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EX-4.1 - SUN HEALTHCARE GROUP INCex41.htm
EX-31.2 - SUN HEALTHCARE GROUP INCex312.htm
EX-21.1 - SUN HEALTHCARE GROUP INCex211.htm
EX-31.1 - SUN HEALTHCARE GROUP INCex311.htm
EX-23.2 - SUN HEALTHCARE GROUP INCex232.htm
EX-23.1 - SUN HEALTHCARE GROUP INCex231.htm
EX-32.1 - SUN HEALTHCARE GROUP INCex321.htm
EX-4.2.3 - SUN HEALTHCARE GROUP INCex423.htm
EX-32.2 - SUN HEALTHCARE GROUP INCex322.htm
EX-10.16 - SUN HEALTHCARE GROUP INCex1016.htm
EX-10.18 - SUN HEALTHCARE GROUP INCex1018.htm
EX-10.12 - SUN HEALTHCARE GROUP INCex1012.htm




UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________
FORM 10-K
(Mark One)
x    Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2009
OR
o    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from _____ to _____
 
Commission file number 1-12040
 
SUN HEALTHCARE GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State of Incorporation)
85-0410612
(I.R.S. Employer Identification No).
18831 Von Karman, Suite 400
Irvine, CA  92612
(949) 255-7100
(Address, including zip code, and telephone number of principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
Common Stock, par value $.01 per share
Name of Exchange on Which Registered
The NASDAQ Stock Market LLC (Nasdaq Global Select Market)
 
 
Securities registered pursuant to Section 12(g) of the Act:  None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. oYes     xNo
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. oYes     xNo
 
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. xYes     oNo
 
Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to e submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   xYes     oNo
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filero     Accelerated filerx     Non-accelerated filero     Smaller reporting companyo
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). oYes     xNo
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as reported on the NASDAQ Global Select Market, as of the last business day of the registrant's most recently completed second fiscal quarter was $369.0 million.
 
     On March 2, 2010, Sun Healthcare Group, Inc. had 43,766,400 outstanding shares of Common Stock.
 
Documents Incorporated by Reference:  Part III of this Form 10-K incorporates information by reference from the Registrant’s definitive proxy statement for the 2010 Annual Meeting to be filed prior to April 30, 2010.




INDEX
   
Page
PART I
   
     
Item 1.
Business
1
Item 1A.
Risk Factors
7
Item 1B.
Unresolved Staff Comments
15
Item 2.
Properties
15
Item 3.
Legal Proceedings
17
     
PART II
   
     
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
 
 
Purchases of Equity Securities
17
Item 6.
Selected Financial Data
19
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
 
 
Operations
23
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
51
Item 8.
Financial Statements and Supplementary Data
51
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial
 
 
Disclosure
51
Item 9A.
Controls and Procedures
52
Item 9B.
Other Information
52
     
PART III
   
     
Item 10.
Directors, Executive Officers and Corporate Governance
53
Item 11.
Executive Compensation
53
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related
 
 
Stockholder Matters
53
Item 13.
Certain Relationships and Related Transactions and Director Independence
53
Item 14.
Principal Accountant Fees and Services
53
     
PART IV
   
     
Item 15.
Exhibits and Financial Statement Schedules
54
     
Signatures
 
57
___________________
     References throughout this document to the Company, “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

    Sun Healthcare Group®, SunBridge®, SunDance®, CareerStaff Unlimited®, SolAmor®, Rehab Recovery Suites® and related names are trademarks of Sun Healthcare Group, Inc. and its subsidiaries.
__________________________________________

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information provided in this Annual Report on Form 10-K (“Annual Report”) contains “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”).  Any statements that do not relate to historical or current facts or matters are forward-looking statements.  Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs, the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions are forward-looking statements.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution investors that any forward-looking statements made by us herein are not guarantees of future performance and that investors should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this report.  Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements.  You should carefully consider the disclosures we make concerning risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements, including those described in this report under Part I, Item 1A – “Risk Factors” and any of those made in our other reports filed with the Securities and Exchange Commission.  There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.


 
 

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART I

Item 1.  Business

Overview

Sun Healthcare Group, Inc.’s (NASDAQ GS: SUNH) subsidiaries provide nursing, rehabilitative and related specialty healthcare services principally to the senior population in the United States. Our core business is providing inpatient services, primarily through 183 skilled nursing centers, 14 assisted and independent living centers and eight mental health centers. At December 31, 2009, our centers had 23,205 licensed beds located in 25 states, of which 22,423 were available for occupancy. Our subsidiaries also provide rehabilitation therapy services to affiliated and non-affiliated centers and medical staffing and other ancillary services primarily to non-affiliated centers and other third parties. For the year ended December 31, 2009, our total net revenues from continuing operations were $1.9 billion.

Business Segments

Our subsidiaries currently engage in the following three principal business segments:

 
Ø
inpatient services, primarily skilled nursing centers;
 
Ø
rehabilitation therapy services; and
 
Ø
medical staffing services.

Inpatient services.    As of December 31, 2009, we operated 205 healthcare facilities (consisting of 183 skilled nursing centers, 14 assisted and independent living centers and eight mental health centers) in 25 states with 23,205 licensed beds through SunBridge Healthcare Corporation (“SunBridge”) and other subsidiaries. Our skilled nursing centers provide services that include daily nursing, therapeutic rehabilitation, social services, housekeeping, nutrition and administrative services for individuals requiring certain assistance for activities in daily living. Rehab Recovery Suites (“RRS”), which specialize in Medicare and managed care patients, are located in 63 of our skilled nursing centers, and 47 of our skilled nursing centers contain wings dedicated to the care of residents afflicted with Alzheimer’s disease. Our assisted living centers provide services that include minimal nursing assistance, housekeeping, nutrition, laundry and administrative services for individuals requiring minimal assistance for activities in daily living. Our independent living centers provide services that include security, housekeeping, nutrition and limited laundry services for individuals requiring no assistance for activities in daily living. Our mental health centers provide a range of inpatient and outpatient behavioral health services for adults and children through specialized treatment programs. We also provide hospice services, including palliative care, social services, pain management and spiritual counseling, through our subsidiary SolAmor Hospice Corporation (“SolAmor”), in eight states for individuals facing end of life issues. We generated 89.1%, 88.6%, and 87.8% of our consolidated net revenues through inpatient services in 2009, 2008, and 2007, respectively.

Rehabilitation therapy services.  We provide rehabilitation therapy services through SunDance Rehabilitation Corporation (“SunDance”). SunDance provides a broad array of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. As of December 31, 2009, SunDance provided rehabilitation therapy services to 464 centers in 36 states, 337 of which were operated by nonaffiliated parties and 127 of which were operated by affiliates. In most of our 78 healthcare centers for which SunDance does not provide rehabilitation therapy services, those services are provided by staff employed by the centers, although some centers engage third-party therapy companies for such services. We generated 5.6%, 4.9%, and 5.3% of our consolidated net revenues through rehabilitation therapy services in 2009, 2008, and 2007, respectively.

