

Active consolidated affiliates

   272      276      322  

Average external ownership interest

   34.0 %    32.1 %    32.5 %

Of our active consolidated affiliates at December 31, 2005, approximately 79% of them are in our inpatient and surgery centers segments. Fluctuations in Minority interests in earnings of consolidated affiliates generally follow the same trends as our inpatient and surgery centers segments. However, resyndication activities in 2005 and the absorption of losses for certain partnerships in 2005 combined to increase these expenses from 2004 to 2005.

Loss from Continuing Operations Before Income Tax Expense (Benefit) and Cumulative Effect of Accounting Change

Our Loss from continuing operations before income tax expense (benefit) and cumulative effect of accounting change (“loss from continuing operations”) in 2005 includes $215.0 million associated with the settlement of our securities litigation and a $37.9 million recovery of bad debt associated with Meadowbrook. If these two items are excluded, our loss from continuing operations becomes $167.7 million, which represents a $125.5 million increase over our 2004 net loss from continuing operations. This increase is primarily due to a decrease in net operating revenues as a result of declining volumes, higher other operating expenses associated with professional service fees, and increased interest expense, as discussed above.

The decrease in our loss from continuing operations from 2003 to 2004 is primarily due to the 15.3% decrease in operating expenses year over year. Operating expenses decreased as a result of the $431.1 million decrease in impairment charges and a $170.9 million decrease in Government, class action, and related settlements expense offset by a $135.7 million increase in Professional fees—reconstruction and restatement. Increased interest expense during 2004 (as a result of higher average borrowing rates), as discussed above, also offset the decrease in operating expenses.

Provision for Income Tax Expense (Benefit)

We realized a $39.8 million income tax expense from continuing operations in 2005 as compared to an $11.9 million income tax expense from continuing operations in 2004. Deferred tax expense increased by

 

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approximately $23 million to reflect the change in the noncurrent deferred taxes associated with certain indefinite lived assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state tax liabilities. A current federal tax expense was also charged in 2005 and 2004 associated with ownership in corporate joint ventures.

We realized an $11.9 million income tax expense from continuing operations in 2004 compared to a $28.4 million income tax benefit from continuing operations in 2003. Deferred tax expense increased by approximately $20 million to reflect the change in the noncurrent deferred taxes associated with certain indefinite lived assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state income tax liabilities. A current federal tax expense was also charged in 2004 associated with ownership in corporate joint ventures.

Consolidated Adjusted EBITDA

Management continues to believe that an understanding of Consolidated Adjusted EBITDA is an important measure of operating performance, leverage capacity, our ability to service our debt, and our ability to make capital expenditures for our stakeholders.

We use Consolidated Adjusted EBITDA to assess our operating performance. We believe it is meaningful because it provides investors with a measure used by our internal decision makers for evaluating our business. Our internal decision makers believe Consolidated Adjusted EBITDA is a meaningful measure, because it represents a transparent view of our recurring operating performance and allows management to readily view operating trends, perform analytical comparisons, and perform benchmarking between segments. Additionally, our management believes the inclusion of professional fees associated with litigation, financial restructuring, government investigations, forensic accounting, creditor advisors, accounting reconstruction, audit and tax work associated with the reconstruction process, the implementation of Sarbanes-Oxley Section 404, and non-ordinary course charges incurred after March 19, 2003 and related to our overall corporate restructuring distort within EBITDA their ability to efficiently assess and view the core operating trends on a consolidated basis and within segments. Additionally, we use Consolidated Adjusted EBITDA as a significant criterion in our determination of performance-based cash bonuses and stock awards. We reconcile consolidated Adjusted EBITDA to loss from continuing operations.

We also use Consolidated Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is also a component of certain material covenants contained within the documents governing our long-term indebtedness, as discussed in more detail in Note 8, Long-term Debt, to our accompanying consolidated financial statements. These covenants are material terms of these agreements because they govern several of our credit agreements, which in turn represent a substantial portion of our capitalization. Non-compliance with these financial covenants under our credit facilities—our interest coverage ratio and our leverage ratio—could result in the lenders requiring us to immediately repay all amounts borrowed. In addition, if we cannot satisfy these financial covenants, we would be prohibited under the documents governing our long-term indebtedness from engaging in certain activities, such as incurring additional indebtedness, making certain payments, and acquiring and disposing of assets. Consequently, Consolidated Adjusted EBITDA is critical to our assessment of our liquidity.

In general terms, the definition of Consolidated Adjusted EBITDA, per the documents governing our long-term indebtedness, allow us to add back to Consolidated Adjusted EBITDA charges classified as “Restructuring Charges.” Costs which we classify as “Restructuring Charges” include professional fees associated with certain litigation, financial restructuring, government investigations, forensic accounting, creditor advisors, accounting reconstruction, audit and tax work associated with the reconstruction process, compliance with Sarbanes-Oxley Section 404, and non-ordinary course charges incurred after March 19, 2003 related to our overall corporate restructuring.

 

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However, Consolidated Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Consolidated Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Consolidated Adjusted EBITDA should not be considered a substitute for net loss from continuing operations or cash flows from operating, investing, or financing activities. Because Consolidated Adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles in the United States of America and is thus susceptible to varying calculations, Consolidated Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenue and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements.

As noted earlier in this Item, certain previously reported financial results have been reclassified to conform to the current year presentation. Such reclassifications primarily relate to facilities we closed or sold in 2005 that qualify under FASB Statement No. 144 to be reported as discontinued operations. These reclassifications may also impact previously reported Consolidated Adjusted EBITDA amounts. The facilities that were classified as discontinued operations in 2005 had a positive impact of approximately $56 million and $21 million, respectively, on 2004 and 2003 Consolidated Adjusted EBITDA reported in our 2004 annual report.

From 2003 through 2005, our Consolidated Adjusted EBITDA was as follows:

Reconciliation of Loss from Continuing Operations to Consolidated Adjusted EBITDA

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Loss from continuing operations

   $ (384,585 )   $ (54,128 )   $ (429,376 )

Provision for income tax expense (benefit)

     39,792       11,914       (28,382 )

Cumulative effect of accounting change, net of income tax expense

     —         —         2,456  

Depreciation and amortization

     167,112       176,959       185,552  

Loss (gain) on disposal of assets

     14,776       9,539       (14,967 )

Impairment charges

     45,203       37,290       468,345  

Loss (gain) on early extinguishment of debt

     33       (45 )     (2,259 )

Interest expense and amortization of debt discounts and fees

     338,701       302,635       265,327  

Interest income

     (17,141 )     (13,090 )     (7,273 )

Gain on sale of marketable securities

     (8 )     —         (698 )
                        

Consolidated Adjusted EBITDA before government, class action and related settlements expense, professional fees—reconstruction and restatement, and other restructuring charges

     203,883       471,074       438,725  

Government, class action, and related settlements expense

     215,000       —         170,949  

Professional fees—reconstruction and restatement

     169,804       206,244       70,558  

Sarbanes-Oxley related costs

     32,204       17,534       —    

Restructuring activities under FASB Statement No. 146

     8,190       3,973       2,571  
                        

Consolidated Adjusted EBITDA

   $ 629,081     $ 698,825     $ 682,803  
                        

 

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Reconciliation of Consolidated Adjusted EBITDA to Net Cash Provided by Operating Activities

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Consolidated Adjusted EBITDA

   $ 629,081     $ 698,825     $ 682,803  

Professional fees—reconstruction and restatement

     (169,804 )     (206,244 )     (70,558 )

Sarbanes-Oxley related costs

     (32,204 )     (17,534 )     —    

Interest expense and amortization of debt discounts and fees

     (338,701 )     (302,635 )     (265,327 )

Interest income

     17,141       13,090       7,273  

Provision for doubtful accounts

     98,417       113,783       128,296  

Amortization of debt issue costs, debt discounts, and fees

     39,023       21,838       7,831  

Amortization of restricted stock

     1,998       614       (2,932 )

Accretion of debt securities

     (410 )     —         —    

(Gain) loss on sale of investments, excluding marketable securities

     (221 )     (3,601 )     16,509  

Equity in net income of nonconsolidated affiliates

     (29,432 )     (9,949 )     (15,769 )

Distributions from nonconsolidated affiliates

     22,457       17,029       8,561  

Minority interest in earnings of consolidated affiliates

     96,728       94,389       98,196  

Stock-based compensation

     —         (460 )     —    

Current portion of income tax provision

     (22,295 )     (17,253 )     2,826  

Restructuring charges under FASB Statement No. 146

     (8,190 )     (3,973 )     (2,571 )

Other operating cash used in discontinued operations

     (47,823 )     (33,473 )     (35,813 )

Cash payments related to government, class action, and related settlements

     (165,434 )     (6,997 )     —    

Change in assets and liabilities, net of acquisitions

     (88,770 )     34,147       14,868  
                        

Net Cash Provided by Operating Activities

   $ 1,561     $ 391,596     $ (574,193 )
                        

Our Consolidated Adjusted EBITDA approximated 19.6%, 19.9%, and 18.7% of net operating revenues in 2005, 2004, and 2003, respectively. Consolidated Adjusted EBITDA decreased from 2004 to 2005 due to the declining volumes experienced by each of our operating segments and increased operating expenses associated with professional service fees, as discussed above. Consolidated Adjusted EBITDA increased by 2.3% from 2003 to 2004. This increase was due primarily to our ability to control operating expenses as our segments experienced declining volumes. In 2004, net operating revenues decreased by 4.0%, while operating expenses decreased by 15.3%.

Impact of Inflation

The health care industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. Although we cannot predict our ability to cover future cost increases, we believe that through adherence to cost containment policies and labor and supply management, the effects of inflation on future operating results should be manageable.

