SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

For the transition period from          to     

0-49813
(Commission file number)

MARINER HEALTH CARE, INC.

(678) 443-7000
(Registrant’s Telephone Number, Including Area Code)

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

     There were 20,015,000 shares of Common Stock of the registrant outstanding as of November 4, 2004.

     Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No o

TABLE OF CONTENTS

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PART I

ITEM 1. FINANCIAL STATEMENTS

MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

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

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MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

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

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MARINER HEALTH CARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

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

5

MARINER HEALTH CARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1 GENERAL

Nature of Business

     Mariner Health Care, Inc. through its subsidiaries (collectively, the “Company”) provides long-term health care services, primarily through the operation of skilled nursing facilities. As of September 30, 2004, the Company operated 252 skilled nursing facilities and two stand-alone assisted living facilities with an aggregate of 30,614 licensed beds. The Company owns 70% of its facilities. The Company also operates twelve long-term acute care hospitals (“LTACs”) in four states, with 640 licensed beds. The Company’s facilities are located in 23 states with significant concentrations in Texas, North Carolina, California, Colorado, South Carolina and Maryland and clusters in twelve geographic markets in nine of the states in which the Company operates. Skilled nursing services and LTACs represent the Company’s two reportable segments (see Note 5).

Recent Developments

     On June 29, 2004, the Company entered into a merger agreement (the “Merger Agreement”) with National Senior Care, Inc. (“NSC”) and NCARE Acquisition Corp. (“NCARE”), a wholly-owned subsidiary of NSC established for the purpose of acquiring the Company. The parties to the Merger Agreement entered into the First Amendment (“First Amendment”) to the Merger Agreement on October 21, 2004. The terms of the First Amendment are summarized in the Current Report on Form 8-K filed by the Company on October 22, 2004. Pursuant to the Merger Agreement, NCARE will acquire the issued and outstanding shares of common stock of the Company for $30.00 per share in cash. The merger is expected to close in the fourth quarter of 2004 and is subject to various conditions contained in the Merger Agreement, including but not limited to the approval of the stockholders of the Company, receipt of financing by NSC and other regulatory, governmental and licensing approvals. On October 22, 2004, the Company filed its definitive proxy statement to obtain shareholder approval of the merger. The Annual Shareholders meeting to elect directors, amend the bylaws and approve the merger will be held on November 30, 2004.

     In connection with the Company’s pending merger with NSC, on November 2, 2004, the Company announced and commenced a cash tender offer and consent solicitation for all of its outstanding 8 1/4% Senior Subordinated Notes due 2013. The tender offer and consent solicitation are being made pursuant to an Offer to Purchase and Consent Solicitation Statement and related Consent and Letter of Transmittal dated November 2, 2004, which set forth a more detailed description of the tender offer and consent solicitation. The tender offer will expire at 5:00 p.m. (EST) on December 1, 2004, unless extended or terminated and is conditioned on the consummation of the merger. The consent solicitation will expire at 5:00 p.m. (EST) on November 16, 2004, unless extended or terminated and is also conditioned on the consummation of the merger.

Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. Accordingly, these unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report for the year ended December 31, 2003 on Form 10-K filed with the SEC. In the opinion of management, the financial information included herein reflects all adjustments considered necessary for a fair presentation of interim results and all such adjustments are of a normal and recurring nature. Operating results for interim periods are not necessarily indicative of the results that may be expected for the entire year.

Use of Estimates

     The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Although these estimates are based on management’s knowledge of current events, such estimates may ultimately differ from actual results.

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Comprehensive (Loss) Income

     Comprehensive (loss) income includes net (loss) income, as well as charges and credits to stockholders’ equity not included in net (loss) income. The components of comprehensive (loss) income, net of income taxes, consist of the following (in thousands of dollars):

Reclassifications

     Certain prior year amounts have been reclassified to conform to the current period financial statement presentation.

NOTE 2 STOCK BASED COMPENSATION

     As of September 30, 2004, the Company maintained two stock-based compensation plans that are described in Note 3 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees”, and related interpretations (“APB 25”). The Company recognized stock based compensation expense of $0.05 million and $0.3 million for the three and nine months ended September 30, 2004, respectively, and there was no stock based compensation expense for the three and nine months ended September 30, 2003. On May 13, 2004, warrants to purchase 753,786 shares of common stock at an exercise price of $28.04 expired and became void, and all rights associated therewith were terminated.

     In March 2004, the Financial Accounting Standards Board (“FASB”) issued an Exposure Draft of a proposed Statement of Financial Accounting Standards entitled “Share-Based Payment.” This proposed Statement addresses accounting for stock based compensation and would result in stock based compensation costs, including options, being recognized as an expense in the financial statements. The proposed Statement would eliminate the ability to account for stock based compensation transactions using APB No. 25, and generally would require that such transactions be accounted for using a fair value based method. In October 2004, the FASB voted to delay the effective date of its proposed standard such that if approved, the proposed Statement would be applied prospectively to public entities for awards that are granted, modified or settled in cash in interim or annual periods beginning after June 15, 2005.

     The Company’s pro forma basic net (loss) income and diluted net (loss) income per share, assuming the election had been made to recognize compensation expense on stock-based awards, are as follows (in thousands of dollars, except per share amounts):

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NOTE 3 NET REVENUE

     Revenue is recorded based on estimated net realizable amounts due from patients and third-party payors for health care services provided, including anticipated settlements under reimbursement agreements with Medicare, Medicaid and other third-party payors, and is recognized in the period in which the services are provided. Revenue is recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Revenue realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. The methods of making such estimates are reviewed periodically, and differences between the net amounts accrued and subsequent settlements or estimates of expected settlements are reflected in the current period results of operations.

     All providers participating in the Medicare and Medicaid programs are required to meet certain financial cost reporting requirements. Federal and state regulations generally require the submission of annual cost reports covering revenues, costs and expenses associated with the services provided to Medicare beneficiaries and Medicaid recipients. Annual cost reports are subject to routine audits and retroactive adjustments. These audits often require several years to reach the final determination of amounts due to, or by, the Company under these programs.

     Retroactive adjustments are estimated in the recording of revenues in the period in which the related services are rendered. These amounts are adjusted in future periods as adjustments become known or as cost reporting years are no longer subject to audits, reviews or investigations. Changes in estimates related to third party receivables resulted in an increase in net revenue of $1.7 million during the nine months ended September 30, 2004. Changes in estimates related to third party receivables did not have a material impact on net revenues for the three months ended September 30, 2004 and the three and nine months ended September 30, 2003. The Company believes adequate provision has been made to reflect any adjustments that may result from the audit of cost reports. However, due to the complexity of the laws and regulations governing the Medicare and Medicaid programs, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term.

