SELECT MEDICAL CORP - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q


		(Mark One)




þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
















		For the Quarter Ended June 30, 2002




o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Period From __________ to __________.

Commission File Number: 000-32499

SELECT MEDICAL CORPORATION

(Exact name of Registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		23-2872718 (I.R.S. employer identification number)

4716 Old Gettysburg Road, P.O. Box 2034, Mechanicsburg, Pennsylvania 17055
(Address of principal executive offices and zip code)

(717) 972-1100
(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 periods as 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 o

As of July 31, 2002, the number of outstanding shares of the Registrant’s Common Stock was 46,649,937.

TABLE OF CONTENTS


PART I FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
	CONSOLIDATED BALANCE SHEETS
	CONSOLIDATED STATEMENTS OF OPERATIONS
	Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
	CONSOLIDATED STATEMENTS OF CASH FLOWS
	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
FIRST ADDENDUM TO LEASE AGREEMENT
SECOND ADDENDUM TO LEASE AGREEMENT
THIRD ADDENDUM TO LEASE AGREEMENT

TABLE OF CONTENTS


PART I	FINANCIAL INFORMATION	3




ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS




	Consolidated Balance Sheets	3




	Consolidated Statements of Operations	4




	Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income	5




	Consolidated Statements of Cash Flows	6




	Notes to Consolidated Financial Statements	7




ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	20




ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	31




PART II	OTHER INFORMATION	32




ITEM 1.	LEGAL PROCEEDINGS	32




ITEM 2.	CHANGES IN SECURITIES AND USE OF PROCEEDS	32




ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	32




ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	33




ITEM 5.	OTHER INFORMATION	34




ITEM 6.	EXHIBITS AND REPORTS ON FORM 8-K	34




SIGNATURES		34

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PART I FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

SELECT MEDICAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)


			June 30,			December 31,
			2002			2001

Assets			(unaudited)
Current Assets:




	Cash and cash equivalents		$	28,834		$	10,703




	Accounts receivable, net of allowance for doubtful accounts of $76,866 and $79,889 in 2002 and 2001, respectively			235,541			218,393




	Current deferred tax asset			28,942			28,945




	Other current assets			18,507			18,444

Total Current Assets				311,824			276,485




Property and equipment, net				98,599			92,005




Goodwill				203,771			199,850




Trademark				37,875			37,875




Other intangibles				9,245			9,532




Non-current deferred tax asset				5,103			6,674




Other assets				27,016			28,424

Total Assets			$	693,433		$	650,845

		Liabilities and Stockholders’ Equity




Current Liabilities:




	Bank overdrafts		$	9,707		$	6,083




	Current portion of long-term debt and notes payable			28,636			26,774




	Accounts payable			31,199			33,520




	Accrued payroll			27,507			27,160




	Accrued vacation			14,910			12,820




	Accrued restructuring			1,142			1,819




	Accrued other			29,357			23,568




	Income taxes payable			7,649			1,735




	Due to third party payors			28,698			16,257

Total Current Liabilities				178,805			149,736




Long-term debt, net of current portion				244,239			261,649

Total Liabilities				423,044			411,385




Commitments and Contingencies




Minority interest in consolidated subsidiary companies				5,361			5,176




Stockholders’ Equity:




	Common stock — $.01 par value: Authorized shares - 200,000,000 in 2002 and 2001 Issued shares - 47,109,000 in 2002 and 46,488,000 in 2001			471			465




	Capital in excess of par			237,580			231,349




	Retained earnings			28,701			5,924




	Treasury stock, at cost - 461,000 shares			(1,560	)		(1,560	)




	Accumulated other comprehensive loss			(164	)		(1,894	)

Total Stockholders’ Equity				265,028			234,284

Total Liabilities and Stockholders’ Equity			$	693,433		$	650,845

See accompanying notes.

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SELECT MEDICAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)


				For the Quarter Ended June 30,						For the Six Months Ended June 30,

				2002			2001			2002			2001

Net operating revenues				$	280,272		$	234,199		$	552,192		$	459,287

Costs and expenses:




	Cost of services				228,183			188,688			449,918			369,961




	General and administrative				9,326			8,554			19,012			16,994




	Bad debt expense				8,577			8,305			19,020			16,648




	Depreciation and amortization				6,180			7,863			12,206			15,679

Total costs and expenses					252,266			213,410			500,156			419,282

Income from operations					28,006			20,789			52,036			40,005




Other income and expense:




Interest income					(136	)		(39	)		(207	)		(280	)




Interest expense					6,815			7,506			13,593			15,522

Income before minority interests, income taxes and extraordinary item					21,327			13,322			38,650			24,763




Minority interest in consolidated subsidiary companies					570			865			1,173			2,272

Income before income taxes and extraordinary item					20,757			12,457			37,477			22,491




Income tax expense					8,156			4,859			14,700			8,772

Income before extraordinary item					12,601			7,598			22,777			13,719




Extraordinary item (net of tax benefit of $5,547)					—			8,676			—			8,676

Net income (loss)				$	12,601		$	(1,078	)	$	22,777		$	5,043




Less: Preferred dividends					—			(207	)		—			(2,513	)

Net income (loss) available to common stockholders				$	12,601		$	(1,285	)	$	22,777		$	2,530

Net income (loss) per common share:




		Basic:




			Income before extraordinary item	$	0.27		$	0.17		$	0.49		$	0.32




			Extraordinary item		—			(0.20	)		—			(0.25	)

			Net income (loss) per common share	$	0.27		$	(0.03	)	$	0.49		$	0.07




		Diluted:




			Income before extraordinary item	$	0.25		$	0.16		$	0.46		$	0.29




			Extraordinary item		—			(0.19	)		—			(0.20	)

			Net income (loss) per common share	$	0.25		$	(0.03	)	$	0.46		$	0.09




Weighted average shares outstanding:




		Basic			46,442			43,259			46,262			34,417




		Diluted			49,469			47,205			49,054			41,788

See accompanying notes.

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Select Medical Corporation
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
(in thousands)
(unaudited)


				Common Stock		Capital in		Retained		Treasury			Accumulated Other			Comprehensive
		Common Stock		Par Value		Excess of Par		Earnings		Stock			Comprehensive Loss			Income

Balance at December 31, 2001			46,488	$	465	$	231,349	$	5,924	$	(1,560	)	$	(1,894	)




	Net income								22,777							$	22,777




	Other comprehensive income													1,730			1,730

	Total comprehensive income															$	24,507

	Issuance of common stock		621		6		3,887




Valuation of non-employee options							152




Tax benefit of stock option exercises							2,192

Balance at June 30, 2002			47,109	$	471	$	237,580	$	28,701	$	(1,560	)	$	(164	)

See accompanying notes.

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SELECT MEDICAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)


			For the Six Months Ended June 30,

			2002			2001

Operating activities




Net income			$	22,777		$	5,043




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




	Depreciation and amortization			12,206			15,679




	Provision for bad debts			19,020			16,648




	Minority interests			1,173			2,272




	Extraordinary item			—			8,676




	Changes in operating assets and liabilities, net of effects from acquisition of businesses:




		Accounts receivable		(35,895	)		(25,997	)




		Other current assets		(1,240	)		872




		Other assets		1,556			5,639




		Accounts payable		(2,379	)		2,137




		Due to third-party payors		14,626			3,714




		Accrued expenses		6,882			11,518




		Income taxes		11,749			5,695

Net cash provided by operating activities				50,475			51,896

Investing activities




Purchases of property and equipment, net				(17,948	)		(10,810	)




Proceeds from disposal of assets				—			808




Earnout payments				(536	)		(4,763	)




Acquisition of businesses, net of cash acquired				(3,303	)		(11,723	)

Net cash used in investing activities				(21,787	)		(26,488	)

Financing activities




Issuance of 9.5% Senior Subordinated Notes				—			175,000




Net repayments on credit facility debt				(12,981	)		(96,000	)




Repayment of 10% Senior Subordinated Notes				—			(90,000	)




Payment of deferred financing fees				(67	)		(4,681	)




Principal payments on seller and other debt				(3,947	)		(10,561	)




Proceeds from initial public offering, net of fees				—			89,169




Redemption of Class A Preferred Stock				—			(52,838	)




Payment of Class A and Class B Preferred Stock Dividends				—			(19,248	)




Proceeds from issuance of common stock				3,893			10




Proceeds from (repayment of) bank overdrafts				3,624			(3,449	)




Distributions to minority interests				(1,151	)		(1,846	)

Net cash used in financing activities				(10,629	)		(14,444	)

Effect of exchange rate changes on cash and cash equivalents				72			(20	)

Net increase in cash and cash equivalents				18,131			10,944




Cash and cash equivalents at beginning of period				10,703			3,151

Cash and cash equivalents at end of period			$	28,834		$	14,095

Supplemental Cash Flow Information




Cash paid for interest			$	11,794		$	15,423




Cash paid for income taxes			$	3,358		$	2,328

See accompanying notes.

- 6 -

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

The unaudited condensed consolidated financial statements of Select Medical Corporation (the “Company”) as of June 30, 2002 and for the three and six month periods ended June 30, 2002 and 2001, have been prepared in accordance with generally accepted accounting principles. In the opinion of management, such information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for such periods. All intercompany transactions and balances have been eliminated. The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results to be expected for the full fiscal year ending December 31, 2002.

Certain information and disclosures normally included in the notes to consolidated financial statements have been condensed or omitted as permitted by the rules and regulations of the Securities and Exchange Commission, although the Company believes the disclosure is adequate to make the information presented not misleading. The accompanying unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2001 contained in the Company’s Form 10-K filed with the Securities Exchange Commission.