However, we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. In addition, as a result of increasing regulatory and competitive pressures and a continuing industry-wide shift of patients to managed care plans, our ability to maintain margins through price increases to non-Medicare patients is limited.

Relationships and Transactions with Related Parties

HealthSouth and its prior management and board of directors engaged in numerous relationships and transactions with related parties. These transactions involved certain venture capital firms, investments, real

 

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property, and indebtedness of management. For more information on our historic relationships and transactions with related parties, please see Note 7, Investment in and Advances to Nonconsolidated Affiliates, Note 11, Shareholders’ Deficit, and Note 20, Related Party Transactions, to our accompanying consolidated financial statements.

As part of our restructuring process, we have eliminated our interests in and relationships with related parties. These types of transactions are not material to our ongoing operations, and therefore, will not be presented as a separate discussion within this Item. When these relationships or transactions were significant to our results of operations during the years ended December 31, 2005, 2004, or 2003, information regarding the relationship or transaction(s) have been included within this Item.

Segment Results of Operations

Our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. We currently provide various patient care services through four operating divisions and certain other services through a fifth division, which correspond to our five reporting business segments: (1) inpatient, (2) surgery centers, (3) outpatient, (4) diagnostic, and (5) corporate and other. For additional information regarding our business segments, including a detailed description of the services we provide and financial data for each segment, please see Item 1, Business, and Note 25, Segment Reporting, to our accompanying consolidated financial statements. Future changes to this organizational structure may result in changes to the reportable segments disclosed.

Inpatient

We are the nation’s largest provider of inpatient rehabilitation services. Our inpatient rehabilitation facilities provide comprehensive services to patients who require intensive institutional rehabilitation care. Patient care is provided by nursing and therapy staff as directed by a physician order. Internal case managers monitor each patient’s progress and provide documentation of patient status, achievement of goals, functional outcomes and efficiency.

Our inpatient segment operates IRFs, LTCHs, home health, and skilled nursing units and provides treatment on both an inpatient and outpatient basis. As of December 31, 2005, our inpatient segment operated 93 freestanding IRFs, 10 LTCHs, and 101 outpatient facilities near our IRFs or LTCHs. In addition to HealthSouth facilities, our inpatient segment manages 14 inpatient rehabilitation units, 11 outpatient facilities, and 2 gamma knife radiosurgery centers through management contracts. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.

 

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For the years ended December 31, 2005, 2004, and 2003, our inpatient segment comprised approximately 56.4%, 57.5%, and 54.6%, respectively, of consolidated net operating revenues. For 2003 through 2005, this segment’s operating results were as follows:

 

     For the year ended December 31,
     2005    2004    2003
     (In Thousands)

Inpatient

        

Net operating revenues

   $ 1,810,401    $ 2,020,409    $ 1,997,963

Operating expenses*

     1,417,394      1,583,496      1,561,460
                    

Operating earnings

   $ 393,007    $ 436,913    $ 436,503
                    

Discharges

     107      121      119

Outpatient visits

     1,650      2,167      2,317
     (Not In Thousands)

Full time equivalents

     16,795      19,859      19,430

Average length of stay

     15.9 days      16.0 days      16.3 days

* Includes divisional overhead, but excludes corporate overhead allocation. See Note 25, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in the net income of nonconsolidated affiliates.

During 2005, 2004, and 2003, inpatient’s net operating revenues were derived from the following payor sources:

 

     For the year ended December 31,  
         2005             2004             2003      

Medicare

   71.2 %   70.6 %   71.1 %

Medicaid

   2.3 %   2.6 %   2.3 %

Workers’ compensation

   2.8 %   3.3 %   3.8 %

Managed care and other discount plans

   15.9 %   15.0 %   14.4 %

Other third-party payors

   5.2 %   6.6 %   6.3 %

Patients

   0.5 %   0.1 %   0.1 %

Other income

   2.1 %   1.8 %   2.0 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

Our inpatient segment’s payor mix is weighted heavily towards Medicare. Our IRFs receive Medicare reimbursements under PPS. Under IRF-PPS, our IRFs receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by the Department of Health and Human Services. With PPS, our facilities retain the difference, if any, between the fixed payment from Medicare and their operating costs. Thus, our facilities are rewarded for being high quality, low cost providers. For additional information regarding Medicare reimbursement, please see the “Sources of Revenue” section of Item 1, Business, of this annual report.

Due to the significance of Medicare payments to our inpatient facilities, the number of patient discharges is a key metric utilized by the segment to monitor and evaluate its performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity within the segment. The segment’s primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Supply costs include all expenses associated with supplies used while providing patient care. These costs include pharmaceuticals, needles, bandages, food, and other similar items.

 

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Significant Changes in Regulations Governing IRF Reimbursement

As discussed in Item 1, Business, “Sources of Revenues,” two recent changes in regulations governing IRF reimbursement have combined to create a very challenging operating environment for our inpatient division. The first change occurred on May 7, 2004, when CMS issued a final rule stipulating revised criteria for qualifying as an IRF under Medicare. This rule, known as the “75% Rule,” has created significant volume volatility in our inpatient division. The second change, which became effective on October 1, 2005, relates to reduced unit pricing applicable to IRFs.

The 75% Rule, as revised, generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF-PPS methodology, 75% of a facility’s total patient population must require treatment for at least one of 13 designated medical conditions. As a practical matter, this means that to maintain our current level of revenue from our IRFs we will need to reduce the number of nonqualifying patients treated at our IRFs and replace them with qualifying patients, establish other sources of revenues at our IRFs, or both. The Deficit Reduction Act of 2005, signed by President Bush on February 8, 2006 as Public Law 109-171, extended the phase-in schedule for the 75% Rule by one year and delayed implementation of the 65% compliance threshold until July 1, 2007.

On August 15, 2005, CMS published a final rule, as amended by the subsequent correction notice published on September 30, 2005, that updates the IRF-PPS for the federal fiscal year 2006 (which covers discharges occurring on or after October 1, 2005 and on or before September 30, 2006). Although the final rule includes an overall market basket update of 3.6%, it makes several other adjustments that we estimate will result in a net reduction in reimbursement to us. For example, the final rule (1) reduces the standard payment rates by 1.9%, (2) implements changes to Case-Mix Groups, comorbidity tiers, and relative weights, (3) updates the formula for the low income patient payment adjustment, (4) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, (5) implements new and revised payment adjustments on a budget-neutral basis, (6) implements a new indirect medical education teaching adjustment, (7) increases the rural add-on to 21.3%, and (8) incorporates several other modifications to Medicare reimbursement for IRFs. Although CMS predicted that overall payments to IRFs nationwide would increase by 3.4%, we estimate that the revised IRF-PPS will reduce Medicare reimbursement to our IRFs by 3.5% to 4%, primarily owing to the changes to Case-Mix Groups, comorbidity tiers, and relative weights. We estimate this net impact on reimbursement will reduce our inpatient division’s net operating revenues by approximately $10 million per quarter for the first three quarters of 2006 as compared to 2005. These estimates do not take into account potential changes in our case-mix resulting from our compliance with the 75% Rule, which could have the effect of increasing the acuity of our case-mix and therefore reducing the overall net impact of the IRF-PPS changes.

The volume volatility created by the 75% Rule had a significantly negative impact on our inpatient division’s net operating revenues in 2005. Thus far, we have been able to partially mitigate the impact of the 75% Rule on our inpatient division’s operating earnings by implementing the mitigation strategies discussed in Item 1, Business, “Our Business—Operating Divisions.” However, the combination of volume volatility created by the 75% Rule and lower unit pricing resulting from IRF-PPS changes reduced our operating earnings in 2005 and will have a continuing negative impact on our operating earnings in 2006. In addition, because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or continue to mitigate the negative effects of the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

On February 6, 2006, President Bush proposed a federal budget for fiscal year 2007. Among other things, the budget would eliminate Medicare payment increases for IRFs for the 2007 fiscal year. In 2008 and 2009, the budget proposes that IRFs and certain other providers receive a Medicare payment update of market basket minus 0.4%. These provisions are expected to reduce Medicare IRF spending by $1.59 billion in fiscal years

 

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2007 through 2011. The President’s budget also calls for reductions in Medicare payments to IRFs for hip and knee replacements to decrease variances in payments based on site of care. Specifically, for services provided to hip and knee replacement patients, the proposal would pay IRFs the average amount paid to skilled nursing facilities (“SNFs”), plus one third of the difference between the average IRF payment amount and the average SNF payment rate. The President’s budget would reduce Medicare spending by more than $2.4 billion by adjusting payment for hip and knee replacements in post-acute care settings. If the budget proposal is enacted by Congress, it could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Moreover, the proposed budget would phase out all Medicare bad debt reimbursement to providers between 2007 and 2011. To enhance the long-term financing of the Medicare program, the budget also proposes automatic reductions in provider updates if general revenues are projected to exceed 45% of total Medicare financing. While legislation is necessary to enact these changes, Congress could consider this and other legislation in the future that would reduce Medicare reimbursement for IRF services. The potential effect of the President’s budget on our inpatient division is not known at this time.

Change in Ownership of Certain Facilities

Since 2003, we have been involved in a legal dispute regarding the lease of Braintree Rehabilitation Hospital in Braintree, Massachusetts and New England Rehabilitation Hospital in Woburn, Massachusetts. In 2005, a judgment was entered against us that upheld the landlord’s termination of our lease of these two facilities and placed us as the manager, rather than the owner, of these two facilities. We have appealed this decision, but a hearing on our appeal has not yet been scheduled.

During the appeals process, we have been cooperating with the landlord and have retroactively paid the net cash proceeds of the facilities to the landlord since the date the lease was deemed to have been terminated. Our 2005 results of operations include only the $5.4 million management fee we earned for operating the facilities on behalf of the landlord during the year. In 2004 and 2003, the results of operations of these two facilities were included in our consolidated statements of operations on a gross basis. As a result, our net operating revenues and operating earnings were negatively impacted by approximately $106.3 million and $3.6 million, respectively, in 2005.