     The following is a summary by dollars and percentage of net revenue by payor type for the periods indicated (in thousands of dollars):

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NOTE 4 DISCONTINUED OPERATIONS AND OTHER DIVESTITURES

Discontinued Pharmacy Operations

     During the nine months ended September 30, 2003, the Company earned and received the payments for post-closing operating results (“Earnout Payments”) in connection with the sale of the institutional pharmacy services business (“APS Division”) to Omnicare, Inc. of $18.0 million, at which time the Company recorded a gain on sale of $10.8 million, net of taxes of $7.2 million.

Other Discontinued Operations and Other Divestitures

     The results of operations and cash flows of any divested facilities that qualify for discontinued operations under Statement of Financial Accounting Standard (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) are reclassified as discontinued operations for all periods presented. There were no assets held for sale at September 30, 2004, however, the operations and cash flows of any divested facilities that qualify for discontinued operations have been reclassified to discontinued operations. The net assets of the facilities that were sold during the nine months ended September 30, 2004 were $8.0 million at December 31, 2003. In addition, during the three and nine months ended September 30, 2004, the Company recorded net gains of $0.5 million and $3.2 million, respectively, primarily related to sales of certain non-operating assets, which are included in other operating expenses in the unaudited condensed consolidated statements of operations.

     Operating results for the discontinued operations were as follows for the periods indicated (in thousands of dollars):

NOTE 5 SEGMENT INFORMATION

     The Company has two reportable segments, skilled nursing services, which provides long-term health care through the operation of skilled nursing facilities and assisted living facilities in the United States, and LTACs, which provide services for the relatively high sub-acute clinical need patients.

     The Company primarily evaluates segment performance and allocates resources based on operating profit (loss), which is defined as net revenue less operating, and general and administrative expenses. The Company’s reportable segments are strategic business units that offer different services to different types of patients. They are each managed separately because they provide services to patients with different acuity levels, and because the conditions of participation in the Medicare and Medicaid programs, as well as the reimbursement methodologies and licensing requirements are different for each business under these programs.

     The following table summarizes revenues, operating profit (loss), depreciation and amortization and total assets for the Company for the periods presented for the two reportable segments, excluding the results of discontinued operations. The income statement items included in the “Other” category consist of corporate items not considered to be an operating segment and eliminations. The assets included in the “Other” category consist primarily of cash, non-facility related property and equipment, excess reorganization value, goodwill, restricted investments, notes receivable and deferred financing costs (in thousands of dollars).

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(1)

Operating profit does not include depreciation and amortization or merger related costs. Total operating profit less depreciation and amortization and merger related costs was $6.9 million and $37.2 million for the three and nine months ended September 30, 2004, respectively, and $6.3 million and $19.6 million for the three and nine months ended September 30, 2003, respectively.

NOTE 6 SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION

     Certain subsidiaries (the “Guarantor Subsidiaries”) guarantee repayment of debt under both the Company’s $225.0 million senior credit facility (the “Senior Credit Facility”), which consists of a $135.0 million term loan facility and a $90.0 million revolving credit facility, and the Company’s $175.0 million aggregate principal amount of 8 1/4% Senior Subordinated Notes due 2013 (the “Notes”). Separate complete financial statements of the respective Guarantor Subsidiaries are not presented because the Guarantor Subsidiaries are wholly-owned (directly or indirectly) by the Company and fully and unconditionally guarantee the debt under the Senior Credit Facility and the Notes on a joint and several basis.

     The following unaudited condensed consolidating financial data is presented to illustrate the composition of Mariner Health Care, Inc. (the “Parent”), the Guarantor Subsidiaries, and the Company’s subsidiaries that do not guarantee the debt under the Senior Credit Facility and the Notes (the “Non-Guarantor Subsidiaries”) for the periods indicated.

     The Non-Guarantor Subsidiaries include the Professional Health Care Management, Inc. (“PHCMI”) entities, certain joint ventures and our captive insurance subsidiaries. There are certain restrictions on the ability of the Non-Guarantor Subsidiaries to pay dividends, make loans or advances and transfer certain property and assets to the Company and its other subsidiaries.

     The Company does not have any subsidiaries that are accounted for by the Parent under the equity method. As such, the principal elimination entries eliminate intercompany balances and transactions. Information regarding the Guarantor Subsidiaries and Non-Guarantor Subsidiaries is as follows for the periods presented (in thousands of dollars):

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CONDENSED SELECTED COMBINING BALANCE SHEET
September 30, 2004

CONDENSED SELECTED COMBINING BALANCE SHEET
December 31, 2003

CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the three months ended September 30, 2004

CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the three months ended September 30, 2003

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CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the nine months ended September 30, 2004

CONDENSED SELECTED COMBINING STATEMENT OF OPERATIONS
For the nine months ended September 30, 2003

CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the nine months ended September 30, 2004

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CONDENSED SELECTED COMBINING STATEMENT OF CASH FLOWS
For the nine months ended September 30, 2003

(1)

Net cash provided by operating activities includes net cash (utilized) provided by discontinued operations and payment of reorganization items.

NOTE 7 VARIABLE INTEREST ENTITIES

     In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”), which addresses the consolidation of entities whose equity holders have either (a) not provided sufficient equity at risk to allow the entity to finance its own activities or (b) do not possess certain characteristics of a controlling financial interest. A revised version of FIN 46 was issued in December 2003 with modifications to clarify some requirements, ease some implementation problems and add new scope exceptions. FIN 46 sets forth a model to evaluate potential consolidation of these entities, known as variable interest entities (“VIEs”), based on an assessment of which party to the VIE, if any, absorbs a majority of the exposure to its expected losses, receives a majority of its expected residual returns, or both, which is referred to for purposes of FIN 46 as the “primary beneficiary.” FIN 46 also requires disclosures about VIEs that a company is not required to consolidate but in which it has a significant variable interest. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after March 15, 2004, except for companies with special purpose entities which must apply the provisions of FIN 46 to those special purpose entities no later than the first reporting period ending after December 15, 2003.

     The Company has evaluated the impact of FIN 46 on its unaudited condensed consolidated financial statements and identified three joint ventures as VIEs for which it has determined that it is the primary beneficiary. These joint ventures, which operate skilled nursing facilities that are managed by the Company, are 50% owned and have historically been consolidated due to control. The Company has historically provided funds for working capital and has other long-term notes from these joint ventures, which are eliminated in consolidation. The joint ventures have revenues, which are included in the unaudited condensed consolidated financial statements of $9.8 million, $29.5 million, $9.6 million, and $27.4 million for the three and nine months ended September 30, 2004 and September 30, 2003, respectively. These joint ventures have net liabilities that are included in the accompanying unaudited condensed consolidated financial statements of approximately $39.5 million and $39.9 million at September 30, 2004 and December 31, 2003, respectively.

