Edgar Filing: KINDRED HEALTHCARE, INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2009

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

EXCHANGE ACT OF 1934

For the transition period from to .

Commission file number: 001-14057

KINDRED HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)


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

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

(502) 596-7300

(Registrant’s telephone number, including area code)

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

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

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class of Common Stock		Outstanding at July 31, 2009
Common stock, $0.25 par value		39,031,952 shares

1 of 45

KINDRED HEALTHCARE, INC.

FORM 10-Q

INDEX


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited):
	Condensed Consolidated Statement of Operations — for the three months ended June 30, 2009 and 2008 and for the six months ended June 30, 2009 and 2008	3
	Condensed Consolidated Balance Sheet — June 30, 2009 and December 31, 2008	4
	Condensed Consolidated Statement of Cash Flows — for the three months ended June 30, 2009 and 2008 and for the six months ended June 30, 2009 and 2008	5
	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42

Item 4.	Controls and Procedures	43

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	44

Item 4.	Submission of Matters to a Vote of Security Holders	44

Item 6.	Exhibits	44

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Revenues	$	1,073,054		$	1,026,041		$	2,142,528		$	2,060,516

Salaries, wages and benefits		620,830			587,416			1,236,048			1,179,656
Supplies		83,912			80,769			164,248			158,603
Rent		86,882			85,860			172,083			169,483
Other operating expenses		221,755			213,544			442,160			437,517
Other income		(2,823	)		(5,167	)		(5,695	)		(9,884	)
Depreciation and amortization		31,355			30,545			61,845			61,103
Interest expense		2,229			2,907			4,707			7,828
Investment income		(1,033	)		(2,335	)		(2,508	)		(5,582	)

		1,043,107			993,539			2,072,888			1,998,724

Income from continuing operations before income taxes		29,947			32,502			69,640			61,792
Provision for income taxes		12,409			13,025			28,761			25,105

Income from continuing operations		17,538			19,477			40,879			36,687
Discontinued operations, net of income taxes:
Loss from operations		(897	)		(528	)		(1,478	)		(3,048	)
Gain (loss) on divestiture of operations		(24,051	)		2,712			(24,051	)		2,712

Net income (loss)	$	(7,410	)	$	21,661		$	15,350		$	36,351

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.45		$	0.50		$	1.05		$	0.95
Discontinued operations:
Loss from operations		(0.02	)		(0.01	)		(0.04	)		(0.08	)
Gain (loss) on divestiture of operations		(0.62	)		0.07			(0.62	)		0.07

Net income (loss)	$	(0.19	)	$	0.56		$	0.39		$	0.94

Diluted:
Income from continuing operations	$	0.45		$	0.49		$	1.05		$	0.94
Discontinued operations:
Loss from operations		(0.02	)		(0.01	)		(0.04	)		(0.08	)
Gain (loss) on divestiture of operations		(0.62	)		0.07			(0.62	)		0.07

Net income (loss)	$	(0.19	)	$	0.55		$	0.39		$	0.93

Shares used in computing earnings (loss) per common share:
Basic		38,307			37,714			38,246			37,579
Diluted		38,415			38,474			38,366			38,273

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(Unaudited)

(In thousands, except per share amounts)


	June 30, 2009			December 31, 2008
ASSETS
Current assets:
Cash and cash equivalents	$	39,727		$	140,795
Cash – restricted		5,305			5,104
Insurance subsidiary investments		156,932			196,983
Accounts receivable less allowance for loss of $24,734 – June 30, 2009 and $27,548 – December 31, 2008		660,526			611,032
Inventories		22,122			22,325
Deferred tax assets		76,351			58,296
Income taxes		1,197			47,257
Other		21,132			20,843

		983,292			1,102,635

Property and equipment		1,459,746			1,392,636
Accumulated depreciation		(710,574	)		(656,676	)

		749,172			735,960

Goodwill		74,306			72,244
Intangible assets less accumulated amortization of $2,210 – June 30, 2009 and $1,817 – December 31, 2008		63,973			64,367
Assets held for sale		32,197			7,786
Insurance subsidiary investments		52,196			48,610
Deferred tax assets		106,206			100,751
Other		54,286			49,408

	$	2,115,628		$	2,181,761

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	155,276		$	178,246
Salaries, wages and other compensation		282,734			281,542
Due to third party payors		23,369			33,122
Professional liability risks		49,677			55,447
Other accrued liabilities		80,468			76,832
Long-term debt due within one year		83			81

		591,607			625,270

Long-term debt		274,791			349,433
Professional liability risks		209,116			187,804
Deferred credits and other liabilities		106,149			104,279

Commitments and contingencies

Stockholders’ equity:
Common stock, $0.25 par value; authorized 175,000 shares; issued 39,018 shares – June 30, 2009 and 38,909 shares – December 31, 2008		9,754			9,727
Capital in excess of par value		815,439			812,141
Accumulated other comprehensive loss		(3,304	)		(3,619	)
Retained earnings		112,076			96,726

		933,965			914,975

	$	2,115,628		$	2,181,761

See accompanying notes.

KINDRED HEALTHCARE, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(In thousands)


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Cash flows from operating activities:
Net income (loss)	$	(7,410	)	$	21,661		$	15,350		$	36,351
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		31,714			31,269			62,519			62,674
Amortization of stock-based compensation costs		2,660			3,626			5,099			7,395
Provision for doubtful accounts		7,631			6,788			14,647			15,160
Deferred income taxes		(7,328	)		(8,429	)		(9,507	)		(13,147	)
(Gain) loss on divestiture of discontinued operations		24,051			(2,712	)		24,051			(2,712	)
Other		32			(517	)		236			(1,093	)
Change in operating assets and liabilities:
Accounts receivable		22,274			17,997			(64,141	)		(84,146	)
Inventories and other assets		(2,026	)		2,714			(9,561	)		(4,458	)
Accounts payable		(2,383	)		(11,382	)		(10,268	)		(11,030	)
Income taxes		2,878			(2,612	)		46,101			38,984
Due to third party payors		(19,154	)		(11,316	)		(9,753	)		(14,807	)
Other accrued liabilities		30,331			(3,133	)		22,261			4,989

Net cash provided by operating activities		83,270			43,954			87,034			34,160

Cash flows from investing activities:
Purchase of property and equipment		(38,896	)		(39,920	)		(78,882	)		(64,860	)
Acquisitions		(59,793	)		(24,325	)		(75,397	)		(26,405	)
Sale of assets		–			20,760			–			27,239
Purchase of insurance subsidiary investments		(22,415	)		(33,835	)		(58,672	)		(69,068	)
Sale of insurance subsidiary investments		25,927			28,034			80,019			66,933
Net change in insurance subsidiary cash and cash equivalents		(4,783	)		(1,525	)		15,675			38,428
Change in other investments		2,000			7,000			2,000			7,000
Other		5,347			194			4,394			1,288

Net cash used in investing activities		(92,613	)		(43,617	)		(110,863	)		(19,445	)

Cash flows from financing activities:
Proceeds from borrowings under revolving credit		266,100			353,100			656,900			728,100
Repayment of borrowings under revolving credit		(359,900	)		(343,500	)		(731,500	)		(737,700	)
Repayment of long-term debt		(20	)		(19	)		(40	)		(38	)
Repayment of capital lease obligation		–			(15,993	)		–			(16,268	)
Payment of deferred financing costs		(118	)		(48	)		(427	)		(179	)
Issuance of common stock		–			5,056			–			5,778
Other		(442	)		2,991			(2,172	)		(8,469	)

Net cash provided by (used in) financing activities		(94,380	)		1,587			(77,239	)		(28,776	)

Change in cash and cash equivalents		(103,723	)		1,924			(101,068	)		(14,061	)
Cash and cash equivalents at beginning of period		143,450			16,892			140,795			32,877

Cash and cash equivalents at end of period	$	39,727		$	18,816		$	39,727		$	18,816

Supplemental information:
Interest payments	$	1,837		$	2,546		$	3,907		$	7,633
Income tax payments (refunds)		16,367			23,641			(8,803	)		(2,690	)

See accompanying notes.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

Business

Kindred Healthcare, Inc. is a healthcare services company that through its subsidiaries operates hospitals, nursing centers and a contract rehabilitation services business across the United States (collectively, the “Company”). At June 30, 2009, the Company’s hospital division operated 82 long-term acute care (“LTAC”) hospitals in 24 states. The Company’s health services division operated 222 nursing centers in 27 states. The Company also operated a contract rehabilitation services business that provides rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several transactions related to the divestiture of unprofitable hospitals and nursing centers to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains, losses or impairments associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2009 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet. See Note 2 for a summary of discontinued operations.

Impact of recent accounting pronouncements

In June 2009, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168 (“SFAS 168”), “The FASB Accounting Standards Codification^™ and the Hierarchy of Generally Accepted Accounting Principles–a replacement of FASB Statement No. 162,” which identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This statement establishes the FASB Accounting Standards Codification^™ (the “FASB Codification”) as the sole source of authoritative accounting principles recognized by the FASB. SFAS 168 is effective for all financial statements issued for interim and annual reporting periods beginning after September 15, 2009. The adoption of SFAS 168 is not expected to have an impact on the Company’s business, financial position, results of operations or liquidity.

In May 2009, the FASB issued SFAS No. 165 (“SFAS 165”), “Subsequent Events,” which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This statement requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. SFAS 165 is effective for all interim and annual reporting periods beginning after June 15, 2009. The adoption of SFAS 165 is not expected to have an impact on the Company’s business, financial position, results of operations or liquidity.

In April 2009, the FASB issued the following guidance related to fair value measurements and disclosures and the recognition of other-than-temporary impairments of financial instruments:

•

FASB Staff Position (“FSP”) SFAS No. 157-4 (“SFAS 157-4”), “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” which provides additional guidance for determining whether the market for a security is inactive and whether transactions in inactive markets are distressed.

