SELECT MEDICAL CORP - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the Quarter Ended September 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 [X] NO [ ]

As of October 31, 2002, the number of outstanding shares of the Registrant’s Common Stock was 46,667,205.

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 Flow
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
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
AMENDED AND RESTATED COST SHARING AGREEMENT
STOCK PURCHASE AGREEMENT DATED AS OF 9-16-2002
MUTUAL TERMINATION OF CONSULTING AGREEMENT

TABLE OF CONTENTS


PART I FINANCIAL INFORMATION		3









ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS









	Consolidated balance sheets	3




	Consolidated statements of operations	4




	Consolidated statement 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		33









ITEM 4. CONTROLS AND PROCEDURES		33









PART II OTHER INFORMATION		33









ITEM 1. LEGAL PROCEEDINGS		33









ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS		34









ITEM 3. DEFAULTS UPON SENIOR SECURITIES		34









ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		34









ITEM 5. OTHER INFORMATION		34









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









SIGNATURES		35

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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)


				September 30,			December 31,
				2002			2001

			Assets	(unaudited)




Current Assets:




	Cash and cash equivalents			$	59,969		$	10,703




	Accounts receivable, net of allowance for doubtful accounts of $79,145 and $79,889 in 2002 and 2001, respectively				229,968			218,393




	Current deferred tax asset				27,006			28,945




	Other current assets				17,309			18,444

Total Current Assets					334,252			276,485




Property and equipment, net					105,433			92,005




Goodwill					204,749			199,850




Trademark					37,875			37,875




Other intangibles					9,107			9,532




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




Other assets					25,010			28,424

Total Assets				$	721,529		$	650,845

		Liabilities and Stockholders’ Equity




Current Liabilities:




	Bank overdrafts			$	8,515		$	6,083




	Current portion of long-term debt and notes payable				30,380			26,774




	Accounts payable				33,915			33,520




	Accrued payroll				35,675			27,160




	Accrued vacation				14,638			12,820




	Accrued restructuring				1,006			1,819




	Accrued other				34,964			23,568




	Income taxes payable				9,812			1,735




	Due to third-party payors				35,566			16,257

Total Current Liabilities					204,471			149,736




Long-term debt, net of current portion					238,373			261,649

Total Liabilities					442,844			411,385




Commitments and Contingencies




Minority interest in consolidated subsidiary companies					5,471			5,176




Stockholders’ Equity:




	Common stock — $.01 par value: Authorized shares - 200,000,000 Issued shares - 46,667,000 in 2002 and 46,488,000 in 2001				467			465




	Capital in excess of par				236,203			231,349




	Retained earnings				38,056			5,924




	Treasury stock, at cost - 461,000 shares in 2001				—			(1,560	)




	Accumulated other comprehensive loss				(1,512	)		(1,894	)

Total Stockholders’ Equity					273,214			234,284

Total Liabilities and Stockholders’ Equity				$	721,529		$	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						For the Nine Months Ended
				September 30,						September 30,

				2002			2001			2002			2001

Net operating revenues				$	278,983		$	239,155		$	831,175		$	698,442

Costs and expenses:




	Cost of services				231,054			194,900			680,972			564,861




	General and administrative				10,317			8,951			29,329			25,945




	Bad debt expense				8,611			9,360			27,631			26,008




	Depreciation and amortization				6,518			8,150			18,724			23,829

Total costs and expenses					256,500			221,361			756,656			640,643

Income from operations					22,483			17,794			74,519			57,799




Other income and expense:




Interest income					(181	)		(102	)		(388	)		(382	)




Interest expense					6,875			7,026			20,468			22,548

Income before minority interests, income taxes and extraordinary item					15,789			10,870			54,439			35,633




Minority interest in consolidated subsidiary companies					390			473			1,563			2,745

Income before income taxes and extraordinary item					15,399			10,397			52,876			32,888




Income tax expense					6,044			4,054			20,744			12,826

Income before extraordinary item					9,355			6,343			32,132			20,062




Extraordinary item					—			—			—			8,676

Net income				$	9,355		$	6,343		$	32,132		$	11,386




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

Net income available to common stockholders				$	9,355		$	6,343		$	32,132		$	8,873

Net income per common share:




		Basic:




			Income before extraordinary item	$	0.20		$	0.14		$	0.69		$	0.46




			Extraordinary item		—			—			—			(0.23	)

			Income per common share	$	0.20		$	0.14		$	0.69		$	0.23





		Diluted:




			Income before extraordinary item	$	0.19		$	0.13		$	0.65		$	0.42




			Extraordinary item		—			—			—			(0.20	)

			Income per common share	$	0.19		$	0.13		$	0.65		$	0.22





Weighted average shares outstanding:




		Basic			46,653			45,328			46,394			38,094




		Diluted			49,268			49,223			49,126			44,333

See accompanying notes

-4-

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


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

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




	Net income											32,132							$	32,132




	Other comprehensive income																382			382

	Total comprehensive income																		$	32,514

	Issuance of common stock		640			6			4,019




	Retirement of treasury stock		(461	)		(4	)		(1,556	)				1,560




	Valuation of non-employee options								152




	Tax benefit of stock option exercises								2,239

Balance at September 30, 2002			46,667		$	467		$	236,203		$	38,056	$	—		$	(1,512	)

See accompanying notes

-5-

SELECT MEDICAL CORPORATION
Consolidated Statements of Cash Flow
(in thousands)
(unaudited)


			For the Nine Months
			Ended September 30,

			2002			2001

Operating activities




Net income			$	32,132		$	11,386




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




	Depreciation and amortization			18,724			23,829




	Provision for bad debts			27,631			26,008




	Minority interests			1,563			2,745




	Extraordinary item			—			8,676




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




		Accounts receivable		(39,161	)		(32,690	)




		Other current assets		(72	)		808




		Other assets		3,566			3,710




		Accounts payable		382			7,843




		Due to third-party payors		21,494			8,815




		Accrued expenses		20,019			17,113




		Income taxes		16,478			7,202

Net cash provided by operating activities				102,756			85,445

Investing activities




Purchases of property and equipment, net				(28,805	)		(16,109	)




Proceeds from disposal of assets				—			808




Earnout payments				(563	)		(4,842	)