For additional information, see Note 24, Contingencies and Other Commitments, to our accompanying consolidated financial statements.

Net Operating Revenues

Our inpatient segment’s net operating revenues declined by 10.4% from 2004 to 2005. The change in classification of our Braintree and Woburn facilities contributed to approximately $106.3 million, or 50.6%, of the decline. The remainder of the decrease in net operating revenues is due to declining volumes. Excluding the impact of the change in classification, discharges were approximately 7.6% lower than 2004 due to the continued phase-in of the 75% Rule and the majority of our facilities moving to the 50% phase. Our inpatient segment also experienced a 10.7% decrease in outpatient volumes due to continued competition from physicians offering physical therapy within their own offices, as well as the decrease in our inpatient volumes. Due to this continued competition from physicians and resulting decrease in outpatient visits, we evaluated our outpatient satellite sites and closed 22 sites during 2005. Declining volumes were offset slightly by favorable pricing from Medicare during the first nine months of 2005 due to the Medicare market basket adjustment discussed below. However, the PPS Final Rule, as discussed above, negatively impacted our fourth quarter earnings by approximately $10.0 million. Human capital constraints in key clinical positions (therapists and nurses) at some of our hospitals also negatively impacted volumes as facilities managed volumes within these constraints.

Net operating revenues of our inpatient segment increased by 1.1% from 2003 to 2004. This increase is primarily due to the higher net revenue per discharge, or improvement in our reimbursement per case, as well as a 2.3% increase in discharges. The increase in net operating revenues per discharge is due primarily to the 1.4%

 

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increase in the segment’s Case Mix Index (“CMI”). An increase in CMI indicates that our patients have a higher acuity. For Medicare, which was over 70% of inpatient’s 2004 net operating revenues, the result of an increase in CMI is an increased payment to the segment. In addition, a market basket adjustment of 3.1% was received from Medicare in October 2004. A market basket adjustment is made to Medicare rates by the Department of Health and Human Services to account for inflationary impacts on provider costs. The increased reimbursements were offset by a 6.5% decrease in outpatient visits due primarily to increased competition from physicians offering physical therapy within their own offices. Due to this increased competition and resulting decrease in outpatient visits, we evaluated our outpatient satellite sites and closed 23 sites during 2004.

Operating Expenses

LOGO

Salaries and Benefits

Salaries and benefits comprised over 58% of inpatient’s operating expenses in each year.

Salaries and benefits decreased by $116.8 million, or 12.1%, from 2004 to 2005 primarily as a result of the change in facility classification discussed above and fewer full-time equivalents due to the decline in volumes. The change in classification of our Braintree and Woburn facilities contributed approximately $66.1 million, or 56.6%, to the decrease. Full-time equivalents, excluding the employees of the Braintree and Woburn facilities, declined by 9.6% from 2004 to 2005 which more than offset the 4.8% increase in average salaries and benefits per full-time equivalent due to merit and market rate adjustments. In addition, costs associated with contract labor decreased by approximately 50% year over year. However, excluding the impact of the change in facility classification discussed above, salaries and benefits as a percent of net operating revenues remained consistent from 2004 to 2005 approximating 47.8% and 47.7%, respectively. The segment’s ability to maintain this ratio while experiencing a 5.0% decline in net operating revenues (excluding the impact of the change in facility classification) is evidence of our facilities’ ability to adjust staffing levels to accommodate changing volumes.

 

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From 2003 to 2004, salaries and benefits increased by $57.9 million, or 6.4%. Approximately 65% of the increase is due to costs associated with annual merit increases and increases in group medical expenses and workers’ compensation costs. The remainder of the increase in salaries and benefits is due to an increase of 429 full-time equivalents due to the increased acuity of our patients, as discussed above. In addition, staffing shortages for both therapists and nurses resulted in the increased use of higher priced contract labor in order to provide appropriate care for our patients.

Supplies

From 2004 to 2005, supplies expense decreased by $13.5 million, or 11.1%. Approximately $6.2 million of the decrease is due to the change in classification of our Braintree and Woburn facilities. The remainder is due to the decline in volumes during 2005. Supplies expense as a percent of net operating revenues remained flat at approximately 6.0% each year.

Supplies expense increased by $13.7 million, or 12.7% from 2003 to 2004. This increase is primarily due to increased costs of supplies and the higher acuity of our patients in 2004. Higher acuity correlates to a higher cost patient, especially in drug expenses.

Provision for Doubtful Accounts

Our inpatient segment’s provision for doubtful accounts fluctuated between 1.5% of net operating revenues and 2.5% of net operating revenues from 2003 through 2005. During 2005, the segment’s provision for doubtful accounts decreased by $4.1 million, or 9.0%, due to the decrease in net operating revenues year over year. However, the provision for doubtful accounts as a percent of net operating revenues remained relatively flat, approximating 2.3% and 2.2% in 2005 and 2004, respectively.

From 2003 to 2004, the provision for doubtful accounts increased from 1.6% to 2.2% of net operating revenues due to a focus more on other operational projects and less on collection activities.

All Other Operating Expenses

From 2004 to 2005, all other operating expenses decreased by 7.0% due to the change in facility classification and the reduction in volumes discussed above. The inpatient segment’s all other operating expenses in 2005 also include an approximate $1.8 million impairment charge related to long-lived assets. Approximately $0.5 million of this charge relates to assets at our Pendleton facility in New Orleans, Louisiana. This facility was abandoned due to the damage caused by Hurricane Katrina. The remainder of the impairment charge is the result of continued negative cash flows experienced by one of our facilities in Texas.

All other operating expenses decreased by 12.1% from 2003 to 2004. As the inpatient segment digested the change to PPS, faced the challenge of mitigating the 75% Rule impact on net operating revenues, and realigned expenses going forward, a broad range of expenses were eliminated by the segment in this category during 2004.

Operating Earnings

Net operating earnings of our inpatient segment decreased by $43.9 million, or 10.0%, from 2004 to 2005. Approximately $3.6 million of this decrease is due to the change in classification of our Braintree and Woburn facilities. The remainder is due to the declining volumes experienced by the segment and the reimbursement challenges presented by the 75% Rule. Operating earnings increased by less than 1% from 2003 to 2004.

 

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Surgery Centers

We operate one of the largest networks of ambulatory surgery centers (“ASCs”) in the United States. As of December 31, 2005, we provided these services through the operation of our network of 158 freestanding ASCs and 3 surgical hospitals in 35 states, with a concentration of centers in California, Texas, Florida, and North Carolina.

Our surgery centers provide the facilities and medical support staff necessary for physicians to perform non emergency surgical procedures in more than a dozen specialties, such as orthopedic, GI, ophthalmology, plastic, and general surgery. For 2003 through 2005, this segment’s operating results were as follows:

 

     For the year ended December 31,  
     2005    2004    2003  
     (In Thousands)  

Surgery Centers

        

Net operating revenues

   $ 773,403    $ 817,661    $ 871,303  

Operating expenses*

     692,099      724,078      913,941  
                      

Operating earnings (loss)

   $ 81,304    $ 93,583    $ (42,638 )
                      

Cases

     647      707      747  
     (Not In Thousands)  

Full time equivalents

     4,483      4,662      4,830  

* Includes divisional overhead, but excludes corporate overhead allocation. See Note 25, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in the net income of nonconsolidated affiliates.

During the years ended December 31, 2005, 2004, and 2003, our surgery centers segment derived its net operating revenues from the following payor sources:

 

     For the year ended December 31,  
         2005             2004             2003      

Medicare

   17.8 %   18.1 %   14.3 %

Medicaid

   2.7 %   2.7 %   2.3 %

Workers’ compensation

   10.5 %   10.7 %   12.5 %

Managed care and other discount plans

   59.2 %   55.5 %   55.1 %

Other third-party payors

   3.7 %   0.4 %   4.9 %

Patients

   4.8 %   11.0 %   9.3 %

Other income

   1.3 %   1.6 %   1.6 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

Our commercial revenues, which are included in “Other third-party payors” in the above chart, increased by approximately $25 million from 2004 to 2005. This increase is the result of an increase in out-of-network cases that yield higher net revenue per case. The number of plastic surgery cases performed by our centers decreased by approximately 7% from 2004 to 2005. As a result, net operating revenues from cases where the patient has primary financial responsibility decreased from the prior year.

The number of cases performed by our centers is a key metric utilized by the segment to regularly evaluate its performance. The segment’s primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees, as well as all related costs of benefits provided to employees. Supply costs include all expenses associated with medical supplies used while providing patient care at our centers. Such costs include sterile disposables, pharmaceuticals, implants, and other similar items.

 

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Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As existing physician partners retire or change geographic location, it is important that the surgery centers segment periodically provide other physicians with opportunities to purchase ownership interests in our ASCs in order to maintain or increase case volumes and net operating revenues. Our ability to resyndicate our partnerships is a key success factor for our surgery centers segment.

Net Operating Revenues

As noted above, our ability to efficiently resyndicate our partnership portfolio is critical to the success of our surgery centers segment. Since 2003, our surgery centers segment has experienced a decline in the number of cases performed at our centers. Management attributes the majority of the decline in each year to our inability to resyndicate partnership interests in each center and the negative publicity HealthSouth received as a result of the events leading up to March 19, 2003. Because of our inability to report financial information during 2003 and 2004, there was no resyndication activity during 2003 and minimal activity during the latter half of 2004. Resyndication activity increased in 2005, but the majority of this activity also took place in the latter half of the year. We expect to begin seeing the results of this resyndication activity in 2006.