2. Accounting Policies

Reclassifications

Certain amounts on the December 31, 2001 consolidated balance sheet have been reclassified to conform to the classifications used on the June 30, 2002 consolidated balance sheet.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. Adoption of SFAS No. 146 is required with the beginning of fiscal year 2003. The Company does not anticipate a significant impact on its results of operations from adopting this Statement.

- 7 -

Company are effective for fiscal periods beginning after May 15, 2002 although, early adoption of SFAS 145 is permitted. The Company believes that the adoption of SFAS 145 will require the reclassification of its extraordinary items recorded in 1999, 2000 and 2001 to the other income and expense category of its consolidated statement of operations.

In October 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS No. 144 supersedes the accounting provisions of APB 30 that address the disposal of a segment of a business and requires that such long-lived assets be reported at fair value less cost to sell. SFAS No. 144 requires that long-lived assets to be abandoned, exchanged for similar productive assets or distributed to owners in a spin-off be considered held for use until they are abandoned, exchanged or distributed. It also eliminates the exception to consolidation for a subsidiary while control is expected to be temporary. The Company adopted SFAS No. 144 on January 1, 2002 with no material effect on net income.

3. Stock Option Plans

On April 11, 2002, the Company’s Board of Directors adopted the Select Medical Corporation Second Amended and Restated 1997 Stock Option Plan, which was approved by the stockholders on May 13, 2002. The amended plan provides for the grant of non-qualified stock options to key employees to purchase an additional 3,000,000 shares of common stock. A substantial portion of these options are Performance Accelerated Vesting Options. The Performance Accelerated Vesting Options will vest and become exercisable on the seventh anniversary of the grant of such options, but the vesting schedule for these options will be accelerated if the Company meets or exceeds its performance-based targets of earnings per share (EPS) and return on equity (ROE). The EPS target for 2002 is $0.84 and for each subsequent year, the EPS target will be calculated by increasing the immediately preceding year’s EPS target by fifteen percent. The ROE target for 2002 is 13.5%, and for each subsequent year the ROE target shall be determined by increasing the target percentage for the immediately preceding year by .5%. Twenty percent (20%) of a grant of Performance Accelerated Vesting Options shall vest and become exercisable after the completion of each fiscal year in which the Company meets or exceeds both its earnings per share and return on equity targets. No accelerated vesting shall occur in years in which the Company fails to meet either of its targets. In addition, if the Company meets both of these targets in 2002, 2003 and 2004, and the Company’s earnings per share for fiscal year 2004 is greater than or equal to $1.21, then all Performance Accelerated Vesting Options will become fully vested and immediately exercisable.

On February 12, 2002, the Company’s Board of Directors adopted the 2002 Non-Employee Directors’ Plan, which was amended on April 11, 2002, and approved by the stockholders on May 13, 2002. Under the terms of the Non-Employee Directors’ Plan, directors who are not employees of the Company may be granted non-qualified stock options to purchase up to 250,000 shares of the Company’s common stock (such number being subject to adjustment under the terms of the plan), at a price of not less than 100% of the market price on the date the option is granted. Options expire no later than ten years after the date of grant. On February 12, 2002, the Company granted 28,000 options at $14.04 per share.

During the six months ended June 30, 2002, the Company granted stock options under its Second Amended and Restated 1997 Stock Option Plan totaling 4,284,080 shares of Common Stock at exercise prices ranging from $12.66 to $15.25 per share. Of this amount, 2,294,200 were issued as Performance Accelerated Vesting Options.

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4. Segment Information

The Company’s segments consist of (i) inpatient hospitals and (ii) outpatient rehabilitation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on EBITDA of the respective business units. EBITDA is defined as earnings before interest, minority interest, income taxes, depreciation and amortization and extraordinary item. All segment revenues are from external customers.

The following table summarizes selected financial data for the Company’s reportable segments:


	Three Months Ended June 30, 2002

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	152,073,000	$	124,639,000	$	3,560,000		$	280,272,000




EBITDA		17,281,000		23,075,000		(6,170,000	)		34,186,000




Total assets		315,115,000		330,800,000		47,518,000			693,433,000




Capital expenditures		6,257,000		2,492,000		240,000			8,989,000


	Three Months Ended June 30, 2001

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	119,035,000	$	111,958,000	$	3,206,000		$	234,199,000




EBITDA		13,583,000		20,631,000		(5,562,000	)		28,652,000




Total assets		262,027,000		311,375,000		39,106,000			612,508,000




Capital expenditures		3,254,000		2,024,000		207,000			5,485,000


	Six Months Ended June 30, 2002

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	300,901,000	$	244,333,000	$	6,958,000		$	552,192,000




EBITDA		32,948,000		44,123,000		(12,829,000	)		64,242,000




Total assets		315,115,000		330,800,000		47,518,000			693,433,000




Capital expenditures		12,440,000		4,927,000		581,000			17,948,000


	Six Months Ended June 30, 2001

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	232,185,000	$	220,631,000	$	6,471,000		$	459,287,000




EBITDA		26,978,000		39,686,000		(10,980,000	)		55,684,000




Total assets		262,027,000		311,375,000		39,106,000			612,508,000




Capital expenditures		6,309,000		3,766,000		735,000			10,810,000

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A reconciliation of EBITDA to net income (loss) is as follows:


	For the three months ended June 30,						For the six months ended June 30,

	2002			2001			2002			2001

EBITDA	$	34,186,000		$	28,652,000		$	64,242,000		$	55,684,000




Depreciation and amortization		(6,180,000	)		(7,863,000	)		(12,206,000	)		(15,679,000	)




Interest income		136,000			39,000			207,000			280,000




Interest expense		(6,815,000	)		(7,506,000	)		(13,593,000	)		(15,522,000	)




Minority interest		(570,000	)		(865,000	)		(1,173,000	)		(2,272,000	)




Income tax expense		(8,156,000	)		(4,859,000	)		(14,700,000	)		(8,772,000	)




Extraordinary item		—			(8,676,000	)		—			(8,676,000	)

Net income (loss)	$	12,601,000		$	(1,078,000	)	$	22,777,000		$	5,043,000

5. Restructuring Charges

The following summarizes the Company’s restructuring activity:


	Lease Termination
	Costs			Severance			Total

December 31, 2001	$	1,687,000		$	132,000		$	1,819,000




Amounts paid in 2002		(632,000	)		(45,000	)		(677,000	)

June 30, 2002	$	1,055,000		$	87,000		$	1,142,000

Management expects to pay out the remaining restructuring reserves through 2003 which is consistent with the original plan.

6. Intangible Assets

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and other intangible assets with indefinite lives are no longer subject to periodic amortization but are instead reviewed annually, or more frequently if impairment indicators arise. Additionally, a transitional impairment test is required within six months of the date of adoption utilizing data as of the beginning of the year. These reviews require the Company to estimate the fair value of its identified reporting units and compare those estimates against the related carrying values. For each of the reporting units, the estimated fair value is determined utilizing the expected present value of the future cash flows of the units.

During the quarter ended March 31, 2002, the Company conducted its initial transition test. In all instances, the estimated fair value of the reporting units exceeded their book values and therefore no write-down of goodwill was required at January 1, 2002.

Amortization expense for intangible assets for the six months ended June 30, 2002 was $390,000. Estimated amortization expense for intangible assets for each of the five years commencing January 1, 2002 will be approximately $553,000.

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Intangible assets consist of the following:


		As of June 30, 2002

		Gross Carrying		Accumulated
		Amount		Amortization

Amortized intangible assets




Management services agreements		$	11,404,000	$	(2,159,000	)




Unamortized intangible assets




Goodwill		$	203,771,000




Trademarks			37,875,000

	Total	$	241,646,000

The following table reflects unaudited pro forma results of operations, net of related tax effect, of the Company, giving effect to SFAS No. 142 as if it were adopted on January 1, 2001:


	For the Quarter Ended June 30,					For the Six Months Ended June 30,

	2002		2001			2002		2001

Reported net income (loss)	$	12,601,000	$	(1,078,000	)	$	22,777,000	$	5,043,000




Add back: Goodwill amortization		—		1,237,000			—		2,469,000




Add back: Trademark amortization		—		152,000			—		304,000

Adjusted net income	$	12,601,000	$	311,000		$	22,777,000	$	7,816,000

Basic earnings per share:




Reported net income (loss)	$	0.27	$	(0.03	)	$	0.49	$	0.07




Goodwill amortization		—		0.03			—		0.07




Trademark amortization		—		—			—		0.01

Adjusted net income	$	0.27	$	—		$	0.49	$	0.15

Diluted earnings per share:




Reported net income (loss)	$	0.25	$	(0.03	)	$	0.46	$	0.09




Goodwill amortization		—		0.03			—		0.06




Trademark amortization		—		—			—		0.01

Adjusted net income	$	0.25	$	—		$	0.46	$	0.16

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The changes in the carrying amount of goodwill for the Company’s reportable segments for the six months ended June 30, 2002, are as follows:


			Outpatient
	Specialty Hospitals		Rehabilitation			All Other		Total

Balance as of January 1, 2002	$	84,391,000	$	114,875,000		$	584,000	$	199,850,000




Goodwill acquired during year		—		4,466,000			—		4,466,000




Income tax benefits recognized		—		(1,939,000	)		—		(1,939,000	)




Earn-out payments		—		536,000			—		536,000




Translation adjustment		—		867,000			—		867,000




Other		—		(9,000	)		—		(9,000	)

Balance as of June 30, 2002	$	84,391,000	$	118,796,000		$	584,000	$	203,771,000

7. Net Income (Loss) per Share

The following table sets forth the computation of basic and diluted earnings (loss) per share:


		Three Months Ended June 30,					Six Months Ended June 30,

		2002		2001			2002		2001

Numerator:




Net income before extraordinary item		$	12,601,000	$	7,598,000		$	22,777,000	$	13,719,000




Extraordinary item, net of $5,547,000 tax benefit			—		(8,676,000	)		—		(8,676,000	)

Net income (loss)			12,601,000		(1,078,000	)		22,777,000		5,043,000




	Less: Class A and Class B Preferred stock dividends		—		207,000			—		2,513,000

	Numerator for basic earnings per share – income (loss) available to common stockholders		12,601,000		(1,285,000	)		22,777,000		2,530,000




Effect of dilutive securities:




	Class B Preferred stock dividends		—		61,000			—		1,067,000

	Numerator for diluted earnings per share – income (loss) available to common stockholders after assumed conversions	$	12,601,000	$	(1,224,000	)	$	22,777,000	$	3,597,000

Denominator:




	Denominator for basic earnings per share –weighted average shares		46,442,000		43,259,000			46,262,000		34,417,000




	Effect of dilutive securities:




	a) Stock options		1,884,000		1,887,000			1,706,000		1,387,000




	b) Warrants		1,143,000		1,046,000			1,086,000		892,000




	c) Convertible preferred stock		—		1,013,000			—		5,092,000

Denominator for diluted earnings per share-adjusted weighted average shares and assumed conversions			49,469,000		47,205,000			49,054,000		41,788,000

- 12 -


		Three Months Ended June 30,					Six Months Ended June 30,

		2002		2001			2002		2001

Basic income (loss) per common share:




Income before extraordinary item		$	0.27	$	0.17		$	0.49	$	0.32




	Extraordinary item		—		(0.20	)		—		(0.25	)

	Income (loss) per common share	$	0.27	$	(0.03	)	$	0.49	$	0.07

Diluted income (loss) per common share:




Income before extraordinary item		$	0.25	$	0.16		$	0.46	$	0.29




	Extraordinary item		—		(0.19	)		—		(0.20	)

	Diluted income (loss) per common share	$	0.25	$	(0.03	)	$	0.46	$	0.09

8. Supplemental Disclosures of Cash Flow Information

Non-cash investing and financing activities are comprised of the following for the six months ended June 30, 2002 and 2001:


	2002		2001

Conversion of preferred stock into common stock	$	—	$	60,000,000




Preferred stock dividends	$	—	$	—




Minority interest repurchase	$	—	$	4,973,000




Notes issued with acquisitions	$	1,380,000	$	—




Tax benefit of stock option exercises	$	2,192,000	$	—

9. Commitments and Contingencies

Litigation

On August 10, 1998 a complaint in the U.S. District Court for the Eastern District of Pennsylvania was filed that named as defendants NovaCare, Inc. (now known as NAHC, Inc.), other named defendants and 100 defendants who were to be named at a later time. This qui tam action sought triple damages and penalties under the False Claims Act against NAHC. The Department of Justice did not intervene in this action. The allegations involve, among other things, the distinction between individual and group billing in physical rehabilitation clinics that the Company acquired from NovaCare. On October 16, 2000 the relator plaintiff made a motion to amend the complaint to, among other things, add Select Medical Corporation and some of its subsidiaries acquired in the NovaCare acquisition as defendants in this case. This motion was granted in September of 2001. The amended complaint alleges that from about January 1, 1995 through the present, the defendants submitted false or fraudulent bills for physical therapy to various federal health programs. The United States Attorneys Office has asserted that because the complaint is being amended to add allegations against new defendants, it is entitled to a new period to determine whether to intervene in the new allegations. On January 3, 2002, NAHC entered into a settlement agreement with the relator plaintiff and the government, pursuant to which, in exchange for a payment by NAHC of $375,000, the parties settled all claims arising out of conduct that took place before the Company’s acquisition of the NovaCare subsidiaries that are defendants in the case. Claims against the Company and the NovaCare subsidiaries regarding conduct occurring after the NovaCare acquisition were not settled. As of July 31, 2002, the government had not advised the Company whether it intends to intervene in any remaining claims, and the Company and the subsidiaries have not been served with the amended complaint. Based on a review of the amended complaint, the Company does not believe that this lawsuit is meritorious and intends to vigorously defend against this action. However, because of the uncertain nature of the litigation, the Company cannot predict the outcome of this matter.

- 13 -

The Company is subject to legal proceedings and claims that have arisen in the ordinary course of its business and have not been finally adjudicated, which include malpractice claims covered under the Company’s insurance policies, as well as claims that were covered under policies issued by PHICO Insurance Company, which are discussed below. In the opinion of management, the outcome of these actions will not have a material adverse effect on the financial position or results of operations of the Company.

Other

In February 2002, PHICO Insurance Company (“PHICO”), at the request of the Pennsylvania Insurance Department, was placed in liquidation by an order of the Commonwealth Court of Pennsylvania (“Liquidation Order”). The Company had placed its primary malpractice insurance coverage through PHICO from June 1998 through December 2000. In January 2001, these policies were replaced by policies issued with other issuers. Currently, the Company has approximately 19 unsettled cases in 9 states from the policy years covered by PHICO issued policies. The Liquidation Order refers these claims to the various state guaranty associations. These state guaranty association statutes generally provide for coverage between $100,000-$300,000 per insured claim, depending on the state. Some states also have catastrophic loss funds to cover settlements in excess of the available state guaranty funds. Most state insurance guaranty statutes provide for net worth, subrogation and residency limitations that, if applicable, may limit or prevent the Company from recovering from these state guaranty association funds. At this time, the Company believes that it will meet the requirements for coverage under most of the applicable state guarantee association statutes, and that the resolution of these claims will not have a material adverse effect on the Company’s financial position, cash flow or results of operations. However, because the rules related to state guarantee funds are subject to interpretation and because these claims are still in the process of resolution, the Company’s conclusions may change as this process progresses.

10. Financial Information for Subsidiary Guarantors and Non-Guarantor Subsidiaries

The Company conducts a significant portion of its business through its subsidiaries. Presented below is condensed consolidating financial information for the Company, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries at June 30, 2002 and for the six months ended June 30, 2002 and 2001.

The equity method has been used by the Company with respect to investments in subsidiaries. The equity method has been used by Subsidiary Guarantors with respect to investments in Non-Guarantor Subsidiaries. Separate financial statements for Subsidiary Guarantors are not presented.

The following table sets forth the Non-Guarantor Subsidiaries:

Canadian Back Institute Limited

Kentucky Orthopedic Rehabilitation, LLC.

Medical Information Management Systems, LLC.

Metro Therapy, Inc.

Millennium Rehab Services, LLC.

Rehab Advantage Therapy Services, LLC.

Select Houston Partners, L.P.

Select Management Services, LLC.

Select Specialty Hospital – Biloxi, Inc.

Select Specialty Hospital – Central Pennsylvania, L.P.

TJ Corporation I, LLC.

- 14 -


			Select Medical Corporation
			Condensed Consolidating Balance Sheet
			June 30, 2002

			Select Medical Corporation						Non-Guarantor
			(Parent Company Only)			Subsidiary Guarantors			Subsidiaries			Eliminations			Consolidated

			(dollars in thousands)
Assets




	Current Assets:




	Cash and cash equivalents		$	20,724		$	6,418		$	1,692		$	—		$	28,834




	Accounts receivable, net			(367	)		200,348			35,560			—			235,541




	Current deferred tax asset			1,881			27,054			7			—			28,942




	Other current assets			2,425			13,328			2,754			—			18,507

Total Current Assets				24,663			247,148			40,013			—		$	311,824




Property and equipment, net				6,584			71,500			20,515			—			98,599




Investment in affiliates				330,454			68,013			—			(398,467	)(a)		—




Goodwill				5,854			160,410			37,507			—			203,771




Trademark				—			37,875			—			—			37,875




Other intangibles				—			961			8,284			—			9,245




Non-current deferred tax asset				(31	)		5,134			—			—			5,103




Other assets				11,344			15,105			567			—			27,016

Total Assets			$	378,868		$	606,146		$	106,886		$	(398,467	)	$	693,433

Liabilities and Stockholders’ Equity




	Current Liabilities:




		Bank overdrafts	$	9,707		$	—		$	—		$	—		$	9,707




		Current portion of long-term debt and notes payable		570			28,048			18			—			28,636




		Accounts payable		1,220			25,668			4,311			—			31,199




		Intercompany accounts		18,549			(23,853	)		5,304			—			—




		Accrued payroll		658			26,822			27			—			27,507




		Accrued vacation		2,968			10,475			1467			—			14,910




		Accrued restructuring		—			1,142			—			—			1,142




		Accrued other		12,590			16,709			58			—			29,357




		Income taxes		9,755			981			(3,087	)		—			7,649




		Due to third party payors		(29,688	)		59,393			(1,007	)		—			28,698

Total Current Liabilities				26,329			145,385			7,091			—			178,805




Long-term debt, net of current portion				87,511			110,517			46,211			—			244,239

Total Liabilities				113,840			255,902			53,302			—			423,044




Commitments and Contingencies




Minority interest in consolidated subsidiary companies				—			1,129			4,232			—			5,361




Stockholders’ Equity:




	Common stock			471			—			—			—			471




	Capital in excess of par			237,580			—			—			—			237,580




	Retained earnings			28,701			44,208			14,248			(58,456	)(b)		28,701




	Subsidiary investment			—			304,907			35,104			(340,011	)(a)		—




	Treasury stock, at cost			(1,560	)		—			—			—			(1,560	)




	Accumulated other comprehensive loss			(164	)		—			—			—			(164	)

Total Stockholders’ Equity				265,028			349,115			49,352			(398,467	)		265,028

Total Liabilities and Stockholders’ Equity			$	378,868		$	606,146		$	106,886		$	(398,467	)	$	693,433