•

FSP SFAS No. 115-2 (“SFAS 115-2”) and SFAS No. 124-2 (“SFAS 124-2”), “Recognition and Presentation of Other-Than-Temporary Impairments,” which clarify the recognition and measurement of other-than-temporary impairments of debt and equity securities.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Impact of recent accounting pronouncements (Continued)

•

FSP SFAS No. 107-1 (“SFAS 107-1”) and Accounting Principles Board No. 28-1 (“APB 28-1”), “Interim Disclosures about Fair Value of Financial Instruments,” which require an entity to provide disclosures about the fair value of financial instruments in both interim and annual financial statements.

The provisions above related to fair value measurements and other-than-temporary impairments are effective for all interim and annual reporting periods beginning after June 15, 2009. The adoption of these provisions is not expected to have a material impact on the Company’s business, financial position, results of operations or liquidity.

On January 1, 2009, the Company adopted FSP Emerging Issues Task Force 03-6-1 (“EITF 03-6-1”), “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings (loss) per common share calculation pursuant to the two-class method. The adoption of EITF 03-6-1 has been applied retrospectively in the accompanying unaudited condensed consolidated financial statements and did not have a material impact on the Company’s earnings (loss) per common share calculations. See Note 5.

In December 2007, the FASB issued SFAS No. 141 (revised 2007) (“SFAS 141R”), “Business Combinations,” which significantly changes the accounting for business combinations, including, among other changes, new accounting concepts in determining the fair value of assets and liabilities acquired, recording the fair value of contingent considerations and contingencies at the acquisition date and expensing acquisition and restructuring costs. SFAS 141R is applied prospectively and is effective for business combinations which occur during fiscal years beginning after December 15, 2008. The Company’s adoption of SFAS 141R on January 1, 2009 did not have a material impact on the Company’s business, financial position, results of operations or liquidity at June 30, 2009 or for the six months ended June 30, 2009. However, any future business combinations may significantly impact the Company’s financial position and results of operations when compared to acquisitions accounted for under the previous generally accepted accounting principles and may result in more earnings volatility and generally lower earnings due to the expensing of acquisition costs and restructuring costs.

In April 2009, the FASB issued FSP SFAS No. 141(R)-1 (“SFAS 141(R)-1”), “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies,” which will amend the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination under SFAS 141R. SFAS 141(R)-1 is effective for all business combinations which occur during fiscal years beginning after December 15, 2008. The Company’s adoption of SFAS 141(R)-1 retroactive to January 1, 2009 did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION (Continued)

Comprehensive income (loss)

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


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009		2008
Net income (loss)	$	(7,410	)	$	21,661		$	15,350	$	36,351
Net unrealized investment gains (losses), net of income taxes		1,169			(1,051	)		315		(1,768	)

Comprehensive income (loss)	$	(6,241	)	$	20,610		$	15,665	$	34,583

Other information

The accompanying unaudited condensed consolidated financial statements are prepared in accordance with the instructions for Form 10-Q of Regulation S-X and do not include all of the disclosures normally required by generally accepted accounting principles or those normally required in annual reports on Form 10-K. Accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2008 filed with the Securities and Exchange Commission (the “SEC”) on Form 10-K. The accompanying condensed consolidated balance sheet at December 31, 2008 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.

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

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

The Company has performed an evaluation of subsequent events through August 6, 2009, which is the date the financial statements were issued.

Reclassifications

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

NOTE 2 – DISCONTINUED OPERATIONS

In accordance with SFAS No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets,” the divestiture of unprofitable businesses discussed in Note 1 have been accounted for as discontinued operations. Accordingly, the results of operations of these businesses for all periods presented and the gains, losses or impairments related to these divestitures have been classified as discontinued operations, net of income taxes, in the accompanying unaudited condensed consolidated statement of operations.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

In June 2009, the Company purchased for resale six under-performing nursing centers (the “Nursing Centers”) previously leased from Ventas, Inc. (“Ventas”) for $55.7 million. In addition, the Company paid a lease termination fee of $2.3 million. The Nursing Centers were included in master lease agreements with Ventas and the Company does not have the ability to terminate a lease of an individual facility. The aggregate annual rent for the Nursing Centers was approximately $6 million for the year ended December 31, 2008. The Nursing Centers, which contained 777 licensed beds, generated pretax losses of approximately $3 million for both the year ended December 31, 2008 and for the six months ended June 30, 2009. The Company intends to dispose of the Nursing Centers within one year. The Company recorded a pretax loss of $39.1 million ($24.0 million net of income taxes) in the second quarter of 2009 related to these divestitures.

In June 2008, the Company recorded a pretax gain of $9.5 million ($5.9 million net of income taxes) related to the divestiture of discontinued operations and a pretax charge of $5.1 million ($3.1 million net of income taxes) related to a hospital asset impairment.

At June 30, 2009, the Company held for sale the Nursing Centers and two hospitals. The Company expects to generate approximately $25 million in proceeds from the sales of the Nursing Centers and $7.8 million in proceeds from the sales of the two hospitals.

A summary of discontinued operations follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Revenues	$	16,970		$	29,330		$	33,082		$	67,360

Salaries, wages and benefits		9,877			17,615			18,987			40,357
Supplies		992			2,047			1,984			4,958
Rent		1,628			2,616			3,297			5,150
Other operating expenses		5,568			7,193			10,540			20,309
Depreciation		359			724			674			1,571
Interest expense		7			–			7			2
Investment income		(3	)		(5	)		(4	)		(30	)

		18,428			30,190			35,485			72,317

Loss from operations before income taxes		(1,458	)		(860	)		(2,403	)		(4,957	)
Income tax benefit		(561	)		(332	)		(925	)		(1,909	)

Loss from operations		(897	)		(528	)		(1,478	)		(3,048	)
Gain (loss) on divestiture of operations, net of income taxes		(24,051	)		2,712			(24,051	)		2,712

	$	(24,948	)	$	2,184		$	(25,529	)	$	(336	)

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2 – DISCONTINUED OPERATIONS (Continued)

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


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Revenues:
Hospital division	$	1,286		$	10,492		$	2,349		$	26,072
Health services division		15,684			18,838			30,733			41,288

	$	16,970		$	29,330		$	33,082		$	67,360

Operating income (loss):
Hospital division	$	(642	)	$	(2,014	)	$	(1,492	)	$	(3,103	)
Health services division		1,175			4,489			3,063			4,839

	$	533		$	2,475		$	1,571		$	1,736

Rent:
Hospital division	$	11		$	1,050		$	101		$	2,009
Health services division		1,617			1,566			3,196			3,141

	$	1,628		$	2,616		$	3,297		$	5,150

Depreciation:
Hospital division	$	–		$	339		$	–		$	689
Health services division		359			385			674			882

	$	359		$	724		$	674		$	1,571

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


	June 30, 2009			December 31, 2008
Long-term assets:
Property and equipment, net	$	31,442		$	7,730
Other		755			56

		32,197			7,786
Current liabilities (included in other accrued liabilities)		(1,445	)		(111	)

	$	30,752		$	7,675

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3 – SIGNIFICANT QUARTERLY ADJUSTMENTS

Operating results for the second quarter of 2008 included pretax income of $8.3 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute and a pretax charge of $1.9 million related to a prior period rent escalator adjustment for ten leased facilities.

NOTE 4 – REVENUES

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

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


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Medicare	$	456,298		$	443,165		$	919,027		$	898,382
Medicaid		269,182			266,253			535,327			525,719
Medicare Advantage		83,589			65,105			164,845			127,038
Other		336,071			318,021			666,039			641,614

		1,145,140			1,092,544			2,285,238			2,192,753
Eliminations		(72,086	)		(66,503	)		(142,710	)		(132,237	)

	$	1,073,054		$	1,026,041		$	2,142,528		$	2,060,516

NOTE 5 – EARNINGS (LOSS) PER SHARE

Earnings (loss) per common share are based upon the weighted average number of common shares outstanding during the respective periods. The diluted calculation of earnings (loss) per common share includes the dilutive effect of stock options. On January 1, 2009, the Company adopted EITF 03-6-1, which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings (loss) per common share calculation pursuant to the two-class method.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 5 – EARNINGS (LOSS) PER SHARE (Continued)

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


	Three months ended June 30,												Six months ended June 30,
	2009						2008						2009						2008
	Basic			Diluted			Basic			Diluted			Basic			Diluted			Basic			Diluted
Earnings (loss):
Income from continuing operations:
As reported in Statement of Operations	$	17,538		$	17,538		$	19,477		$	19,477		$	40,879		$	40,879		$	36,687		$	36,687
Allocation to participating unvested restricted stockholders		(323	)		(322	)		(461	)		(452	)		(762	)		(759	)		(903	)		(887	)

Available to common stockholders	$	17,215		$	17,216		$	19,016		$	19,025		$	40,117		$	40,120		$	35,784		$	35,800

Discontinued operations, net of income taxes:
Loss from operations:
As reported in Statement of Operations	$	(897	)	$	(897	)	$	(528	)	$	(528	)	$	(1,478	)	$	(1,478	)	$	(3,048	)	$	(3,048	)
Allocation to participating unvested restricted stockholders		17			17			12			12			28			27			75			74

Available to common stockholders	$	(880	)	$	(880	)	$	(516	)	$	(516	)	$	(1,450	)	$	(1,451	)	$	(2,973	)	$	(2,974	)

Gain (loss) on divestiture of operations:
As reported in Statement of Operations	$	(24,051	)	$	(24,051	)	$	2,712		$	2,712		$	(24,051	)	$	(24,051	)	$	2,712		$	2,712
Allocation to participating unvested restricted stockholders		442			441			(64	)		(63	)		448			447			(67	)		(66	)

Available to common stockholders	$	(23,609	)	$	(23,610	)	$	2,648		$	2,649		$	(23,603	)	$	(23,604	)	$	2,645		$	2,646

Net income (loss):
As reported in Statement of Operations	$	(7,410	)	$	(7,410	)	$	21,661		$	21,661		$	15,350		$	15,350		$	36,351		$	36,351
Allocation to participating unvested restricted stockholders		136			136			(513	)		(503	)		(286	)		(285	)		(895	)		(879	)