From 2004 to 2005, net operating revenues decreased by $44.3 million, or 5.4%. Declining volumes contributed to an approximate $67.8 million decrease in net operating revenues. Although the majority of this decrease is due to the limited resyndication activities discussed above, approximately $25.6 million of the decrease is due to the reclassification of five surgery centers that became equity method investments rather than consolidated entities in 2005 as a result of changes in control of these entities. The net operating revenues lost through volume declines were offset by a shift in case mix to ophthalmology cases which generate higher average net revenue per case. This shift in case mix increased net operating revenues by approximately $28.7 million. The remainder of the 2005 decrease in net operating revenues of $5.2 million is primarily attributable to a decrease in rental income associated with subleases that were terminated during the year.

From 2003 to 2004, our surgery centers segment experienced a $53.6 million, or 6.2%, decrease in net operating revenues. Approximately 85% of this decrease was due to declining volumes, as discussed above. The remainder of the decrease is due to a shift in case mix to procedures that carry lower average net revenue per case.

 

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Operating Expenses

LOGO

Salaries and Benefits

In each year, salaries and benefits represents over 29% of our surgery centers segment’s operating expenses.

Salaries and benefits decreased by approximately $9.1 million, or 3.4%, from 2004 to 2005. This decrease is primarily attributable to a reduction of 179 full-time equivalents year over year due to the decline in the number of cases performed by our surgery centers and the segment’s focus to improve operational performance and productivity. Salaries and benefits as a percent of net operating revenues remained flat at approximately 33% from 2004 to 2005.

During 2004, salaries and benefits decreased by $4.8 million, or 1.8%. Although full-time equivalents decreased by 168 year over year, increased costs associated with group medical insurance and workers’ compensation coverage offset these reductions.

Supplies

Supplies represents over 20% of our surgery centers segment’s operating expenses in each year, making it important for our ASCs to appropriately manage and monitor these costs.

Although total supplies cost decreased by $9.8 million, or 5.1%, from 2004 to 2005, supplies as a percent of net operating revenue remained flat at approximately 24%. The volume declines experienced by the segment in 2005 resulted in decreased supplies cost of approximately $16.3 million. However, this was offset by increased pricing associated with implants and prosthetics. The shift in case mix to more ophthalmology cases also contributed to an increase in the average supply cost per case in 2005.

From 2003 to 2004, supplies expense remained relatively flat. Although the average supply cost per case increased by approximately 6.6% year over year, there was a decrease in supplies used during the year due to the decline in the number of cases in 2004.

 

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Provision for Doubtful Accounts

From 2004 to 2005, our surgery centers segment’s provision for doubtful accounts remained relatively flat at approximately 1.8% of net operating revenues and 1.9% of net operating revenues, respectively. From 2003 to 2004, this segment was able to decrease its provision for doubtful accounts from 3.6% of net operating revenues to 1.8% of net operating revenues. This decrease is due to the positive impact of segment-wide business office manager training, outsourced billing statements (which provided consistent delivery and appearance of statements), and utilization of an outside collection agency during 2004.

All Other Operating Expenses

From 2004 to 2005, all other operating expenses decreased by approximately 5.3%. As discussed earlier in this Item, we reclassified five facilities from consolidated entities to equity method investments due to changes in control of these entities. This reclassification favorably impacted both Minority interest in earnings of consolidated affiliates and Equity in net income of nonconsolidated affiliates. In addition, all other operating expenses decreased due to the closure and/or sale of under-performing facilities in 2005 that did not qualify as discontinued operations.

All other operating expenses decreased by approximately 40.4% from 2003 to 2004 due primarily to a $173.6 million reduction in impairment charges year over year. Although impairment charges decreased significantly year over year, our surgery centers segment’s 2004 operating expenses include a $2.7 million charge for the impairment of long-lived assets. Due to facility closings and facilities experiencing negative cash flow from operations, we examined all of our facilities for impairment. The above impairment charge is the result of that review.

Our surgery centers segment’s operating expenses in 2003 include a $176.2 million goodwill impairment charge. We performed an impairment review as required by FASB Statement No. 142 as of October 1, 2003 and concluded that a potential goodwill impairment existed in our surgery centers segment. The amount of the impairment, which was determined by calculating the implied fair value of goodwill, primarily recognizes the decline in the expected future operating performance of our surgery centers.

Operating Earnings (Loss)

The decrease in this segment’s operating earnings from 2004 to 2005 was due to the volume declines discussed above. Operating earnings of our surgery centers segment increased by approximately $136.2 million from 2003 to 2004. Although the segment experienced a decline in net operating revenues, the segment decreased its provision for doubtful accounts (as discussed above) and did not record a goodwill impairment charge in 2004, thus improving its operating results.

Outpatient

We are one of the largest operators of free standing outpatient rehabilitation facilities in the United States. As of December 31, 2005, we provided outpatient rehabilitative health care services through 620 facilities. We have locations in 40 states, with a concentration of centers in Florida, Texas, New Jersey, Missouri, and Connecticut.

Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and we are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our outpatient centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.

 

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For 2003 through 2005, this segment’s operating results were as follows:

 

     For the year ended December 31,  
     2005    2004    2003  
     (In Thousands)  

Outpatient

        

Net operating revenues

   $ 379,417    $ 441,752    $ 519,864  

Operating expenses*

     347,467      402,545      574,099  
                      

Operating earnings (loss)

   $ 31,950    $ 39,207    $ (54,235 )
                      

Visits

     3,810      4,451      5,394  
     (Not In Thousands)  

Full time equivalents

     3,897      4,674      5,476  

* Includes divisional overhead, but excludes corporate overhead allocation. See Note 25, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in the net income of nonconsolidated affiliates.

For the years ended December 31, 2005, 2004, and 2003, outpatient’s net operating revenues were derived from the following payor sources:

 

     For the year ended December 31,  
         2005             2004             2003      

Medicare

   13.6 %   12.6 %   9.9 %

Medicaid

   0.7 %   0.6 %   4.1 %

Workers’ compensation

   22.0 %   24.7 %   27.3 %

Managed care and other discount plans

   47.2 %   49.6 %   44.6 %

Other third-party payors

   10.5 %   6.6 %   8.5 %

Patients

   1.3 %   1.2 %   1.2 %

Other income

   4.7 %   4.7 %   4.4 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

The number of visits patients make to our centers is a key metric utilized by the segment to regularly evaluate its performance. Outpatient’s net operating revenues include revenues from patient visits, as well as revenues generated from trainers and management contracts. Outpatient has contracts with schools, municipalities, and other parties around the country to provide physical therapists and/or athletic trainers for various events. Outpatient also receives management and administrative fees for facilities it manages, but does not own. Trainer income, management fees, and administrative fees comprise the majority of the segment’s other income.

The segment’s most significant operating expense is salaries and benefits, which includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Due to the nature of the services provided by our outpatient centers, supplies expense does not represent a significant portion of the segment’s operating expenses, unlike our other business segments.

Our outpatient segment participates in a slower growing, lower margin business than our other operating segments. Due to regulatory changes, physicians that once referred business to us are now treating patients at their own facilities. Due to the relatively low barriers to entry associated with an outpatient facility, our outpatient segment continues to face increased competition from physician-owned physical therapy sites. The segment is also facing an industry-wide shortage of physical therapists. To combat the shortage, our outpatient segment implemented key incentive plans to help recruit and retain therapists. These incentive plans have begun to reduce therapist turnover rates and have increased the segment’s overall clinical productivity.

 

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Net Operating Revenues

From 2003 to 2005, patient visits to our outpatient facilities decreased by over 1.5 million visits. This decreased volume negatively impacted net operating revenues by approximately $60.6 million in 2005 and approximately $86.9 million in 2004. Management attributes the volume decline in each year to increased competition from physician-owned physical therapy sites, expiration of noncompete agreements from prior acquisitions, and the nationwide physical therapist shortage. The volume impact of these factors resulted in the net closure of 108 facilities in 2005 and 70 facilities during 2004 that did not qualify for discontinued operations. These closures accounted for approximately $30.2 million and $16.3 million, respectively, of the total volume decrease in 2005 and 2004, respectively. The remainder of the decrease in each year represents the impact of the above factors on our facilities that remained open.

In 2004, our outpatient segment was able to achieve higher net patient revenue per visit, increasing this metric by approximately $2 per visit. The increased net patient revenue per visit yielded approximately $11.0 million in additional net operating revenues during 2004. The increase per visit was due to the segment’s examination and elimination of managed care contracts with low reimbursement rates, a price increase on some services, and an increase in manual therapy services. There was no significant impact to net operating revenues as a result of pricing in 2005.

During 2005 and 2004, non-patient revenues decreased by $3.0 million, or 14.5%, and $2.2 million, or 9.5%, respectively, due to facility closures and contract terminations during the year.

Operating Expenses

LOGO

Salaries and Benefits

Salaries and benefits represent over 48% of outpatient’s operating expenses in each year.

In 2005 and 2004, salaries and benefits decreased by $29.4 million, or 11.9%, and $28.1 million, or 10.2%, respectively. The majority of this decrease is due to the closure of facilities in 2005 and 2004, as described

 

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above, which resulted in a 777 and an 802 decrease in full-time equivalents, respectively. This decrease in full- time equivalents in each year decreased salaries and benefits by approximately $41.1 million and $40.3 million in 2005 and 2004, respectively. Decreased costs associated with fewer full-time equivalents were offset by increasing costs associated with employee benefits in both years.

Provision for Doubtful Accounts

The provision for doubtful accounts of our outpatient segment increased from 2.8% to 4.2% of net operating revenues from 2003 to 2004, respectively. In 2005, the provision for doubtful accounts decreased to 1.9% of net operating revenues. These changes resulted from the segment’s reorganization of its billing and collecting function during 2004 and 2005.