 
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Medical staffing services.  We provide temporary medical staffing in 44 states through CareerStaff Unlimited, Inc. (“CareerStaff”). For the year ended December 31, 2009, CareerStaff derived 56.1% of its revenues from hospitals and other providers, 24.7% from skilled nursing centers, 15.3% from schools and 3.9% from prisons. CareerStaff provides (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians and (v) related medical personnel. We generated 5.3%, 6.5%, and 6.9% of our consolidated net revenues through medical staffing services in 2009, 2008, and 2007, respectively.

See Note 14 – “Segment Information” to our consolidated financial statements included in this Annual Report on Form 10-K for additional information regarding our segments.

Competition

Our businesses are competitive. The nature of competition within the inpatient services industry varies by location. We compete with other healthcare centers based on key factors such as the number of centers in the local market, the types of services available, quality of care, reputation, age and appearance of each center and the cost of care in each locality. Increased competition in the future could limit our ability to attract and retain residents or to expand our business.

We also compete with other companies in providing rehabilitation therapy services, medical staffing services and hospice services, and in employing and retaining qualified nurses, therapists and other medical personnel. The primary competitive factors for the ancillary services markets are quality of services, charges for services and responsiveness to customer needs.

We believe the following strengths will allow us to continue to improve our operations and profitability:

National footprint.    The size of our operations has enabled us to realize the benefits of economies of scale, purchasing power and increased year over year operating efficiencies. Furthermore, our geographic diversity helps to mitigate our risk associated with adverse state regulatory changes related to Medicaid reimbursement in any one state.

Core inpatient services business.    Our inpatient business has achieved consistent revenue and earnings growth by expanding our services and increasing our focus on integrated skilled nursing care and rehabilitation therapy services to attract high-acuity patients throughout all nursing and rehabilitation centers and through targeting specific centers with Rehab Recovery Suites that exclusively specialize in Medicare and managed care patients. Our hospice business, which serves patients in certain of our nursing centers, in-home settings and in non-affiliated centers, has become an important contributor to the strength of our inpatient business.

Quality of care.    We have initiated programs to provide a high quality of care to our patients. These programs have resulted in third-party recognition for our quality of care and clinical services.

Ancillary businesses support our inpatient services and provide diversification.    Our rehabilitation therapy business complements our core inpatient services business and is particularly attractive to high-acuity patients who require more intensive and medically complex care. Our medical staffing business, which primarily services non-affiliated providers, derives a majority of its revenues from its placement of therapists. We also place physicians, nurses and pharmacists.

Infrastructure in place to leverage growth.    We have an established corporate and regional infrastructure in place to leverage our growth. For the year ended December 31, 2009, our corporate overhead as a percentage of revenues was 3.3%, compared to 3.4% for the year ended December 31, 2008.

 
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Experienced management team with a proven track record.    We have a strong and committed management team that has substantial industry knowledge and a proven track-record of operations success in the long-term care industry. Our chief executive officer, our chief financial officer and the chief operating officer of our operating subsidiaries have over 80 years of cumulative healthcare experience. Our management team has successfully acquired and integrated numerous businesses, assets and properties, and we believe this experience positions us well to continue to successfully implement our growth and integration strategies.

Business Strategy

We intend to build on our competitive strengths to grow our business and strengthen our position as a nationwide provider of senior healthcare services by achieving the following objectives:

Continue our inpatient growth.    We intend to increase our inpatient revenue and profitability by maintaining high occupancy rates and by continuing to focus on attracting more high-acuity and Medicare patients. We are currently implementing this strategy by focusing on our clinical and case management and by developing Rehab Recovery Suites that exclusively specialize in Medicare and managed care patients. In addition, we are developing relationships with key referral sources and creating specialty Medicare/managed care and Alzheimer’s units within our centers to meet unique clinical needs within a community. We plan to take advantage of our marketing infrastructure and brand image to attract new patients and to expand our referral and customer bases.

Seek growth in our hospice and ancillary businesses.     We will seek to grow our SolAmor hospice operations through acquisitions and internal growth. We will continue to focus on our rehabilitation therapy business, a key driver of our Medicare services and revenues, by improving our clinical product offering, labor productivity and operating profitability and eliminating less profitable third-party contracts. We believe that our hospice and ancillary services provide us with diversified revenue sources, favorable payor mix and growth opportunities.

Increase operational efficiency and leverage our existing platform.    We will continue to focus on improving operating efficiency without compromising our high quality of care. We plan to reduce costs and enhance efficiency through various methods, including:
 
Ø
reducing labor and billing expenses through technological advances and operational improvements that allow management to allocate employees more efficiently;
 
Ø
reducing overhead through process improvement initiatives and frequent re-examination of costs;
 
Ø
continuing to improve therapist productivity in our rehabilitation services business;
 
Ø
controlling litigation expense by focusing on risk management;
 
Ø
improving our balance sheet by reducing our indebtedness; and
 
Ø
monitoring and analyzing the operations and profitability of individual business units.

Employees and Labor Relations

As of December 31, 2009, we and our subsidiaries had 30,029 full-time, part-time and per diem employees. Of this total, there were 24,451 employees in our inpatient services operations, 2,987 employees in our rehabilitation therapy services operations, 1,850 employees in our medical staffing business, 436 employees in our hospice operations and 305 employees at our corporate and regional offices.

As of December 31, 2009, SunBridge operated 35 centers with union employees. Approximately 2,856 of our employees (9.5% of all of our employees) who worked in healthcare centers in Alabama, California, Connecticut, Georgia, Massachusetts, Maryland, Montana, New Jersey, Ohio, Rhode Island, Washington and West Virginia were covered by collective bargaining contracts. Collective bargaining agreements covering

 
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approximately 1,429 of these employees (4.8% of all our employees) either are currently in renegotiations or will shortly be in renegotiations due to the expiration of the collective bargaining agreements.

Federal and State Regulatory Oversight

The healthcare industry is extensively regulated. In the ordinary course of business, our operations are continuously subject to federal, state and local regulatory scrutiny, supervision and control. This often includes inquiries, investigations, examinations, audits, site visits and surveys. As more fully described below, various laws, including anti-kickback, anti-fraud and abuse provisions codified under the Social Security Act, prohibit certain business practices and relationships that might affect the provision and cost of healthcare services reimbursable under Medicare and Medicaid. Sanctions for violating these anti-kickback, anti-fraud and abuse provisions include criminal penalties, civil sanctions, fines and possible exclusion from government programs such as Medicare and Medicaid. If a center is decertified as a Medicare or Medicaid provider by the Centers for Medicare and Medicaid Services (“CMS”) or a state, the center will not thereafter be reimbursed for caring for residents that are covered by Medicare and Medicaid, and the center would be forced to care for such residents without being reimbursed or to transfer such residents.