Available to common stockholders	$	(7,274	)	$	(7,274	)	$	21,148		$	21,158		$	15,064		$	15,065		$	35,456		$	35,472

Shares used in the computation:
Weighted average shares outstanding – basic computation		38,307			38,307			37,714			37,714			38,246			38,246			37,579			37,579

Dilutive effect of employee stock options					108						760						120						694

Adjusted weighted average shares outstanding – diluted computation					38,415						38,474						38,366						38,273

Earnings (loss) per common share:
Income from continuing operations	$	0.45		$	0.45		$	0.50		$	0.49		$	1.05		$	1.05		$	0.95		$	0.94
Discontinued operations:
Loss from operations		(0.02	)		(0.02	)		(0.01	)		(0.01	)		(0.04	)		(0.04	)		(0.08	)		(0.08	)
Gain (loss) on divestiture of operations		(0.62	)		(0.62	)		0.07			0.07			(0.62	)		(0.62	)		0.07			0.07

Net income (loss)	$	(0.19	)	$	(0.19	)	$	0.56		$	0.55		$	0.39		$	0.39		$	0.94		$	0.93

Number of antidilutive stock options excluded from shares used in the diluted earnings (loss) per common share computation					3,030						408						3,030						544

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA

At June 30, 2009, the Company operated three business segments: the hospital division, the health services division and the rehabilitation division. The hospital division operates LTAC hospitals. The health services division operates nursing centers. The rehabilitation division provides rehabilitation services primarily in long-term care settings. For segment purposes, the Company defines operating income as earnings before interest, income taxes, depreciation, amortization and rent. Operating income reported for each of the Company’s business segments excludes the allocation of corporate overhead.

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

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


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Revenues:
Hospital division	$	487,145		$	461,064		$	979,654		$	937,231
Health services division		537,545			525,162			1,067,487			1,044,705
Rehabilitation division		120,450			106,318			238,097			210,817

		1,145,140			1,092,544			2,285,238			2,192,753
Eliminations		(72,086	)		(66,503	)		(142,710	)		(132,237	)

	$	1,073,054		$	1,026,041		$	2,142,528		$	2,060,516

Income from continuing operations:
Operating income (loss):
Hospital division	$	91,027		$	85,886		$	191,926		$	182,688
Health services division		79,522			87,962			155,096			161,253
Rehabilitation division		13,599			10,178			29,052			21,664
Corporate:
Overhead		(33,586	)		(33,200	)		(67,673	)		(68,131	)
Insurance subsidiary		(1,182	)		(1,347	)		(2,634	)		(2,850	)

		(34,768	)		(34,547	)		(70,307	)		(70,981	)

Operating income		149,380			149,479			305,767			294,624
Rent		(86,882	)		(85,860	)		(172,083	)		(169,483	)
Depreciation and amortization		(31,355	)		(30,545	)		(61,845	)		(61,103	)
Interest, net		(1,196	)		(572	)		(2,199	)		(2,246	)

Income from continuing operations before income taxes		29,947			32,502			69,640			61,792
Provision for income taxes		12,409			13,025			28,761			25,105

	$	17,538		$	19,477		$	40,879		$	36,687

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6 – BUSINESS SEGMENT DATA (Continued)


	Three months ended June 30,				Six months ended June 30,
	2009		2008		2009		2008
Rent:
Hospital division	$	36,834	$	37,750	$	73,279	$	73,657
Health services division		48,565		46,611		95,839		92,937
Rehabilitation division		1,459		1,393		2,910		2,751
Corporate		24		106		55		138

	$	86,882	$	85,860	$	172,083	$	169,483

Depreciation and amortization:
Hospital division	$	13,018	$	11,455	$	25,530	$	22,758
Health services division		12,038		13,292		23,723		27,184
Rehabilitation division		549		485		1,096		872
Corporate		5,750		5,313		11,496		10,289

	$	31,355	$	30,545	$	61,845	$	61,103

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	17,730	$	20,022	$	32,060	$	33,578
Health services division		11,946		10,744		33,786		17,879
Rehabilitation division		172		280		362		562
Corporate:
Information systems		8,838		8,616		12,291		12,448
Other		210		258		383		393

	$	38,896	$	39,920	$	78,882	$	64,860


	June 30, 2009		December 31, 2008
Assets at end of period:
Hospital division	$	875,750	$	847,394
Health services division		627,331		574,710
Rehabilitation division		48,948		45,733
Corporate		563,599		713,924

	$	2,115,628	$	2,181,761

Goodwill:
Hospital division	$	68,577	$	68,577
Health services division		889		639
Rehabilitation division		4,840		3,028

	$	74,306	$	72,244

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – INSURANCE RISKS

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

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

The provision for loss for insurance risks, including the cost of coverage maintained with unaffiliated commercial insurance carriers, follows (in thousands):


	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Professional liability:
Continuing operations	$	14,905		$	10,349		$	29,793		$	25,752
Discontinued operations		638			(2,020	)		508			(1,219	)

Workers compensation:
Continuing operations	$	9,317		$	6,227		$	19,163		$	16,277
Discontinued operations		(43	)		416			(890	)		972

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


	June 30, 2009						December 31, 2008
	Professional liability		Workers compensation		Total		Professional liability		Workers compensation		Total
Assets:
Current:
Insurance subsidiary investments	$	74,720	$	82,212	$	156,932	$	109,494	$	87,489	$	196,983
Reinsurance recoverables		89		–		89		89		–		89
Other		–		325		325		–		–		–

		74,809		82,537		157,346		109,583		87,489		197,072
Non-current:
Insurance subsidiary investments		52,196		–		52,196		48,610		–		48,610
Reinsurance recoverables		23,456		1,015		24,471		17,167		–		17,167
Deposits		5,000		1,547		6,547		2,000		1,466		3,466
Other		–		51		51		–		142		142

		80,652		2,613		83,265		67,777		1,608		69,385

	$	155,461	$	85,150	$	240,611	$	177,360	$	89,097	$	266,457

Liabilities:
Allowance for insurance risks:
Current	$	49,677	$	24,130	$	73,807	$	55,447	$	25,348	$	80,795
Non-current		209,116		60,071		269,187		187,804		57,993		245,797

	$	258,793	$	84,201	$	342,994	$	243,251	$	83,341	$	326,592

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7 – INSURANCE RISKS (Continued)

Provisions for loss for professional liability risks retained by the Company’s limited purpose insurance subsidiary have been discounted based upon actuarial estimates of claim payment patterns using a discount rate of 2% for the 2009 policy year, 3% for the 2008 policy year and 5% for all prior policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $265.8 million at June 30, 2009 and $251.8 million at December 31, 2008.

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

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS

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

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


	June 30, 2009									December 31, 2008
	Amortized cost		Unrealized gains		Unrealized losses			Fair value		Amortized cost		Unrealized gains		Unrealized losses			Fair value
Cash and cash equivalents (a)	$	102,473	$	–	$	–		$	102,473	$	118,148	$	–	$	–		$	118,148
Corporate bonds		42,173		651		(60	)		42,764		35,110		314		(698	)		34,726
Asset backed securities		39,433		527		(173	)		39,787		59,509		886		(292	)		60,103
Equities		14,087		450		(3,482	)		11,055		13,750		402		(3,307	)		10,845
Commercial paper		8,599		10		(11	)		8,598		9,825		34		–			9,859
U.S. Treasury notes		4,388		63		–			4,451		11,760		152		–			11,912

	$	211,153	$	1,701	$	(3,726	)	$	209,128	$	248,102	$	1,788	$	(4,297	)	$	245,593

(a)	Includes $5.7 million and $13.2 million of money market funds at June 30, 2009 and December 31, 2008, respectively.

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

The Company considered the unrealized losses related to its insurance subsidiary investments at June 30, 2009 to be temporary and did not record any impairment losses related to these investments in the second quarter or the six months ended June 30, 2009.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 8 – INSURANCE SUBSIDIARY INVESTMENTS (Continued)

The decrease in total fair value of insurance subsidiary investments at June 30, 2009 from December 31, 2008 was primarily attributable to a $34 million distribution from the insurance subsidiary to the Company during the six months ended June 30, 2009. This distribution was the result of improved professional liability underwriting results in prior years of the Company’s limited purpose insurance subsidiary.

NOTE 9 – LEASES

In April 2009, the Company provided Ventas with notices to renew the master lease agreements for an additional five years for 87 nursing centers and 22 LTAC hospitals (collectively, the “Renewal Facilities”). The initial lease term for the Renewal Facilities was scheduled to expire in April 2010. The Company’s option to renew the leases on the Renewal Facilities would have expired on April 30, 2009. No additional rent or other consideration was paid in connection with these renewals. The effectiveness of the renewals is contingent upon there being no events of default under the master lease agreements upon the renewal effective date in April 2010.

NOTE 10 – CONTINGENCIES

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

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

Principal contingencies are described below:

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

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

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

Litigation – The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations and sanctions in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. The U.S. Department of Justice (the “DOJ”), the Centers for Medicare and Medicaid Services (“CMS”) or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 10 – CONTINGENCIES (Continued)

Other indemnifications – In the ordinary course of business, the Company enters into contracts containing standard indemnification provisions and indemnifications specific to a transaction such as a disposal of an operating facility. These indemnifications may cover claims related to employment-related matters, governmental regulations, environmental issues and tax matters, as well as patient, third party payor, supplier and contractual relationships. Obligations under these indemnities generally are initiated by a breach of the terms of a contract or by a third party claim or event.

NOTE 11 – FAIR VALUE OF ASSETS AND LIABILITIES

On January 1, 2008, the Company adopted SFAS No. 157 (“SFAS 157”), “Fair Value Measurements,” which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles.