     During the three months ended December 31, 2003, the Company entered into an administrative services agreement with a new operator of certain facilities that the Company divested. The services are for 26 facilities and include accounting support, procurement of business supplies, billing and collections, and information technology services. Applying the principles of FIN 46, the Company has determined that the new operator of the divested facilities is a VIE. The Company has also determined that it is not the “primary beneficiary” and accordingly, the Company is not required to consolidate the new operator. The total receivable from this new operator at September 30, 2004 is $2.2 million.

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NOTE 8 EARNINGS PER SHARE

     As required by SFAS No. 128, “Earnings Per Share”, the Company has presented basic and diluted income per common share amounts in the accompanying unaudited condensed consolidated financial statements. Basic income per common share is calculated based on the weighted average common shares outstanding during the period. Diluted income per common share is calculated similarly to basic income per common share except that the weighted average shares outstanding are increased to include additional shares from the assumed exercise of stock options, if dilutive. The number of additional shares is calculated by assuming that outstanding stock options that are dilutive were exercised and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the period.

     Below is the reconciliation of basic and diluted income from continuing operations per weighted average common share (in thousands, except per share data):

     For the nine months ended September 30, 2004, options to purchase 30,000 shares of common stock at an option price of $21.55 per share were not included in the computation of diluted income per share because the option price exceeded the average market price. The options were still outstanding at September 30, 2004.

NOTE 9 INCOME TAXES

     The provision (benefit) for income taxes is allocated between continuing operations, discontinued operations, and extraordinary items in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). For the three and nine months ended September 30, 2004, no federal income tax provision and a state income tax provision of $3.4 million and $5.0 million, respectively, was recorded. The effective tax rates vary from statutory tax rates primarily due to the utilization of net operating loss (“NOL”) carryforwards. In addition, income earned in certain states for which state NOLs are not available and a revision to the Company’s assessment of its NOL position resulted in a higher effective tax rate in the three and nine months ended September 30, 2004.

     As of December 31, 2003, the Company had approximately $563.5 million of NOL carryforwards, utilization of which were subject to limitations pursuant to Section 382 of the Internal Revenue Code. Of the total NOL carryforwards, $118.4 million is unencumbered by any Section 382 limitations. Of the remainder, approximately $143.0 million of NOL carryforwards are subject to certain restrictions under Section 382 that apply to a company that emerges from bankruptcy. The remaining $302.1 million of NOL carryforwards are subject to the additional Section 382 restrictions in connection with the existence of net unrealized built-in gain at the time of a December 1999 ownership change that occurred when the largest shareholder sold its equity interest in the Company to another entity prior to the Company filing bankruptcy. Utilization of these NOLs will require the recognition of built-in gain within five years of such date, or by December 31, 2004. While the Company is still currently in the process of evaluating the full extent of the limitations and restrictions on the utilization of the NOL carryforwards under the provisions of Section 382, it is likely that the use of $302.1 million of NOL carryforwards originating prior to the ownership change in December 1999 will be subject to significant limitation and thus the Company’s estimate of their availability has changed this quarter. Management performed extensive analysis on all restrictions impacting the NOLs in the current period. While all aspects of these restrictions continue to be analyzed, the current period analysis indicated that the state NOLs utilized in the computation of prior period tax expense should be limited due to the lack of the generation of built-in gains. As a result, the Company recorded an additional $2.1 million of state income tax during the three months ended September 30, 2004.

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NOTE 10 COMMITMENTS AND CONTINGENCIES

     From time to time, the Company is party to various legal proceedings in the ordinary course of business. As is typical in the health care industry, the Company expects to remain subject to claims that its services have resulted in resident injury or other adverse effects. In addition, resident, visitor and employee injuries will also subject the Company to the risk of litigation. The health care industry in general continues to experience an increasing trend in the frequency and severity of litigation and claims. There are currently no outstanding uninsured litigation matters against the Company that it believes could have a material adverse effect on its operations or cash flows. Below is a summary of significant outstanding litigation to which the Company is a party.

Bexar County Investigation

     On July 30, 2004, the Company received notice from the Bexar County District Attorney’s office that one of the Company’s facilities, as well as the administrator and director of nursing for the facility, are the targets of a criminal investigation involving possible misdemeanor and felony violations of state law. The investigation involves the death of a hospice resident that was possibly caused by a medication error. The Company has retained counsel to represent it and its employees with respect to this investigation. The matter is in the investigative stage, and the Company is not aware of any formal actions that have been brought at this time. In the event a formal action is brought, the Company intends to vigorously contest any allegations of misconduct by the Company.

Royal Surplus Lines Litigation

     On June 11, 2001, one of the Company’s prior liability insurance carriers, Royal Surplus Lines Insurance Company (“Royal”), commenced an adversary proceeding in the United States Bankruptcy Court for the District of Delaware (“Bankruptcy Court”), styled Royal Surplus Lines Insurance Company v. Mariner Health Group (“MHG”) et al., Adversary Proceeding No. A-01-4626 (MFW). In its complaint, Royal sought among other things, declaratory judgments that it would not be required to insure some claims falling under two professional and general liability (“PL/GL”) policies issued to one of the Company’s subsidiaries by Royal. One of the Company’s prior excess liability insurance carriers, Northfield Insurance Company (“Northfield”), moved to intervene in the Royal adversary proceeding on July 25, 2001. The Company did not oppose the motion to intervene, and it was granted.

     Prior to the commencement of any significant discovery by the parties, we agreed to mediate the issues arising out of the Royal adversary proceeding. After the mediation, Royal agreed to dismiss its complaint without prejudice, the Company agreed to dismiss its counterclaim without prejudice, and Royal and the Company agreed to work together to resolve claims in an alternative dispute resolution procedure. Northfield did not agree to dismiss its complaint in intervention. Accordingly, Northfield and the Company are currently engaged in discovery. The Company has also filed a bad faith counterclaim against Northfield arising out of its claims handling and litigation tactics.