Acquisition of businesses, net of cash acquired				(7,761	)		(15,425	)

Net cash used in investing activities				(37,129	)		(35,568	)

Financing activities




Issuance of 9.5% Senior Subordinated Notes				—			175,000




Net repayments on credit facility debt				(16,972	)		(99,962	)




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




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




Principal payments on seller and other debt				(4,524	)		(16,586	)




Proceeds from initial public offering, net of fees				—			89,181




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				4,025			38




Proceeds from (repayment of) bank overdrafts				2,432			(4,340	)




Distributions to minority interests				(1,264	)		(2,251	)

Net cash used in financing activities				(16,370	)		(25,687	)

Effect of exchange rate changes on cash and cash equivalents				9			(107	)

Net increase in cash and cash equivalents				49,266			24,083




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

Cash and cash equivalents at end of period			$	59,969		$	27,234

Supplemental Cash Flow Information




Cash paid for interest			$	14,200		$	17,545




Cash paid for income taxes			$	4,552		$	2,951

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 September 30, 2002 and for the three and nine month periods ended September 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 nine months ended September 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

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.

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. The Company reported extraordinary items in 1999, 2000 and 2001 as a result of debt extinguishments. The provisions of SFAS 145 that affect the 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.

-7-

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 nine months ended September 30, 2002, the Company granted stock options under its Second Amended and Restated 1997 Stock Option Plan totaling 4,447,956 shares of Common Stock at exercise prices ranging from $12.66 to $15.25 per share. Of this amount, 2,308,200 were issued as Performance Accelerated Vesting Options.

-8-

4. Segment Information

The Company’s segments consist of (i) specialty 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 September 30, 2002

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	155,637,000	$	119,179,000	$	4,167,000		$	278,983,000




EBITDA		16,522,000		19,025,000		(6,546,000	)		29,001,000




Total assets		318,164,000		324,934,000		78,431,000			721,529,000




Capital expenditures		5,908,000		4,067,000		882,000			10,857,000


	Three Months Ended September 30, 2001

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	129,442,000	$	106,083,000	$	3,630,000		$	239,155,000




EBITDA		14,189,000		17,421,000		(5,666,000	)		25,944,000




Total assets		260,606,000		309,374,000		56,216,000			626,196,000




Capital expenditures		2,519,000		2,346,000		434,000			5,299,000


	Nine Months Ended September 30, 2002

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	456,538,000	$	363,512,000	$	11,125,000		$	831,175,000




EBITDA		49,470,000		63,148,000		(19,375,000	)		93,243,000




Total assets		318,164,000		324,934,000		78,431,000			721,529,000




Capital expenditures		18,348,000		8,994,000		1,463,000			28,805,000


	Nine Months Ended September 30, 2001

	Specialty		Outpatient
	Hospitals		Rehabilitation		All Other			Total

Net revenue	$	361,627,000	$	326,715,000	$	10,100,000		$	698,442,000




EBITDA		41,167,000		57,107,000		(16,646,000	)		81,628,000




Total assets		260,606,000		309,374,000		56,216,000			626,196,000




Capital expenditures		8,828,000		6,112,000		1,169,000			16,109,000

-9-

A reconciliation of EBITDA to net income is as follows:


	For the Three Months Ended						For the Nine Months Ended
	September 30,						September 30,

	2002			2001			2002			2001

EBITDA	$	29,001,000		$	25,944,000		$	93,243,000		$	81,628,000




Depreciation and amortization		(6,518,000	)		(8,150,000	)		(18,724,000	)		(23,829,000	)




Interest income		181,000			102,000			388,000			382,000




Interest expense		(6,875,000	)		(7,026,000	)		(20,468,000	)		(22,548,000	)




Minority interest		(390,000	)		(473,000	)		(1,563,000	)		(2,745,000	)




Income tax expense		(6,044,000	)		(4,054,000	)		(20,744,000	)		(12,826,000	)




Extraordinary item, net of taxes		—			—			—			(8,676,000	)

Net income	$	9,355,000		$	6,343,000		$	32,132,000		$	11,386,000

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		(734,000	)		(79,000	)		(813,000	)

September 30, 2002	$	953,000		$	53,000		$	1,006,000

All employees to be terminated have been severed and the Company expects to pay out the remaining restructuring reserves through 2003.

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 nine months ended September 30, 2002 was $528,000. Estimated amortization expense for intangible assets for each of the five years commencing January 1, 2002 will be approximately $553,000.

-10-

Intangible assets consist of the following:


		As of September 30, 2002

		Gross Carrying		Accumulated
		Amount		Amortization

Amortized intangible assets




Management services agreements		$	11,404,000	$	(2,297,000	)

Unamortized intangible assets




Goodwill		$	204,749,000




Trademarks			37,875,000





	Total	$	242,624,000

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				For the Nine Months Ended
	September 30,				September 30,

	2002		2001		2002		2001

Reported net income	$	9,355,000	$	6,343,000	$	32,132,000	$	11,386,000




Add back: Goodwill amortization		—		1,164,000		—		3,633,000




Add back: Trademark amortization		—		152,000		—		456,000





Adjusted net income	$	9,355,000	$	7,659,000	$	32,132,000	$	15,475,000

Basic earnings per share:




Reported net income	$	0.20	$	0.14	$	0.69	$	0.23




Goodwill amortization		—		.03		—		0.10




Trademark amortization		—		—		—		0.01





Adjusted net income	$	0.20	$	0.17	$	0.69	$	0.34

Diluted earnings per share:




Reported net income	$	0.19	$	0.13	$	0.65	$	0.22




Goodwill amortization		—		.03		—		0.08




Trademark amortization		—		—		—		0.01





Adjusted net income	$	0.19	$	0.16	$	0.65	$	0.31

-11-

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


	Specialty		Outpatient			All
	Hospitals		Rehabilitation			Other		Total

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




Goodwill acquired during year		—		6,933,000			—		6,933,000




Income tax benefits recognized		—		(2,735,000	)		—		(2,735,000	)




Earn-out payments		—		563,000			—		563,000




Translation adjustment		—		160,000			—		160,000




Other		—		(22,000	)		—		(22,000	)