(a)		Elimination of investments in subsidiaries




(b)		Elimination of investments in subsidiaries’ earnings

- 15 -


		Select Medical Corporation
		Condensed Consolidating Statement of Operations
		For the Six Months Ended June 30, 2002

		Select Medical Corporation						Non-Guarantor
		(Parent Company Only)			Subsidiary Guarantors			Subsidiaries		Eliminations			Consolidated

		(dollars in thousands)
Net operating revenues		$	6,502		$	447,326		$	98,364	$	—		$	552,192

Costs and expenses:




	Cost of services		—			369,233			80,685		—			449,918




	General and administrative		19,012			—			—		—			19,012




	Bad debt expense		—			15,820			3,200		—			19,020




	Depreciation and amortization		827			8,833			2,546		—			12,206

Total costs and expenses			19,839			393,886			86,431		—			500,156

Income (loss) from operations			(13,337	)		53,440			11,933		—			52,036




Other income and expense:




Intercompany interest and royalty fees			10,567			(10,863	)		296		—			—




Intercompany management fees			(24,735	)		23,373			1,362		—			—




Interest income			(167	)		(40	)		—		—			(207	)




Interest expense			3,684			7,666			2,243		—			13,593

Income (loss) before minority interests and income taxes			(2,686	)		33,304			8,032		—			38,650




Minority interest in consolidated subsidiary companies			—			6			1,167		—			1,173

Income (loss) before income taxes			(2,686	)		33,298			6,865		—			37,477




Income tax expense (benefit)			(1,308	)		14,727			1,281		—			14,700




Equity in earnings of subsidiaries			24,155			4,032			—		(28,187	)(a)		—

Net income		$	22,777		$	22,603		$	5,584	$	(28,187	)	$	22,777

(a)

Elimination of equity in net income (loss) from consolidated subsidiaries.

- 16 -


			Select Medical Corporation
			Condensed Consolidating Statement of Cash Flows
			For the Six Months Ended June 30, 2002

			Select Medical Corporation			Subsidiary			Non-Guarantor
			(Parent Company Only)			Guarantors			Subsidiaries			Eliminations			Consolidated

			(dollars in thousands)
Operating activities




Net income (loss)			$	22,777		$	22,603		$	5,584		$	(28,187	)(a)	$	22,777




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




	Depreciation and amortization			827			8,833			2,546			—			12,206




	Provision for bad debts			—			15,820			3,200			—			19,020




	Minority interests			—			6			1,167			—			1,173




	Changes in operating assets and liabilities, net of effects from acquisition of businesses:




		Equity (loss) in earnings of subsidiaries		(24,155	)		(4,032	)		—			28,187	(a)		—




		Intercompany		(16,920	)		20,475			(3,555	)		—			—




		Accounts receivable		(124	)		(30,108	)		(5,663	)		—			(35,895	)




		Other current assets		(461	)		(739	)		(40	)		—			(1,240	)




		Other assets		1,150			(862	)		1,268			—			1,556




		Accounts payable		(1,870	)		(250	)		(259	)		—			(2,379	)




		Due to third-party payors		(237	)		12,842			2,021			—			14,626




		Accrued expenses		670			7,489			(1,277	)		—			6,882




		Income taxes		9,443			5,393			(3,087	)		—			11,749

Net cash provided by (used in) operating activities				(8,900	)		57,470			1,905			—			50,475

Investing activities




Purchases of property and equipment, net				(561	)		(14,870	)		(2,517	)		—			(17,948	)




Earnout payments				—			(536	)		—			—			(536	)




Acquisition of businesses, net of cash acquired				—			(3,303	)		—			—			(3,303	)

Net cash used in investing activities				(561	)		(18,709	)		(2,517	)		—			(21,787	)

Financing activities




Intercompany debt reallocation				34,114			(36,852	)		2,738			—			—




Net repayments on credit facility debt				(11,640	)		—			(1,341	)		—			(12,981	)




Principal payments on seller and other debt				(370	)		(3,577	)		—			—			(3,947	)




Proceeds from issuance of common stock				3,893			—			—			—			3,893




Proceeds from bank overdrafts				3,624			—			—			—			3,624




Payment of deferred financing costs				(67	)		—			—			—			(67	)




Distributions to minority interests				—			—			(1,151	)		—			(1,151	)

Net cash provided by (used in) financing activities				29,554			(40,429	)		246			—			(10,629	)

Effect of exchange rate changes on cash and cash equivalents				72			—			—			—			72

Net increase (decrease) in cash and cash equivalents				20,165			(1,668	)		(366	)		—			18,131




Cash and cash equivalents at beginning of period				559			8,086			2,058			—			10,703

Cash and cash equivalents at end of period			$	20,724		$	6,418		$	1,692		$	—		$	28,834

(a)

Elimination of equity in earnings of subsidiary.

- 17 -


		Select Medical Corporation
		Condensed Consolidating Statement of Operations
		For the Six Months Ended June 30, 2001

		Select Medical Corporation						Non-Guarantor
		(Parent Company Only)			Subsidiary Guarantors			Subsidiaries			Eliminations			Consolidated

		(dollars in thousands)
Net operating revenues		$	6,023		$	372,521		$	80,743		$	—		$	459,287

Costs and expenses:




	Cost of services		—			305,097			64,864			—			369,961




	General and administrative		16,994			—			—			—			16,994




	Bad debt expense		—			14,427			2,221			—			16,648




	Depreciation and amortization		919			12,356			2,404			—			15,679

Total costs and expenses			17,913			331,880			69,489			—			419,282

Income (loss) from operations			(11,890	)		40,641			11,254			—			40,005




Other income and expense:




Intercompany charges			(21,688	)		18,359			3,329			—			—




Interest income			(102	)		(177	)		(1	)		—			(280	)




Interest expense			3,575			9,279			2,668			—			15,522

Income before minority interests and income taxes			6,325			13,180			5,258			—			24,763




Minority interest in consolidated subsidiary companies			—			578			1,694			—			2,272

Income before income taxes			6,325			12,602			3,564			—			22,491




Income tax expense			2,594			5,903			275			—			8,772




Equity in earnings of subsidiaries			9,988			1,878			—			(11,866	)(a)		—

Income (loss) before extraordinary item		$	13,719		$	8,577		$	3,289		$	(11,866	)	$	13,719




Extraordinary item			8,676			—			—			—			8,676

Net income (loss)		$	5,043		$	8,577		$	3,289		$	(11,866	)	$	5,043

(a)

Elimination of equity in net income (loss) from consolidated subsidiaries

- 18 -


			Select Medical Corporation
			Condensed Consolidating Statement of Cash Flows
			For the Six Months Ended June 30, 2001

			Select Medical
			Corporation (Parent
			Company Only)			Subsidiary Guarantors			Non-Guarantor Subsidiaries			Eliminations			Consolidated

			(dollars in thousands)
Operating activities




Net income (loss)			$	5,043		$	8,577		$	3,289		$	(11,866	)(a)	$	5,043




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




	Depreciation and amortization			919			12,356			2,404			—			15,679




	Provision for bad debts			—			14,427			2,221			—			16,648




	Minority interests			—			578			1,694			—			2,272




	Extraordinary item			8,676			—			—			—			8,676




	Changes in operating assets and liabilities, net of effects from acquisition of businesses:




		Equity (loss) in earnings of subsidiaries		(9,988	)		(1,878	)		—			11,866	(a)		—




		Intercompany		31,263			(34,877	)		3,614			—			—




		Accounts receivable		29			(18,602	)		(7,424	)		—			(25,997	)




		Other current assets		92			1,188			(408	)		—			872




		Other assets		47			6,230			(638	)		—			5,639




		Accounts payable		1,572			(429	)		994			—			2,137




		Due to third-party payors		(6,000	)		11,080			(1,366	)		—			3,714




		Accrued expenses		344			9,577			1,597			—			11,518




		Income taxes		(8,343	)		14,982			(944	)		—			5,695

Net cash provided by operating activities				23,654			23,209			5,033			—			51,896

Investing activities




Purchases of property and equipment, net				(735	)		(8,851	)		(1,224	)		—			(10,810	)




Proceeds from disposal of assets				—			808			—			—			808




Earnout payments				—			(4,763	)		—			—			(4,763	)




Acquisition of businesses, net of cash acquired				(11,723	)		—			—			—			(11,723	)

Net cash used in investing activities				(12,458	)		(12,806	)		(1,224	)		—			(26,488	)

Financing activities




Issuance of 9.5% Senior Subordinated Notes				175,000			—			—			—			175,000




Net repayments on credit facility debt				(96,000	)		—			—			—			(96,000	)




Repayment of 10% Senior Subordinated Notes				(90,000	)		—			—			—			(90,000	)




Payment of deferred financing fees				(4,681	)		—			—			—			(4,681	)




Principal payments on seller and other debt				(10,561	)		—			—			—			(10,561	)




Proceeds from initial public offering, net of fees				89,169			—			—			—			89,169




Redemption of Class A Preferred Stock				(52,838	)		—			—			—			(52,838	)




Payment of Class A and Class B Preferred Stock Dividends				(19,248	)		—			—			—			(19,248	)




Proceeds from issuance of common stock				10			—			—			—			10




Proceeds from (repayment of) bank overdrafts				9,258			(9,939	)		(2,768	)		—			(3,449	)




Distributions to minority interests				—			(680	)		(1,166	)		—			(1,846	)

Net cash provided by (used in) financing activities				109			(10,619	)		(3,934	)		—			(14,444	)

Effect of exchange rate changes on cash and cash equivalents				(20	)		—			—			—			(20	)

Net increase (decrease) in cash and cash equivalents				11,285			(216	)		(125	)		—			10,944




Cash and cash equivalents at beginning of period				—			1,015			2,136						3,151

Cash and cash equivalents at end of period			$	11,285		$	799		$	2,011		$	—		$	14,095

(a)

Elimination of equity in earnings of subsidiary

- 19 -

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

You should read this discussion together with our consolidated financial statements and notes thereto contained in our Form 10-K filed with the Securities Exchange Commission on March 5, 2002.