PricewaterhouseCoopers Litigation

     On July 22, 2004, the Company voluntarily dismissed without prejudice its complaint in the State Court of Fulton County, Georgia (originally filed in August 2002) against PricewaterhouseCoopers, LLP (“PwC”) and several former officers of MHG (the “Individual Defendants”) and re-filed the action in the Superior Court of Fulton County, Georgia. In response, PwC filed motions in the State Court seeking attorneys’ fees and expenses relating to the State Court action and to strike Mariner’s voluntary dismissal of the State Court action. On September 30, 2004, the State Court granted PwC’s motion to strike Mariner’s voluntary dismissal and granted a motion by PwC to dismiss Mariner’s complaint with prejudice. The Company believes the Court erred in its rulings and is considering all available options, including appeal.

     The State Court action asserted claims for fraud against the Individual Defendants and claims for fraud and negligent misrepresentation against PwC. These claims arose from the July 1998 acquisition of MHG by Paragon, one of the Company’s predecessors. The Company sought actual damages (including compensatory and consequential damages) and punitive damages, in an amount to be determined at trial.

Indemnity Insurance Company of North America Litigation

     In May 2003, the Company filed a complaint in the United States District Court for the Eastern District of Texas, Beaumont Division, entitled Mariner Health Care, Inc. v. Indemnity Insurance Company of North America, Inc. (“IINA”), Case No. 103 CV

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0279. The Company is seeking a declaratory judgment determining its rights and the obligations of IINA, under an IINA policy of insurance regarding property damage and related losses at the Company’s facilities in Beaumont and Houston, Texas caused by Tropical Storm Allison in June 2001. The Company additionally asserts breach of contract and unfair claims handling practices claims against IINA. The Company seeks statutory damages, punitive damages and attorneys’ fees under Texas Insurance Code and the Texas Civil Practice and Remedies Code. IINA has answered the Company’s complaint and the parties are in the process of pretrial discovery, with an anticipated trial date in the second or third quarter of 2005.

     On January 30, 2004, the Company moved to amend its complaint to include, as plaintiffs, the Company’s affiliates Cornerstone Health Management Company, Mariner Health Care of Nashville, Inc. and Living Centers of Texas, Inc., and to make other conforming amendments. That motion was granted on February 7, 2004 and the first amended complaint was filed on March 16, 2004.

Alabama False Claims Act Litigation

     On June 10, 2004 the Company was served with a complaint filed in the U.S. District Court of Alabama entitled United States of America ex rel Patrick Bruce Atkins, MD and Patrick Bruce Atkins, MD, a natural person v. Charles M. McInteer, MD et. al. The complaint alleges violations of the Federal False Claims Act, conspiracy and common law fraud in connection with psychiatric services rendered by third party psychiatrists in nursing facilities in Alabama, including one facility operated by a subsidiary of the Company. To date, the United States has declined to intervene in this litigation. No specific allegations of fraud were made against the Company, and accordingly it filed a motion to dismiss the complaint as to its facility on June 30, 2004. On October 27, 2004 the Court granted the Company’s motion to dismiss.

     While the Company is not able to predict the outcome of any of these matters, based on currently available facts it does not believe that the resolution of any of these proceedings will have a material adverse effect on its financial position, results of operations or cash flows.

Formation Notice Letter

     On October 26, 2004 and October 27, 2004, the Company received notices from Formation Properties III, LLC (“Formation”) and its counsel seeking indemnification under the asset purchase agreement dated as of August 19, 2003 by and among Formation, the Company, and various of its subsidiaries for $10.5 million plus interest. Pursuant to the asset purchase agreement, Formation purchased a majority of the Company’s Florida facilities in the fourth quarter of 2003. In its notice, Formation alleges breaches of representations, warranties and covenants contained in the asset purchase agreement with respect to certain financial statements delivered by the Company pursuant to such agreement. The asset purchase agreement limits the amount that Formation can recover on an indemnification claim to $4.0 million unless it is determined that the Company committed fraud or intentionally and knowingly made a misrepresentation. Accordingly, Formation also alleges that the Company’s actions constituted fraud and/or an intentional and knowing misrepresentation. The Company is in the process of evaluating Formation’s claim.

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

     The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes and the selected financial data included in Item 6, both included in our Annual Report on Form 10-K for the year ended December 31, 2003. Our discussion of our results of operations and financial position includes various forward-looking statements about our markets, the demand for our services, and our future results. These statements are based on certain assumptions that we consider reasonable. For information about risks and exposures relating to our business and our company, you should read the section entitled “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2003.

     The following discussion includes EBITDA, which is not a financial measure compliant with accounting principles generally accepted in the United States, or GAAP. For purposes of Regulation G promulgated by the SEC, or Regulation G, a non-GAAP financial measure is a numerical measure of a registrant’s historical or future financial performance, financial position or cash flows that excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable financial measure calculated and presented in accordance with GAAP in the statement of operations,

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statement of stockholders’ equity, balance sheet or statement of cash flows (or equivalent statements) of the registrant; or includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable financial measure so calculated and presented. Pursuant to the requirements of Regulation G, we have provided reconciliations of the non-GAAP financial measures to the most directly comparable GAAP financial measures.

     Management believes that the presentation of EBITDA provides useful information to investors regarding our results of operations because it is useful for trending, analyzing and benchmarking the performance and value of our business. We use EBITDA primarily as a performance measure and believe that the GAAP financial measure most directly comparable to EBITDA is net (loss) income. Although we use EBITDA as a financial measure to assess the performance of our business, the use of EBITDA is limited because it does not consider certain material costs necessary to operate our business. These costs include the cost to service our debt, the non-cash depreciation and amortization associated with our long-lived assets, and the cost of our federal and state tax obligations. Because EBITDA does not consider these important elements of our cost structure, a user of our financial information who relies on EBITDA as the only measure of our performance could draw an incomplete or misleading conclusion regarding our financial performance. Consequently, a user of our financial information should consider net (loss) income an important measure of our financial performance because it provides the most complete measure of our performance.

     We define EBITDA as net (loss) income before taxes, interest expense, interest income, and depreciation and amortization. Other companies may define EBITDA differently and, as a result, our measure of EBITDA may not be directly comparable to EBITDA of other companies. EBITDA does not represent net (loss) income, as defined by GAAP.

     We also present certain adjustments to EBITDA that exclude (gain) loss on sale of discontinued operations, net of tax, loss (income) from discontinued operations, net of tax, and loss (income) from operations of divested facilities that did not qualify for discontinued operations. These adjustments are presented because this is the formula used to calculate compliance with certain ratios appearing in our $225.0 million senior credit facility, or the Senior Credit Facility, which consists of a $135.0 million term loan facility and a $90.0 million revolving credit facility, and our $175.0 million aggregate principal amount of 8 1/4% senior subordinated notes due 2013, or the Notes. In addition, we have excluded merger related costs because they are non-recurring in nature. The adjustments to EBITDA presented below are reconciled to net (loss) income, which we believe is the most directly comparable GAAP financial measure.