Our skilled nursing centers and mental health centers are currently licensed under applicable state law, and are certified or approved as providers under the Medicare and Medicaid programs. State and local agencies survey all skilled nursing centers on a regular basis to determine whether such centers are in compliance with governmental operating and health standards and conditions for participation in government sponsored third-party payor programs. From time to time, we receive notice of noncompliance with various requirements for Medicare/Medicaid participation or state licensure. We review such notices for factual correctness, and based on such reviews, either take appropriate corrective action or challenge the stated basis for the allegation of noncompliance. Where corrective action is required, we work with the reviewing agency to create mutually agreeable measures to be taken to bring the center or service provider into compliance. Under certain circumstances, the federal and state agencies have the authority to take adverse actions against a center or service provider, including the imposition of a monitor, the imposition of monetary penalties and the decertification of a center or provider from participation in the Medicare and/or Medicaid programs or licensure revocation. When appropriate, we vigorously contest such sanctions. Challenging and appealing notices or allegations of noncompliance can require significant legal expenses and management attention.

Various states in which we operate centers have established minimum staffing requirements or may establish minimum staffing requirements in the future. Our ability to satisfy such staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse’s assistants and other staff. Failure to comply with such minimum staffing requirements may result in the imposition of fines or other sanctions.

Most states in which we operate have statutes which require that, prior to the addition or construction of new nursing home beds, the addition of new services or certain capital expenditures in excess of defined levels, we first must obtain a certificate of need (“CON”), which certifies that the state has made a determination that a need exists for such new or additional beds, new services or capital expenditures. The certification process is intended to promote quality healthcare at the lowest possible cost and to avoid the unnecessary duplication of services, equipment and centers.

We are subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to, or the recommendation of, a particular provider for medical products and services. These laws include:
 
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the “anti-kickback” provisions of the Medicare and Medicaid programs, which prohibit, among other things, knowingly and willfully soliciting, receiving, offering or paying any remuneration (including any kickback, bribe or rebate) directly or indirectly in return for or to induce the referral of an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part under Medicare or Medicaid; and
   
the “Stark laws” which prohibit, with limited exceptions, the referral of patients by physicians for certain services, including physical therapy and occupational therapy, to an entity in which the physician has a financial interest.

False claims are prohibited pursuant to criminal and civil statutes. These provisions prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid or failing to refund overpayments or improper payments. Suits alleging false claims can be brought by individuals, including employees and competitors.  Newly adopted legislation has expanded the scope of the federal False Claims Act and eased some requirements for the filing of a lawsuit under the act.  We believe that our billing practices are compliant with the False Claims Act and similar state laws.  However, if our practices, policies and procedures are found not to comply with the provisions of those laws, we could be subject to civil sanctions.

Commencing January 1, 2010, recovery audit contractors, or RACs, operating under the Medicare Integrity Program, seek to identify alleged Medicare overpayments based on the medical necessity of services provided in nursing centers.  Similar audits are conducted by various state agencies under the Medicaid program.

As of December 31, 2009, we have approximately $5.2 million of claims that are under various stages of review or appeal with the Medicare Administration Contractors/Fiscal Intermediaries.  We cannot assure you that future recoveries will not be material or that any appeal of a medical review or RAC audit that we are pursuing will be successful.
 
 
We are also subject to regulations under the privacy and security provisions of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). The privacy rules provide for, among other things, (i) giving consumers the right and control over the release of their medical information, (ii) the establishment of boundaries for the use of medical information and (iii) civil or criminal penalties for violation of an individual’s privacy rights.

These privacy regulations apply to “protected health information,” which is defined generally as individually identifiable health information transmitted or maintained in any form or medium, excluding certain education records and student medical records. The privacy regulations limit a provider’s use and disclosure of most paper, oral and electronic communications regarding a patient’s past, present or future physical or mental health or condition, or relating to the provision of healthcare to the patient or payment for that healthcare.

The security regulations require us to ensure the confidentiality, integrity, and availability of all electronic protected health information that we create, receive, maintain or transmit. We must protect against reasonably anticipated threats or hazards to the security of such information and the unauthorized use or disclosure of such information. 

Compliance Process

Our compliance program, referred to as the “Compliance Process,” was initiated in 1996. It has evolved as the requirements of federal and private healthcare programs have changed.  There are seven principal elements to the Compliance Process:

 
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Written Policies, Procedures and Standards of Conduct.    Our business lines have extensive policies and procedures (“P&Ps”) modeled after applicable laws, regulations, government manuals and industry practices and customs. The P&Ps govern the clinical, reimbursement, and operational aspects of each subsidiary. To emphasize adherence to our P&Ps, we publish and distribute a Code of Conduct and an employee handbook.   

Designated Compliance Officer and Compliance Committee.    We have a Chief Compliance Officer whose responsibilities include, among other things: (i) overseeing the Compliance Process; (ii) overseeing compliance with judicial and regulatory requirements, and functioning as the liaison with the state agencies and the federal government on matters related to the Compliance Process and such requirements; (iii) reporting to our board of directors, the Compliance Committee of our board of directors, and senior corporate managers on the status of the Compliance Process; and (iv) overseeing the coordination of a comprehensive training program which focuses on the elements of the Compliance Process and employee background screening process. Compliance matters are reported to the Compliance Committee of our board of directors on a regular basis. The Compliance Committee is comprised solely of independent directors.

Effective Training and Education.    Every employee, director and officer is trained on the Compliance Process and Code of Conduct. Training also occurs for appropriate employees in applicable provisions of the Medicare and Medicaid laws, fraud and abuse prevention, clinical standards, and practices, and claim submission and reimbursement P&Ps.

Effective Lines of Communication.    Employees are encouraged to report issues of concern without fear of retaliation using a Four Step Reporting Process, which includes the toll-free “Sun Quality Line.” The Four Step Reporting Process encourages employees to discuss clinical, ethical or financial concerns with supervisors and local management since these individuals will be most familiar with the laws, regulations, and policies that impact their concerns. The Sun Quality Line is an always-available option that may be used for anonymous reporting if the employee so chooses. Reported concerns are internally reviewed and proper follow-up is conducted.

Internal Monitoring and Auditing.    Our Compliance Process puts internal controls in place to meet the following objectives: (i) accuracy of claims, reimbursement submissions, cost reports and source documents; (ii) provision of patient care, services, and supplies as required by applicable standards and laws; (iii) accuracy of clinical assessment and treatment documentation; and (iv) implementation of judicial and regulatory requirements (e.g., background checks, licensing and training). Each business line monitors and audits compliance with P&Ps and other standards to ensure that the objectives listed above are met. Data from these internal monitoring and auditing systems are analyzed and acted upon through a quality improvement process. We have designated the subsidiary presidents and each member of the operations management team as Compliance Liaisons. Each Compliance Liaison is responsible for making certain that all requirements of the Compliance Process are completed at the operational level for which the Compliance Liaison is responsible.