Balance as of September 30, 2002	$	84,391,000	$	119,774,000		$	584,000	$	204,749,000

7. Net Income per Share

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


		Three Months Ended				Nine Months Ended
		September 30,				September 30,

		2002		2001		2002		2001

Numerator:




Net income before extraordinary item		$	9,355,000	$	6,343,000	$	32,132,000	$	20,062,000




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

Net income			9,355,000		6,343,000		32,132,000		11,386,000




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

	Numerator for basic earnings per share – income available to common stockholders		9,355,000		6,343,000		32,132,000		8,873,000




Effect of dilutive securities:




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

	Numerator for diluted earnings per share – income available to common stockholders after assumed conversions	$	9,355,000	$	6,343,000	$	32,132,000	$	9,940,000

Denominator:




	Denominator for basic earnings per share – weighted average shares		46,653,000		45,328,000		46,394,000		38,094,000




	Effect of dilutive securities:




	a) Stock options		1,536,000		2,648,000		1,649,000		1,822,000




	b) Warrants		1,079,000		1,247,000		1,083,000		1,041,000




	c) Convertible preferred stock		—		—		—		3,376,000

Denominator for diluted earnings per share – adjusted weighted average shares and assumed conversions			49,268,000		49,223,000		49,126,000		44,333,000

-12-


		Three Months Ended				Nine Months Ended
		September 30,				September 30,

		2002		2001		2002		2001

Basic income per common share:




Income before extraordinary item		$	0.20	$	0.14	$	0.69	$	0.46




	Extraordinary item		—		—		—		(0.23	)

	Income per common share	$	0.20	$	0.14	$	0.69	$	0.23

Diluted income per common share:




Income before extraordinary item		$	0.19	$	0.13	$	0.65	$	0.42




	Extraordinary item		—		—		—		(0.20	)

	Diluted income per common share	$	0.19	$	0.13	$	0.65	$	0.22

8. Supplemental Disclosures of Cash Flow Information

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


	2002		2001

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




Minority interest repurchase	$	—	$	4,973,000




Notes issued with acquisitions	$	1,827,000	$	2,523,000




Tax benefit of stock option exercises	$	2,239,000	$	—




Liabilities assumed with acquisitions	$	—	$	283,000

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 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 the Company 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. On January 3, 2002, NAHC and its related subsidiaries (including the subsidiaries acquired in the NovaCare acquisition) 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 alleged conduct occurring after the NovaCare acquisition were not covered by the settlement. In September 2002, the Company learned that the United States Attorney for the Eastern District of Pennsylvania had notified the court that the United States had decided not to intervene in this case. As of October 31, 2002, 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 it intends to vigorously defend against this action if it is pursued by the relator plaintiff. 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 18 unsettled cases in 8 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 September 30, 2002 and for the nine months ended September 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

		September 30, 2002

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

								(dollars in thousands)
Assets




Current Assets:




	Cash and cash equivalents	$	35,263		$	23,266		$	1,440		$	—		$	59,969




	Accounts receivable, net		(427	)		192,779			37,616			—			229,968




	Current deferred tax asset		1,752			25,074			180			—			27,006




	Other current assets		2,562			11,928			2,819			—			17,309

Total Current Assets			39,150			253,047			42,055			—			334,252




Property and equipment, net			6,751			78,218			20,464			—			105,433




Investment in affiliates			332,914			68,058			—			(400,972	)(a)		—




Goodwill			5,854			164,655			34,240			—			204,749




Trademark			—			37,875			—			—			37,875




Other intangibles			—			823			8,284			—			9,107




Non-current deferred tax asset			7,611			(2,508	)		—			—			5,103




Other assets			10,958			13,083			969			—			25,010

Total Assets		$	403,238		$	613,251		$	106,012		$	(400,972	)	$	721,529

Liabilities and Stockholders’ Equity




Current Liabilities:




	Bank overdrafts	$	8,515		$	—		$	—		$	—		$	8,515




	Current portion of long-term debt and notes payable		570			29,345			465			—			30,380




	Accounts payable		1,856			26,830			5,229			—			33,915




	Intercompany accounts		17,877			(9,544	)		(8,333	)		—			—




	Accrued payroll		401			35,218			56			—			35,675




	Accrued vacation		3,258			9,977			1,403			—			14,638




	Accrued restructuring		—			1,006			—			—			1,006




	Accrued other		18,824			15,749			391			—			34,964




	Income taxes		11,359			1,835			(3,382	)		—			9,812




	Due to third party payors		(20,142	)		53,047			2,661			—			35,566

Total Current Liabilities			42,518			163,463			(1,510	)		—			204,471




Long-term debt, net of current portion			87,506			103,582			47,285			—			238,373

Total liabilities			130,024			267,045			45,775			—			442,844




Commitments and Contingencies




Minority interest in consolidated subsidiary companies			—			234			5,237			—			5,471




Stockholders’ Equity:




	Common stock		467			—			—			—			467




	Capital in excess of par		236,203			—			—			—			236,203




	Retained earnings		38,056			49,190			15,177			(64,367	)(b)		38,056




	Subsidiary investment		—			296,782			39,823			(336,605	)(a)		—




	Accumulated other comprehensive loss		(1,512	)		—			—			—			(1,512	)

Total Stockholders’ Equity			273,214			345,972			55,000			(400,972	)		273,214

Total Liabilities and Stockholders’ Equity		$	403,238		$	613,251		$	106,012		$	(400,972	)	$	721,529

(a)		Elimination of investments in subsidiaries.




(b)		Elimination of investments in subsidiaries’ earnings.