Overview

     The accompanying unaudited condensed consolidated financial statements set forth certain information with respect to our financial position, results of operations and cash flows which should be read in conjunction with the following discussion and analysis. As used in this report, references to “we,” “us,” “our,” “Mariner” or similar terms include Mariner Health Care, Inc. and its operating subsidiaries.

     We are one of the largest providers of long-term health care services in the United States, based on net revenue, the number of facilities operated and licensed beds. We provide these services primarily through the operation of skilled nursing facilities (which include “skilled nursing facilities” under Medicare and “nursing facilities” under Medicaid) and long-term acute care hospitals, or LTACs. Skilled nursing services and LTACs also constitute our reportable business segments under GAAP. We currently operate 252 skilled nursing facilities and two stand-alone assisted living facilities with an aggregate of 30,614 licensed beds. We own 70% of our facilities. We also operate twelve LTACs with 640 licensed beds. Our facilities are located in 23 states with significant concentrations in Texas, North Carolina, California, Colorado, South Carolina, and Maryland and clusters in twelve geographic markets in nine of the states in which we operate.

     On June 29, 2004, we entered into a merger agreement, or the Merger Agreement, with National Senior Care, Inc. (“NSC”) and NCARE Acquisition Corp. (“NCARE”), a wholly-owned subsidiary of NSC established for the purpose of acquiring Mariner. The parties to the Merger Agreement entered into the First Amendment, or the First Amendment, to the Merger Agreement on October 21, 2004. The terms of the First Amendment are summarized in the Current Report on Form 8-K we filed on October 22, 2004. Pursuant to the Merger Agreement, NCARE will acquire the issued and outstanding shares of common stock of Mariner for $30.00 per share in cash. The merger is expected to close in the fourth quarter of 2004 and is subject to various conditions contained in the Merger Agreement, including but not limited to the approval of the Mariner’s stockholders, receipt of financing by NSC and other regulatory, governmental and licensing approvals. On October 22, 2004, we filed our definitive proxy statement to obtain shareholder approval of the merger. The Annual Shareholders meeting to elect directors, amend the bylaws and approve the merger will be held on November 30, 2004.

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     In connection with our pending merger with NSC, on November 2, 2004, we announced and commenced a cash tender offer and consent solicitation for all of our outstanding 8 1/4% Senior Subordinated Notes due 2013. The tender offer and consent solicitation are being made pursuant to an Offer to Purchase and Consent Solicitation Statement and related Consent and Letter of Transmittal dated November 2, 2004, which set forth a more detailed description of the tender offer and consent solicitation. The tender offer will expire at 5:00 p.m. (EST) on December 1, 2004, unless extended or terminated and is conditioned on the consummation of the merger. The consent solicitation will expire at 5:00 p.m. (EST) on November 16, 2004, unless extended or terminated and is also conditioned on the consummation of the merger.

     Services provided at our skilled nursing facilities and assisted living facilities are our primary service offering and account for 92% of our revenue. Through our skilled nursing facilities, we provide 24-hour care to patients requiring skilled nursing services, including assistance with activities of daily living, or ADL, therapy and rehabilitation services. Our LTACs accommodate the relatively high acuity needs of patients discharged from short-term, acute-care hospitals when the patients’ condition warrants more intensive care than can be provided in a typical nursing facility.

     The following table sets forth our revenues, operating profit (loss), depreciation and amortization and total assets for our two reportable segments, skilled nursing services and LTACs. The operating profit (loss) is defined as net revenue less operating and general and administrative expenses. The income statement items included in the “Other” category consist of corporate items not considered to be an operating segment and eliminations. The assets included in the “Other” category consist primarily of cash, non-facility property and equipment, excess reorganization value, goodwill, restricted investments, notes receivable and deferred financing costs (in thousands of dollars).

(1)

Operating profit does not include depreciation and amortization or merger related costs. Total operating profit less depreciation and amortization and merger related costs was $6.9 million and $37.2 million for the three and nine months ended September 30, 2004, respectively, and $6.3 million and $19.6 million for the three and nine months ended September 30, 2003, respectively.

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Critical Accounting Policies and Estimates

General

     The unaudited condensed consolidated financial statements are based on the application of critical accounting policies and estimates, which require management to make estimates and assumptions. We believe that some of the more critical judgment areas in the application of accounting policies that affect our financial condition and results of operations are estimates and assumptions pertaining to (a) revenue recognition, (b) collectibility of accounts receivable, (c) insurance and professional liability risks and (d) income taxes.

Revenue Recognition

     We have agreements with third-party payors that provide for payments to our skilled nursing facilities and LTACs. These payment arrangements may be based upon prospective rates, reimbursable costs, established charges, discounted charges or per diem payments. Revenue is reported at the estimated net realizable amounts from Medicare, Medicaid, other third-party payors and individual patients for services rendered. Retroactive adjustments that are likely to result from future examinations by third-party payors are accrued on an estimated basis in the period the related services are rendered and adjusted as necessary in future periods based on final settlements. There is at least a reasonable possibility that recorded estimates may change by a material amount in the near term. Consistent with health care industry accounting practices, changes to these third-party revenue estimates are recorded in the year of change or at the time the adjustment becomes known.

Receivables

     Receivables consist primarily of amounts due from the Medicare and Medicaid programs, other government programs, managed care health plans, commercial insurance companies and individual patients. Allowances for doubtful accounts are established to the extent that a portion of these receivables may become uncollectible. In establishing the allowance for doubtful accounts, we consider a number of factors, including the age of the accounts, changes in collection patterns, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry conditions. Changes in these estimates are charged or credited to the results of operations in the period of the change. If circumstances occur, such as an economic downturn, higher than expected defaults or denials, or reduced collections, the estimates of the recoverability of our receivables could be reduced by a material amount. During the nine months ended September 30, 2004, we collected net cash of $6.2 million of previously reserved accounts receivable balances primarily related to facilities divested during the three months ended December 31, 2003. Our provision for bad debt totaled $4.8 million, $11.9 million, $4.3 million, and $11.8 million for the three and nine months ended September 30, 2004 and September 30, 2003, respectively, which represented 1.2%, 1.0%, 1.0%, and 0.9% of net revenue for the respective periods. Our allowance for doubtful accounts related to patient accounts receivable was $105.9 million and $97.4 million as of September 30, 2004 and December 31, 2003 respectively, which represented 35.5% and 30.8% of patient accounts receivable at September 30, 2004 and December 31, 2003, respectively.