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:


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

Level 2		Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

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

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – FAIR VALUE OF ASSETS AND LIABILITIES (Continued)

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


	Fair value measurements						Assets/liabilities at fair value		Total gains (losses)
	Level 1		Level 2		Level 3		Assets/liabilities at fair value		Total gains (losses)
June 30, 2009:
Recurring:
Assets:
Available-for-sale securities	$	21,209	$	91,148	$	–	$	112,357	$	–
Deposits held in money market funds		20,856		–		–		20,856		–

	$	42,065	$	91,148	$	–	$	133,213	$	–

Liabilities	$	–	$	–	$	–	$	–	$	–

Non-recurring:
Assets:
Acquired previously leased nursing centers	$	–	$	–	$	25,000	$	25,000	$	(24,051	)

Liabilities	$	–	$	–	$	–	$	–	$	–

December 31, 2008:
Recurring:
Assets:
Available-for-sale securities	$	35,960	$	104,688	$	–	$	140,648	$	–
Deposits held in money market funds		124,539		–		–		124,539		–

	$	160,499	$	104,688	$	–	$	265,187	$	–

Liabilities	$	–	$	–	$	–	$	–	$	–

Recurring measurements

The Company’s available-for-sale securities are held by its wholly owned limited purpose insurance subsidiary and are comprised of money market funds, corporate bonds, asset backed securities, equities, commercial paper and U.S. Treasury notes. These available-for-sale securities and the insurance subsidiary’s cash and cash equivalents of $96.8 million, classified as insurance subsidiary investments, are maintained for the payment of claims and expenses related to professional liability and workers compensation risks.

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

The fair value of actively traded debt and equity securities and money market funds are based upon quoted market prices and are generally classified as Level 1. The fair value of inactively traded debt securities are based upon either quoted market prices of similar securities or observable inputs such as interest rates using either a market or income valuation approach and are generally classified as Level 2.

KINDRED HEALTHCARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 11 – FAIR VALUE OF ASSETS AND LIABILITIES (Continued)

Recurring measurements (Continued)

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


	June 30, 2009				December 31, 2008
(In thousands)	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	39,727	$	39,727	$	140,795	$	140,795
Cash–restricted		5,305		5,305		5,104		5,104
Insurance subsidiary investments		209,128		209,128		245,593		245,593
Tax refund escrow investments		216		216		216		216
Long-term debt, including amounts due within one year		274,874		274,843		349,514		349,503

Non-recurring measurements

In June 2009, the Company purchased the Nursing Centers from Ventas for $55.7 million. In addition, the Company paid a lease termination fee of $2.3 million. The Company used unobservable inputs for the valuation methodology that are significant to the fair value measurement and required management’s judgment related to the assumptions market participants would use in pricing the asset. The valuation of these assets also includes sales comparisons of similar properties and past transactions, in addition to expected proceeds negotiated with potential buyers. In accordance with SFAS 144, the assets had a carrying value of $61.4 million and were adjusted to a fair value of approximately $25 million, less cost to sell of $1.1 million, resulting in an impairment charge of $37.5 million ($23.1 million net of income taxes). In addition, another charge of $1.6 million ($0.9 million net of income taxes) was recorded related to the lease terminations, net of unamortized deferred rent credits.

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

Cautionary Statement

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

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

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

Cautionary Statement (Continued)

•

the increase in the costs of defending and insuring against alleged professional liability claims and the Company’s ability to predict the estimated costs related to such claims, including the impact of differences in actuarial assumptions and estimates compared to eventual outcomes,

•

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

•

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

•

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

•

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

•

changes in generally accepted accounting principles or practices, and

•

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

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

General

The accompanying unaudited condensed consolidated financial statements, including the notes thereto, should be read in conjunction with the following discussion and analysis.

The Company is a healthcare services company that through its subsidiaries operates hospitals, nursing centers and a contract rehabilitation services business across the United States. At June 30, 2009, the Company’s hospital division operated 82 LTAC hospitals (6,520 licensed beds) in 24 states. The Company’s health services division operated 222 nursing centers (27,623 licensed beds) in 27 states. The Company also operated a contract rehabilitation services business that provides rehabilitative services primarily in long-term care settings.

In recent years, the Company has completed several strategic divestitures to improve its future operating results. For accounting purposes, the operating results of these businesses and the gains, losses or impairments associated with these transactions have been classified as discontinued operations in the accompanying unaudited condensed consolidated statement of operations for all periods presented. Assets not sold at June 30, 2009 have been measured at the lower of carrying value or estimated fair value less costs of disposal and have been classified as held for sale in the accompanying unaudited condensed consolidated balance sheet.

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of commitments and contingencies. The Company relies on historical experience and on various other assumptions that management believes to be reasonable under the circumstances to make judgments about the carrying values of assets and

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

Critical Accounting Policies (Continued)

liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.

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

Revenue recognition

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

Operating results for the second quarter of 2008 included pretax income of approximately $8 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute.

Collectibility of accounts receivable

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

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

The provision for doubtful accounts totaled $8 million and $7 million for the second quarter of 2009 and 2008, respectively, and $15 million and $14 million for the six months ended June 30, 2009 and 2008, respectively.

Allowances for insurance risks

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

Critical Accounting Policies (Continued)

Allowances for insurance risks (Continued)

of 2% for the 2009 policy year, 3% for the 2008 policy year and 5% for all prior policy years. The discount rates are based upon the risk free interest rate for the respective year. Amounts equal to the discounted loss provision are funded annually. The Company does not fund the portion of professional liability risks related to estimated claims that have been incurred but not reported. Accordingly, these liabilities are not discounted. The allowance for professional liability risks aggregated $259 million at June 30, 2009 and $243 million at December 31, 2008. If the Company did not discount any of the allowances for professional liability risks, these balances would have approximated $266 million at June 30, 2009 and $252 million at December 31, 2008.

The Company received distributions from its limited purpose insurance subsidiary of $34 million and $39 million during the six months ended June 30, 2009 and 2008, respectively, as a result of improved professional liability underwriting results in prior years. These proceeds were used to repay borrowings under the Company’s revolving credit facility and had no impact on earnings.

Changes in the number of professional liability claims and the cost to settle these claims significantly impact the allowance for professional liability risks. A relatively small variance between the Company’s estimated and actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the allowance for professional liability risks. For example, a 1% variance in the allowance for professional liability risks at June 30, 2009 would impact the Company’s operating income by approximately $3 million.

The provision for professional liability risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $15 million and $11 million for the second quarter of 2009 and 2008, respectively, and $29 million and $26 million for the six months ended June 30, 2009 and 2008, respectively.

Provisions for loss for workers compensation risks retained by the Company’s limited purpose insurance subsidiary are not discounted and amounts equal to the loss provision are funded annually. The allowance for workers compensation risks aggregated $84 million at June 30, 2009 and $83 million at December 31, 2008. The provision for workers compensation risks (continuing operations), including the cost of coverage maintained with unaffiliated commercial insurance carriers, aggregated $9 million and $6 million for the second quarter of 2009 and 2008, respectively, and $19 million and $16 million for the six months ended June 30, 2009 and 2008, respectively.

Accounting for income taxes

The provision for income taxes is based upon the Company’s estimate of annual taxable income or loss for each respective accounting period. The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. The Company also recognizes as deferred tax assets the future tax benefits from net operating and capital loss carryforwards. A valuation allowance is provided for these deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

The Company’s effective income tax rate was 41.4% and 40.1% for the second quarter of 2009 and 2008, respectively, and 41.3% and 40.6% for the six months ended June 30, 2009 and 2008, respectively.

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

Critical Accounting Policies (Continued)

Accounting for income taxes (Continued)

There are significant uncertainties with respect to capital loss carryforwards that could affect materially the realization of certain deferred tax assets. Accordingly, the Company has recognized deferred tax assets to the extent it is more likely than not they will be realized and a valuation allowance is provided for deferred tax assets to the extent that it is uncertain that the deferred tax asset will be realized. The Company recognized net deferred tax assets totaling $183 million at June 30, 2009 and $159 million at December 31, 2008.

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

Valuation of long-lived assets and goodwill

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

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

The Company’s other intangible assets with finite lives are amortized under SFAS No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets,” using the straight-line method over their estimated useful lives ranging from one to five years.

In accordance with SFAS 142, the Company is required to perform an impairment test for goodwill and indefinite lived intangible assets at least annually or more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. The Company performs its annual goodwill impairment test at the end of each fiscal year for each of its reporting units. A reporting unit is either an operating segment or one level below the operating segment, referred to as a component. Because the components within the Company’s operating segments have similar economic characteristics, the Company aggregates the components of its operating segments into one reporting unit. Accordingly, the Company has determined that its reporting units are hospitals, nursing centers, and rehabilitation services.

The goodwill impairment test involves a two-step process. The first step is a comparison of each reporting unit’s fair value to its carrying value. If the carrying value of the reporting unit is greater than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. Based upon the results of the step one impairment test for goodwill and the impairment test of indefinite lived intangible assets, no impairment charges were recorded in connection with the Company’s annual impairment tests at December 31, 2008.

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

Critical Accounting Policies (Continued)

Valuation of long-lived assets and goodwill (Continued)

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

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

The Company has determined that during the first six months of 2009 there were no events or changes in circumstances since December 31, 2008 requiring an interim impairment test. Although the Company has determined that there was no goodwill or other indefinite lived intangible asset impairments as of June 30, 2009 and December 31, 2008, continued declines in the value of the Company’s common stock or adverse changes in the operating environment and related key assumptions used to determine the fair value of the Company’s reporting units and indefinite lived intangible assets may result in future impairment charges for a portion or all of these assets. An impairment charge could have a material adverse effect on the Company’s business, financial position and results of operations, but would not be expected to have an impact on the Company’s cash flows or liquidity.

Recently Issued Accounting Pronouncements

In June 2009, the FASB issued SFAS 168, which identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This statement establishes the FASB Codification as the sole source of authoritative accounting principles recognized by the FASB. SFAS 168 is effective for all financial statements issued for interim and annual reporting periods beginning after September 15, 2009. The adoption of SFAS 168 is not expected to have an impact on the Company’s business, financial position, results of operations or liquidity.

In May 2009, the FASB issued SFAS 165, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are

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

Recently Issued Accounting Pronouncements (Continued)

available to be issued. This statement requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. SFAS 165 is effective for all interim and annual reporting periods beginning after June 15, 2009. The adoption of SFAS 165 is not expected to have an impact on the Company’s business, financial position, results of operations or liquidity.