-15-


					Select Medical Corporation

					Condensed Consolidating Statement of Operations

		For the Nine Months Ended September 30, 2002

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

								(dollars in thousands)
Net operating revenues		$	10,402		$	676,897		$	143,876		$	—		$	831,175

Costs and expenses:




	Cost of services		—			561,303			119,669			—			680,972




	General and administrative		29,329			—			—			—			29,329




	Bad debt expense		—			23,457			4,174			—			27,631




	Depreciation and amortization		1,261			13,559			3,904			—			18,724

Total costs and expenses			30,590			598,319			127,747			—			756,656

Income (loss) from operations			(20,188	)		78,578			16,129			—			74,519




Other income and expense:




Intercompany interest and royalty fees			16,097			(16,507	)		410						—




Intercompany management fees			(43,573	)		41,412			2,161						—




Interest income			(318	)		(69	)		(1	)		—			(388	)




Interest expense			5,799			11,137			3,532			—			20,468

Income before minority interests and income taxes			1,807			42,605			10,027			—			54,439




Minority interest in consolidated subsidiary companies			—			21			1,542			—			1,563

Income before income taxes			1,807			42,584			8,485			—			52,876




Income tax expense			474			18,298			1,972						20,744




Equity in earnings of subsidiaries			30,799			3,299			—			(34,098	)(a)		—

Net income		$	32,132		$	27,585		$	6,513		$	(34,098	)	$	32,132

(a)

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

-16-


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

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

				(dollars in thousands)
Operating activities




Net income				$	32,132		$	27,585		$	6,513		$	(34,098	)(a)	$	32,132




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




	Depreciation and amortization				1,261			13,559			3,904			—			18,724




	Provision for bad debts				—			23,457			4,174			—			27,631




	Minority interests				—			21			1,542			—			1,563




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




		Equity in earnings of subsidiaries			(30,799	)		(3,299	)		—			34,098	(a)		—




		Intercompany			(14,364	)		21,077			(6,713	)		—			—




		Accounts receivable			(64	)		(30,404	)		(8,693	)		—			(39,161	)




		Other current assets			(598	)		631			(105	)		—			(72	)




		Other assets			1,536			1,164			866			—			3,566




		Accounts payable			(1,234	)		957			659			—			382




		Due to third-party payors			9,309			6,496			5,689			—			21,494




		Accrued expenses			6,937			14,067			(985	)		—			20,019




		Income taxes			3,534			16,326			(3,382	)		—			16,478

Net cash provided by operating activities					7,650			91,637			3,469			—			102,756

Investing activities




Purchases of property and equipment, net					(1,444	)		(23,833	)		(3,528	)		—			(28,805	)




Earnout payments					—			(563	)		—			—			(563	)




Acquisition of businesses, net of cash acquired					—			(5,548	)		(2,213	)		—			(7,761	)

Net cash used in investing activities					(1,444	)		(29,944	)		(5,741	)		—			(37,129	)

Financing activities




Intercompany debt reallocation					37,429			(42,365	)		4,936			—			—




Net repayments on credit facility debt					(14,960	)		—			(2,012	)		—			(16,972	)




Principal payments on seller and other debt					(370	)		(4,148	)		(6	)		—			(4,524	)




Proceeds from issuance of common stock					4,025			—			—			—			4,025




Proceeds from bank overdrafts					2,432			—			—			—			2,432




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




Distributions to minority interests					—			—			(1,264	)		—			(1,264	)

Net cash provided by (used in) financing activities					28,489			(46,513	)		1,654			—			(16,370	)

Effect of exchange rate changes on cash and cash equivalents					9			—			—			—			9

Net increase (decrease) in cash and cash equivalents					34,704			15,180			(618	)		—			49,266




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

Cash and cash equivalents at end of period				$	35,263		$	23,266		$	1,440		$	—		$	59,969

(a) Elimination of equity in earnings of subsidiary.

-17-


					Select Medical Corporation

					Condensed Consolidating Statement of Operations

		For the Nine Months Ended September 30, 2001

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

			(dollars in thousands)
Net operating revenues		$	9,429		$	566,128		$	122,885		$	—		$	698,442

Costs and expenses:




	Cost of services		—			465,260			99,601			—			564,861




	General and administrative		25,945			—			—			—			25,945




	Bad debt expense		—			22,461			3,547			—			26,008




	Depreciation and amortization		1,327			18,754			3,748			—			23,829

Total costs and expenses			27,272			506,475			106,896			—			640,643

Income (loss) from operations			(17,843	)		59,653			15,989			—			57,799




Other income and expense:




Intercompany charges			(31,572	)		25,998			5,574			—			—




Interest income			(311	)		(70	)		(1	)		—			(382	)




Interest expense			5,367			13,297			3,884			—			22,548

Income before minority interests and income taxes			8,673			20,428			6,532			—			35,633




Minority interest in consolidated subsidiary companies			—			578			2,167			—			2,745

Income before income taxes			8,673			19,850			4,365			—			32,888




Income tax expense			4,296			8,132			398			—			12,826




Equity in earnings of subsidiaries			15,685			2,382			—			(18,067	)(a)		—

Income before extraordinary item			20,062			14,100			3,967			(18,067	)		20,062




Extraordinary item			8,676			—			—			—			8,676

Net income		$	11,386		$	14,100		$	3,967		$	(18,067	)	$	11,386

-18-


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

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

			(dollars in thousands)




Operating activities
Net income				$	11,386		$	14,100		$	3,967		$	(18,067	)(a)	$	11,386
Adjustments to reconcile net income to net cash provided by operating activities:
	Depreciation and amortization				1,327			18,754			3,748			—			23,829
	Provision for bad debts				—			22,461			3,547			—			26,008
	Minority interests				—			578			2,167			—			2,745
	Extraordinary item				8,676			—			—			—			8,676
	Changes in operating assets and liabilities, net of effects from acquisition of businesses:
		Equity in earnings of subsidiaries			(15,685	)		(2,382	)		—			18,067	(a)		—
		Intercompany			57,169			(53,564	)		(3,605	)		—			—
		Accounts receivable			118			(23,468	)		(9,340	)		—			(32,690	)
		Other current assets			168			1,266			(626	)		—			808
		Other assets			(1,629	)		5,910			(571	)		—			3,710
		Accounts payable			2,078			4,369			1,396			—			7,843
		Due to third-party payors			(9,400	)		14,914			3,301			—			8,815
		Accrued expenses			6,493			8,439			2,181			—			17,113
		Income taxes			(9,229	)		17,863			(1,432	)		—			7,202

Net cash provided by operating activities					51,472			29,240			4,733			—			85,445

Investing activities
Purchases of property and equipment, net					(1,137	)		(13,128	)		(1,844	)		—			(16,109	)
Proceeds from disposal of assets					—			808			—			—			808
Earnout payments					—			(4,842	)		—			—			(4,842	)
Acquisition of businesses, net of cash acquired					(15,425	)		—			—			—			(15,425	)