Forward Looking Statements

This discussion contains forward-looking statements relating to the financial condition, results of operations, plans, objectives, future performance and business of Select Medical Corporation. These statements include, without limitation, statements preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions. These forward-looking statements involve risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to factors including the following:

• a change in government reimbursement for our services that would affect our revenue;

• the failure of our long-term acute care hospitals to maintain their status as such, which could negatively impact our profitability;

• private third party payors of our services may undertake cost containment initiatives that would decrease our revenue;

• shortages in qualified nurses could increase our operating costs significantly;

• future acquisitions may use significant resources and expose us to unforeseen risks, and

• the effects of liability and other claims asserted against us.

For a discussion of these and other factors affecting our business, see the section captioned “Risk Factors” in our Form 10-K under Item 1 – Business.

Overview

We are a leading operator of specialty acute care hospitals for long term stay patients in the United States. We are also the second largest operator of outpatient rehabilitation clinics in the United States. As of June 30, 2002, we operated 66 specialty acute care hospitals in 22 states and 740 outpatient rehabilitation clinics in 32 states, the District of Columbia and seven Canadian provinces. We began operations in 1997 under the leadership of our current management team.

We operate through two business segments, our specialty acute care hospital segment and our outpatient rehabilitation segment. For the three months ended June 30, 2002, we had net operating revenues of $280.3 million. Of this total, we earned approximately 55% of our net operating revenues from our specialty hospitals and approximately 45% from our outpatient rehabilitation business.

Our specialty acute care hospital segment consists of hospitals designed to serve the needs of long term stay acute patients. These patients typically suffer from serious and often complex medical conditions that require a high degree of care. Our outpatient rehabilitation business consists of clinics and contract services that provide physical, occupational and speech rehabilitation services. Our patients are typically diagnosed with musculoskeletal impairments that restrict their ability to perform normal activities of daily living.

- 20 -

The following table sets forth operating statistics for our specialty acute care hospitals and our outpatient rehabilitation clinics for each of the periods presented. The data in the table reflect the changes in the number of specialty acute care hospitals and outpatient rehabilitation clinics we operate that resulted from acquisitions, start-up activities and closures. The operating statistics reflect data for the period of time these operations were managed by us.


			Three months ended June 30,						Six months ended June 30,

			2002			2001			2002			2001

Specialty Hospital Data




	# of Hospitals — Start of Period			64			56			64			54




	# of Hospital Start-ups			2			2			2			4

	# of Hospitals — End of Period			66			58			66			58

	# of Licensed Beds			2,383			2,117			2,383			2,117




	# of Admissions			5,019			4,224			10,230			8,415




	# of Patient Days			153,942			125,587			303,811			249,327




	Average Length of Stay			31			29			30			30




	Net Revenue Per Patient Day (a)		$	987		$	947		$	990		$	930




	Occupancy Rate			73	%		66	%		72	%		67	%




	% Patient Days – Medicare			76	%		75	%		77	%		76	%




Outpatient Rehabilitation Data




	# of Clinics Owned — Start of Period			667			624			664			636




		# of Clinics Acquired		6			2			7			2




		# of Clinic Start-ups		18			4			32			13




		# of Clinics Closed/Sold/Consolidated		(5	)		(7	)		(17	)		(28	)

	# of Clinics Owned — End of Period			686			623			686			623
	# of Clinics Managed — End of Period			54			48			54			48





	Total # of Clinics (All) – End of Period			740			671			740			671

	# of Visits (U.S.)			995,050			966,088			1,959,466			1,912,268




	Net Revenue Per Visit (U.S.) (b)		$	86		$	81		$	86		$	81

(a)		Net revenue per patient day is calculated by dividing specialty hospital patient service revenues by the total number of patient days.




(b)		Net revenue per visit is calculated by dividing outpatient rehabilitation clinic revenue by the total number of visits. For purposes of this computation, outpatient rehabilitation clinic revenue does not include our Canadian subsidiary and contract services revenue.

Our goal is to open approximately eight to ten new specialty acute care hospitals each year utilizing our “hospital within a hospital” model. We also intend to open new clinics in our current markets where we can benefit from existing referral relationships and brand awareness to produce incremental growth. From time to time, we also intend to evaluate acquisition opportunities that may enhance the scale of our business and expand our geographic reach.

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Sources of Revenue

Our net operating revenues are derived from a number of sources, including commercial, managed care, private and governmental payors. Our net operating revenues include amounts estimated by management to be reimbursable from each of the applicable payors and the federal Medicare program. Amounts we receive for treatment of patients are generally less than the standard billing rates. We account for the differences between the estimated reimbursement rates and the standard billing rates as contractual adjustments, which we deduct from gross revenues to arrive at net operating revenues.

Our specialty hospitals are paid by Medicare under a cost-based reimbursement methodology. These payments are subject to final cost report settlements based on administrative review and audit by third parties. An annual cost report is filed for each provider to report the cost of providing services and to settle the difference between the interim payments we receive and final costs. We record adjustments to the original estimates in the periods that such adjustments become known. Because our routine payments from Medicare are different than the final reimbursement due to us under the cost based reimbursement system, we record a receivable or payable for the difference. At June 30, 2002 and December 31, 2001, we had a net amount due to Medicare of $11.3 million and $3.4 million respectively. We recorded this amount as due to third party payors on our balance sheet.

On March 22, 2002, the Centers for Medicare and Medicaid Services (“CMS”) published a proposed rule to establish a prospective payment system for Medicare payment of inpatient hospital services furnished by long-term acute care hospitals such as ours. CMS accepted comments on the proposed rule through May 21, 2002. Current expectations are that the regulations may be final by the CMS deadline of October 2002, with implementation at a later date.

Results of Operations

The following table outlines, for the periods indicated, selected operating data as a percentage of net operating revenues.


	Three Months Ended						Six Months Ended
	June 30,						June 30,

	2002			2001			2002			2001

Net Operating revenues		100.0	%		100.0	%		100.0	%		100.0	%




Cost of services (a)		81.4	%		80.6	%		81.6	%		80.6	%




General and administrative		3.3	%		3.7	%		3.4	%		3.7	%




Bad debt expense		3.1	%		3.5	%		3.4	%		3.6	%

EBITDA (b)		12.2	%		12.2	%		11.6	%		12.1	%




Depreciation and amortization		2.2	%		3.3	%		2.2	%		3.4	%

Income from operations		10.0	%		8.9	%		9.4	%		8.7	%




Interest expense, net		2.4	%		3.2	%		2.4	%		3.3	%

Income before minority interests, and income taxes		7.6	%		5.7	%		7.0	%		5.4	%




Minority interests		0.2	%		0.4	%		0.2	%		0.5	%

Income before income taxes		7.4	%		5.3	%		6.8	%		4.9	%




Income tax expense		2.9	%		2.1	%		2.7	%		1.9	%

Net income before extraordinary item		4.5	%		3.2	%		4.1	%		3.0	%




Extraordinary item		—	%		3.7	%		—	%		1.9	%

Net income (loss)		4.5	%		(0.5	)%		4.1	%		1.1	%

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The following table summarizes selected financial data by business segment, for the periods indicated.


			Three Months Ended									Six months Ended
			June 30,						%			June 30,						%
			2002			2001			Change			2002			2001			Change

			(dollars in thousands)
Net operating revenues:




	Specialty hospitals		$	152,073		$	119,035			27.8	%	$	300,901		$	232,185			29.6	%




	Outpatient rehabilitation			124,639			111,958			11.3			244,333			220,631			10.7




	Other			3,560			3,206			11.0			6,958			6,471			7.5

		Total company	$	280,272		$	234,199			19.7	%	$	552,192		$	459,287			20.2	%

EBITDA: (b) Specialty hospitals			$	17,281		$	13,583			27.2	%	$	32,948		$	26,978			22.1	%




	Outpatient rehabilitation			23,075			20,631			11.8			44,123			39,686			11.2




	Other			(6,170	)		(5,562	)		(10.9	)		(12,829	)		(10,980	)		(16.8	)

		Total company	$	34,186		$	28,652			19.3	%	$	64,242		$	55,684			15.4	%

Income (loss) from operations:




	Specialty hospitals		$	14,134		$	10,926			29.4	%	$	26,753		$	21,841			22.5	%




	Outpatient rehabilitation			20,488			16,924			21.1			39,010			32,275			20.9




	Other			(6,616	)		(7,061	)		6.3			(13,727	)		(14,111	)		2.7

		Total company	$	28,006		$	20,789			34.7	%	$	52,036		$	40,005			30.1	%

EBITDA margins: (b) Specialty hospitals				11.4	%		11.4	%		0.0	%		10.9	%		11.6	%		(5.8	)%




	Outpatient rehabilitation			18.5			18.4			0.5			18.1			18.0			0.4




	Other			N/M			N/M			N/M			N/M			N/M			N/M

	Total company			12.2	%		12.2	%		0.0	%		11.6	%		12.1	%		(4.0	)%

Total assets:




	Specialty hospitals		$	315,115		$	262,027					$	315,115		$	262,027




	Outpatient rehabilitation			330,800			311,375						330,800			311,375




	Other			47,518			39,106						47,518			39,106

	Total company		$	693,433		$	612,508					$	693,433		$	612,508

Purchases of property and equipment, net:




	Specialty hospitals		$	6,257		$	3,254					$	12,440		$	6,309




	Outpatient rehabilitation			2,492			2,024						4,927			3,766




	Other			240			207						581			735

	Total company		$	8,989		$	5,485					$	17,948		$	10,810

		N/M – Not Meaningful




(a)		Cost of services include salaries, wages and benefits, operating supplies, lease and rent expense and other operating costs.