In April 2009, the FASB issued the following guidance related to fair value measurements and disclosures and the recognition of other-than-temporary impairments of financial instruments:

•

SFAS 157-4, which provides additional guidance for determining whether the market for a security is inactive and whether transactions in inactive markets are distressed.

•

SFAS 115-2 and SFAS 124-2, which clarify the recognition and measurement of other-than-temporary impairments of debt and equity securities.

•

SFAS 107-1 and APB 28-1, which require an entity to provide disclosures about the fair value of financial instruments in both interim and annual financial statements.

On January 1, 2009, the Company adopted EITF 03-6-1, which requires that unvested restricted stock that entitles the holder to receive nonforfeitable dividends before vesting be included as a participating security in the basic and diluted earnings (loss) per common share calculation pursuant to the two-class method. The adoption of EITF 03-6-1 has been applied retrospectively in the accompanying unaudited condensed consolidated financial statements and did not have a material impact on the Company’s earnings (loss) per common share calculations.

In December 2007, the FASB issued SFAS 141R, which significantly changes the accounting for business combinations, including, among other changes, new accounting concepts in determining the fair value of assets and liabilities acquired, recording the fair value of contingent considerations and contingencies at the acquisition date and expensing acquisition and restructuring costs. SFAS 141R is applied prospectively and is effective for business combinations which occur during fiscal years beginning after December 15, 2008. The Company’s adoption of SFAS 141R on January 1, 2009 did not have a material impact on the Company’s business, financial position, results of operations or liquidity at June 30, 2009 or for the six months ended June 30, 2009. However, any future business combinations may significantly impact the Company’s financial position and results of operations when compared to acquisitions accounted for under the previous generally accepted accounting principles and may result in more earnings volatility and generally lower earnings due to the expensing of acquisition costs and restructuring costs.

In April 2009, the FASB issued SFAS 141(R)-1, which will amend the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination under SFAS 141R. SFAS 141(R)-1 is effective for all business combinations which occur during fiscal years beginning after December 15, 2008. The Company’s adoption of SFAS 141(R)-1 retroactive to January 1, 2009 did not have a material impact on the Company’s business, financial position, results of operations or liquidity.

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

Results of Operations – Continuing Operations

Hospital division

Revenues increased 6% in the second quarter of 2009 to $487 million compared to $461 million in the second quarter of 2008 and increased 5% to $980 million for the six months ended June 30, 2009 from $937 million in the same period in 2008. Revenue growth in both periods was primarily a result of reimbursement rate increases associated with higher average patient acuity levels, increases in admissions and ongoing development of new hospitals. Aggregate admissions increased 2% in the second quarter of 2009 compared to the same period last year. On a same-store basis, aggregate admissions rose 2% in the second quarter of 2009 and rose 1% for the six months ended June 30, 2009 compared to the same periods in 2008, while non-government same-store admissions increased 12% in both the second quarter and for the six months ended June 30, 2009 compared to the same periods in 2008.

Hospital operating margins were relatively unchanged in the second quarter of 2009 and for the six months ended June 30, 2009 compared to the same periods in 2008. Reimbursement rate increases were offset by the increased costs of providing services to higher acuity patients. Hospital wage and benefit costs increased 5% to $221 million in the second quarter of 2009 from $210 million in the same period in 2008 and increased 3% to $439 million for the six months ended June 30, 2009 from $424 million in the same period in 2008. Average hourly wage rates grew 3% in the second quarter of 2009 and 2% for the six months ended June 30, 2009 compared to the respective prior year periods, while employee benefit costs increased 14% in the second quarter of 2009 and 8% for the six months ended June 30, 2009 compared to the respective prior year periods.

Professional liability costs were $7 million and $3 million in the second quarter of 2009 and 2008, respectively, and $13 million and $9 million for the six months ended June 30, 2009 and 2008, respectively. The increase in professional liability costs in the second quarter and the six months ended June 30, 2009 was primarily the result of increased claims frequency.

Health services division

Revenues increased 2% in the second quarter of 2009 to $538 million compared to $526 million in the second quarter of 2008 and increased 2% to $1.1 billion for the six months ended June 30, 2009 from $1.0 billion in the same period in 2008. Revenue growth in both periods was primarily attributable to reimbursement rate increases that reflected both inflationary adjustments and higher average patient acuity. On a same-store basis, aggregate patient days declined 1% in the second quarter of 2009 and declined 2% for the six months ended June 30, 2009 compared to the respective prior year periods. Same-store Medicare patient days declined 5% and non-government same-store patient days increased 5% in the second quarter of 2009 compared to the same period in 2008. Same-store Medicare patient days declined 6% and non-government same-store patient days increased 3% for the six months ended June 30, 2009 compared to the same period in 2008.

Operating results for the second quarter of 2008 also included pretax income of approximately $8 million related to the favorable settlement of a prior year nursing center Medicaid cost report dispute.

Nursing center operating margins declined in the second quarter of 2009 and for the six months ended June 30, 2009 compared to the same periods in 2008 as growth in labor costs exceeded revenue growth for both periods. Nursing center wage and benefit costs increased 4% to $272 million in the second quarter of 2009 from $261 million in the same period in 2008 and increased 3% to $545 million for the six months ended June 30, 2009 from $527 million in the same period in 2008. Average hourly wage rates grew 2% in both the second

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

Results of Operations – Continuing Operations (Continued)

Health services division (Continued)

quarter of 2009 and for the six months ended June 30, 2009 compared to the respective prior year periods, while employee benefit costs increased 13% in the second quarter of 2009 and 9% for the six months ended June 30, 2009 compared to the respective prior year periods.

Professional liability costs were $8 million and $7 million in the second quarter of 2009 and 2008, respectively, and $16 million for the six months ended June 30, 2009 and 2008.

Rehabilitation division

Revenues increased 13% in the second quarter of 2009 to $121 million compared to $106 million in the second quarter of 2008 and increased 13% to $238 million for the six months ended June 30, 2009 from $211 million in the same period in 2008. The increase in revenues in both periods was primarily attributable to growth in new contracts and the volume of services provided to existing customers. Revenues derived from unaffiliated customers aggregated $49 million and $40 million in the second quarter of 2009 and 2008, respectively, and $95 million and $79 million for the six months ended June 30, 2009 and 2008, respectively.

Operating margins in both the second quarter of 2009 and for the six months ended June 30, 2009 increased primarily due to improvements in therapist productivity levels and the volume of services provided to existing customers.

Corporate overhead

Operating income for the Company’s operating divisions excludes allocations of corporate overhead. These costs aggregated $34 million and $33 million in the second quarter of 2009 and 2008, respectively, and $68 million for each of the six months ended June 30, 2009 and 2008. As a percentage of consolidated revenues, corporate overhead totaled 3.1% and 3.2% in the second quarter of 2009 and 2008, respectively, and totaled 3.2% and 3.3% for the six months ended June 30, 2009 and 2008, respectively.

Corporate expenses included the operating losses from the Company’s limited purpose insurance subsidiary of $1 million and $2 million in the second quarter of 2009 and 2008, respectively, and $2 million and $3 million for the six months ended June 30, 2009 and 2008, respectively.

Capital costs

Rent expense increased 1% to $87 million in the second quarter of 2009 compared to the second quarter of 2008 and increased 2% to $172 million for the six months ended June 30, 2009 from $170 million in the same period in 2008. Rent expense in the second quarter of 2008 included a charge of approximately $2 million related to a prior period rent escalator adjustment for ten leased facilities. The increase in both periods resulted primarily from contractual inflation and contingent rent increases.

Depreciation and amortization expense increased 3% in the second quarter of 2009 to $32 million compared to $30 million in the second quarter of 2008 and increased 1% to $62 million for the six months ended June 30, 2009 from $61 million in the same period in 2008. The increase in both periods was primarily a result of the Company’s ongoing capital expenditure program.

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

Results of Operations – Continuing Operations (Continued)

Capital costs (Continued)

Interest expense aggregated $3 million in the second quarter of both 2009 and 2008 and aggregated $5 million and $8 million for the six months ended June 30, 2009 and 2008, respectively. The decline for the six months ended June 30, 2009 was primarily attributable to lower interest rates under the Company’s revolving credit facility compared to the same period last year.

Investment income related primarily to the Company’s insurance subsidiary investments totaled $2 million and $3 million in the second quarter of 2009 and 2008, respectively, and totaled $3 million and $6 million for the six months ended June 30, 2009 and 2008, respectively. The decline in both periods was primarily attributable to lower investment yields on the Company’s insurance subsidiary’s investment portfolio compared to the same periods last year.

Consolidated results

Income from continuing operations before income taxes decreased 8% to $30 million in the second quarter of 2009 compared to $33 million in the second quarter of 2008 and increased 13% to $70 million for the six months ended June 30, 2009 from $62 million in the same period in 2008. Income from continuing operations decreased 10% to $17 million in the second quarter of 2009 compared to $19 million in the second quarter of 2008 and increased 11% to $41 million for the six months ended June 30, 2009 from $36 million in the same period in 2008.

Results of Operations – Discontinued Operations

Loss from discontinued operations aggregated $1 million in the second quarter of both 2009 and 2008, and aggregated $2 million and $3 million for the six months ended June 30, 2009 and 2008, respectively. In the second quarter of 2009, the Company recorded a net loss of $24 million related to the planned divestiture of the Nursing Centers. In the second quarter of 2008, the Company recorded a net gain of $3 million related to the divestiture of discontinued operations.

Liquidity

Operating cash flows

Cash flows provided by operations (including discontinued operations) aggregated $87 million for the six months ended June 30, 2009 compared to $34 million for the same period in 2008. Operating cash flows were favorably impacted by federal income tax refunds of $25 million for each of the six months ended June 30, 2009 and 2008. During both periods, the Company maintained sufficient liquidity to fund its ongoing capital expenditure program and finance ongoing hospital development expenditures, as well as its acquisition and strategic divestiture activities.