All Other Operating Expenses

From 2004 to 2005, all other operating expenses decreased by approximately 10.7% due primarily to the closure of under-performing facilities and a $2.7 million decrease in impairment charges year over year. Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing a $0.8 million impairment charge to long-lived assets in 2005. We determined the fair value of the impaired long-lived assets at a facility primarily based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

All other operating expenses decreased by approximately 51.8% from 2003 to 2004. This decrease primarily resulted from a $136.5 million decrease in impairment charges year over year. Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing an impairment charge of $2.4 million related to long-lived assets and $1.0 million related to intangible assets in 2004. We wrote these assets down to zero, or their estimated fair value, based on expected negative operating cash flows of these facilities in future years.

The segment’s 2003 operating expenses include approximately $140.0 million of impairment charges. As a result of the events leading up to March 19, 2003, we performed an impairment review, as required by FASB Statement No. 142, and concluded that a potential goodwill impairment existed in the outpatient segment. We calculated the implied fair value of the outpatient segment’s goodwill and determined that the outpatient segment’s goodwill was impaired by $135.9 million. Our outpatient segment also recorded a $4.1 million impairment charge related to long-lived assets in 2003.

Operating Earnings (Loss)

Operating earnings decreased from 2004 to 2005 due primarily to the declining volumes, as discussed above. In 2004, operating earnings increased by $93.4 million due primarily to a reduction in impairment charges. Our outpatient segment experienced an operating loss in 2003 due primarily to the $135.9 million goodwill impairment charge recorded by the segment.

Diagnostic

We are one of the largest operators of freestanding diagnostic imaging centers in the United States. As of December 31, 2005, we performed diagnostic services through the operation of our network of approximately 85 diagnostic centers in 27 states and the District of Columbia, with a concentration of centers in Texas, Georgia, Alabama, Florida, and the Washington D.C. area. In addition, the division operates five electro-shock wave lithotripter units.

Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services, and fluoroscopy. We do not provide all services at all sites, although approximately 71% of our diagnostic centers are multi-modality centers offering multiple types of service. Our outpatient diagnostic procedures are performed by experienced

 

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radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. These radiologists prepare an interpretation which is then delivered to the referring physician.

Due to the equipment utilized when performing diagnostic services for our patients, our diagnostic segment generally has high capital costs, including costs for maintaining its equipment.

For 2003 to 2005, our diagnostic segment’s operating results were as follows:

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Diagnostic

      

Net operating revenues

   $ 226,506     $ 234,652     $ 262,014  

Operating expenses*

     227,544       241,228       297,338  
                        

Operating loss

   $ (1,038 )   $ (6,576 )   $ (35,324 )
                        

Scans

     710       736       822  
     (Not In Thousands)  

Full time equivalents

     1,116       1,223       1,250  

* Includes divisional overhead, but excludes corporate overhead allocation. See Note 25, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in the net income of nonconsolidated affiliates.

For the years ended December 31, 2005, 2004, and 2003, diagnostic derived its net operating revenues from the following payor sources:

 

     For the year ended December 31,  
         2005             2004             2003      

Medicare

   19.5 %   17.3 %   16.5 %

Medicaid

   3.4 %   3.3 %   2.7 %

Workers’ compensation

   9.6 %   9.2 %   7.8 %

Managed care and other discount plans

   60.1 %   61.0 %   63.5 %

Other third-party payors

   4.4 %   6.1 %   7.2 %

Patients

   2.2 %   2.2 %   1.4 %

Other income

   0.8 %   0.9 %   0.9 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

The number of scans performed is a key metric utilized by the segment to regularly evaluate its performance. The segment’s primary operating expenses include salaries and benefits, professional and medical director fees, and supplies. Salaries and benefits expense represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees at our centers, as well as all related costs of benefits provided to employees. Professional and medical director fees primarily include fees paid under contracts with radiologists and other clinical professionals to read and interpret the scans performed at our centers. Payments under these contracts are normally tied to the number of scans read by each independent contractor, associated revenues with each scan, or cash collections. Supply costs include all expenses associated with supplies used while performing diagnostic services for our patients. These costs primarily consist of the film costs associated with each scan.

Our diagnostic segment has struggled over the past several years due to poor margins for the diagnostic market in general, strong competition from physician-owned diagnostic service centers, increased pricing

 

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pressure from payors, and the age of equipment in our installed base. We see competition only increasing as diagnostic equipment manufacturers continue to lower prices and offer special financing to encourage physicians to purchase equipment through their own practices, resulting in a decline in the number of procedures performed at our diagnostic centers.

Net Operating Revenues

The decrease in net operating revenues in each year is due to volume decreases caused primarily by competition from physician-owned diagnostic centers and the closure of under-performing facilities that did not qualify for discontinued operations.

Operating Expenses

LOGO

Salaries and Benefits

The declining volumes of our diagnostic segment over the past several years has led management to take an active role in increasing efficiencies by reducing the number of full-time equivalents. However, our diagnostic centers have relatively few full-time equivalents on a per facility basis, and there are certain staffing requirements that are mandated for any volume level given the nature of services we provide.

Salaries and benefits decreased by $2.1 million, or 3.4%, from 2004 to 2005. This decrease was primarily the result of eliminating full-time positions at certain business offices by outsourcing the segment’s collections processes to a third-party and the closure of under-performing facilities that did not qualify for discontinued operations in 2005. Due to these headcount reductions at the segment’s business offices and the closure of under-performing facilities, salaries and benefits remained at approximately 26.0% of net operating revenues in 2005 in spite of the decline in revenues.

 

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Salaries and benefits grew from 22.8% of net operating revenues in 2003 to 26.0% of net operating revenues in 2004. Although volumes declined in 2004, our diagnostic centers did not further adjust their staffing levels due to management’s conclusion that minimum staffing levels had been achieved for the operation of our centers. Therefore, salaries and benefits grew as a percent of net operating revenues due to the decline in net operating revenues in 2004 without a commensurate reduction in personnel costs.

Supplies

In 2005 and 2004, supplies expense decreased by approximately 12.2% and 11.0%, respectively, due to the decrease in volumes during each year, more favorable supply pricing, and improved efficiency.

Professional and Medical Director Fees

From 2003 through 2005, professional and medical director fees generally followed the same trend as our net operating revenues and cash collections.

Provision for Doubtful Accounts

In 2003, our diagnostic segment’s provision for doubtful accounts was 16.7% of net operating revenues. This high percentage was primarily the result of a decline in operational efficiency within the segment as a result of (1) outsourcing the diagnostic segment’s collection activities to a third-party vendor (beginning March 2002), and (2) the conversion of 44 of the segment’s clinics to a new patient accounting system which failed to meet expectations. The contract with the third-party vendor was terminated in April 2003, and the 44 clinics were taken off the new patient accounting system during the summer of 2003.

During 2004, we made progress collecting aged receivables, which is reflected in the decrease in the provision for doubtful accounts to 16.1% of net operating revenues. In 2005, we continued to implement new information systems to improve cash collections in our diagnostic segment, and we outsourced collection activities to a third-party. These new systems along with management’s focus on collections decreased the segment’s provision for doubtful accounts to 15.5% of net operating revenues in 2005.

All Other Operating Expenses

From 2004 to 2005, all other operating expenses decreased by 1.3%. This decrease is primarily the result of the closure of under-performing facilities that did not qualify for discontinued operations treatment in 2005 offset by a $5.0 million impairment charge related to long-lived assets. Triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing a $5.0 million impairment charge to long-lived assets in 2005. We determined the fair value of the impaired long-lived assets at a facility primarily based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

During 2004, all other operating expenses decreased by 33.8% due primarily to a year over year reduction in impairment charges and the closure of under-performing facilities that did not qualify for discontinued operations treatment. In 2004, triggering events related to facility closings and facilities experiencing negative cash flow from operations resulted in the segment recognizing an impairment charge of $0.9 million related to long-lived assets. We wrote these assets down to zero, or their estimated fair value, based on expected negative operating cash flows of these facilities in future years.

During 2003, we performed an impairment review as required by FASB Statement No. 142 and concluded a potential goodwill impairment existed in our diagnostic segment. We calculated the implied fair value of the diagnostic segment’s goodwill and determined that an impairment charge of $23.5 million was appropriate. After this impairment charge, there is no goodwill remaining on our diagnostic segment. Our diagnostic segment also recorded a $0.5 million impairment charge related to long-lived assets in 2003.

 

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Operating Loss

In 2005, our diagnostic segment decreased its operating loss by closing additional under-performing facilities and decreasing its provision for doubtful accounts, as discussed above.

In 2004, the segment’s operating loss decreased by approximately 81.4%. Although our diagnostic segment experienced a decline in net operating revenues year over year, the segment decreased its total operating expenses due primarily to a year over year reduction in the provision for doubtful accounts and impairment charges, as discussed above.

We continue to focus on operational improvements to increase our margins and respond to the increased competition in this industry.

Corporate and Other

Corporate and other includes revenue-producing functions that are managed directly from our corporate office and that do not fall within one of the four operating segments discussed above, including other patient care services and certain non-patient care services.

 

    Medical Centers. This category formerly included our acute care business which, for all practical purposes, we have now exited. Specifically, as described later in this Item under the heading “Results of Discontinued Operations,” we have signed an agreement to sell our acute care hospital located in Birmingham, Alabama. In addition, on January 4, 2006, we executed a letter of intent with an undisclosed party regarding the sale of the property and equipment which were to have comprised our Digital Hospital in Birmingham, Alabama. Any sale of the Digital Hospital will not involve conveyance of our interest in any certificate of need from our acute care hospital. The letter of intent expires, subject to certain conditions, on March 31, 2006 unless otherwise extended in accordance with the terms of the letter of intent. As of December 31, 2005, we had invested approximately $210 million in the Digital Hospital project. We have not signed a definitive agreement with respect to the Digital Hospital, and there can be no assurance any sale will take place. See Note 5, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the impairment charge we recognized in 2005 relating to the Digital Hospital. As of December 31, 2005, this category continues to include a physician practice located at the University of Miami Sports Center. During 2005, 2004, and 2003, net operating revenues from this category comprised 5.8%, 2.8%, and 7.8%, respectively, of corporate and other’s net operating revenues.