Accrued Insurance Obligation for Professional and General Liability

     PL/GL costs for the long-term care industry have become increasingly expensive and difficult to estimate. Specifically, rising costs of eldercare malpractice liability litigation, losses stemming from these malpractice lawsuits and a declining number of insurers willing to write insurance policies in our industry has caused many insurance carriers to raise the cost of insurance premiums. Additionally, the Company has experienced an increase in severity as well as frequency of claims asserted resulting in increased defense costs.

     We are currently self-insured for individual claims up to $1.0 million for professional liability, except in Colorado, where we maintain first dollar coverage. The accrued insurance obligation related to self-insured losses for professional liability are recorded on an undiscounted basis and are based upon internal and external evaluations of the merits of individual claims, analysis of claims history and independent actuarially determined estimates. We periodically review the methods of determining these estimates and establishing the resulting accrued insurance obligation and provision for loss with any resulting adjustments being reflected in current earnings. Insurance expense for PL/GL was $16.3 million, $47.7 million, $21.6 million, and $63.1 million for the three and nine months ended September 30, 2004 and September 30, 2003, respectively. The decrease in insurance expense for PL/GL is due primarily to facilities divested during the three months ended December 31, 2003, partially offset by rising rates and defense costs.

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     Although we believe that the accrued insurance obligation is adequate, the ultimate liability may be in excess of or less than the amounts recorded. Changes in the number of PL/GL claims and increases in costs to settle these claims could significantly impact our accrued insurance obligation. A relatively small variance between our estimated and ultimate actual number of claims or average cost per claim could have a material impact, either favorable or unfavorable, on the adequacy of the accrued insurance obligation.

Accounting for Income Taxes

     The provision (benefit) for income taxes is allocated between continuing operations, discontinued operations, and extraordinary items in accordance with SFAS No. 109, “Accounting for Income Taxes”, or SFAS No. 109. For the three and nine months ended September 30, 2004, no federal income tax provision and a state income tax provision of $3.4 million and $5.0 million, respectively, was recorded. The effective tax rates vary from statutory tax rates primarily due to the utilization of net operating loss, or NOLs, carryforwards. In addition, income earned in certain states for which state NOLs are not available and a revision to our assessment of its NOL position resulted in a higher effective tax rate in the three and nine months ended September 30, 2004.

     As of December 31, 2003, we had approximately $563.5 million of NOL carryforwards utilization, of which were subject to limitations pursuant to Section 382 of the Internal Revenue Code. Of the total NOL carryforwards, $118.4 million is unencumbered by any Section 382 limitations. Of the remainder, approximately $143.0 million of NOL carryforwards are subject to certain restrictions under Section 382 that apply to a company that emerges from bankruptcy. The remaining $302.1 million of NOL carryforwards are subject to the additional Section 382 restrictions in connection with the existence of net unrealized built-in gain at the time of a December 1999 ownership change that occurred when our largest shareholder sold its equity interest in the Company to another entity prior to our filing bankruptcy. Utilization of these NOLs will require the recognition of built-in gain within five years of such date, or by December 31, 2004. While we are still currently in the process of evaluating the full extent of the limitations and restrictions on the utilization of the NOL carryforwards under the provisions of Section 382, it is likely that the use of $302.1 million of NOL carryforwards originating prior to the ownership change in December 1999 will be subject to significant limitation and thus our estimates of their availability has changed this quarter. Management performed extensive analysis on all restrictions impacting the NOLs in the current period. While all aspects of these restrictions continue to be analyzed, the current period analysis indicated that the state NOLs utilized in our computation of prior period tax expense should be limited due to the lack of the generation of built-in gains. As a result, we recorded an additional $2.2 million of state income tax during the three months ended September 30, 2004.

     The provision for income taxes is based upon our estimate of taxable income or loss for each respective accounting period. We recognize an asset or liability for the deferred tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of assets are recovered or liabilities are settled. We also recognize as deferred tax assets the future tax benefits from net operating loss carryforwards.

     SFAS No.109 requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences are deductible. In making this determination, we consider all available positive and negative evidence affecting specific deferred tax assets, including our past and anticipated future performance, the reversal of deferred tax liabilities, and the implementation of tax planning strategies.

     Objective positive evidence is necessary to support a conclusion that a valuation allowance is not needed for all or a portion of deferred tax assets when significant negative evidence exists. Cumulative losses in recent years are the most compelling form of negative evidence considered by management in this determination. We believe the deferred tax assets will not be recognized under the “more likely than not” standard. As the bankruptcy pre-emergence net deferred tax assets are realized, a reduction in the valuation allowance established in connection with fresh-start reporting will be recorded. Pursuant to American Institute of Certified Public Accountants Statement of Position 90-7, “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code”, any reduction in the valuation allowance will first reduce reorganization value in excess of amount allocable to identified assets recorded in fresh-start reporting and other intangible assets, with any excess being treated as an increase to capital surplus.

     If there is a cumulative ownership change involving share holders who own 5% or more of our common stock of more than 50% during the two year period following our emergence from bankruptcy (May 13, 2002), the remaining NOL carryforwards will be foregone with no net impact to our consolidated financial statements. This could result in higher future tax payments if we are

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profitable. The Company is unaware of any such changes to date. However, because of the SEC rules and regulations regarding the timing of public filings, management will continue to evaluate the status of the potential ownership change as additional information becomes available.

Asset Impairment

Long-lived Assets

     We review the carrying value of our long-lived assets for impairment whenever events or circumstances indicate that the carrying amount may not exceed the future undiscounted cash flows or an adjustment to the estimated useful life is necessary in accordance with Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, or SFAS No. 144. These indicators of impairment can include, but are not limited to, a history of operating losses with expected future losses, changes in the regulatory environment affecting reimbursement, decreases in cash flows or cash flow deficiencies, changes in the way an asset is used in the business, and commitment to a plan to sell or otherwise dispose of an asset.

Impairment of Reorganization Value in Excess of Amounts Allocable to Identifiable Assets and Goodwill

     Reorganization value in excess of amounts allocable to identifiable assets, or excess reorganization value, represents the portion of reorganization value that could not be attributed to specific tangible or identified intangible assets recorded in connection with our adoption of fresh-start reporting.

     In accordance with SFAS No.142, “Goodwill and Other Intangible Assets”, (“SFAS No. 142”), we are required to review the excess reorganization value and goodwill for impairment at least annually or more frequently if events or changes in circumstances indicate the asset might be impaired.