Net cash used in investing activities					(16,562	)		(17,162	)		(1,844	)		—			(35,568	)

Financing activities
Issuance of 9.5% Senior Subordinated Notes					175,000			—			—			—			175,000
Net repayments on credit facility debt					(99,962	)		—			—			—			(99,962	)
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					(16,586	)		—			—			—			(16,586	)
Proceeds from initial public offering, net of fees					89,181			—			—			—			89,181
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					38			—			—			—			38
Proceeds from (repayment of) bank overdrafts					8,366			(9,938	)		(2,768	)		—			(4,340	)
Distributions to minority interests					—			(680	)		(1,571	)		—			(2,251	)

Net cash used in financing activities					(10,730	)		(10,618	)		(4,339	)		—			(25,687	)

Effect of exchange rate changes on cash and cash equivalents					(107	)		—			—			—			(107	)

Net increase (decrease) in cash and cash equivalents					24,073			1,460			(1,450	)		—			24,083
Cash and cash equivalents at beginning of period					—			1,015			2,136			—			3,151

Cash and cash equivalents at end of period				$	24,073		$	2,475		$	686		$	—		$	27,234

(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;

• a government investigation or assertion that we have violated applicable regulations may result in increased costs and a significant use of internal resources,

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

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

• conditions in the malpractice insurance market may increase the cost of malpractice insurance and force us to assume higher self-insured retentions;

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

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

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 September 30, 2002, we operated 68 specialty acute care hospitals in 22 states and 743 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 September 30, 2002, we had net operating revenues of $279.0 million. Of this total, we earned approximately 57% of our net operating revenues from our specialty hospitals and approximately 43% 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						Nine Months Ended
			September 30,						September 30,

			2002			2001			2002			2001

Specialty Hospital Data




	# of Hospitals — Start of Period			66			58			64			54




		# of Hospital Start-ups		2			1			4			5

	# of Hospitals — End of Period			68			59			68			59

	# of Licensed Beds			2,461			2,152			2,461			2,152




	# of Admissions			5,262			4,320			15,492			12,735




	# of Patient Days			155,105			131,851			458,916			381,178




	Average Length of Stay			30			31			30			30




	Net Revenue Per Patient Day (a)		$	1,003		$	981		$	994		$	948




	Occupancy Rate			69	%		67	%		71	%		67	%




	% Patient Days – Medicare			76	%		74	%		76	%		75	%




Outpatient Rehabilitation Data




	# of Clinics Owned — Start of Period			686			623			664			636




		# of Clinics Acquired		2			5			9			7




		# of Clinic Start-ups		14			18			46			31




		# of Clinics Closed/Sold/Consolidated		(13	)		(7	)		(30	)		(35	)

	# of Clinics Owned — End of Period			689			639			689			639




	# of Clinics Managed — End of Period			54			49			54			49

	Total # of Clinics (All) – End of Period			743			688			743			688

	# of Visits (U.S)			957,517			925,276			2,916,983			2,837,544




	Net Revenue Per Visit (U.S.) (b)		$	87		$	82		$	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.

As of September 30, 2002, our specialty hospitals were paid by Medicare under a cost-based reimbursement methodology. Beginning on October 1, 2002, our hospitals will begin a transition to a prospective payment system. 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 September 30, 2002 and December 31, 2001, we had a net amount due to Medicare of $17.5 million and $3.4 million respectively. We recorded this amount as due to third party payors on our balance sheet.

On August 30, 2002, the Centers for Medicare and Medicaid Services (“CMS”) published a final rule establishing a prospective payment system for Medicare payment of inpatient hospital services furnished by long-term acute care hospitals such as ours. See “Long Term Acute Care Hospital Medicare Reimbursement.”

Results of Operations

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,

	2002			2001			2002			2001

Net Operating revenues		100.0	%		100.0	%		100.0	%		100.0	%




Cost of services (a)		82.8	%		81.6	%		81.9	%		80.9	%




General and administrative		3.7	%		3.7	%		3.5	%		3.7	%




Bad debt expense		3.1	%		3.9	%		3.3	%		3.7	%

EBITDA (b)		10.4	%		10.8	%		11.3	%		11.7	%




Depreciation and amortization		2.3	%		3.4	%		2.3	%		3.4	%

Income from operations		8.1	%		7.4	%		9.0	%		8.3	%




Interest expense, net		2.4	%		2.8	%		2.4	%		3.2	%

Income before minority interests, and income taxes		5.7	%		4.6	%		6.6	%		5.1	%




Minority interests		0.1	%		0.2	%		0.2	%		0.4	%

Income before income taxes		5.6	%		4.4	%		6.4	%		4.7	%




Income tax expense		2.2	%		1.7	%		2.5	%		1.8	%

Income before extraordinary item		3.4	%		2.7	%		3.9	%		2.9	%




Extraordinary item		—	%		—	%		—	%		1.3	%

Net income		3.4	%		2.7	%		3.9	%		1.6	%

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


			Three Months Ended									Nine Months Ended
			September 30,						%			September 30,						%
			2002			2001			Change			2002			2001			Change

				(dollars in thousands)
Net operating revenues:




	Specialty hospitals		$	155,637		$	129,442			20.2	%	$	456,538		$	361,627			26.2	%




	Outpatient rehabilitation			119,179			106,083			12.3			363,512			326,715			11.3




	Other			4,167			3,630			14.8			11,125			10,100			10.1

		Total company	$	278,983		$	239,155			16.7	%	$	831,175		$	698,442			19.0	%

EBITDA: (b)




	Specialty hospitals		$	16,522		$	14,189			16.4	%	$	49,470		$	41,167			20.2	%




	Outpatient rehabilitation			19,025			17,421			9.2			63,148			57,107			10.6




	Other			(6,546	)		(5,666	)		(15.5	)		(19,375	)		(16,646	)		(16.4	)

		Total company	$	29,001		$	25,944			11.8	%	$	93,243		$	81,628			14.2	%

Income (loss) from operations:




	Specialty hospitals		$	13,184		$	11,272			17.0	%	$	39,937		$	33,113			20.6	%




	Outpatient rehabilitation			16,311			13,595			20.0			55,321			45,870			20.6




	Other			(7,012	)		(7,073	)		0.9			(20,739	)		(21,184	)		2.1

		Total company	$	22,483		$	17,794			26.4	%	$	74,519		$	57,799			28.9	%

EBITDA margins: (b)




	Specialty hospitals			10.6	%		11.0	%		(3.6	)%		10.8	%		11.4	%		(5.3	)%




	Outpatient rehabilitation			16.0			16.4			(2.4	)		17.4			17.5			(0.6	)




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

	Total company			10.4	%		10.8	%		(3.7	)%		11.2	%		11.7	%		(4.3	)%

Total assets:




	Specialty hospitals		$	318,164		$	260,606					$	318,164		$	260,606




	Outpatient rehabilitation			324,934			309,374						324,934			309,374




	Other			78,431			56,216						78,431			56,216

	Total company		$	721,529		$	626,196					$	721,529		$	626,196

Purchases of property and equipment, net:




	Specialty hospitals		$	5,908		$	2,519					$	18,348		$	8,828




	Outpatient rehabilitation			4,067			2,346						8,994			6,112




	Other			882			434						1,463			1,169

	Total company		$	10,857		$	5,299					$	28,805		$	16,109

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:


	For the Three Months Ended						For the Nine Months Ended
	September 30,						September 30,

	2002			2001			2002			2001

				(in thousands)
EBITDA	$	29,001		$	25,944		$	93,243		$	81,628




Depreciation and amortization		(6,518	)		(8,150	)		(18,724	)		(23,829	)




Interest income		181			102			388			382




Interest expense		(6,875	)		(7,026	)		(20,468	)		(22,548	)




Minority interest		(390	)		(473	)		(1,563	)		(2,745	)




Income tax expense		(6,044	)		(4,054	)		(20,744	)		(12,826	)




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

Net income	$	9,355		$	6,343		$	32,132		$	11,386

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

Net Operating Revenues

Our net operating revenues increased by 16.7% to $279.0 million for the three months ended September 30, 2002 compared to $239.2 million for the three months ended September 30, 2001.

Specialty Acute Care Hospitals. Our specialty hospital net operating revenues increased 20.2% to $155.6 million for the three months ended September 30, 2002 compared to $129.4 million for the three months ended September 30, 2001. Net operating revenues for the specialty hospitals opened before January 1, 2001 and operated throughout both periods increased 6.5% to $134.2 million for the three months ended September 30, 2002 from $126.0 million for the three months ended September 30, 2001. This resulted from a higher occupancy rate and higher net revenue per patient day. The remaining increase of $18.0 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 12.3% to $119.2 million for the three months ended September 30, 2002 compared to $106.1 million for the three months ended September 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 within the last twelve months. These acquisitions provided approximately $8.0 million of net operating revenue for the three months ended September 30, 2002.

Other. Our other revenues increased to $4.2 million for the three months ended September 30, 2002 compared to $3.6 million for the three months ended September 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.

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Operating Expenses

Our operating expenses increased by 17.2% to $250.0 million for the three months ended September 30, 2002 compared to $213.2 million for the three months ended September 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 and 2002, costs associated with the increased patient volumes and the operating expenses associated with the acquisitions that occurred within the last twelve months. As a percentage of our net operating revenues, our operating expenses were 89.6% for the three months ended September 30, 2002 compared to 89.2% for the three months ended September 30, 2001. Cost of services as a percentage of operating revenues increased to 82.8% for the three months ended September 30, 2002 from 81.6% for the three months ended September 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 and an increase in our health insurance costs in our NovaCare outpatient operations. During the same time period, general and administrative expense as a percentage of net operating revenues were 3.7% for both the three months ended September 30, 2002 and 2001. Our bad debt expense as a percentage of net operating revenues was 3.1% for the three months ended September 30, 2002 compared to 3.9% for the three months ended September 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 11.8% to $29.0 million for the three months ended September 30, 2002 compared to $25.9 million for the three months ended September 30, 2001. Our EBITDA margins declined to 10.4% for the three months ended September 30, 2002 compared to 10.8% for the three months ended September 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. We also experienced a decline in our outpatient margins due to an increase in our health insurance costs in our NovaCare outpatient operations. If we exclude the dilutive effect caused by the hospitals opened or developed since December 31, 2000, our total EBITDA margins would be 11.6% for the three months ended September 30, 2002 compared to 11.5% for the three months ended September 30, 2001. For cash flow information, see “-Capital Resources and Liquidity.”

Specialty Acute Care Hospitals. Our specialty hospital EBITDA increased by 16.4% to $16.5 million for the three months ended September 30, 2002 compared to $14.2 million for the three months ended September 30, 2001. Our EBITDA margins were 10.6% for the three months ended September 30, 2002 compared to 11.0% for the three months ended September 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 $17.5 million, an increase of 14.4% over the EBITDA for these hospitals in the same period last year of $15.3 million. This increase in same hospital EBITDA resulted from an increase in non-Medicare revenue per patient day and a reduction in bad debt expense. Our EBITDA margin in these same store hospitals increased to 13.1% from 12.2%.

Outpatient Rehabilitation. Our outpatient rehabilitation EBITDA increased by 9.2% to $19.0 million for the three months ended September 30, 2002 compared to $17.4 million for the three months ended September 30, 2001. Approximately $1.1 million of this increase was related to the EBITDA generated by the acquisitions that occurred within the last twelve months. Our EBITDA margins declined to 16.0% for the three months ended September 30, 2002 from 16.4% for the three months ended September 30, 2001. The reduction in EBITDA margins was related to an increase in health insurance costs experienced in our NovaCare outpatient operations.

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Other. Our other EBITDA loss increased to $6.5 million for the three months ended September 30, 2002 compared to a loss of $5.7 million for the three months ended September 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 26.4% to $22.5 million for the three months ended September 30, 2002 compared to $17.8 million for the three months ended September 30, 2001. The increase in income from operations resulted from the EBITDA increases described above, and a reduction in amortization expense of $2.2 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 and clinic development.

Interest Expense

Interest expense remained relatively consistent between the two periods. Interest expense was $6.9 million for the three months ended September 30, 2002 and $7.0 million for the three months ended September 30, 2001.