Cash and cash equivalents totaled $40 million at June 30, 2009 compared to $141 million at December 31, 2008. The Company’s long-term debt at June 30, 2009 aggregated $275 million compared to $350 million at December 31, 2008 (substantially all of which related to borrowings under the Company’s revolving credit facility at each date). Based upon the Company’s existing cash levels, expected operating cash flows and capital spending (including planned acquisition and development activities), and the availability of borrowings under the Company’s revolving credit facility, management believes that the Company has the necessary financial resources to satisfy its expected short-term and long-term liquidity needs.

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

Liquidity (Continued)

Strategic divestitures

In June 2009, the Company purchased the Nursing Centers from Ventas for approximately $56 million. In addition, the Company paid a lease termination fee of approximately $2 million. The Nursing Centers were included in master lease agreements with Ventas and the Company does not have the ability to terminate a lease of an individual facility. The aggregate annual rent for the Nursing Centers was approximately $6 million for the year ended December 31, 2008. The Nursing Centers, which contained 777 licensed beds, generated pretax losses of approximately $3 million for both the year ended December 31, 2008 and for the six months ended June 30, 2009. The Company expects to generate approximately $25 million in proceeds from the sales of the Nursing Centers. The fair value of the Nursing Centers is classified as Level 3 in the fair value hierarchy, as defined in SFAS 157. See Note 11 of the accompanying Notes to Condensed Consolidated Financial Statements.

The Company expects to dispose of two hospitals in 2009 and generate approximately $8 million in proceeds from the sales.

During the six months ended June 30, 2008, the Company sold five nursing centers and one hospital for approximately $27 million.

Revolving credit facility and financing activities

Under the terms of the Company’s $500 million revolving credit facility, the aggregate amount of the credit may be increased to $600 million at the Company’s option subject to lender approval and certain other conditions. The term of the Company’s revolving credit facility expires in July 2012.

Interest rates under the Company’s revolving credit facility are based, at the Company’s option, upon (a) the London Interbank Offered Rate (“LIBOR”) plus the applicable margin or (b) the applicable margin plus the higher of the prime rate or 0.5% over the federal funds rate. The Company’s revolving credit facility is collateralized by substantially all of the Company’s assets including certain owned real property and is guaranteed by substantially all of the Company’s subsidiaries. The terms of the Company’s revolving credit facility include a certain defined fixed payment ratio covenant and covenants which limit acquisitions and annual capital expenditures. The Company was in compliance with the terms of its revolving credit facility at June 30, 2009.

Despite the recent turmoil within the financial markets both nationally and globally, the Company is not aware of any individual lender limitations to extend credit under its revolving credit facility. However, the obligations of each of the lending institutions in the Company’s revolving credit facility are separate and the availability of future borrowings under the Company’s revolving credit facility could be impacted by the ongoing volatility and disruptions in the financial credit markets or other events.

In April 2009, the Company provided Ventas with notices to renew the master lease agreements for an additional five years for the Renewal Facilities. The initial lease term for the Renewal Facilities was scheduled to expire in April 2010. The Company’s option to renew the leases on the Renewal Facilities would have expired on April 30, 2009. No additional rent or other consideration was paid in connection with these renewals. The effectiveness of the renewals is contingent upon there being no events of default under the master lease agreements upon the renewal effective date in April 2010.

In May 2008, the Company received a cash distribution of $7 million related to a partnership land sale. The Company has a noncontrolling ownership interest in the partnership which is accounted for under the equity method of accounting. No gain or loss was recognized on the land sale.

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

Liquidity (Continued)

Revolving credit facility and financing activities (Continued)

In April 2008, the Company repaid a capital lease obligation of approximately $16 million in connection with a purchase option under a hospital lease agreement.

Capital Resources

Excluding acquisitions, capital expenditures totaled $79 million for the six months ended June 30, 2009 compared to $65 million for the same period in 2008. Excluding acquisitions, routine capital expenditures could approximate $100 million to $110 million in 2009, while hospital development could approximate $50 million to $60 million in 2009. Management believes that its capital expenditure program is adequate to improve and equip existing facilities. The Company’s capital expenditure program is financed generally through the use of internally generated funds. At June 30, 2009, the estimated cost to complete and equip construction in progress approximated $34 million.

At June 30, 2009, the Company’s remaining permitted acquisition amount under its revolving credit facility aggregated $224 million.

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

During the second quarter of 2008, the Company acquired four nursing centers that were previously leased for approximately $24 million.

Other Information

Effects of inflation and changing prices

The Company derives a substantial portion of its revenues from the Medicare and Medicaid programs. Currently, Congress is considering various healthcare reforms that could materially impact the Medicare and Medicaid programs that could have a material adverse effect on the Company’s business, financial position, results of operations and liquidity. In addition, Congress and certain state legislatures have enacted or may enact additional significant cost containment measures limiting the Company’s ability to recover its cost increases through increased pricing of its healthcare services. Medicare revenues in LTAC hospitals and nursing centers are subject to fixed payments under the Medicare prospective payment systems.

Medicaid reimbursement rates in many states in which the Company operates nursing centers also are based upon fixed payment systems. Generally, these rates are adjusted annually for inflation. However, these adjustments may not reflect the actual increase in the costs of providing healthcare services.

LTAC PPS maintains LTAC hospitals as a distinct provider type, separate from short-term acute care hospitals. Only providers certified as LTAC hospitals may be paid under this system. To maintain certification under LTAC PPS, a hospital’s average length of stay for Medicare patients must be at least 25 days.

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

Other Information (Continued)

Effects of inflation and changing prices (Continued)

CMS is currently evaluating various certification criteria for designating a hospital as a LTAC hospital. If such certification criteria were developed and enacted into legislation, the Company’s hospitals may not be able to maintain their status as LTAC hospitals or may need to adjust their operations.

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

(1)

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

(2)

enhanced medical necessity review of LTAC hospital cases;

(3)

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

(4)

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

(5)

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

(6)

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

(7)

a three-year moratorium on the application of the so-called “25 Percent Rule” to freestanding LTAC hospitals;

(8)

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

(9)

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

(10)

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

On May 1, 2007, CMS issued regulatory changes regarding Medicare reimbursement for LTAC hospitals (the “2007 Final Rule”) that became effective for discharges occurring on or after July 1, 2007. The 2007 Final Rule was amended on June 29, 2007 by revising the high cost outlier threshold. The 2007 Final Rule projected an overall decrease in payments to all Medicare certified LTAC hospitals of approximately 1.2%. Included in the 2007 Final Rule were (1) an increase to the standard federal payment rate of 0.71% (which was eliminated for discharges occurring on or after April 1, 2008 by the SCHIP Extension Act); (2) revisions to payment methodologies impacting short-stay outliers, which reduce payments by 0.9% (currently subject to a three-year moratorium pursuant to the SCHIP Extension Act); (3) adjustments to the wage index component of the federal payment resulting in projected reductions in payments of 0.5%; (4) an increase in the high cost outlier threshold per discharge to $20,707, resulting in projected reductions of 0.4%; and (5) an extension of the policy known as the “25 Percent Rule” to all LTAC hospitals, with a three-year phase-in, which CMS projected would not result in payment reductions for the first year of implementation (also currently subject to a three-year moratorium pursuant to the SCHIP Extension Act).

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

Other Information (Continued)

Effects of inflation and changing prices (Continued)

In the 2007 Final Rule, the so-called “25 Percent Rule” was expanded to all LTAC hospitals, regardless of whether they are co-located with another hospital. Under the 2007 Final Rule, all LTAC hospitals were to be paid the LTAC PPS rates for admissions from a single referral source up to 25% of aggregate Medicare admissions. Patients reaching high cost outlier status in the short-term hospital were not to be counted when computing the 25% limit. Admissions beyond the 25% threshold were to be paid at a lower amount based upon short-term acute care hospital rates. However, as set forth above, the SCHIP Extension Act has placed a three-year moratorium on the expansion of the “25 Percent Rule” to freestanding hospitals. In addition, the SCHIP Extension Act provides for a three-year period during which (1) LTAC hospitals that are co-located with another hospital may admit up to 50% of their patients from their host hospitals and still be paid according to LTAC PPS, and (2) LTAC hospitals that are co-located with an urban single hospital or a MSA Dominant hospital may admit up to 75% of their patients from such urban single or MSA Dominant hospital and still be paid according to LTAC PPS.

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

CMS has regulations governing payments to LTAC hospitals that are co-located with another hospital, such as a hospital-in-hospital (“HIH”). The rules generally limit Medicare payments to the HIH if the Medicare admissions to the HIH from the host hospital exceed 25% of the total Medicare discharges for the HIH’s cost reporting period. There are limited exceptions for admissions from rural, urban single and MSA Dominant hospitals. Admissions that exceed this “25 Percent Rule” are paid using the short-term acute care inpatient payment system (“IPPS”). Patients transferred after they have reached the short-term acute care outlier payment status are not counted toward the admission threshold. Patients admitted prior to meeting the admission threshold, as well as Medicare patients admitted from a non-host hospital, are eligible for the full payment under LTAC PPS. If the HIH’s admissions from the host hospital exceed the limit in a cost reporting period, Medicare will pay the lesser of (1) the amount payable under LTAC PPS or (2) the amount payable under IPPS. At June 30, 2009, the Company operated 16 HIHs with 692 licensed beds.

On August 1, 2007, CMS issued final regulations regarding Medicare hospital inpatient payments to short-term acute care hospitals as well as certain provisions affecting LTAC hospitals. These regulations adopt a new system for classifying patients into diagnostic categories called Medicare Severity Diagnosis Related Groups or more specifically, for LTAC hospitals, “MS-LTC-DRGs.” LTAC PPS is based upon discharged-based MS-LTC-DRGs similar to the system used to pay short-term acute care hospitals. This new MS-LTC-DRG system replaces the previous diagnostic related group system for LTAC hospitals and became effective for discharges occurring on or after October 1, 2007. The MS-LTC-DRG system creates additional severity-adjusted categories for most diagnoses, resulting in an expansion of the aggregate number of diagnostic groups from 538 to 745. CMS stated that MS-LTC-DRG weights were developed in a budget neutral manner and as such, the estimated aggregate payments under LTAC PPS would be unaffected by the annual recalibration of MS-LTC-DRG payment weights.