Enforcement of Standards.    Our policies, the Code of Conduct and the employee handbook, as well as all associated training materials, clearly indicate that employees who violate our standards will be subjected to discipline. Sanctions range from oral warnings to suspensions and/or to termination of employment. We have also adopted a proactive approach to offset the need for punitive measures. First, we have implemented employee background review practices that surpass industry standards. Second, as noted above, we devote significant resources to employee training. Finally, we have adopted a performance management program intended to make certain that all employees are aware of what duties are expected of them and understand that compliance with policies, procedures, standards and laws related to job functions is required.

Responses to Detected Offenses and Development of Corrective Actions.    Correction of detected misconduct or a violation of our policies is the responsibility of every manager. As appropriate, a manager is expected to

 
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develop and implement corrective action plans and monitor whether such actions are likely to keep a similar violation from occurring in the future.

Our Compliance Process incorporates the terms of a revised Permanent Injunction and Final Judgment entered on September 14, 2005 (“PIFJ”). The PIFJ, which resulted from investigations by the Bureau of Medi-Cal Fraud and Elder Abuse of the Office of the California Attorney General and applies to our California centers, requires compliance with certain clinical practices that are substantially consistent with existing law and our current practices, and imposes staffing requirements and specific training obligations. All California administrators are trained on the requirements of the PIFJ, as required.  The PIFJ also requires us to issue to the State of California annual reports documenting our compliance efforts. A breach of the PIFJ could subject us to substantial monetary penalties.

General Information

Sun Healthcare Group, Inc. was incorporated in Delaware in 1993.  Our principal executive offices are located at 18831 Von Karman, Suite 400, Irvine, CA 92612, and our telephone number is (949) 255-7100.  We maintain a website at www.sunh.com.  Through the “For more information about Sun Healthcare Group, Inc.” and “SEC Filings” links on our website, we make available free of charge, as soon as reasonably practicable after such information has been filed or furnished to the Securities and Exchange Commission, each of our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”).

Item 1A. Risk Factors

Our business depends on reimbursement under federal and state programs, and legislation or regulatory action may reduce or otherwise adversely affect the amount of reimbursements.

Our revenues are heavily dependent on payments administered under the Medicare and Medicaid programs. The economic downturn has caused many states to institute freezes on or reductions in Medicaid reimbursements to address state budget concerns.  Moreover, for the 2010 federal fiscal year, CMS effectively reduced our Medicare reimbursement rates; for the 2011 federal fiscal year, CMS is implementing changes to the Resource Utilization Group classification system, which may impact our Medicare revenues adversely.  In addition, the skilled nursing center exception to the statutory cap on Medicare reimbursements for therapy services expired on December 31, 2009.  If the skilled nursing center exception is not extended, reimbursement for therapy services rendered to our residents and patients will be reduced.  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Revenues from Medicare, Medicaid and Other Sources.”

In addition to these reductions, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. Aspects of certain of these initiatives, such as further reductions in funding of the Medicare and Medicaid programs, additional changes in reimbursement regulations by CMS, enhanced pressure to contain healthcare costs by Medicare, Medicaid and other payors, and additional operational requirements, could adversely affect us.

In addition to reducing our revenues, healthcare reform may increase our costs and otherwise adversely affect our business.

Both the U.S. House of Representatives and the U.S. Senate have each recently proposed comprehensive reforms to the country’s healthcare system.  There can be no assurance as to the ultimate content, timing or

 
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effect of any legislation that seeks to address healthcare reform, nor is it possible at this time to estimate the impact of potential legislation on us.  Any significant healthcare reform legislation may have a material adverse effect on our financial condition, results of operations and cash flows.  In addition, we incur considerable administrative costs in monitoring any changes made within the Medicare and Medicaid programs (such as the pending change in Resource Utilization Group categories), determining the appropriate actions to be taken in response to those changes, and implementing the required actions to meet the new requirements and minimize the repercussions of the changes to our organization, reimbursement rates and costs. A major reform of the healthcare delivery system could render determining and implementing appropriate actions more complex and costly.  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Revenues from Medicare, Medicaid and Other Sources.”

Our revenue and collections have been adversely affected by the economic downturn, and there may be further adverse consequences of the downturn.

In addition to state and federal budgetary actions that have impacted the amount of reimbursements that we receive for services under state and federal programs, the economic downturn has resulted in reduced demand for our staffing services that we provide through or to other healthcare providers and has impacted our ability to collect our receivables from nongovernmental sources.  If current economic conditions do not improve or worsen, this reduction in demand and impact on our receivables collection could continue.  Adverse economic conditions could also result in continued reduced demand for our therapy and staffing services to third party providers and increasing difficulty in collecting our receivables.

Delays in collecting or the inability to collect our accounts receivable could adversely affect our cash flows and financial condition.

Prompt billing and collection are important factors in our liquidity. Billing and collection of our accounts receivable are subject to the complex regulations that govern Medicare and Medicaid reimbursement and rules imposed by nongovernment payors.  Our inability to bill and collect on a timely basis pursuant to these regulations and rules could subject us to payment delays that could negatively impact our cash flows and ultimately our financial condition.  In addition, commercial payors and other customers, as well as individual patients, may be unable to make payments to us for which they are responsible.  The recent economic downturn has resulted in a decrease in our ability to collect accounts receivable from some of our customers.  A continuation or worsening of recent unfavorable economic conditions may result in a decrease in our collections, then we will have to make larger allowances for doubtful accounts or incur bad debt write-offs, both of which would have an adverse impact on our financial condition, results of operations and cash flows.

Our business is subject to reviews, audits and investigations under federal and state programs and by private payors, which could adversely impact our revenues and results of operations.

We are subject to review or audit by federal and state governmental agencies to verify compliance with the requirements of the Medicare and Medicaid programs and other federal and state programs.  Audits under the Medicare and Medicaid programs have intensified in recent years.  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Revenues from Medicare, Medicaid and Other Sources.”  Private payors also may have the right by contract to review or audit our files.  Such an investigation could result in our paying back amounts that we have been paid pursuant to these programs; our paying fines or penalties; the suspension of our ability to collect payment for new residents to a skilled nursing center; exclusion of a skilled nursing center from participation in one or more governmental programs; revocation of a license to operate a skilled nursing center; or loss of a contract with a private payor.  Any of these events could adversely impact our revenues and results of operations.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Our hospice business is subject to a cap on the amount paid by Medicare and other Medicare payment limitations, which limitations could adversely affect our hospice revenues and earnings.

Payments made by Medicare for hospice services are subject to a cap amount on a per hospice basis.  Our ability to comply with this limitation depends on a number of factors, including number of admissions, average length of stay, acuity level of our patients and patients that transfer into and out of our hospice programs.  Our hospice revenue and profitability may be materially reduced if we are unable to comply with this and other Medicare payment limitations.  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Revenues from Medicare, Medicaid and Other Sources.”


Possible changes in the case mix of residents and patients as well as payor mix and payment methodologies may significantly affect our profitability.