 

    Other Patient Care Services. In some markets, we provide other limited patient care services. We evaluate market opportunities on a case-by-case basis in determining whether to provide additional services of these types. We may provide these services as a complement to our facility-based businesses or as stand-alone businesses. During 2005, 2004, and 2003, net operating revenues from other patient care services comprised 3.1%, 3.2%, and 4.9%, respectively, of corporate and other’s net operating revenues.

 

    Non-Patient Care Services. We also provide certain services that do not involve the provision of patient care, including the operation of the conference center located at our corporate campus, operation of medical office buildings, various corporate marketing activities, our clinical research activities, and other services that are generally intended to complement our patient care activities. During 2005, 2004, and 2003, net operating revenues from non-patient care services comprised 91.1%, 94.0%, and 87.3% of corporate and other’s net operating revenues. This category’s net operating revenues include earned premiums of HCS, Ltd. (“HCS”). HCS handles medical malpractice, workers’ compensation, and other claims for us. HCS is a wholly owned subsidiary of HealthSouth Corporation, and, as such, these earned premiums eliminate in consolidation.

 

    Corporate Functions. All our corporate departments and related overhead are contained within this segment. These departments, which include among others accounting, communications, compliance, human resources, information technology, internal audit, legal, payor strategies, reimbursement, tax, and treasury, provide support functions to our operating divisions.

 

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For 2003 through 2005, this segment’s operating results were as follows:

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Corporate and Other

      

Net operating revenues

   $ 79,106     $ 85,473     $ 80,247  

Operating expenses*

     607,758       404,915       568,249  
                        

Operating loss

   $ (528,652 )   $ (319,442 )   $ (488,002 )
                        
     (Not In Thousands)  

Full time equivalents

     927       760       717  

* Includes all corporate overhead. See Note 25, Segment Reporting, to our accompanying consolidated financial statements. Includes the effect of minority interests in earnings of consolidated affiliates and equity in net income of nonconsolidated affiliates. This line item also includes approximately $215 million and $171 million, respectively, in 2005 and 2003 related to Government, class action, and related settlements expense.

Corporate and other’s primary operating expense is salaries and benefits. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees at our corporate headquarters (excluding any divisional management allocated to each operating segment) in Birmingham, Alabama, as well as all related costs of benefits provided to these employees. All general and administrative costs related to the operation of our corporate office are included in other operating expenses. The most significant general and administrative expenses relate to insurance including property and casualty, general liability, and directors and officers’ coverage.

Net Operating Revenues

Changes in net operating revenues from year to year relate to changes in earned premiums of HCS, which eliminate in consolidation.

 

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Operating Expenses

LOGO

Salaries and Benefits

From 2004 to 2005, salaries and benefits decreased by $10.6 million, or 13.2%, primarily due to lower claims and premiums expense associated with workers’ compensation. Salaries and benefits did not change materially from 2003 to 2004.

All Other Operating Expenses

All other operating expenses of the corporate and other segment include $24.4 million, $30.2 million, and $127.9 million of impairment charges related to the Digital Hospital in 2005, 2004, and 2003, respectively. In each year, the impairment charge represents the excess of costs incurred during the construction of the Digital Hospital over the estimated fair market value of the property, including the River Point facility, a 60,000 square foot office building, which shares the construction site and would be included with any sale of the Digital Hospital. The impairment of the Digital Hospital in 2003 was based on an appraisal that considered alternative uses for the property. The impairment of the Digital Hospital in 2004 and 2005 was determined using a weighted average fair value approach that considered the 2003 appraisal and other potential scenarios.

In addition to the $24.4 million impairment charge related to the Digital Hospital in 2005, the corporate and other segment recorded $9.0 million in other long-lived asset impairment charges. We determined the fair value of the impaired long-lived assets based on the assets’ estimated fair value using valuation techniques that included discounted future cash flows and third-party appraisals.

All other operating expenses increased by 65.8% from 2004 to 2005. The primary contributor to this increase is the $215.0 million settlement associated with our securities litigation, as discussed above in this Item, “Consolidated Results of Operations.” Excluding the amount recorded for the securities litigation settlement, all other operating expenses in the corporate and other segment would have decreased by less than 1.0% in 2005 due to the following:

 

    Meadowbrook recovery. As discussed earlier in this Item, we recorded a $37.9 million recovery related to Meadowbrook in 2005.

 

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    Professional fees—reconstruction and restatement. These fees decreased by $36.4 million from 2004 to 2005, showing the decreased use of consultants as our new management team was in place.

These decreases were offset by increased expenses associated with accounting, legal, and consulting professional fees. We incurred these fees in 2005 as a result of Sarbanes-Oxley costs and strategic agenda consulting.

From 2003 to 2004, all other operating expenses had a net decrease of approximately 33.2%. This decrease was primarily the result of the following:

 

    Software development costs. We began funding Source Medical for the HCAP software development in 2001. In 2004, we gave approximately $6.5 million less to Source Medical for software development. For additional information regarding Source Medical, see Note 7, Investment in and Advances to Nonconsolidated Affiliates, to our accompanying consolidated financial statements.

 

    Impairment of Long-Lived Assets. During 2003, the corporate and other segment recorded long-lived asset impairments of $128.0 million, while in 2004, long-lived asset impairments approximated $30.2 million. Both charges related primarily to the Digital Hospital, as discussed above.

 

    Government, Class Action, and Related Settlements. There were no government, class action, or related settlements recorded in 2004.

The above decreases in 2004 were offset by a $135.7 million increase in Professional fees—reconstruction and restatement. As noted throughout this filing, significant changes have occurred at HealthSouth since the events leading up to March 19, 2003. The steps taken to stabilize our business and operations, provide vital management assistance, and coordinate our legal strategy came at significant financial cost. Much of the audit and reconstruction efforts occurred in 2004 causing these fees to increase from 2003.

Operating Loss

Our operating loss for the corporate and other segment increased from 2004 to 2005 due primarily to the securities litigation settlement. Our operating loss for the corporate and other segment decreased from 2003 to 2004 due to the decrease in all other operating expenses discussed above.

Results of Discontinued Operations

In our continuing effort to streamline operations, we identified 19 entities in our inpatient segment, 328 outpatient rehabilitation facilities, 25 surgery centers, 27 diagnostic centers, and 46 other facilities during 2005, 2004, and 2003 that met the requirements of FASB Statement No. 144 to report as discontinued operations. For the facilities identified during these years that met the requirements of FASB Statement No. 144 to report as discontinued operations, we reclassified our consolidated balance sheet for the year ended December 31, 2004 and our consolidated statements of operations and consolidated statements of cash flows for the years ended December 31, 2004 and 2003 to show the results of those facilities as discontinued operations.

When determining if a closed facility qualifies for discontinued operations under FASB Statement No. 144, we consider the proximity of the facility to other HealthSouth facilities offering similar services as well as other facilities within the same regional cost center that remain open. If we believe HealthSouth will retain patients by transferring the services to another HealthSouth facility, we will not treat the closed facility as a discontinued operation. We do not account for facilities that were closed or sold as discontinued operations until we have exited the specific market.

 

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The operating results of discontinued operations, by operating segment and in total, are as follows:

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Inpatient:

      

Net operating revenues

   $ —       $ 4,699     $ 26,114  

Costs and expenses

     637       6,544       18,148  
                        

(Loss) income from discontinued operations

     (637 )     (1,845 )     7,966  

Gain (loss) on disposal of assets of discontinued operations

     362       (642 )     (464 )

Income tax expense

     —         —         —    
                        

(Loss) income from discontinued operations

   $ (275 )   $ (2,487 )   $ 7,502  
                        

Surgery Centers:

      

Net operating revenues

   $ 18,854     $ 44,181     $ 57,608  

Costs and expenses

     30,967       56,846       99,628  

Impairments

     112       1,750       —    
                        

Loss from discontinued operations

     (12,225 )     (14,415 )     (42,020 )

Gain on disposal of assets of discontinued operations

     6,181       1,134       11,299  

Income tax expense

     —         —         —    
                        

Loss from discontinued operations

   $ (6,044 )   $ (13,281 )   $ (30,721 )
                        

Outpatient:

      

Net operating revenues

   $ 11,815     $ 48,007     $ 78,742  

Costs and expenses

     16,852       52,102       74,316  

Impairments

     —         822       —    
                        

(Loss) income from discontinued operations

     (5,037 )     (4,917 )     4,426  

Gain (loss) on disposal of assets of discontinued operations

     165       (1,203 )     (1,758 )

Income tax expense

     —         —         —    
                        

(Loss) income from discontinued operations

   $ (4,872 )   $ (6,120 )   $ 2,668  
                        

Diagnostic:

      

Net operating revenues

   $ 2,191     $ 11,410     $ 21,009  

Costs and expenses

     4,733       17,702       25,435  

Impairments

     —         133       —    
                        

Loss from discontinued operations

     (2,542 )     (6,425 )     (4,426 )

Gain on disposal of assets of discontinued operations

     289       3,077       1,289  

Income tax expense

     —         —         —    
                        

Loss from discontinued operations

   $ (2,253 )   $ (3,348 )   $ (3,137 )
                        

Corporate and Other:

      

Net operating revenues

   $ 76,802     $ 153,609     $ 228,218  

Costs and expenses

     118,331       232,457       238,150  

Impairments

     6,693       16,577       —    
                        

Loss from discontinued operations

     (48,222 )     (95,425 )     (9,932 )

Gain on disposal of assets of discontinued operations

     257       319       28,439  

Income tax expense

     —         —         —    
                        

(Loss) income from discontinued operations

   $ (47,965 )   $ (95,106 )   $ 18,507  
                        

Total:

      

Net operating revenues

   $ 109,662     $ 261,906     $ 411,691  

Costs and expenses

     171,520       365,651       455,677  

Impairments

     6,805       19,282       —    
                        

Loss from discontinued operations

     (68,663 )     (123,027 )     (43,986 )

Gain on disposal of assets of discontinued operations

     7,254       2,685       38,805  

Income tax expense

     —         —         —    
                        

Loss from discontinued operations

   $ (61,409 )   $ (120,342 )   $ (5,181 )
                        

 

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Inpatient. Our inpatient segment identified 19 facilities as discontinued operations. The decrease in net operating revenues and costs and expenses in each year is due to the timing of the closure of these facilities.