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

Other Information (Continued)

Effects of inflation and changing prices (Continued)

On July 31, 2008, CMS issued final regulations regarding the re-weighting of MS-LTC-DRGs for discharges occurring on or after October 1, 2008. CMS announced that this update was made in a budget neutral manner, and that estimated aggregate LTAC Medicare payments would be unaffected by these regulations. Based upon the Company’s experience under these final regulations, it appears that the re-weighting increased payments for the care of higher acuity patients. On May 29, 2009, CMS issued an interim final rule that revised the October 1, 2008 payment weights. Effective June 3, 2009, CMS reduced MS-LTC-DRG payment weights by 3.9%, resulting in approximately a 0.9% reduction of the estimated total LTAC PPS payments in the federal fiscal year ending September 30, 2009. No retroactive adjustments to payments were made. On July 31, 2009, CMS finalized this interim rule without changes.

On July 31, 2009, CMS issued final regulations regarding Medicare reimbursement for LTAC hospitals for the fiscal year beginning October 1, 2009. These final regulations include a recalibration of the MS-LTC-DRG payment weights as well as updates to the payment rates. CMS indicated that these changes will result in a 3.3% increase to average Medicare payments to LTAC hospitals. The reductions that resulted from a recalibration of MS-LTC-DRG payment weights on June 3, 2009 are incorporated into the final October 1, 2009 payment weights.

The Company cannot predict the ultimate long-term impact of LTAC PPS. This payment system is subject to significant change. Slight variations in patient acuity or length of stay could significantly change Medicare revenues generated under LTAC PPS. In addition, the Company’s hospitals may not be able to appropriately adjust their operating costs to changes in patient acuity and length of stay or to changes in reimbursement rates. In addition, there can be no assurance that LTAC PPS will not have a material adverse effect on revenues from non-government third party payors. Various factors, including a reduction in average length of stay, have negatively impacted revenues from non-government third party payors in recent years.

On July 31, 2008, CMS issued final regulations regarding Medicare reimbursement for nursing centers for the fiscal year beginning October 1, 2008. These regulations included, among other things, a market basket increase to the federal payment rates of 3.4% and updates to the wage indexes which adjust the federal payment. CMS estimates that the overall impact of these proposed changes will be a net increase in payments of 3.4%.

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

In addition, for the fiscal year beginning October 1, 2010, CMS will increase the number of RUG categories for nursing centers from 53 to 66 and amend the criteria, including the provision of therapy services, currently used to classify patients into these categories. CMS has indicated that these changes will be enacted in a budget neutral manner. While the Company is unable to estimate the impact of these changes, the operating results of its contract rehabilitation services business may be adversely affected.

On February 1, 2006, Congress passed the Deficit Reduction Act of 2005. This legislation provided for, among other things, an annual $1,740 Medicare Part B outpatient therapy cap that was effective on January 1, 2006. CMS subsequently increased the therapy cap to $1,780 on January 1, 2007, to $1,810 on January 1, 2008 and to $1,840 on January 1, 2009. The legislation also required CMS to implement a broad process for reviewing

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

Other Information (Continued)

Effects of inflation and changing prices (Continued)

medically necessary therapy claims, creating an exception to the cap. The exception process, which was set to expire on January 1, 2007, was included in the Tax Relief and Health Care Act of 2006 and continued to function as an exception to the Medicare Part B outpatient therapy cap until January 1, 2008. The SCHIP Extension Act further extended the Medicare Part B outpatient therapy cap until June 30, 2008. The Medicare Improvements for Patients and Providers Act of 2008, enacted on July 15, 2008, extended the therapy cap exception process from July 1, 2008 to December 31, 2009.

The Company believes that its operating margins may continue to be under pressure because of deterioration in pricing flexibility, changes in payor mix, changes in length of stay and growth in operating expenses in excess of increases in payments by third party payors. In addition, as a result of competitive pressures, the Company’s ability to maintain operating margins through price increases to private patients is limited.

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

Condensed Consolidated Statement of Operations

(Unaudited)

(In thousands, except per share amounts)


	2008 Quarters												2009 Quarters
	First			Second			Third			Fourth			First			Second
Revenues	$	1,034,475		$	1,026,041		$	997,129		$	1,036,219		$	1,069,474		$	1,073,054

Salaries, wages and benefits		592,240			587,416			597,216			597,291			615,218			620,830
Supplies		77,834			80,769			77,766			80,780			80,336			83,912
Rent		83,623			85,860			84,865			84,325			85,201			86,882
Other operating expenses		223,973			213,544			207,773			209,093			220,405			221,755
Other income		(4,717	)		(5,167	)		(4,313	)		(3,210	)		(2,872	)		(2,823	)
Depreciation and amortization		30,558			30,545			29,174			29,745			30,490			31,355
Interest expense		4,921			2,907			3,710			3,835			2,478			2,229
Investment income		(3,247	)		(2,335	)		(671	)		(843	)		(1,475	)		(1,033	)

		1,005,185			993,539			995,520			1,001,016			1,029,781			1,043,107

Income from continuing operations before income taxes		29,290			32,502			1,609			35,203			39,693			29,947
Provision (benefit) for income taxes		12,080			13,025			(510	)		13,549			16,352			12,409

Income from continuing operations		17,210			19,477			2,119			21,654			23,341			17,538
Discontinued operations, net of income taxes:
Income (loss) from operations		(2,520	)		(528	)		(1,321	)		970			(581	)		(897	)
Gain (loss) on divestiture of operations		–			2,712			(22,058	)		(1,430	)		–			(24,051	)

Net income (loss)	$	14,690		$	21,661		$	(21,260	)	$	21,194		$	22,760		$	(7,410	)

Earnings (loss) per common share:
Basic:
Income from continuing operations	$	0.45		$	0.50		$	0.05		$	0.56		$	0.60		$	0.45
Discontinued operations:
Income (loss) from operations		(0.07	)		(0.01	)		(0.03	)		0.02			(0.02	)		(0.02	)
Gain (loss) on divestiture of operations		–			0.07			(0.57	)		(0.04	)		–			(0.62	)

Net income (loss)	$	0.38		$	0.56		$	(0.55	)	$	0.54		$	0.58		$	(0.19	)

Diluted:
Income from continuing operations	$	0.44		$	0.49		$	0.05		$	0.55		$	0.60		$	0.45
Discontinued operations:
Income (loss) from operations		(0.06	)		(0.01	)		(0.03	)		0.03			(0.02	)		(0.02	)
Gain (loss) on divestiture of operations		–			0.07			(0.56	)		(0.04	)		–			(0.62	)

Net income (loss)	$	0.38		$	0.55		$	(0.54	)	$	0.54		$	0.58		$	(0.19	)

Shares used in computing earnings (loss) per common share:
Basic		37,444			37,714			38,034			38,123			38,184			38,307
Diluted		38,061			38,474			38,894			38,265			38,315			38,415

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

Operating Data

(Unaudited)

(In thousands)


	2008 Quarters												2009 Quarters
	First			Second			Third			Fourth			First			Second
Revenues:
Hospital division	$	476,167		$	461,064		$	434,774		$	465,317		$	492,509		$	487,145
Health services division		519,543			525,162			521,074			527,518			529,942			537,545
Rehabilitation division		104,499			106,318			106,796			109,707			117,647			120,450

		1,100,209			1,092,544			1,062,644			1,102,542			1,140,098			1,145,140
Eliminations		(65,734	)		(66,503	)		(65,515	)		(66,323	)		(70,624	)		(72,086	)

	$	1,034,475		$	1,026,041		$	997,129		$	1,036,219		$	1,069,474		$	1,073,054

Income from continuing operations:
Operating income (loss):
Hospital division	$	96,802		$	85,886		$	64,818		$	97,861		$	100,899		$	91,027
Health services division		73,291			87,962			79,133			81,428			75,574			79,522
Rehabilitation division		11,486			10,178			7,448			8,959			15,453			13,599
Corporate:
Overhead		(34,931	)		(33,200	)		(30,937	)		(33,951	)		(34,087	)		(33,586	)
Insurance subsidiary		(1,503	)		(1,347	)		(1,775	)		(2,032	)		(1,452	)		(1,182	)

		(36,434	)		(34,547	)		(32,712	)		(35,983	)		(35,539	)		(34,768	)

Operating income		145,145			149,479			118,687			152,265			156,387			149,380
Rent		(83,623	)		(85,860	)		(84,865	)		(84,325	)		(85,201	)		(86,882	)
Depreciation and amortization		(30,558	)		(30,545	)		(29,174	)		(29,745	)		(30,490	)		(31,355	)
Interest, net		(1,674	)		(572	)		(3,039	)		(2,992	)		(1,003	)		(1,196	)

Income from continuing operations before income taxes		29,290			32,502			1,609			35,203			39,693			29,947
Provision (benefit) for income taxes		12,080			13,025			(510	)		13,549			16,352			12,409

	$	17,210		$	19,477		$	2,119		$	21,654		$	23,341		$	17,538

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

Operating Data (Continued)

(Unaudited)

(In thousands)


	2008 Quarters								2009 Quarters
	First		Second		Third		Fourth		First		Second
Rent:
Hospital division	$	35,907	$	37,750	$	36,461	$	36,198	$	36,445	$	36,834
Health services division		46,326		46,611		46,972		46,703		47,274		48,565
Rehabilitation division		1,358		1,393		1,405		1,399		1,451		1,459
Corporate		32		106		27		25		31		24

	$	83,623	$	85,860	$	84,865	$	84,325	$	85,201	$	86,882

Depreciation and amortization:
Hospital division	$	11,303	$	11,455	$	11,719	$	13,673	$	12,512	$	13,018
Health services division		13,892		13,292		11,536		9,925		11,685		12,038
Rehabilitation division		387		485		547		546		547		549
Corporate		4,976		5,313		5,372		5,601		5,746		5,750