The sources and amount of our revenues are determined by a number of factors, including the licensed bed capacity and occupancy rates of our healthcare centers, the mix of residents and patients and the rates of reimbursement among payors. Likewise, services provided by our ancillary businesses vary based upon payor and payment methodologies. Changes in the case mix of the residents and patients as well as payor mix among private pay, Medicare and Medicaid will significantly affect our profitability. In particular, any significant decrease in our population of high-acuity residents and patients or any significant increase in our Medicaid population could have a material adverse effect on our financial position, results of operations and cash flows, especially if states operating Medicaid programs continue to limit, or more aggressively seek limits on, reimbursement rates.

We are subject to a number of lawsuits, which could adversely impact us.

Skilled nursing center operators, including our inpatient services subsidiaries, are subject to lawsuits seeking to hold them liable for alleged negligent or other wrongful conduct of employees that allegedly result in injury or death to residents of the centers. We currently have numerous patient care lawsuits pending against us, as well as other types of lawsuits. Adverse determinations in legal proceedings or any governmental investigations that could lead to lawsuits, whether currently asserted or arising in the future, and any adverse publicity arising therefrom, could have a material adverse effect on our business reputation, financial position, results of operations or cash flows.

We rely primarily on self-funded insurance programs for general and professional liability and workers’ compensation claims against us.

We self-insure for the majority of our insurable risks, including general and professional liabilities, workers’ compensation liabilities and employee health insurance liabilities, through the use of self-insurance or self-funded insurance policies, which vary by the states in which we operate. We rely upon self-funded insurance programs for general and professional liability claims up to $5.0 million per claim, which amounts we are responsible for funding.  We maintain excess insurance policies for claims above this amount.  There is a risk that the amounts funded to our programs of self-insurance and future cash flows may not be sufficient to respond to all claims asserted under those programs.

At December 31, 2009 and 2008, we had recorded reserves of $94.9 million and $87.3 million, respectively, for general and professional liabilities, but we had only pre-funded $3.4 million in each of those years for such claims.  At December 31, 2009 and 2008, we had recorded reserves of $94.9 million and $87.3 million, respectively, for workers’ compensation liabilities, and had only pre-funded $12.0 million and $22.1 million, respectively, for such claims.  We cannot assure you that a claim in excess of our insurance coverage limits will not arise. A claim against us that is not covered by, or is in excess of, the coverage limits provided by our excess

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


insurance policies could have a material adverse effect upon us. Furthermore, we cannot assure you that we will be able to obtain adequate additional liability insurance in the future or that, if such insurance is available, it will be available on acceptable terms.

Our operations are extensively regulated and adverse determinations against us could result in severe penalties, including loss of licensure and decertification.

In the ordinary course of business, we are continuously subject to a wide variety of federal, state and local laws and regulations and to state and federal regulatory scrutiny, supervision and control in various areas, including referral of patients, false claims under Medicare and Medicaid, health and safety laws, environmental laws and the protection of health information. Such regulatory scrutiny often includes inquiries, civil and criminal investigations, examinations, audits, site visits and surveys, some of which are non-routine. See Item 1 – “Business—Federal and State Regulatory Oversight” and Item 3 — “Legal Proceedings.” If we are found to have engaged in improper practices, we could be subject to civil, administrative or criminal fines, penalties or restitutionary relief or corporate settlement agreements with federal, state or local authorities, and reimbursement authorities could also seek our suspension or exclusion from participation in their program. The exclusion of centers from participating in Medicare or Medicaid could have a material adverse effect on our financial position, results of operations and cash flows.  We cannot predict the future course of any laws or regulations to which we are subject, including Medicare and Medicaid statutes and regulations, the intensity of federal and state enforcement actions or the extent and size of any potential sanctions, fines or penalties.  Changes in existing laws or regulations, or the enactment of new laws or regulations, could result in changes to our operations requiring significant capital expenditures or additional operating expenses.  Evolving interpretations of existing, new or amended laws and regulations or heightened enforcement efforts could also negatively impact our financial position, results of operations and cash flows.
 

Our business is dependent on referral sources, which have no obligation to refer residents and patients to our skilled nursing centers.

We rely on referrals from physicians, hospitals and other healthcare providers to provide our skilled nursing centers with our patient population.  These referral sources are not obligated to refer business to us and may refer business to other long term care providers.  If we fail to maintain our existing referral sources, fail to develop new relationships, or fail to achieve or maintain a reputation for providing high quality of care, our patient population, payor mix, revenue and profitability could be adversely affected.

Providers of commercial insurance and other nongovernmental payors are increasingly seeking to control costs, which efforts could negatively impact our revenues.

Private insurers are seeking to control healthcare costs through direct contracts with healthcare providers, and reviews of the propriety of, and charges for, services provided. These private payors are increasingly demanding discounted fee structures.  These cost control efforts could have a material adverse effect on our financial position, results of operations and cash flows.
 
We continue to seek acquisitions and other strategic opportunities, which may result in the use of a significant amount of management resources or significant costs and we may not be able to fully realize the potential benefit of such transactions.
 
We continue to seek acquisitions and other strategic opportunities. Accordingly, we are often engaged in evaluating potential transactions and other strategic alternatives. In addition, from time to time, we engage in preliminary discussions that may result in one or more transactions. Although there is uncertainty that any of these discussions will result in definitive agreements or the completion of any transaction, we may devote a significant amount of our management resources to such a transaction, which could negatively impact our

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


operations.  In addition, we may incur significant costs in connection with seeking acquisitions or other strategic opportunities regardless of whether the transaction is completed and in combining our operations if such a transaction is completed.  In the event that we consummate an acquisition or strategic alternative in the future, we can give no assurance that we would fully realize the potential benefit of such a transaction.

We face national, regional and local competition.

The healthcare industry is highly competitive and subject to continual changes in the method by which services are provided and the types of companies providing services. Our nursing and rehabilitation centers compete primarily on a local and regional basis with many long-term care providers, some of whom may own as few as a single nursing center. Our ability to compete successfully varies from location to location depending on a number of factors, including the number of competing centers in the local market, the types of services available, quality of care, reputation, age and appearance of each center and the cost of care in each locality. Increased competition in the future could limit our ability to attract and retain residents or to expand our business.

State efforts to regulate the construction or expansion of healthcare providers could impair our ability to expand our operations or make acquisitions.

Some states require healthcare providers (including skilled nursing centers, hospices and assisted living centers) to obtain prior approval, in the form of a CON, for the purchase, construction or expansion of healthcare centers; capital expenditures exceeding a prescribed amount; or changes in services or bed capacity. To the extent that we are required to obtain a CON or other similar approvals to expand our operations, either by acquiring centers or other companies or expanding or providing new services or other changes, our expansion could be adversely affected by our failure or inability to obtain the necessary approvals, changes in the standards applicable to those approvals, and possible delays and expenses associated with obtaining those approvals. We cannot make any assurances that we will be able to obtain a CON or other similar approval for any future projects requiring this approval.

We may be unable to reduce costs to offset completely any decreases in our revenues.