(b)		We define EBITDA as income (loss) before interest, income taxes, depreciation and amortization and other income, minority interest and extraordinary items. EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles. Items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA is a key measure used by management to evaluate our operations and provides useful information to investors. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated

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by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Because EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is susceptible to varying calculations, EBITDA as presented may not be comparable to similarly titled measures of other companies.

The following table reconciles EBITDA to net income (loss):


	For the Three Months Ended						For the Six months Ended
	June 30,						June 30,

	2002			2001			2002			2001

	(in thousands)
EBITDA	$	34,186		$	28,652		$	64,242		$	55,684




Depreciation and amortization		(6,180	)		(7,863	)		(12,206	)		(15,679	)




Interest income		136			39			207			280




Interest expense		(6,815	)		(7,506	)		(13,593	)		(15,522	)




Minority interest		(570	)		(865	)		(1,173	)		(2,272	)




Income tax expense		(8,156	)		(4,859	)		(14,700	)		(8,772	)




Extraordinary item, net of taxes		—			(8,676	)		—			(8,676	)

Net income (loss)	$	12,601		$	(1,078	)	$	22,777		$	5,043

Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001

Net Operating Revenues

Our net operating revenues increased by 19.7% to $280.3 million for the three months ended June 30, 2002 compared to $234.2 million for the three months ended June 30, 2001.

Specialty Acute Care Hospitals. Our specialty hospital net operating revenues increased 27.8% to $152.1 million for the three months ended June 30, 2002 compared to $119.0 million for the three months ended June 30, 2001. Net operating revenues for the specialty hospitals opened before January 1, 2001 and operated throughout both periods increased 15.2% to $135.7 million for the three months ended June 30, 2002 from $117.8 million for the three months ended June 30, 2001. This resulted from a higher occupancy rate and a higher net revenue per patient day. The remaining increase of $15.2 million resulted from the internal development of new specialty hospitals that commenced operations in 2001 and 2002.

Outpatient Rehabilitation. Our outpatient rehabilitation net operating revenues increased 11.3% to $124.6 million for the three months ended June 30, 2002 compared to $112.0 million for the three months ended June 30, 2001. The increase was related to an increase in the number of visits, an increase in the net revenue per visit experienced at our outpatient rehabilitation locations and the additional revenues associated with acquisitions that occurred in the third and fourth quarters of 2001 and the first six months of 2002. These acquisitions provided approximately $8.8 million of net operating revenue for the three months ended June 30, 2002.

Other. Our other revenues increased to $3.6 million for the three months ended June 30, 2002 compared to $3.2 million for the three months ended June 30, 2001. The increase in other revenue reflects higher corporate general and administrative costs in 2002, which resulted in higher Medicare reimbursements for those costs.

Operating Expenses

Our operating expenses increased by 19.7% to $246.1 million for the three months ended June 30, 2002 compared to $205.5 million for the three months ended June 30, 2001. Our operating expenses consist of our

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cost of services, general and administrative expense and bad debt expense. The increase in operating expenses was principally related to the internal development of new specialty hospitals that commenced operations in 2001, costs associated with the increased patient volumes and the operating expenses associated with the acquisitions that occurred in the third and fourth quarter of 2001 and first six months of 2002. As a percentage of our net operating revenues, our operating expenses were 87.8% for both the three months ended June 30, 2002 and 2001. Cost of services as a percentage of operating revenues increased to 81.4% for the three months ended June 30, 2002 from 80.6% for the three months ended June 30, 2001. These costs primarily reflect our labor expenses. This increase reflects the higher costs of services as a percentage of revenue in our newly developed specialty hospitals. During the same time period, general and administrative expense as a percentage of net operating revenues decreased to 3.3% for the three months ended June 30, 2002 from 3.7% for the three months ended June 30, 2001. Our bad debt expense as a percentage of net operating revenues was 3.1% for the three months ended June 30, 2002 compared to 3.5% for the three months ended June 30, 2001. This decline in our relative bad debt percentage resulted from improvement in the composition and age of our accounts receivable.

EBITDA

Our total EBITDA increased 19.3% to $34.2 million for the three months ended June 30, 2002 compared to $28.7 million for the three months ended June 30, 2001. Our EBITDA margins remained consistent at 12.2% for both the three months ended June 30, 2002 and the three months ended June 30, 2001. Excluding dilutive effect caused by the hospitals opened in 2001 and 2002, our EBITDA margins would be 13.3% for the three months ended June 30, 2002 compared to 13.0% for the three months ended June 30, 2001. For cash flow information, see “-Capital Resources and Liquidity.”

Specialty Acute Care Hospitals. Our specialty hospital EBITDA increased by 27.2% to $17.3 million for the three months ended June 30, 2002 compared to $13.6 million for the three months ended June 30, 2001. Our EBITDA margins remained consistent at 11.4% for both the three months ended June 30, 2002 and the three months ended June 30, 2001. The hospitals opened before January 1, 2001 and operated throughout both periods had EBITDA of $18.3 million, an increase of 19.3% over the EBITDA of these hospitals in the same period last year. This increase in same hospital EBITDA resulted from an increase in non-Medicare patient days and its associated increased revenue per patient day. Our EBITDA margin in these same store hospitals increased to 13.5% from 13.0%.

Outpatient Rehabilitation. Our outpatient rehabilitation EBITDA increased by 11.8% to $23.1 million for the three months ended June 30, 2002 compared to $20.6 million for the three months ended June 30, 2001. Approximately $0.9 million of this increase was related to the EBITDA generated by the acquisitions that occurred in the third and fourth quarter of 2001 and the first six months of 2002. Our EBITDA margins increased to 18.5% for the three months ended June 30, 2002 from 18.4% for the three months ended June 30, 2001.

Other. Our other EBITDA loss increased to $6.2 million for the three months ended June 30, 2002 compared to a loss of $5.6 million for the three months ended June 30, 2001. This increase resulted from the higher general and administrative costs needed to support the growth of the organization, principally our new hospital development.

Income from Operations

Income from operations increased 34.7% to $28.0 million for the three months ended June 30, 2002 compared to $20.8 million for the three months ended June 30, 2001. The increase in income from operations resulted from the EBITDA increases described above, and a reduction in amortization expense of $2.3 million resulting from the adoption of FAS 142, and was offset by an increase in depreciation expense. The increase in depreciation expense resulted primarily from increases in depreciation on fixed asset additions that are principally related to new hospital development.

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Interest Expense

Interest expense decreased by $0.7 million to $6.8 million for the three months ended June 30, 2002 from $7.5 million for the three months ended June 30, 2001. The decline in interest expense is due to the lower debt levels outstanding in 2002 compared to 2001 and a lower effective interest rate in 2002. The lower debt levels resulted from the scheduled term amortization payments under our credit facility. All repayments have been made with cash flows generated through operations.

Minority Interests

Minority interests in consolidated earnings decreased by 34.1% to $0.6 million for the three months ended June 30, 2002 compared to $0.9 million for the three months ended June 30, 2001. This decrease resulted from a smaller percentage of ownership held by minority interests. The terms of our agreements with some of our minority owners allowed them to sell their minority interests back to us upon the completion of our initial public offering which occurred on April 10, 2001. We completed the purchase of these minority interests between May 2001 and October 2001.

Income Taxes

We recorded income tax expense of $8.2 million for the three months ended June 30, 2002. The expense represented an effective tax rate of 39.3% and approximates the federal and state statutory tax rates. We recorded income tax expense of $4.9 million for the three months ended June 30, 2001. This expense represented an effective tax rate of 39.0%.

Extraordinary Item

We recorded an extraordinary charge in the quarter ended June 30, 2001. The extraordinary item consists of $1.3 million of unamortized deferred financing costs related to the repayment of our U.S. term loan and $12.9 million of deferred financing costs and unamortized discount related to the repayment of our 10% Senior Subordinated Notes. These costs were offset by a tax benefit of $5.5 million.

Six months Ended June 30, 2002 Compared to Six months Ended June 30, 2001

Net Operating Revenues

Our net operating revenues increased by 20.2% to $552.2 million for the six months ended June 30, 2002 compared to $459.3 million for the six months ended June 30, 2001.

Specialty Acute Care Hospitals. Our specialty hospital net operating revenues increased 29.6% to $300.9 million for the six months ended June 30, 2002 compared to $232.2 million for the six months ended June 30, 2001. Net operating revenues for the specialty hospitals opened before January 1, 2001 and operated throughout both periods increased 18.5% to $273.1 million for the six months ended June 30, 2002 from $230.4 million for the six months ended June 30, 2001. This resulted from a higher occupancy rate and a higher net revenue per patient day. The remaining increase of $26.0 million resulted from the internal development of new specialty hospitals that commenced operations in 2001 and 2002.

Outpatient Rehabilitation. Our outpatient rehabilitation net operating revenues increased 10.7% to $244.3 million for the six months ended June 30, 2002 compared to $220.6 million the six months ended June 30, 2001. The increase was related to an increase in the number of visits and the net revenue per visit experienced at our outpatient rehabilitation locations and the additional revenues associated with acquisitions that occurred in the third and fourth quarter of 2001 and the first six months of 2002. These acquisitions provided approximately $16.6 million of net operating revenue for the six months ended June 30, 2002.

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Other. Our other revenues increased to $7.0 million for the six months ended June 30, 2002 compared to $6.5 million for the six months ended June 30, 2001. The increase in other revenue reflects higher corporate general and administrative costs in 2002, which resulted in higher Medicare reimbursements for those costs.