	$	30,558	$	30,545	$	29,174	$	29,745	$	30,490	$	31,355

Capital expenditures, excluding acquisitions (including discontinued operations):
Hospital division	$	13,556	$	20,022	$	19,736	$	15,903	$	14,330	$	17,730
Health services division		7,135		10,744		19,746		12,468		21,840		11,946
Rehabilitation division		282		280		271		329		190		172
Corporate:
Information systems		3,832		8,616		7,051		6,864		3,453		8,838
Other		135		258		489		960		173		210

	$	24,940	$	39,920	$	47,293	$	36,524	$	39,986	$	38,896

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

Operating Data (Continued)

(Unaudited)


	2008 Quarters								2009 Quarters
	First		Second		Third		Fourth		First		Second
Hospital data:
End of period data:
Number of hospitals		81		81		82		82		82		82
Number of licensed beds		6,358		6,358		6,428		6,482		6,520		6,520
Revenue mix %:
Medicare		57		56		54		55		56		55
Medicaid		9		9		11		11		10		10
Medicare Advantage		8		9		9		10		10		11
Commercial insurance and other		26		26		26		24		24		24
Admissions:
Medicare		7,920		7,268		6,786		7,054		7,421		7,117
Medicaid		1,034		1,008		1,148		1,043		1,052		1,053
Medicare Advantage		901		849		869		968		1,094		1,091
Commercial insurance and other		1,814		1,799		1,748		1,727		1,921		1,869

		11,669		10,924		10,551		10,792		11,488		11,130

Admissions mix %:
Medicare		68		67		64		65		65		64
Medicaid		9		9		11		10		9		9
Medicare Advantage		8		8		8		9		9		10
Commercial insurance and other		15		16		17		16		17		17
Patient days:
Medicare		216,737		210,064		188,832		190,794		197,377		197,203
Medicaid		50,335		50,676		54,108		53,304		50,868		50,485
Medicare Advantage		28,453		29,219		28,529		31,744		35,229		36,806
Commercial insurance and other		66,270		67,847		64,449		63,688		65,509		61,960

		361,795		357,806		335,918		339,530		348,983		346,454

Average length of stay:
Medicare		27.4		28.9		27.8		27.0		26.6		27.7
Medicaid		48.7		50.3		47.1		51.1		48.4		47.9
Medicare Advantage		31.6		34.4		32.8		32.8		32.2		33.7
Commercial insurance and other		36.5		37.7		36.9		36.9		34.1		33.2
Weighted average		31.0		32.8		31.8		31.5		30.4		31.1
Revenues per admission:
Medicare	$	34,128	$	35,717	$	34,721	$	36,029	$	37,262	$	37,748
Medicaid		41,853		42,271		40,798		50,577		45,160		45,759
Medicare Advantage		42,167		46,448		45,679		46,305		46,387		46,950
Commercial insurance and other		68,691		66,385		64,431		65,774		61,286		63,716
Weighted average		40,806		42,206		41,207		43,117		42,872		43,769
Revenues per patient day:
Medicare	$	1,247	$	1,236	$	1,248	$	1,332	$	1,401	$	1,362
Medicaid		860		841		866		990		934		954
Medicare Advantage		1,335		1,350		1,391		1,412		1,440		1,392
Commercial insurance and other		1,880		1,760		1,748		1,784		1,797		1,922
Weighted average		1,316		1,289		1,294		1,370		1,411		1,406

Medicare case mix index (discharged patients only)		1.12		1.16		1.14		1.17		1.22		1.23

Average daily census		3,976		3,932		3,651		3,691		3,878		3,807
Occupancy %		67.9		67.1		62.2		62.1		66.0		64.7

Annualized employee turnover %		25.0		25.9		25.7		25.2		21.3		22.1

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

Operating Data (Continued)

(Unaudited)


	2008 Quarters								2009 Quarters
	First		Second		Third		Fourth		First		Second
Nursing center data:
End of period data:
Number of nursing centers:
Owned or leased		218		218		218		218		218		218
Managed		4		4		4		4		4		4

		222		222		222		222		222		222

Number of licensed beds:
Owned or leased		27,569		27,449		27,422		27,252		27,138		27,138
Managed		485		485		485		485		485		485

		28,054		27,934		27,907		27,737		27,623		27,623

Revenue mix %:
Medicare		35		35		33		34		35		35
Medicaid		42		43		43		43		41		41
Medicare Advantage		5		5		5		5		6		6
Private and other		18		17		19		18		18		18
Patient days (excludes managed facilities):
Medicare		401,468		394,520		365,125		361,977		374,853		375,140
Medicaid		1,356,401		1,347,763		1,387,819		1,374,670		1,326,654		1,323,157
Medicare Advantage		64,929		68,850		69,655		69,083		80,352		82,652
Private and other		413,510		406,564		419,071		420,193		403,320		415,510

		2,236,308		2,217,697		2,241,670		2,225,923		2,185,179		2,196,459

Patient day mix %:
Medicare		18		18		16		16		17		17
Medicaid		61		61		62		62		61		60
Medicare Advantage		3		3		3		3		4		4
Private and other		18		18		19		19		18		19
Revenues per patient day:
Medicare Part A	$	428	$	430	$	433	$	455	$	457	$	459
Total Medicare (including Part B)		461		465		474		497		497		500
Medicaid		159		166		163		163		165		167
Medicare Advantage		369		373		370		381		380		392
Private and other		229		227		230		231		235		232
Weighted average		232		237		232		237		243		245

Average daily census		24,575		24,370		24,366		24,195		24,280		24,137
Admissions		18,215		17,634		16,903		17,234		18,166		18,456
Occupancy %		89.3		89.1		89.2		88.9		89.3		88.9
Medicare average length of stay		35.2		35.7		36.5		34.8		34.8		35.5

Annualized employee turnover %		48.2		50.2		51.0		48.9		37.9		39.9

Rehabilitation data:
Revenue mix %:
Company-operated		65		64		62		61		61		60
Non-affiliated		35		36		38		39		39		40
Sites of services (at end of period)		650		658		659		655		661		659
Revenue per site	$	160,767	$	161,578	$	162,058	$	167,492	$	177,984	$	182,775

Therapist productivity %		81.9		81.3		80.1		82.3		84.8		84.8

Annualized employee turnover %		13.1		13.5		13.2		13.3		10.9		11.6

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion of the Company’s exposure to market risk contains “forward-looking statements” that involve risks and uncertainties. Given the unpredictability of interest rates as well as other factors, actual results could differ materially from those projected in such forward-looking information.

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

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

Interest Rate Sensitivity

Principal Amount by Expected Maturity

Average Interest Rate

(Dollars in thousands)


	Expected maturities																				Fair value 6/30/09
	2009			2010			2011			2012			2013			Thereafter			Total		Fair value 6/30/09
Liabilities:
Long-term debt, including amounts due within one year:
Fixed rate	$	41		$	86		$	91		$	96		$	102		$	358		$	774	$	743	(a)
Average interest rate		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%
Variable rate (b)	$	–		$	–		$	–		$	274,100		$	–		$	–		$	274,100	$	274,100

(a)	Calculated based upon the net present value of future principal and interest payments using a discount rate of 6%.

(b)

Interest on borrowings under the Company’s revolving credit facility is payable, at the Company’s option, at (1) LIBOR plus an applicable margin ranging from 1.25% to 2.00% or (2) the applicable margin ranging from 0.25% to 1.00% plus the higher of the prime rate or 0.5% over the federal funds rate. The applicable margin is based upon the Company’s average daily excess availability as defined in the Company’s revolving credit facility.

ITEM 4. CONTROLS AND PROCEDURES

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

The Company has carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2009, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

There has been no change in the Company’s internal control over financial reporting during the Company’s quarter ended June 30, 2009, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

The Company is a party to various legal actions (some of which are not insured), and regulatory and other government investigations and sanctions in the ordinary course of business. The Company is unable to predict the ultimate outcome of pending litigation and regulatory and other government investigations. The DOJ, CMS or other federal and state enforcement and regulatory agencies may conduct additional investigations related to the Company’s businesses in the future which may, either individually or in the aggregate, have a material adverse effect on the Company’s business, financial position, results of operations and liquidity.

Item 4.

Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on May 20, 2009 in Louisville, Kentucky. At the meeting, shareholders elected a board of nine directors pursuant to the following votes:


Director	Votes in Favor	Votes Withheld	Abstentions
Edward L. Kuntz	36,037,874	602,176	–
Joel Ackerman	36,336,817	303,233	–
Ann C. Berzin	34,808,064	1,831,986	–
Jonathan D. Blum	36,201,627	438,423	–
Thomas P. Cooper, M.D.	34,805,292	1,834,758	–
Paul J. Diaz	36,329,957	310,093	–
Isaac Kaufman	34,770,272	1,869,778	–
Frederick J. Kleisner	36,336,921	303,129	–
Eddy J. Rogers, Jr.	34,802,745	1,837,305	–

In addition to electing directors, shareholders of the Company approved the Company’s Amended and Restated Short-Term Incentive Plan by the vote of 35,716,044 in favor, 891,149 against, 32,856 abstentions and no broker non-votes, and the Company’s Amended and Restated Long-Term Incentive Plan by the vote of 35,812,221 in favor, 792,270 against, 35,559 abstentions and no broker non-votes.

At the Annual Meeting, the Company’s shareholders also ratified the appointment of PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm for fiscal year 2009 by the vote of 36,282,331 in favor, 346,613 against, 11,106 abstentions and no broker non-votes.

Item 6.

Exhibits


10.1		Renewal Notice to Lessor, dated April 30, 2009, regarding the Second Amended and Restated Master Lease Agreements Nos. 1-4, between Ventas Realty, Limited Partnership, as Lessor and Kindred Healthcare, Inc. and Kindred Healthcare Operating, Inc. as Tenant.

31		Rule 13a-14(a)/15d-14(a) Certifications.

32		Section 1350 Certifications.

SIGNATURES

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


		KINDRED HEALTHCARE, INC.

Date: August 6, 2009		/s/ PAUL J. DIAZ
		Paul J. Diaz
		President and Chief Executive Officer

Date: August 6, 2009		/s/ RICHARD A. LECHLEITER
		Richard A. Lechleiter
		Executive Vice President and Chief Financial Officer