Reduced levels of occupancy in our healthcare centers and reductions in reimbursements from Medicare and Medicaid would adversely impact our cash flow and revenues. Fluctuation in our occupancy levels may become more common as we increase our emphasis on patients with shorter stays but higher acuities. If we are unable to put in place corresponding adjustments in costs in response to declines in census or other revenue shortfalls, we would be unable to prevent future decreases in earnings.  Our centers are able to reduce some of their costs as occupancy decreases, although the decrease in costs will in most cases be less than the decrease in revenues.  However, our centers are not able to reduce their costs of providing care upon a decrease in reimbursement revenues from federal and state programs.

We continue to be affected by an industry-wide shortage of qualified center care-provider personnel and increasing labor costs.

We, and other providers in the long-term care industry, have had and continue to have difficulties in retaining qualified personnel to staff our healthcare centers, particularly nurses, and in such situations we may be required to use temporary employment agencies to provide additional personnel. The labor costs are generally higher for temporary employees than for full-time employees. In addition, many states in which we operate have increased minimum staffing standards. As minimum staffing standards are increased, we may be required to retain additional staffing. In addition, in recent years we have experienced increases in our labor costs primarily due to

 
11

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


higher wages and greater benefits required to attract and retain qualified personnel and to increase staffing levels in our centers.

A similar situation exists in the rehabilitation therapy industry. We, and other providers, have had and continue to have difficulties in hiring a sufficient number of rehabilitation therapists. Under these circumstances, we, and others in this industry, have been required to offer higher compensation to attract and retain these personnel, and we have been forced to rely on independent contractors, at higher costs, to fulfill our contractual commitments with our customers. Existing contractual commitments, regulatory limitations and the market for these services have made it difficult for us to pass through these increased costs to our customers.

If we are unable to meet minimum staffing standards, we may be subject to fines or other sanctions.

 
Increased attention to the quality of care provided in skilled nursing facilities has caused several states to mandate, and other states to consider mandating, minimum staffing laws that require minimum nursing hours of direct care per resident per day. These minimum staffing requirements further increase the gap between demand for and supply of qualified professionals, and lead to higher labor costs.   Failure to comply with minimum staffing requirements can result in fines and requirements that we provide a plan of correction.  See Item 1 – “Business – Federal and State Regulatory Oversight.”
 
Our ability to satisfy minimum staffing requirements depends upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse’s assistants and other personnel. Attracting and retaining these personnel is difficult, given existing shortages of these employees in the labor markets in which we operate. Furthermore, if states do not appropriate additional funds (through Medicaid program appropriations or otherwise) sufficient to pay for any additional operating costs resulting from minimum staffing requirements, our profitability may be materially adversely affected.

If we lose our key management personnel, we may not be able to successfully manage our business and achieve our objectives.

Our future success depends in large part upon the leadership and performance of our executive management team, particularly Richard K. Matros, our chief executive officer, William A. Mathies, the chief operating officer of our operating subsidiaries, L. Bryan Shaul, our chief financial officer, and key employees at the operating level. If we lose the services of one or more of our executive officers or key employees, or if one or more of them decides to join a competitor or otherwise compete directly or indirectly with us, we may not be able to successfully manage our business or achieve our business objectives. If we lose the services of any of our key employees at the operating or regional level, we may not be able to replace them with similarly qualified personnel, which could harm our business.

We have incurred a significant amount of indebtedness in connection with acquisition activities, which indebtedness could adversely affect our financial condition.

As of December 31, 2009, we had indebtedness of approximately $700.5 million, the ability to borrow up to $50.0 million under our revolving credit facility and a $70.0 million letter of credit facility pursuant to which $62.8 million of letters of credit were outstanding.  Our indebtedness could have adverse consequences, such as requiring us to dedicate a substantial portion of our cash flows from operations to payments on our debt, limiting our ability to fund, and potentially increasing the cost of funding, working capital, capital expenditures, acquisitions and other general corporate requirements and making us more vulnerable to general adverse economic and industry conditions.   If we fail to comply with the payment requirements or financial covenants contained in these agreements, we would be required to seek waivers from our lenders.  Seeking these waivers may be difficult or expensive to obtain and, if we fail to obtain any necessary waivers, which may be expensive

 
12

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


to obtain, the resulting default would allow the lenders to accelerate the maturity of the indebtedness, which would have a material adverse affect on our financial condition. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Loan Agreements.”

The agreements that govern our indebtedness restrict our activities.

The indenture governing our senior subordinated notes and the agreement governing our senior secured credit facilities contain restrictions on our ability to, among other things, make acquisitions and other investments, pay dividends, and incur indebtedness and capital expenditures.  These restrictions may significantly adversely affect implementation of future business strategies, or require us to approach our lenders for consent to allow us to implement such strategies.  Such a consent could be difficult or expensive to obtain.  Our failure to comply with such restrictions and other covenants could adversely affect our financial condition and our ability to borrow.

To the extent that we require additional debt financing in the future, such financing may have less favorable terms than our current debt financing.
 
In the ordinary course of business, mortgages on our centers may become due and payable by their terms and we would seek to refinance such mortgages.  There can be no assurance that we will be able to obtain such refinancing on terms comparable to our current financing, or at all.  In addition, the terms of the indenture governing our senior subordinated notes and our senior secured credit facilities permit us to incur additional indebtedness, subject to certain restrictions.  Accordingly, we could incur additional indebtedness in the future and there can be no assurance that we would be able to obtain such financing on terms comparable to our current financing, or at all.

We do not expect to pay any dividends for the foreseeable future.

We are currently prohibited by the terms of our senior credit facilities from paying dividends to holders of our common stock, and do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future. Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our common stock.

Delaware law and provisions in our Restated Certificate of Incorporation and Amended and Restated Bylaws may delay or prevent takeover attempts by third parties and therefore inhibit our stockholders from realizing a premium on their stock.

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. This section prevents any stockholder who owns 15% or more of our outstanding common stock from engaging in certain business combinations with us for a period of three years following the time that the stockholder acquired such stock ownership unless certain approvals were or are obtained from our board of directors or the holders of 66 2/3% of our outstanding common stock. Our Restated Certificate of Incorporation and Amended and Restated Bylaws also contain several other provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. These provisions include, among other things, (i) advance notice for raising business or making nominations at meetings, (ii) an affirmative vote of the holders of 66 2/3% of our outstanding common stock for stockholders to remove directors or amend our Amended and Restated Bylaws or certain provisions of our Restated Certificate of Incorporation, and (iii) the ability to issue “blank check” preferred stock, which our board of directors, without stockholder approval, can designate and issue with such dividend, liquidation, conversion, voting or other rights, including the right to issue convertible securities with no limitations on conversion. The issuance of blank check preferred stock may

 
13

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


adversely affect the voting and other rights of the holders of our common stock as our board of directors may designate and issue preferred stock with terms that are senior to our common stock.