Assets Held for Sale and Discontinued Operations

     SFAS No. 144 also addresses the accounting for and disclosure of long-lived assets to be disposed of by sale. Under SFAS No. 144, when a long-lived asset or group of assets or disposal group meets certain criteria set forth in SFAS No. 144, including a commitment by a company to a plan to sell the long-lived asset or disposal group within one year, the long-lived asset or disposal group will be measured at the lower of its carrying value or fair value less costs to sell and classified as held for sale on the consolidated balance sheet and is no longer depreciated. We must estimate the fair value less costs to sell in order to determine if there is any potential impairment of the assets held for sale. Estimates may include comparable sales, future cash flows and the use of an outside expert in determining the fair value.

     If additional criteria are met under SFAS No. 144, the related operations and cash flows of the long-lived asset or disposal group will be reported as discontinued operations in the consolidated statements of operations, with all comparable periods restated.

Recent Accounting Pronouncements

     In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or FIN 46, which addresses the consolidation of entities whose equity holders have either (a) not provided sufficient equity at risk to allow the entity to finance its own activities or (b) do not possess certain characteristics of a controlling financial interest. FIN 46 sets forth a model to evaluate potential consolidation of these entities, known as variable interest entities, or VIEs, based on an assessment of which party to the VIE, if any, absorbs a majority of the exposure to its expected losses, receives a majority of its expected residual returns, or both, which is referred to for purposes of FIN 46 as the “primary beneficiary.” FIN 46 also requires disclosures about VIEs that a company is not required to consolidate but in which it has a significant variable interest. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after March 15, 2004 except for companies with special purpose entities which must apply the provisions of FIN 46 to those special purpose entities no later than the first reporting period ending after December 15, 2003.

     We have evaluated the impact of FIN 46 on our unaudited condensed consolidated financial statements and identified three joint ventures as VIEs for which we have determined that we are the primary beneficiary. These joint ventures, which operate skilled nursing facilities that are managed by us, are fifty percent owned by us and have historically been consolidated due to

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control. We have historically provided funds for working capital and have other long-term notes from these joint ventures, which are eliminated in consolidation. The joint ventures have revenues, which are included in our unaudited condensed consolidated financial statements of $9.8 million, $29.5 million, $9.6 million, and $27.4 million for the three and nine months ended September 30, 2004 and September 30, 2003, respectively. These joint ventures have net liabilities that are included in the accompanying unaudited condensed consolidated financial statements of approximately $39.5 million and $39.9 million at September 30, 2004 and December 31, 2003, respectively.

     During the three months ended December 31, 2003, we entered into an administrative services agreement with a new operator of certain facilities that we divested. The services are for 26 facilities and include accounting support, procurement of business supplies, billing and collections, and information technology services. Applying the principles of FIN 46, we have determined that the new operator of the divested facilities is a VIE. We have also determined that we are not the “primary beneficiary” and accordingly, we are not required to consolidate the new operator. The total receivable from this new operator at September 30, 2004 is $2.2 million.

Results of Operations

     The following table represents the unaudited condensed consolidated statements of operations for the periods indicated (in thousands of dollars):

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Reconciliation of EBITDA to net income (in thousands of dollars)

(1) The table presented below contains items that are excluded when calculating EBITDA for the purpose of determining our compliance with certain ratios contained in our Senior Credit Facility and the indenture pertaining to our Notes. This is our Debt Financing EBITDA. In addition, we have excluded merger related costs, because we believe these amounts are non-recurring in nature. This is our Debt Financing EBITDA and MRCs. The ratios contained in our Senior Credit Facility determine our compliance with certain covenants contained in the documents relevant to both debt obligations as well as our ability to draw on our Revolving Credit Facility, issue additional Notes and undertake certain desired corporate actions. If these items were excluded from EBITDA as presented in the table above, Debt Financing EBITDA and MRCs would be $22.5 million, $16.8 million, $74.6 million, and $49.1 million for the three months ended September 30, 2004 and 2003 and the nine months ended September 30, 2004 and 2003, respectively.

(2) The loss from operations of divested facilities relates to divestitures of facilities that did not qualify for discontinued operations presentation.

Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003

     We reported net revenues of $413.1 million during the quarter ended September 30, 2004, compared to $439.8 million for the quarter ended September 30, 2003. The decrease of $26.7 million, or 6.1%, consists primarily of the following:

	•		A decrease of $49.3 million related to divested facilities that do not qualify for discontinued operations presentation.
	•		An increase of $19.5 million in skilled nursing facilities we operated as of September 30, 2004, or same facility operations. This increase is due primarily to:

•

A net increase of $10.9 million in Medicaid revenues due primarily to a rate increase averaging $7.50 per patient day resulting in a $12.2 million increase in revenues, which was partially offset by a decrease in patient days of 10,978, or 0.7% resulting in a decrease in revenues of $1.3 million. The rate increase was primarily due to an increase of $10.8 million associated with the provider tax based Medicaid rate increases in Alabama, California, Georgia, Michigan, Mississippi, and North Carolina. The provider tax paid in connection with these programs offsets a portion of the revenue and is included in other operating expenses.

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	•		A net increase of $5.7 million in Medicare revenues due primarily to a rate increase of $25.88 per patient day resulting in a $8.0 million increase in revenues offset by a decrease in patient days of 7,608, or 2.4% resulting in a $2.3 million decrease in revenues. The rate increase is due primarily to the October 1, 2003 final rules for Medicare Prospective Payment System (“PPS”) for the federal governments 2004 fiscal year, which consisted of an annual market basket increase effective October 1, 2003 and an upward adjustment in base rates to correct previous forecast errors.
	•		A net increase of $2.9 million in private and other revenues due to an increase in rate of $16.11 per patient day resulting in a $6.8 million increase in revenues, which was partially offset by a decrease in patient days of 22,392, or 5.0% that resulted in a $3.9 million reduction of revenues. The increase in rate was attributable to a favorable change in payor mix. The reduction in days is due primarily to the market for private payors continuing to shift to assisted living facilities.

•

An increase of $3.4 million related to LTAC revenues primarily related to an increase in total patient days of 1,536, or 5.4% resulting in a $1.6 million increase in revenues and an increase in the average rate per patient day of $58.62 resulting in an increase in revenues of $1.8 million. The rate increase is due primarily to a 3.1% Medicare federal rate increase and a 5.5% increase in the Medicare budget neutrality rate factor in July 2004.

Operating Expenses

     We reported operating expenses of $364.1 million during the quarter ended September 30, 2004, compared to $399.5 million during the quarter ended September 30, 2003. The decrease of $35.4 million, or 8.9% primarily relates to the following:

•

Wage and related costs decreased $26.1 million due primarily to:

•

A decrease of $29.3 million related to divested facilities that do not qualify for discontinued operations presentation.

•

A partially offsetting increase in same facility operations and LTAC of $3.2 million, primarily related to annual salary and benefit cost increases and an increase in workers compensation expenses.