Minority Interests

Minority interests remained relatively consistent between the two periods. Minority interests was $0.4 million for the three months ended September 30, 2002 compared to $0.5 million for the three months ended September 30, 2001.

Income Taxes

We recorded income tax expense of $6.0 million for the three months ended September 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 $4.1 million for the three months ended September 30, 2001. This expense represented an effective tax rate of 39.0%.

Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30, 2001

Net Operating Revenues

Our net operating revenues increased by 19.0% to $831.2 million for the nine months ended September 30, 2002 compared to $698.4 million for the nine months ended September 30, 2001.

Specialty Acute Care Hospitals. Our specialty hospital net operating revenues increased 26.2% to $456.5 million for the nine months ended September 30, 2002 compared to $361.6 million for the nine months ended September 30, 2001. Net operating revenues for the specialty hospitals opened before January 1, 2001 and operated throughout both periods increased 14.3% to $407.3 million for the nine months ended September 30, 2002 from $356.4 million for the nine months ended September 30, 2001. This resulted from a higher occupancy rate and a higher net revenue per patient day. The remaining increase of $44.0 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 11.3% to $363.5 million for the nine months ended September 30, 2002 compared to $326.7 million the nine months ended September 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

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acquisitions that occurred within the last twelve months. These acquisitions provided approximately $24.6 million of net operating revenue for the nine months ended September 30, 2002.

Other. Our other revenues increased to $11.1 million for the nine months ended September 30, 2002 compared to $10.1 million for the nine months ended September 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 19.6% to $737.9 million for the nine months ended September 30, 2002 compared to $616.8 million for the nine months ended September 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 within the last twelve months. As a percentage of our net operating revenues, our operating expenses were 88.7% for the nine months ended September 30, 2002 compared to 88.3% for the nine months ended September 30, 2001. Cost of services as a percentage of operating revenues increased to 81.9% for the nine months ended September 30, 2002 from 80.9% for the nine months ended September 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 and an increase in our health insurance costs in our NovaCare outpatient operations. During the same time period, general and administrative expense as a percentage of net operating revenues decreased to 3.5% for the nine months ended September 30, 2002 from 3.7% for the nine months ended September 30, 2001. Our bad debt expense as a percentage of net operating revenues was 3.3% for the nine months ended September 30, 2002 compared to 3.7% for the nine months ended September 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 14.2% to $93.2 million for the nine months ended September 30, 2002 compared to $81.6 million for the nine months ended September 30, 2001. Our EBITDA margins declined to 11.2% for the nine months ended September 30, 2002 compared to 11.7% for the nine months ended September 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. We also experienced a decline in outpatient margins due to an increase in our health insurance costs in our NovaCare outpatient operations. If we exclude the dilutive effect caused by the hospitals opened or developed since December 31, 2000, our total EBITDA margins would be 12.5% for the nine months ended September 30, 2002 compared to 12.3% for the nine months ended September 30, 2001. For cash flow information, see “-Capital Resources and Liquidity.”

Specialty Acute Care Hospitals. Our specialty hospital EBITDA increased by 20.2% to $49.5 million for the nine months ended September 30, 2002 compared to $41.2 million for the nine months ended September 30, 2001. Our EBITDA margins were 10.8% for the nine months ended September 30, 2002 compared to 11.4% for the nine months ended September 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 $53.9 million, an increase of 20.6% over the EBITDA of these hospitals in the same period last year of $44.7 million. 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 13.2% from 12.5%.

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Outpatient Rehabilitation. Our outpatient rehabilitation EBITDA increased by 10.6% to $63.1 million for the nine months ended September 30, 2002 compared to $57.1 million for the nine months ended September 30, 2001. Approximately $3.2 million of this increase was related to the EBITDA generated by the acquisitions that occurred within the last twelve months. Our EBITDA margins were 17.4% for the nine months ended September 30, 2002 from 17.5% for the nine months ended September 30, 2001. This decline resulted from a reduction in EBITDA margins that occurred in the current quarter and was related to an increase in health insurance costs experienced in our NovaCare outpatient operations.

Other. Our other EBITDA loss increased to $19.4 million for the nine months ended September 30, 2002 compared to a loss of $16.6 million for the nine months ended September 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 28.9% to $74.5 million for the nine months ended September 30, 2002 compared to $57.8 million for the nine months ended September 30, 2001. The increase in income from operations resulted from the EBITDA increases described above, and a reduction in amortization expense of $6.7 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 $2.0 million to $20.5 million for the nine months ended September 30, 2002 from $22.5 million for the nine months ended September 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 43.1% to $1.6 million for the nine months ended September 30, 2002 compared to $2.7 million for the nine months ended September 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 $20.7 million for the nine months ended September 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 $12.8 million for the nine months ended September 30, 2001. This expense represented an effective tax rate of 39.0%.

Extraordinary Item

We recorded an extraordinary charge in the nine months ended September 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.

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Capital Resources and Liquidity

For the nine months ended September 30, 2002 operating activities provided $102.8 million of cash flow compared to $85.4 million for the nine months ended September 30, 2001. Our accounts receivable days outstanding were 76 days at September 30, 2002 compared to 77 days at December 31, 2001 and 79 days at September 30, 2001.

Investing activities used $37.1 and $35.6 million of cash flow for the nine months ended September 30, 2002 and 2001, respectively. This usage resulted from purchases of property and equipment of $28.8 and $16.1 million in 2002 and 2001, respectively. The majority of this expenditure relates to new hospital and clinic development. Additionally, we incurred earnout related payments of $0.6 million and $4.8 million in 2002 and 2001, respectively. We incurred acquisition payments of $7.8 million and $15.4 million in 2002 and 2001, respectively.

Financing activities used $16.4 and $25.7 million of cash for the nine months ended September 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 $129.8 million as of September 30, 2002 compared to $126.7 million at December 31, 2001. At September 30, 2002 we have $60.0 in cash and cash equivalents compared to $10.7 million at December 31, 2001.

We have a credit agreement with a group of banks. Our credit facility consists of a term facility of $79.8 million and a revolving credit facility of $152.4 million. As of September 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 $147.8 million under our revolving credit facility subject to certain limitations. We have $4.6 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 September 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.