Operating Expenses

Our operating expenses increased by 20.9% to $488.0 million for the six months ended June 30, 2002 compared to $403.6 million for the six months ended June 30, 2001. Our operating expenses consist of our cost of services, general and administrative expense and bad debt expense. The increase in operating expenses was principally related to the internal development of new specialty hospitals that commenced operations in 2001, costs associated with the increased patient volumes and the operating expenses associated with the acquisitions that occurred in the third and fourth quarter of 2001 and first six months of 2002. As a percentage of our net operating revenues, our operating expenses were 88.4% for the six months ended June 30, 2002 compared to 87.9% for the six months ended June 30, 2001. Cost of services as a percentage of operating revenues increased to 81.6% for the six months ended June 30, 2002 from 80.6% for the six months ended June 30, 2001. These costs primarily reflect our labor expenses. This increase reflects the higher costs of services as a percentage of revenue in our newly developed specialty hospitals. During the same time period, general and administrative expense as a percentage of net operating revenues decreased to 3.4% for the six months ended June 30, 2002 from 3.7% for the six months ended June 30, 2001. Our bad debt expense as a percentage of net operating revenues was 3.4% for the six months ended June 30, 2002 compared to 3.6% for the six months ended June 30, 2001. This decline in our relative bad debt percentage resulted from improvement in the composition and age of our accounts receivable.

EBITDA

Our total EBITDA increased 15.4% to $64.2 million for the six months ended June 30, 2002 compared to $55.7 million for the six months ended June 30, 2001. Our EBITDA margins declined to 11.6% for the six months ended June 30, 2002 compared to 12.1% for the six months ended June 30, 2001. The decline in margins is caused by the start-up losses and lower margins incurred in our hospitals that have opened or have been developed since December 31, 2000. Excluding the hospitals opened in 2001 and 2002, our EBITDA margins would be 12.9% for the six months ended June 30, 2002 compared to 12.7% for the six months ended June 30, 2001. For cash flow information, see “-Capital Resources and Liquidity.”

Specialty Acute Care Hospitals. Our specialty hospital EBITDA increased by 22.1% to $32.9 million for the six months ended June 30, 2002 compared to $27.0 million for the six months ended June 30, 2001. Our EBITDA margins were 10.9% for the six months ended June 30, 2002 compared to 11.6% for the six months ended June 30, 2001. The decline in margins is caused by the start-up losses and lower margins incurred in our hospitals that have opened or have been developed since December 31, 2000. The hospitals opened before January 1, 2001 and operated throughout both periods had EBITDA of $36.4 million, an increase of 23.8% over the EBITDA of these hospitals in the same period last year. This increase in same hospital EBITDA resulted from an increase in non-Medicare patient days and its associated increased revenue per patient day. Our EBITDA margin in these same store hospitals increased to 13.3% from 12.7%.

Outpatient Rehabilitation. Our outpatient rehabilitation EBITDA increased by 11.2% to $44.1 million for the six months ended June 30, 2002 compared to $39.7 million for the six months ended June 30, 2001. Approximately $2.1 million of this increase was related to the EBITDA generated by the acquisitions that occurred in the third and fourth quarter of 2001 and the first six months of 2002. Our EBITDA margins increased to 18.1% for the six months ended June 30, 2002 from 18.0% for the six months ended June 30, 2001.

Other. Our other EBITDA loss increased to $12.8 million for the six months ended June 30, 2002 compared to a loss of $11.0 million for the six months ended June 30, 2001. This increase resulted from the

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higher general and administrative costs needed to support the growth of the organization, principally our new hospital development.

Income from Operations

Income from operations increased 30.1% to $52.0 million for the six months ended June 30, 2002 compared to $40.0 million for the six months ended June 30, 2001. The increase in income from operations resulted from the EBITDA increases described above, and a reduction in amortization expense of $4.6 million resulting from the adoption of FAS 142, which was offset by an increase in depreciation expense. The increase in depreciation expense resulted primarily from increases in depreciation on fixed asset additions that are principally related to new hospital development.

Interest Expense

Interest expense decreased by $1.9 million to $13.6 million for the six months ended June 30, 2002 from $15.5 million for the six months ended June 30, 2001. The decline in interest expense is due to the lower debt levels outstanding in 2002 compared to 2001 and a lower effective interest rate in 2002. The lower debt levels resulted from the scheduled term amortization payments under our credit facility and the repayment of all borrowings under the revolving portion of the credit facility. All repayments have been made with cash flows generated through operations.

Minority Interests

Minority interests in consolidated earnings decreased by 48.4% to $1.2 million for the six months ended June 30, 2002 compared to $2.3 million for the six months ended June 30, 2001. This decrease resulted from a smaller percentage of ownership held by minority interests. The terms of our agreements with some of our minority owners allowed them to sell their minority interests back to us upon the completion of our initial public offering which occurred on April 10, 2001. We completed the purchase of these minority interests between May 2001 and October 2001.

Income Taxes

We recorded income tax expense of $14.7 million for the six months ended June 30, 2002. The expense represented an effective tax rate of 39.2% and approximates the federal and state statutory tax rates. We recorded income tax expense of $8.8 million for the six months ended June 30, 2001. This expense represented an effective tax rate of 39.0%.

Extraordinary Item

We recorded an extraordinary charge in the six months ended June 30, 2001. The extraordinary item consists of $1.3 million of unamortized deferred financing costs related to the repayment of our U.S. term loan and $12.9 million of deferred financing costs and unamortized discount related to the repayment of our 10% Senior Subordinated Notes. These costs were offset by a tax benefit of $5.5 million.

Capital Resources and Liquidity

For the six months ended June 30, 2002 operating activities provided $50.5 million of cash flow compared to $51.9 million for the six months ended June 30, 2001. Our accounts receivable days outstanding were 76 days at June 30, 2002 compared to 77 days at December 31, 2001 and 80 days at June 30, 2001.

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Investing activities used $21.8 and $26.5 million of cash flow for the six months ended June 30, 2002 and 2001, respectively. This usage resulted from purchases of property and equipment of $17.9 and $10.8 million in 2002 and 2001, respectively that relate principally to new hospital development. Additionally, we incurred earnout related payments of $0.5 million and $4.8 million in 2002 and 2001, respectively. We incurred acquisition payments of $3.3 million and $11.7 million in 2002 and 2001, respectively.

Financing activities used $10.6 and $14.4 million of cash for the six months ended June 30, 2002 and 2001, respectively. This was due principally to the repayment of credit facility, seller and other debt.

Capital Resources

Net working capital increased to $133.0 million as of June 30, 2002 compared to $126.7 million at December 31, 2001. This increase is principally related to higher cash balances.

We have a credit agreement with a group of banks. Our credit facility consists of a term facility of $83.8 million and a revolving credit facility of $152.4 million. As of June 30, 2002 we had borrowed all of our available loans under the U.S. and Canadian term loans and had availability to borrow an additional $147.7 million under our revolving facility subject to certain limitations. We have $4.7 million outstanding under letters of credit issued through the credit facility. The revolving facility terminates in 2005.

Borrowings under the credit agreement bear interest at a fluctuating rate of interest based upon financial covenant ratio tests. As of June 30, 2002, our weighted average interest rate under our credit agreement was approximately 7.5%. A portion of the amount borrowed under our U.S. term loan portion of our credit agreement is hedged through an interest rate swap transaction, which fixes the rate paid through March 31, 2003. See Item 3, “Quantitative and Qualitative Disclosures on Market Risk” for a discussion of our floating interest rates on borrowings under our credit facility.

We are required to pay a quarterly commitment fee at a rate that ranges from .375% to .500%, based upon financial covenant ratio tests. This fee applies to unused commitments under the revolving credit facility. The terms of the credit agreement include various restrictive covenants. These covenants include:

• restrictions against incurring additional indebtedness,

• disposing of assets,

• incurring capital expenditures,

• making investments,

• restrictions against paying certain dividends,

• engaging in transactions with affiliates,

• incurring contingent obligations, and

• allowing or causing fundamental changes.

The covenants also require us to maintain various financial ratios regarding total indebtedness, interest, fixed charges and net worth. The borrowings are secured by substantially all of the tangible and intangible assets of us and our subsidiaries, including all of the capital stock of our domestic subsidiaries and 65% of the capital stock of our direct foreign subsidiaries. In addition, the loans have been guaranteed by our domestic subsidiaries.

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On June 11, 2001, we issued and sold $175.0 million aggregate principal amount of 9 1 /2% senior subordinated notes due June 15, 2009. The notes were issued under an indenture dated as of June 11, 2001 between us and State Street Bank and Trust Company, N.A., as Trustee. Interest on the notes is payable semiannually in arrears on June 15 and December 15 of each year. The notes are unsecured senior subordinated obligations of Select Medical, are subordinated in right of payment to all existing and future senior indebtedness of Select Medical, and are senior in right of payment to all future subordinated indebtedness of Select Medical. The notes are guaranteed on a senior subordinated basis by all of our wholly-owned domestic subsidiaries, subject to certain exceptions. On or after June 15, 2005, the notes may be redeemed at our option, in whole or in part, at redemption prices that decline annually to 100% on and after June 15, 2008, plus accrued and unpaid interest.

Upon a change of control of Select Medical, each holder of notes may require us to repurchase all or any portion of the holder’s notes at a purchase price equal to 101% of the principal amount plus accrued and unpaid interest to the date of purchase. The indenture contains certain covenants that, among other things, limit the incurrence of additional debt by Select Medical and certain of its subsidiaries; the payment of dividends on capital stock of Select Medical and the purchase, redemption or retirement of capital stock or subordinated indebtedness; investments; certain transactions with affiliates; sales of assets, including capital stock of subsidiaries; and certain consolidations, mergers and transfers of assets. The indenture also prohibits certain restrictions on distributions from certain subsidiaries. All of these limitations and prohibitions, however, are subject to a number of qualifications.