Our board of directors can use these and other provisions to discourage, delay or prevent a change in the control of our company or a change in our management. Any delay or prevention of a change of control transaction or a change in our board of directors or management could deter potential acquirors or prevent the completion of a transaction in which our stockholders could receive a substantial premium over the then current market price for their shares. These provisions could also limit the price that investors might be willing to pay for shares of our common stock.

We lease a significant amount of our centers.

We face risks because of the number of centers that we lease.  We currently lease 112 of our 205 healthcare centers. Our high percentage of leased centers limits our ability to exit markets. Each of our lease agreements provides that the lessor may terminate the lease for a number of reasons, including our default in any payment of rent or taxes or our breach of any covenant or agreement in the lease. Termination of any of our leases could harm our results of operations and, as with default under any of our indebtedness, could have a material adverse impact on our liquidity. Although we believe that we will be able to renew the existing leases that we wish to extend, there is no assurance that we will succeed in obtaining extensions in the future at rental rates that we believe to be reasonable, or at all. Moreover, if some centers should prove to be unprofitable, we could remain obligated for lease payments even if we decided to withdraw from those locations. We could incur special charges relating to the closing of such centers including lease termination costs, impairment charges and other special charges that would reduce our profits.

Natural disasters and other adverse events may harm our centers and residents.

Our centers and residents may suffer harm as a result of natural or other causes, such as storms, earthquakes, floods, fires and other conditions. Such events can disrupt our operations, negatively affect our revenues, and increase our costs or result in a future impairment charge. For example, nine of our healthcare centers are in Florida, which is prone to hurricanes, and 16 of our centers and our executive offices are in California, which is prone to earthquakes.  In addition, as a result of June 2008 flooding in the Midwest, one of our centers in Indiana was severely damaged and the operation was permanently discontinued.

Our ability to use our net operating losses (“NOLs”) and other tax attributes to offset future taxable income could be limited by an ownership change and/or decisions by California and other states to suspend the use of NOLs.

We have significant NOLs, tax credits and amortizable goodwill available to offset our future U.S. federal and state taxable income. Our ability to utilize these NOLs and other tax attributes may be subject to significant limitations under Section 382 of the Internal Revenue Code (and applicable state law) if we undergo an ownership change. An ownership change occurs for purposes of Section 382 of the Internal Revenue Code if, among other things, 5% stockholders (i.e., stockholders who own or have owned 5% or more of our stock (with certain groups of less-than-5% stockholders treated as single stockholders for this purpose)) increase their aggregate percentage ownership of our stock by more than fifty percentage points above the lowest percentage of the stock owned by these stockholders at any time during the relevant testing period. An issuance of our common stock in connection with acquisitions or for any other reason can contribute to or result in an ownership change under Section 382.  Stock ownership for purposes of Section 382 of the Internal Revenue Code is determined under a complex set of attribution rules, so that a person is treated as owning stock directly, indirectly (i.e., through certain entities) and constructively (through certain related persons and certain unrelated persons acting as a group). In the event of an ownership change, Section 382 imposes an annual limitation

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

(based upon our value at the time of the ownership change, as determined under Section 382 of the Internal Revenue Code) on the amount of taxable income and tax liabilities a corporation may offset with NOLs and other tax attributes, such as tax credit carryforwards. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOL and tax credit carryforwards. As a result, our inability to utilize these NOLs or credits as a result of any ownership changes, could adversely impact our operating results and financial condition.

In addition, California and certain states have suspended use of NOLs for certain taxable years, and other states are considering similar measures. As a result, we may incur higher state income tax expense in the future. Depending on our future tax position, continued suspension of our ability to use NOLs in states in which we are subject to income tax could have an adverse impact on our operating results and financial condition.

Failure to maintain effective internal control over our financial reporting could have an adverse effect on our ability to report our financial results on a timely and accurate basis.

We are required to maintain internal control over financial reporting pursuant to Rule 13a-15 under the Exchange Act.  See Item 9A – “Controls and Procedures.”  Failure to maintain such controls could result in misstatements in our financial statements and potentially subject us to sanctions or investigations by the Securities and Exchange Commission or other regulatory authorities or could cause us to delay the filing of required reports with the Securities and Exchange Commission and our reporting of financial results. Any of these events could result in a decline in the price of our common stock.  Although we have taken steps to maintain our internal control structure as required, we cannot assure you that control deficiencies will not result in a misstatement in the future.

Item 1B.  Unresolved Staff Comments

None.

Item 2.  Properties

Inpatient Services

As of December 31, 2009, our subsidiaries operated 205 nursing and rehabilitation centers, assisted living centers and independent living centers. The 205 centers are comprised of 112 properties that are leased and 93 properties that are owned. We hold options to acquire, at fair value or at a set purchase price, ownership of 21 of the centers that we currently lease, of which options on five centers are exercisable or will become exercisable by December 31, 2011. Administrative office space was leased for our inpatient segment in 18 locations in 13 states, and for our hospice operations we leased office space for administrative purposes in 22 locations in ten states.  We generally consider our properties to be in good operating condition and suitable for the purposes for which they are being used. Our leased centers are subject to long-term operating leases or subleases which require us, among other things, to fund all applicable capital expenditures, taxes, insurance and maintenance costs. The annual rent payable under most of the leases generally increases based on a fixed percentage or increases in the U.S. Consumer Price Index. Many of the leases contain renewal options to extend the term. Many of our owned centers are subject to mortgages that may contain requirements that we spend a certain amount to maintain the properties.

In addition to the healthcare centers described above, we divested one healthcare center in 2009. We continue to review our operations to identify centers and operations that do not perform at an appropriate level.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Our aggregate occupancy percentage for all of our nursing and rehabilitation, assisted living, independent living and mental health centers was 88.1% for the year ended December 31, 2009. Our occupancy was 88.9% and 89.8% for the years ended December 31, 2008 and 2007, respectively. The percentages were computed by dividing the average daily number of beds occupied by the total number of available beds for use during the periods indicated (beds of acquired centers are included in the computation following the date of acquisition only). However, we believe that occupancy percentages, either individually or in the aggregate, should not be relied upon alone to determine the performance of a center. Other factors that may impact the performance of a center include, among other things, the sources of payment, terms of reimbursement and the acuity level of the patients.

The following table sets forth certain information concerning the 205 centers in our continuing operations as of December 31, 2009, which consisted of 183 skilled nursing centers, 14 assisted living and independent living centers and eight mental health centers.