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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.

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 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.

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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. We do not anticipate a significant impact on its results of operations from adopting this Statement.

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 nine months ended September 30, 2001 would have been $2.2 million and $6.7 million less, respectively. This would have increased fully diluted earnings per share by approximately $0.03 and $0.09 for the three and nine months ended September 30, 2001, respectively.

Long Term Acute Care Hospital Medicare Reimbursement

On August 30, 2002, the Centers for Medicare & Medicaid Services (“CMS”) published final regulations establishing a prospective payment system for Medicare payment of long-term acute care hospitals (“LTCH-PPS”), which replaces the reasonable cost-based payment system previously in effect. Under LTCH-PPS, each discharged patient will be assigned to a distinct long-term care diagnosis-related group (“LTC-DRG”), and a long-term acute care hospital will generally be paid a pre-determined fixed amount applicable to the assigned LTC-DRG (adjusted for area wage differences). As required by Congress, LTC-DRG payment rates have been set to maintain budget neutrality with total expenditures that would have been made under the reasonable cost-based payment system.

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LTCH-PPS will be phased in over a five-year period, during which a long-term care hospital will be paid a blended amount consisting of set percentages of the LTC-DRG payment rate and the hospital’s reasonable cost-based reimbursement. The LTC-DRG payment will be 20% for a hospital’s cost reporting period beginning on or after October 1, 2002, and will increase by 20% for each cost reporting period thereafter until the hospital’s cost reporting period beginning on or after October 1, 2006, when the hospital will be paid solely on the basis of LTC-DRG payments. A long-term acute care hospital may elect to be paid solely on the basis of LTC-DRG payments (and not be subject to the transition period) at the start of any of its cost reporting periods during the transition period.

The LTCH-PPS regulations refined the criteria that must be met in order for a hospital to be classified as a long-term acute care hospital that is exempt from the prospective payment system applicable to short-term acute care hospitals. For cost reporting periods beginning on or after October 1, 2002, a long-term acute care hospital must have an average inpatient length of stay for Medicare patients (including both Medicare covered and non-covered days) of greater than 25 days. Previously, average lengths of stay were measured with respect to all patients. We currently believe that each of our long term acute care hospitals will meet this requirement.

Under the LTCH-PPS, it may be possible for our hospitals to experience enhanced financial performance. However, there are risks associated with transitioning to the new payment system. We believe that the conversion to the new payment system will be accretive to our earnings, but we are still assessing the potential impact of the LTCH-PPS.

Medical and Professional Malpractice Insurance

In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice, product liability or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts and with deductibles that we believe to be sufficient for our operations. During the last year, unfavorable pricing and availability trends have emerged in the professional liability insurance market and the insurance market in general that have caused the cost of professional liability coverage to increase dramatically. Many insurance underwriters have become more selective in the insurance limits and types of coverage they will provide as a result of the September 11 terrorist attacks, rising settlement costs and the significant failures of some nationally known insurance underwriters, such as PHICO Insurance Company, which provided us medical malpractice coverage from June 1998 to December 2000. In some instances, insurance underwriters will no longer issue new policies in certain states that have a history of high medical malpractice awards. As a result, we are observing that insurance underwriters are increasing premiums and increasing deductibles and self-insured retentions on new policies that they are issuing. Our current insurance policies will expire on December 31, 2002. We cannot provide any assurance that we will be able to renew our current professional liability insurance with terms and coverage consistent with our current coverage. We would expect to experience increased premium costs and be forced to accept increased deductibles or self-insured retentions in order to provide insurance coverage at a reasonable cost.

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ITEM 3. 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 nine months ended September 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 September 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.

ITEM 4. CONTROLS AND PROCEDURES

Within 90 days prior to the filing date of this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC reports. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. In addition, we reviewed our internal controls, and there have been no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of their last evaluation.

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 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. 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

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the case. Claims against the Company and the NovaCare subsidiaries regarding alleged conduct occurring after the NovaCare acquisition were not covered by the settlement. In September 2002, Select learned that the United States Attorney for the Eastern District of Pennsylvania had notified the court that the United States had decided not to intervene in this case. As of October 31, 2002, 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 if it is pursued by the relator plaintiff. 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.

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

None

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 38 hereof.

b. Reports on Form 8-K

Form 8-K dated August 29, 2002, pursuant to Item 9, in connection with the certifications of our Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 which accompanied our Form 10-Q for the quarter ended June 30, 2002, in accordance with Regulation FD

Form 8-K, dated August 27, 2002, pursuant to Item 9, in connection with our press release reaffirming guidance for the quarter ended September 30, 2002 and the year ended December 31, 2002, in accordance with Regulation FD

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SIGNATURES

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


		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: November 13, 2002

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Robert A. Ortenzio, President and Chief Executive Officer of Select Medical Corporation, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Select Medical Corporation;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based upon our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons fulfilling the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 13, 2002

/s/ Robert A. Ortenzio

Robert A. Ortenzio
President and Chief Executive Officer

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CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, Martin F. Jackson, Senior Vice President and Chief Financial Officer of Select Medical Corporation, certify that:

Date: November 13, 2002

/s/ Martin F. Jackson

Martin F. Jackson
Senior Vice President and Chief Financial Officer

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EXHIBIT INDEX


Exhibit		Description

10.1		Amended and Restated Cost Sharing Agreement dated as of August 16, 2002 by and among Select Medical Corporation, Select Transport, Inc. and Select Air II Corporation.









10.2		Stock Purchase Agreement dated as of September 16, 2002 by and among Rocco A. Ortenzio, Robert A. Ortenzio, Select Medical Corporation and Select Air II Corporation.









10.3		Mutual Termination of Consulting Agreement dated as of September 26, 2002 between Select Medical Corporation and LeRoy S. Zimmerman.

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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;

	•		a government investigation or assertion that we have violated applicable regulations may result in increased costs and a significant use of internal resources,

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

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

	•		conditions in the malpractice insurance market may increase the cost of malpractice insurance and force us to assume higher self-insured retentions;

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

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

1.		I have reviewed this quarterly report on Form 10-Q of Select Medical Corporation;

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and