We believe that existing cash balances, internally generated cash flows and borrowings under our revolving credit facility will be sufficient to finance acquisitions, capital expenditures and working capital requirements for at least the next twelve months. Our goal is to open eight to ten additional hospitals during 2002. A new specialty hospital has historically required approximately $3.4 million per hospital over the initial year of operations to fund leasehold improvements, equipment, start-up losses and working capital. From time to time, we may complete acquisitions of specialty hospitals and outpatient rehabilitation businesses. We currently have approximately $148 million of unused capacity under our revolving credit facility which can be used for acquisitions. Based on the size of the acquisition, approval of the acquisition by our lenders may be required. If funds required for future acquisitions exceed this capacity, we will need to increase our credit facilities or obtain additional capital by other means.

Inflation

The health care industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. We have implemented cost control measures, including our case and resource management program, to curtail increases in operating costs and expenses. We have, to date, offset increases in operating costs by increasing reimbursement for services and expanding services. However, we cannot predict our ability to cover or offset future cost increases.

Recent Accounting Pronouncement

In June 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, “ Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. Adoption of SFAS No. 146 is required with the beginning of fiscal year 2003. We do not anticipate a significant impact on its results of operations from adopting this Statement.

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In April 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 145 “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” As a result of rescinding SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” the requirement that gains and losses from the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect is eliminated. We reported extraordinary items in 1999, 2000 and 2001 as a result of debt extinguishments. The provisions of SFAS 145 that affect us are effective for fiscal periods beginning after May 15, 2002 although, early adoption of SFAS 145 is permitted. We believe that the adoption of SFAS 145 will require us to reclassify our extraordinary items recorded in 1999, 2000 and 2001 to the other income and expense category of our consolidated statement of operations.

In October 2001, the Financial Accounting Standards Board approved SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS 144 supersedes the accounting provisions of APB 30 that address the disposal of a segment of a business and requires that such long-lived assets be reported at fair value less cost to sell. SFAS 144 requires that long-lived assets to be abandoned, exchanged for similar productive assets or distributed to owners in a spin-off be considered held for use until they are abandoned, exchanged or distributed. It also eliminates the exception to consolidation for a subsidiary while control is expected to be temporary. We adopted SFAS 144 on January 1, 2002 with no material effect on net income.

In June 2001, the Financial Accounting Standards Board issued No. 142 “Goodwill and Other Intangible Assets” which we adopted on January 1, 2002. This accounting standard eliminates the periodic amortization of goodwill, and instead requires an annual impairment testing of goodwill and introduces the concept of indefinite life intangible assets. There was no asset impairment recognized by Select upon the adoption of this accounting standard. If the new standard had been in effect in 2001, pre-tax amortization expense for the three months and six months ended June 30, 2001 would have been $2.3 million and $4.6 million less, respectively. This would have increased fully diluted earnings per share by approximately $0.03 and $0.07 for the three and six months ended June 30, 2001, respectively.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Quantitative and Qualitative Disclosures About Market Risk

We are exposed to interest rate changes, primarily as a result of floating interest rates on borrowings under our credit facility. A change in interest rates by one percentage point on variable rate debt would have resulted in interest expense fluctuating approximately $0.1 million and $0.2 million for the three and six months ended June 30, 2002, respectively. As required by our credit agreement, on March 30, 2001, we entered into an interest rate swap agreement that fixes the interest rate cost to us on a portion of the U.S. term loans outstanding under our credit facility for a period of four years. The swap became effective on April 27, 2001. In January 2002 we amended the swap to mature in March 2003. The fixed rate portion of all of our outstanding U.S. term loans was 91% as of June 30, 2002.

Approximately 17% of our term-loan borrowings under our credit agreement are denominated in Canadian dollars. Although we are not required by our credit agreement to maintain a hedge on our foreign currency risk, we have entered into a five year agreement that allows us to limit the cost of Canadian dollars to a range of U.S.$0.6631 to U.S.$0.6711 per Canadian dollar to limit our risk on the potential fluctuation in the exchange rate of the Canadian dollar to the U.S. dollar.

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PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On August 10, 1998 a complaint in the U.S. District Court for the Eastern District of Pennsylvania was filed that named as defendants, NovaCare, Inc. (now known as NAHC, Inc.), other named defendants and 100 defendants who were to be named at a later time. This qui tam action sought triple damages and penalties under the False Claims Act against NAHC. The Department of Justice did not intervene in this action. The allegations involve, among other things, the distinction between individual and group billing in physical rehabilitation clinics that we acquired from NovaCare. On October 16, 2000 the relator plaintiff made a motion to amend the complaint to, among other things, add Select Medical Corporation and some of its subsidiaries acquired in the NovaCare acquisition as defendants in this case. This motion was granted in September of 2001. The amended complaint alleges that from about January 1, 1995 through the present, the defendants submitted false or fraudulent bills for physical therapy to various federal health programs. The United States Attorneys Office has asserted that because the complaint is being amended to add allegations against new defendants, it is entitled to a new period to determine whether to intervene in the new allegations. On January 3, 2002, NAHC and its related subsidiaries (including the subsidiaries acquired in the NovaCare acquisition) entered in to a settlement agreement with the relator plaintiff and the government, pursuant to which, in exchange for a payment by NAHC of $375,000, the parties settled all claims arising out of conduct that took place before Select Medical’s acquisition of the NovaCare subsidiaries that are defendants in the case. Claims against the Company and the NovaCare subsidiaries regarding conduct occurring after the NovaCare acquisition were not settled. As of July 31, 2002, the government had not advised the Company whether it intends to intervene in any remaining claims, and Select and the subsidiaries have not been served with the amended complaint. Based on a review of the amended complaint, we do not believe that this lawsuit is meritorious, and we intend to vigorously defend against this action. However, because of the uncertain nature of the litigation, we cannot predict the outcome of this matter.

In addition, as part of our business, we are subject to legal actions alleging liability on our part. To cover claims arising out of the operations of our hospitals and outpatient rehabilitation facilities, we generally maintain professional malpractice liability insurance and general liability insurance in amounts and with deductibles that we believe to be sufficient for our operations. We also maintain umbrella liability coverage covering claims which, due to their nature or amount, are not covered by our insurance policies. We cannot assure you that professional liability insurance will cover all claims against us or continue to be available at reasonable costs for us to maintain adequate levels of insurance. These insurance policies also do not cover punitive damages.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 13, 2002, the Company held its Annual Meeting of Stockholders. At this meeting the stockholders voted in favor of the following items listed and described in the Company’s Proxy Statement dated April 19, 2002.

1) Election of Directors.


	For		Withheld

David S. Chernow		42,180,519		1,506,800




Meyer Feldberg		42,117,632		1,569,687




LeRoy S. Zimmerman		42,090,007		1,597,312

The following directors’ term of office as directors continued after this meeting:


Bryan C. Cressey




James E. Dalton, Jr.




Robert A. Ortenzio




Russell L. Carson




Rocco A. Ortenzio




Leopold Swergold

2) Approval of the adoption of the Select Medical Corporation Amended and Restated 2002 Non-Employee Directors’ Plan.


					Broker
For	Against		Abstain		Non-Votes

34,684,562		6,568,367		27,664		2,406,726

3) Approval of the adoption of the Select Medical Corporation Second Amended and Restated 1997 Stock Option Plan.


					Broker
For	Against		Abstain		Non-Votes

33,741,123		7,512,416		27,054		2,406,726

4) Ratification of the appointment of PricewaterhouseCoopers LLP as the Company’s independent auditors for the fiscal year ending December 31, 2002.


For	Against		Abstain

43,575,439		107,460		4,420

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ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Exhibits

The exhibits to this report are listed in the Exhibit Index appearing on page 35 hereof.

b. Reports on Form 8-K

None.

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.


	SELECT MEDICAL CORPORATION









	By:	/s/ Martin F. Jackson

		Martin F. Jackson Senior Vice President and Chief Financial Officer (Duly Authorized Officer)









	By:	/s/ Scott A. Romberger

		Scott A. Romberger Vice President, Chief Accounting Officer and Controller (Principal Accounting Officer)









Dated: August 9, 2002

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EXHIBIT INDEX


Exhibit		Description

10.1		Select Medical Corporation Second Amended and Restated 1997 Stock Option Plan, incorporated by reference to Appendix C of the Company’s Proxy Statement filed on Schedule 14A on April 19, 2002.









10.2		First Addendum to Lease Agreement by and between Old Gettysburg Associates II and Select Medical Corporation, dated as of February 26, 2002.









10.3		Second Addendum to Lease Agreement by and between Old Gettysburg Associates II and Select Medical Corporation, data as of February 26, 2002.









10.4		Third Addendum to Lease Agreement by and between Old Gettysburg Associates II and Select Medical Corporation, dated as of February 26, 2002.

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	•		a change in government reimbursement for our services that would affect our revenue;

	•		the failure of our long-term acute care hospitals to maintain their status as such, which could negatively impact our profitability;

	•		private third party payors of our services may undertake cost containment initiatives that would decrease our revenue;

	•		shortages in qualified nurses could increase our operating costs significantly;

	•		future acquisitions may use significant resources and expose us to unforeseen risks, and

	•		the effects of liability and other claims asserted against us.

	•		restrictions against incurring additional indebtedness,

	•		disposing of assets,

	•		incurring capital expenditures,

	•		making investments,

	•		restrictions against paying certain dividends,

	•		engaging in transactions with affiliates,

	•		incurring contingent obligations, and

	•		allowing or causing fundamental changes.