Surgery Centers. Twenty-five surgery centers were identified as discontinued operations. Both the decline in net operating revenues and the decline in costs and expenses in each year are due to the timing of the sale or closure of these facilities. As of December 31, 2005, we had three open surgery centers that qualified as discontinued operations. These three facilities were sold in February 2006.

The $11.3 million net gain on disposal of assets in 2003 is due primarily to a gain on disposal of the assets related to our former surgical hospital in Oklahoma.

Outpatient. Our outpatient segment identified 328 facilities as discontinued operations. The timing of the closure of these facilities drove the change in net operating revenues and costs and expenses in each year.

Diagnostic. Our diagnostic segment identified 27 facilities as discontinued operations. The timing of the closure of these facilities drove the change in net operating revenues and costs and expenses in each year.

Corporate and Other. Our corporate and other segment identified 46 facilities as discontinued operations.

On July 20, 2005, we executed an asset purchase agreement with The Board of Trustees of the University of Alabama (the “University of Alabama”) for the sale of the real property, furniture, fixtures, equipment and certain related assets associated with our only remaining operating acute care hospital, which has 219 licensed beds and is located in Birmingham, Alabama. Simultaneously with the execution of this purchase agreement with the University of Alabama, we executed an agreement with an affiliate of the University of Alabama whereby this entity currently provides certain management services to our acute care hospital in Birmingham. On December 31, 2005, we executed an amended and restated asset purchase agreement with the University of Alabama. This amended and restated agreement provides that the University of Alabama will purchase our Birmingham acute care hospital and associated real and personal property as well as our interest in the gamma knife partnership associated with this hospital. We anticipate closing this transaction by the end of the first quarter of 2006. We will transfer the hospital and associated real and personal property at that time, but will transfer our interest in the gamma knife partnership at a later date. The proposed transaction also requires that we acquire and convey title to the University of Alabama for certain professional office buildings that we are currently leasing. Both the certificate of need under which the hospital currently operates, and the licensed beds operated by us at the hospital, will be transferred as part of the sale of the hospital under the amended and restated agreement.

From 2003 to 2004, net operating revenues associated with discontinued operations within our corporate and other segment decreased by $74.6 million. Approximately $72.0 million of this decrease relates to Doctor’s Hospital in Miami, Florida, which was sold in late 2003. From 2004 to 2005, net operating revenues associated with discontinued operations within this segment decreased by $76.8 million. Approximately $20.0 million of this decrease was due to the closure of Metro West hospital in September 2004. An additional $35.0 million was due to the continued poor operating performance of the Birmingham Medical Center in 2005. The change in costs and expenses in each year follow these same trends.

The $16.6 million impairment charge in 2004 primarily relates to a $14.8 million impairment charge associated with the Birmingham Medical Center. Due to continuing negative cash flows from operations of this facility, we had the Birmingham Medical Center appraised as of December 31, 2004. The impairment charge represents the difference between the appraised value and the net book value of the long-lived assets associated with the Birmingham Medical Center.

The net gain on asset disposals in 2003 was primarily the result of our sale of Doctor’s Hospital in that year.

 

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Liquidity and Capital Resources

Our principal sources of liquidity are cash on hand, cash from operations, and our revolving credit agreement.

Historic Sources and Uses of Cash

Historically, our primary sources of funding have been cash flows from operations, borrowings under long-term debt agreements, and sales of limited partnership interests. Funds were used to fund working capital requirements, capital expenditures, and business acquisitions. The following chart shows the cash flows provided by or used in operating, investing, and financing activities for 2005, 2004, and 2003, as well as the effect of exchange rates for those same years:

 

     For the year ended December 31,  
     2005     2004     2003  
     (In Thousands)  

Net cash provided by operating activities*

   $ 1,561     $ 391,596     $ 574,193  

Net cash used in investing activities

     (104,298 )     (186,869 )     (76,873 )

Net cash used in financing activities

     (173,832 )     (224,469 )     (115,885 )

Effect of exchange rate changes on cash and cash equivalents

     (1,248 )     1,251       (31 )
                        

(Decrease) increase in cash and cash equivalents

   $ (277,817 )   $ (18,491 )   $ 381,404  
                        

* Includes approximately $165.4 million and $7.0 million of cash payments, excluding interest, related to government, class action, and related settlements in 2005 and 2004, respectively.

2005 Compared to 2004

Operating activities. Net cash provided by operating activities decreased from 2004 to 2005 as a result of lower net operating revenues in 2005, cash payments for government, class action, and related settlements, and a return to normal payment terms with many of our vendors. As discussed earlier in this Item, our net operating revenues decreased in 2005 due to declining volumes experienced by our operating segments. In addition, we paid approximately $155.0 million, excluding interest, to the United States related to our Medicare program settlement, and we paid $12.5 million to the SEC under a settlement agreement. These settlements are discussed in Item 1, Business, and Note 21, Medicare Program Settlement, and Note 22, SEC Settlement, to our accompanying consolidated financial statements. With our revolving line of credit frozen throughout 2004, we added approximately two weeks to most payment terms of our vendors as part of our cash management and conservation process. After we amended and restated our credit agreement in March 2005 (see below), we were able to return to more normal payment terms with our vendors. This decreased our net cash provided by operating activities year over year.

Investing activities. Net cash used in investing activities decreased from 2004 to 2005 primarily due to a reduction in capital expenditures. During 2005, we decreased capital expenditure budgets and postponed development projects to conserve cash and restructure our business.

Financing activities. Net cash used in financing activities decreased from 2004 to 2005 due primarily to $73.5 million less in debt issuance costs and consent fees paid in 2005 offset by $21.7 million more in net debt payments, including capital lease obligations. See Item 1, Business, and Note 8, Long-term Debt, to our accompanying consolidated financial statements.

2004 Compared to 2003

Operating activities. Net cash provided by operating activities decreased from 2003 to 2004 as a result of lower net operating revenues in 2004 and a reduction in income tax refunds received year over year. In 2004, we received net income tax refunds of approximately $8.1 million, as compared to 2003 when we received $110.3 million in net income tax refunds.

 

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Investing activities. Net cash used in investing activities increased from 2003 to 2004 primarily due to a reduction in proceeds from asset disposals year over year, including those of facilities designated as discontinued operations.

Financing activities. Net cash used in financing activities increased from 2003 to 2004 primarily due to consent fees paid in connection with all of our debt issues covered by the consent solicitations discussed in Item 1, Business, and Note 8, Long-term Debt, to our accompanying consolidated financial statements.

Current Liquidity and Capital Resources

As of December 31, 2005, we had approximately $175.5 million in cash and cash equivalents. This amount excludes approximately $242.5 million in restricted cash, which is cash we cannot use because of various obligations we have under lending agreements, partnership agreements, and other arrangements, primarily related to our captive insurance company. We also had approximately $23.8 million of marketable securities classified as available-for-sale.

On March 10, 2006, we completed the last of a series of recapitalization transactions (the “Recapitalization Transactions”) enabling us to prepay substantially all of our prior indebtedness and replace it with approximately $3 billion of new long-term debt. Although we remain highly leveraged, we believe these Recapitalization Transactions have eliminated significant uncertainty regarding our capital structure and have improved our financial condition in several important ways:

 

    Reduced refinancing risk—The terms governing our prior indebtedness would have required us to refinance approximately $2.7 billion between 2006 and 2009, assuming all noteholders holding options to require us to repurchase their notes in 2007 and 2009 were to exercise those options. Under the terms governing our new indebtedness, we have minimal maturities until 2013 when our new term loans come due. The extension of our debt maturities has substantially reduced the risk and uncertainty associated with our near-term refinancing obligations under our prior debt.

 

    Improved operational flexibility—We have negotiated new loan covenants with higher leverage ratios and lower interest coverage ratios. In addition, our new loan agreements increase our ability to enter into certain transactions (e.g. acquisitions and sale-leaseback transactions).

 

    Increased liquidity—As a result of the Recapitalization Transactions, our revolving line of credit has increased by approximately $150 million. In addition, the increased flexibility provided by the covenants governing our new indebtedness will allow us greater access to our revolving credit facility than we had under our prior indebtedness.

 

    Improved credit profile—By issuing $400 million in convertible perpetual preferred stock and using the net proceeds from that offering to repay a portion of our outstanding indebtedness and to pay fees and expenses related to such prepayment, we were able to reduce the amount we ultimately borrowed under the interim loan agreement. Accordingly, we have improved our capital structure. In addition, by increasing the ratio of our secured debt to unsecured debt, our capital structure is now closer to industry norms. Further, a substantial amount of our new indebtedness is prepayable without penalty, which will enable us to reduce debt and interest expense as operating and non-operating cash flows allow without the substantial cost associated with the prepayment of our prior public indebtedness.