•

Supplies decreased $2.8 million due primarily to:

•

A decrease of $2.6 million related to divested facilities that do not qualify for discontinued operations presentation.

•

Insurance, which consists primarily of professional and general liability insurance costs, decreased $5.8 million due primarily to:

•

A decrease of $7.3 million related to divested facilities that do not qualify for discontinued operations presentation.

•

An increase of $1.5 million in same facility operations and LTAC due primarily to rising PL/GL costs.

•

Other operating expenses decreased $0.3 million primarily related to:

•

A decrease of $9.7 million of other operating expense related to divested facilities that do not qualify for discontinued operations presentation.

•

An increase of $9.4 million of other operating expenses in same facility operations and LTAC due primarily to:

	•		An increase of $3.4 million for provider tax expense related to state Medicaid programs in Alabama, California, Georgia, Michigan, Mississippi, and North Carolina. The provider tax partially offsets Medicaid revenues.
	•		An increase of $6.9 million primarily related to certain contracted and ancillary services that are now outsourced such as physical, speech and occupational therapy and housekeeping and laundry that were previously performed by salaried employees.

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General and Administrative

     We reported general and administrative expenses of $27.0 million during the quarter ended September 30, 2004, compared to $24.5 million during the quarter ended September 30, 2003. The increase of $2.5 million, or 10.2%, relates primarily to the following:

•

An increase of $1.2 million primarily related to increases in wage and related costs.

•

The remaining net increase of $1.3 million relates to miscellaneous expenses, including costs incurred for compliance with Sarbanes-Oxley, and legal costs, primarily related to our claim against an insurance company for certain owned and leased facilities that were damaged by floods.

Merger Related Costs

     We reported merger related costs of $4.9 million during the quarter ended September 30, 2004. The merger related costs consist primarily of professional and legal expenses related to our pending merger.

Depreciation and Amortization

     We reported depreciation and amortization expense of $10.2 million during the quarter ended September 30, 2004, compared to $9.5 million during the quarter ended September 30, 2003. The increase of $0.7 million, or 7.4%, primarily relates to the following:

•

An increase of $1.2 million related to incremental depreciation expense on capital expenditures in same facility operations, LTAC and corporate locations.

•

A decrease of $0.4 million due to the divested facilities that do not qualify for discontinued operations presentation.

Interest Expense

     We reported interest expense of $8.2 million during the quarter ended September 30, 2004, compared to $8.9 million during the quarter ended September 30, 2003. The decrease of $0.7 million, or 7.9%, primarily relates to lower interest rates and outstanding debt as a result of debt pay downs and the refinancing completed during the fourth quarter of 2003.

Discontinued Operations

(Loss) income from Discontinued Operations

     On July 23, 2003, we earned and received $12.0 million as the final payment for post-closing operating results, or Earnout Payments in connection with the sale of the institutional pharmacy services business, or APS Division to Omnicare, Inc. at which time we recorded a gain of $7.2 million, net of taxes of $4.8 million.

     The results of operations of any disposed facilities that qualify for discontinued operations under SFAS No. 144 have been reported as discontinued operations for all periods presented in the accompanying unaudited consolidated statements of operations. A summary of the discontinued operations for the periods presented is as follows (in thousands of dollars):

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Nine Months Ended September 30, 2004 Compared to the Nine Months Ended September 30, 2003

     We reported net revenues of $1,229.7 million during the nine months ended September 30, 2004, compared to $1,285.7 million for the nine months ended September 30, 2003. The decrease of $56.0 million, or 4.4%, consists primarily of the following:

•

A decrease of $146.4 million related to divested facilities that do not qualify for discontinued operations presentation.

•

An increase of $79.4 million in skilled nursing facilities we operated as of September 30, 2004, or same facility operations. This increase is due primarily to:

•

A net increase of $36.0 million in Medicaid revenues due primarily to a rate increase averaging $8.27 per patient day resulting in a $39.4 million increase in revenues, which was partially offset by a decrease in patient days of 30,488, or 0.6% resulting in decrease in revenues of $3.4 million. The rate increase was primarily due to an increase of $30.5 million associated with the provider tax based Medicaid rate increases in Alabama, California, Georgia, Michigan, Mississippi, and North Carolina. In addition, the recently approved Michigan rate increase was retroactive to October 1, 2003, and accordingly, $1.8 million of revenue was recognized during the nine months ended September 30, 2004 for this retroactive adjustment. The provider tax paid in connection with this program offsets a portion of the revenue and is included in other operating expenses.

•

An increase of $29.5 million in Medicare revenues due primarily to a rate increase averaging $26.34 per patient day resulting in a $25.6 million increase in revenues and an increase in patient days of 13,171, or 1.4% resulting in a $3.9 million increase in revenues. The rate increase is due primarily to the October 1, 2003 final rules for Medicare Prospective Payment System (“PPS”) for the federal governments 2004 fiscal year, which consisted of an annual market basket increase effective October 1, 2003 and an upward adjustment in base rates to correct previous forecast errors. The increase in patient days was a direct result of our focus on attracting a higher acuity patient population.

•

A net increase of $13.9 million in private and other revenues due to an increase in rate of $18.32 per patient day resulting in a $23.2 million increase in revenues, which was partially offset by a decrease in patient days of 54,392, or 4.1% that resulted in a $9.3 million reduction of revenues. The increase in rate was attributable to a rate increase we made in July 2003 and to a favorable change in payor mix. The reduction in days is due primarily to the market for private payors shifting to assisted living facilities.

•

An increase of $10.7 million related to LTAC revenues related to an increase in total patient days of 8,874, or 10.0% resulting in a $8.8 million increase in revenues and an increase in rate of $19.53 resulting in a $1.9 million increase in revenues. The increase in patient days is due to an increase of additional licensed beds and additional admitting physicians and the increase in rate is due to an 8.6% rate increase in Medicare during July 2004.

Operating Expenses

     We reported operating expenses of $1,074.4 million during the nine months ended September 30, 2004, compared to $1,168.5 million during the nine months ended September 30, 2003. The decrease of $94.1 million, or 8.0% primarily relates to the following:

•

Wage and related costs decreased $66.8 million due primarily to:

•

A decrease of $85.8 million related to divested facilities that do not qualify for discontinued operations presentation.

•

A partially offsetting net increase in same facility operations and LTAC of $19.0 million, primarily related to annual salary and benefit cost increases and an increase in workers compensation expenses.

•

Supplies decreased $6.5 million due primarily to:

•

A decrease of $7.7 million related to divested facilities that do not qualify for discontinued operations presentation.