 

    Reduced interest rate exposure—By completing the Recapitalization Transactions we have taken advantage of current interest rates, which are relatively low compared to historical rates, and eliminated the need to refinance our debt over the next four years in what we perceive to be a rising interest-rate environment. In addition, we have entered into an interest rate swap to reduce our variable rate debt exposure.

The Recapitalization Transactions included (1) entering into credit facilities that provide for extensions of credit of up to $2.55 billion of senior secured financing, (2) entering into an interim loan agreement that provides

 

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us with $1.0 billion of senior unsecured financing, (3) completing a $400 million offering of convertible perpetual preferred stock, (4) completing cash tender offers to purchase $2.03 billion of our previously outstanding senior notes and $319 million of our previously outstanding senior subordinated notes and consent solicitations with respect to proposed amendments to the indentures governing each outstanding series of notes, and (5) prepaying and terminating our Senior Subordinated Credit Agreement, our Amended and Restated Credit Agreement, and our Term Loan Agreement. In order to complete the Recapitalization Transactions, we also entered into amendments, waivers, and consents to our prior senior secured credit facility, $200 million senior unsecured term loan agreement, and $355 million senior subordinated credit agreement. Detailed descriptions of each of the above transactions are contained in Item 1, Business, “Recapitalization Transactions,” and Note 8, Long-term Debt, to our accompanying consolidated financial statements.

As a result of the Recapitalization Transactions, we expect to record an approximate $350 million to $375 million net loss on early extinguishment of debt in the first quarter of 2006.

We used a portion of the proceeds of the loans under the new senior secured credit facilities, the proceeds of the interim loans, and the proceeds of the $400 million offering of convertible perpetual preferred stock, along with cash on hand, to prepay substantially all of our prior indebtedness and to pay fees and expenses related to such prepayment and the Recapitalization Transactions. The remainder of the proceeds and availability under the senior secured credit facilities are expected to be used for general corporate purposes. In addition, the letters of credit issued under the revolving letter of credit subfacility and the synthetic letter of credit facility will be used in the ordinary course of business to secure workers’ compensation and other insurance coverages and for general corporate purposes. We anticipate refinancing the $1 billion interim loans in the second quarter or third quarter of 2006 through an issuance of high-yield debt securities.

The face value of our long-term debt (excluding notes payable to banks and others, noncompete agreements, and capital lease obligations) before and after the Recapitalization Transactions is summarized in the following table:

 

     As of
December 31, 2005
   As of
March 10, 2006
     (In Thousands)

Revolving credit facility

   $ —      $ 50,000

Term loans

     513,425      3,050,000

Bonds payable

     2,720,907      80,101
             
   $ 3,234,332    $ 3,180,101
             

 

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The following charts show our scheduled payments on long-term debt (excluding notes payable to banks and others, noncompete agreements, and capital lease obligations) for the next five years and thereafter before and after the Recapitalization Transactions. The charts also exclude the convertible perpetual preferred stock.

LOGO

LOGO


* Interim Loan Agreement maturity, which is subject to automatic extension

 

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As noted above, we have negotiated new debt covenants as part of the Recapitalization Transactions. These covenants include higher leverage ratios and lower interest coverage ratios. The following chart shows a comparison of these two restrictive covenants as of March 31, 2006 under our former Amended and Restated Credit Agreement and our new Credit Agreement:

 

         Required Ratios at March 31, 2006    
     New Credit
Agreement
   Former
Amended and
Restated Credit
Agreement

Minimum interest coverage ratio

   1.65 to 1.00    2.00 to 1.00

Maximum leverage ratio

   7.25 to 1.00    5.50 to 1.00

2005 Financial Restructuring

On March 21, 2005, we amended and restated our 2002 Credit Agreement as follows:

 

    The balance of $315 million outstanding under the 2002 Credit Agreement when it was frozen in March 2003 was converted to a term loan. The Term Loan bore interest, at our option, at a rate of (1) LIBOR, adjusted for statutory reserve requirements (“Adjusted LIBOR”), plus 2.50% or (2) 1.50% plus the higher of (a) the Federal Funds Rate plus 0.50% or (b) JPMorgan’s prime rate.

 

    We obtained a $250 million revolving credit facility (the “Revolving Facility”). As of December 31, 2005, no money was drawn on the Revolving Facility. Until we filed our 2004 audited consolidated financial statements with the SEC, the Revolving Facility accrued interest at our option, at a rate of (1) Adjusted LIBOR plus 2.75% or (2) 1.75% plus the higher of (a) the Federal Funds Rate plus 0.50% or (b) JPMorgan’s prime rate. After we filed our audited consolidated financial statements with the SEC for the fiscal year ended December 31, 2004, the interest rates and commitment fees on the Revolving Facility were determined based upon our ratio of (1) consolidated total indebtedness minus the amount by which the unrestricted cash and cash equivalents on such date exceed $50 million to (2) our adjusted consolidated EBITDA for the period of four consecutive fiscal quarters ending on or most recently prior to such date (the “Net Leverage Ratio”). During such period, the Revolving Facility bore interest, at our option, (1) at a rate of Adjusted LIBOR plus a spread ranging from 1.75% to 2.75%, depending on the Net Leverage Ratio or (2) at a rate of a spread ranging from 0.75% to 1.75%, depending on the Net Leverage Ratio, plus the higher of (a) the Federal Funds Rate plus 0.50% or (b) JPMorgan’s prime rate.

 

    We obtained a $150 million letter of credit facility (the “LC Facility”). As of December 31, 2005, approximately $123.8 million of this facility was utilized. A letter of credit participation fee was payable to the Lenders under the LC Facility with respect to a particular commitment under the LC Facility on the aggregate face amount of the commitment outstanding there under upon the later of the termination of the particular commitment under the LC Facility and the date on which the Lenders letters of credit exposure for such commitment cease, in an amount at any time equal to the LIBOR interest rate spread applicable at such time to loans outstanding under the Revolving Facility. In addition, we paid, for our own account, (1) a fronting fee of 0.25% per annum on the aggregate face amount of the letters of credit outstanding under the LC Facility upon the later of the termination of the commitments under the LC Facility and the date on which the Lenders’ letters of credit exposure for such commitment cease, and (2) customary issuance and administration fees relating to the letters of credit.

Until we filed our 2004 audited consolidated financial statements with the SEC, we were subject to commitment fees of 0.75% per annum on the daily amount of the unutilized commitments under the Revolving Facility and the LC Facility. After that filing, the commitment fees ranged between 0.50% and 0.75%, depending on the Net Leverage Ratio.

 

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The Amended and Restated Credit Facility cured all defaults under our 2002 Credit Agreement. Beginning June 30, 2005, it contained affirmative and negative covenants, including a minimum interest expense coverage ratio of 1.75 to 1.00 and a maximum leverage ratio of 5.75 to 1.00 as of December 31, 2005. The required ratios changed over time. The Amended and Restated Credit Facility also contained restrictive covenants related to our use of proceeds from asset sales and ability to pay dividends. For more information regarding the Amended and Restated Credit Facility, see Note 8, Long-term Debt, to our accompanying consolidated financial statements.

On June 15, 2005, we closed a $200 million senior unsecured term loan facility, the net proceeds of which, together with available cash, were used to repay our $245 million 6.875% senior notes due June 15, 2005, and to pay fees and expenses related to the term loan facility. This transaction allowed us to reduce our overall level of outstanding indebtedness.

The facility, which was launched in late May 2005, was increased from $150 million to $200 million based on strong investor demand.

The term loan facility bore interest, at our option, at a rate of (1) Adjusted LIBOR plus 5.0% or (2) 4.0% per year plus the higher of (a) JPMorgan’s prime rate and (b) the Federal Funds Rate plus 0.5%. The term loan facility would have matured on June 15, 2010.

The term loan facility contained affirmative and negative covenants and default and acceleration provisions. In addition, we were responsible for customary fees and expenses associated with the term loan facility.

Funding Commitments

After the above recapitalization transactions, we have scheduled payments of $34.3 million and $20.6 million in 2006 and 2007, respectively, related to long-term debt obligations (including notes payable to banks and others, noncompete agreements, and capital lease obligations; excluding the $1.0 billion interim loan agreement). For additional information about our long-term debt obligations, see Note 8, Long-term Debt, to our accompanying consolidated financial statements.

We also have funding commitments related to legal settlements. As a result of the Medicare Program Settlement discussed in Item 1, Business, we made principal payments of approximately $155 million to the United States during 2005. The remaining principal balance of $170 million will be paid in quarterly installments in 2006 and 2007. These amounts are exclusive of interest from November 4, 2004 at an annual rate of 4.125%. In addition to the Medicare Program Settlement, we reached an agreement with the SEC to resolve claims brought by the SEC against us in March 2003. As a result of the SEC Settlement, we made a $12.5 million payment to the SEC in October 2005. We will make payments of $37.5 million and $50.0 million in 2006 and 2007, respectively.

During 2005, we made capital expenditures of approximately $94 million, of which approximately $14 million related to the Digital Hospital. Total amounts budgeted for capital expenditures for 2006 approximate $147 million. These expenditures include IT initiatives, new business opportunities, and equipment upgrades and purchases. Approximately 50% of this budgeted amount is discretionary and could be revised, if necessary.

For a discussion of risk factors related to our business and our industry, please see Item 1A, Risk Factors.

Off-Balance Sheet Arrangements

In accordance with the definition under SEC rules, the following qualify as off–balance sheet arrangements:

 

    any obligation under certain guarantees or contracts;

 

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    a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets;

 

    any obligation under certain derivative instruments; and

 

    any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the registrant, or engages in leasing, hedging or research and development services with the registrant.

The following discussion addresses each of the above items for