       
Number of Licensed Beds/Units(1)
                     
   
Total
     
Assisted/
       
   
Number of
 
Skilled
 
Independent
 
Mental
   
State
 
Centers
 
Nursing
 
Living
 
Health
 
Total
Ohio
 
17
 
2,392
 
-
 
-
 
2,392
Massachusetts
 
18
 
1,803
 
57
 
-
 
1,860
Kentucky
 
20
 
1,622
 
211
 
-
 
1,833
New Hampshire
 
15
 
1,131
 
474
 
-
 
1,605
Connecticut
 
10
 
1,327
 
72
 
-
 
1,399
California
 
15
 
858
 
-
 
473
 
1,331
Oklahoma
 
9
 
1,110
 
143
 
60
 
1,313
Colorado
 
9
 
1,203
 
97
 
-
 
1,300
Idaho
 
10
 
951
 
163
 
22
 
1,136
Florida
 
9
 
1,120
 
-
 
-
 
1,120
New Mexico
 
12
 
890
 
176
 
-
 
1,066
Georgia
 
9
 
1,002
 
32
 
-
 
1,034
North Carolina
 
8
 
930
 
44
 
-
 
974
Alabama
 
7
 
757
 
26
 
-
 
783
West Virginia
 
7
 
739
 
-
 
-
 
739
Tennessee
 
8
 
693
 
22
 
-
 
715
Montana
 
5
 
538
 
112
 
-
 
650
Washington
 
6
 
513
 
36
 
-
 
549
Maryland
 
3
 
434
 
-
 
-
 
434
Rhode Island
 
2
 
261
 
-
 
-
 
261
Indiana
 
2
 
208
 
-
 
-
 
208
New Jersey
 
1
 
176
 
-
 
-
 
176
Arizona
 
1
 
161
 
-
 
-
 
161
Utah
 
1
 
120
 
-
 
-
 
120
Wyoming
 
1
 
46
 
-
 
-
 
46
  Total
 
205
 
20,985
 
1,665
 
555
 
23,205


(1)
“Licensed Beds” refers to the number of beds for which a license has been issued, which may vary in  some instances from licensed beds available for use, which is used in the computation of occupancy. Available beds for the 205 centers were 22,423.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Rehabilitation Therapy Services

As of December 31, 2009, we leased offices and patient care delivery sites in 37 locations in 11 states to operate our rehabilitation therapy businesses.

Medical Staffing Services

As of December 31, 2009, we leased offices in 43 locations in 17 states to operate our medical staffing business.

Corporate

We lease our executive offices in Irvine, California. We also own three corporate office buildings and lease office space in a fourth building in Albuquerque, New Mexico.

Item 3.  Legal Proceedings

For a description of our legal proceedings, see Note 13(a) – “Other Events – Litigation” of our consolidated financial statements included in this Annual Report on Form 10-K, which is incorporated by reference to this item.

PART II

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

Our common stock trades under the symbol “SUNH” on The NASDAQ Global Select Market. The following table shows the high and low sale prices for the common stock as reported by The NASDAQ Global Select Market for the periods indicated.

         
   
High
 
Low
2009
       
Fourth Quarter
$
9.88
$
8.23
Third Quarter
$
10.00
$
7.80
Second Quarter
$
10.75
$
7.39
First Quarter
$
12.74
$
7.50
         
2008
       
Fourth Quarter
$
16.10
$
 7.98
Third Quarter
$
18.00
$
12.68
Second Quarter
$
15.46
$
12.13
First Quarter
$
18.78
$
11.72

There were approximately 4,538 holders of record of our common stock as of March 2, 2010. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future. Our senior credit facilities prohibit us from paying any dividends or making any distributions to our stockholders. Any future determination to pay dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, results of operations, capital requirements and other factors as our board of directors deems relevant.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

STOCK PRICE PERFORMANCE GRAPH

The following graph and chart compare the cumulative total stockholder return for the period from December 31, 2004 through December 31, 2009 assuming $100 was invested on December 31, 2004 in (i) our common stock, (ii) the Standard & Poor’s 500 Stock Index (“S&P 500 Index”) and (iii) the Hemscott Long-Term Care Index. Cumulative total stockholder return assumes the reinvestment of all dividends. Stock price performances shown in the graph are not necessarily indicative of future price performances.
 
 
12/31/04
12/31/05
12/31/06
12/31/07
12/31/08
12/31/09
             
Sun Healthcare Group, Inc.
   $  100.00
   $    71.76
   $    137.12
   $  186.41
   $     96.08
   $     99.55
Long-Term Care Index
100.00
118.61
146.79
121.47
47.37
74.01
S&P 500 Index
100.00
104.91
121.48
128.16
80.74
102.11


The above performance graph shall not be deemed to be soliciting material or to be filed with the Securities and Exchange Commission under the Securities Act of 1933 or the Securities Exchange Act of 1934 or incorporated by reference in any document so filed.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Item 6.  Selected Financial Data

The following selected consolidated financial data for the periods indicated have been derived from our consolidated financial statements.  The financial data set forth below should be read in connection with Item 7 – “Management's Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and related notes thereto (in thousands, except per share data and percentages):

   
At or For the Year Ended December 31,
 
                               
   
2009 (1)
   
2008 (2)
   
2007 (3)
   
2006 (4)
   
2005 (5)
 
                               
Total net revenues
$
1,881,799
 
$
1,823,503
 
$
1,557,756
 
$
982,658
 
$
716,048
 
Income (loss) before income taxes
                             
and discontinued operations
 
72,096
   
66,576
   
43,179
   
11,259
   
(3,290
)
Income (loss) from continuing
                             
operations
 
42,480
   
113,924
   
54,093
   
11,473
   
(2,504
)
(Loss) income from discontinued
                             
operations
 
(3,809
)
 
(4,637
)
 
3,417
   
15,645
   
27,265
 
Net income
$
38,671
 
$
109,287
 
$
57,510
 
$
27,118
 
$
24,761
 
                               
Basic earnings per common and common equivalent share:
                         
Income (loss) from continuing
                             
operations
$
0.97
 
$
2.63
 
$
1.28
 
$
0.36
 
$
(0.16
)
(Loss) income from discontinued
                             
operations
 
(0.09
)
 
(0.11
)
 
0.08
   
0.50
   
1.71
 
Net income
$
0.88
 
$
2.52
 
$
1.36
 
$
0.86
 
$
1.55
 
                               
Diluted earnings per common and common equivalent share:
             
Income (loss) from continuing
                             
operations
$
0.97
 
$
2.59
 
$
1.25
 
$
0.36
 
$
(0.16
)
(Loss) income from discontinued
                             
operations
 
(0.09
)
 
(0.10
)
 
0.08
   
0.49
   
1.71
 
Net income
$
0.88
 
$
2.49
 
$
1.33
 
$
0.85
 
$
1.55
 
                               
Weighted average number of common and common equivalent shares:
             
Basic
 
43,841
   
43,331
   
42,350
   
31,638
   
16,003
 
Diluted
 
43,963
   
43,963
   
43,390
   
31,788
   
16,003
 
Working capital (deficit)
$
175,604
 
$
172,145
 
$
83,721
 
$
96,245
 
$
(62,786
)
Total assets
$
1,571,194
 
$
1,543,334
 
$
1,373,826
 
$
621,423
 
$
512,306
 
Long-term debt and capital lease obligations, including current portion
$
700,548
 
$
725,841
 
$
729,268
 
$
174,165
 
$
197,779
 
Stockholders' equity (deficit)
$
449,064
 
$
403,709
 
$
246,256
 
$
144,133
 
$
(2,895
)
                               
Supplemental Financial Information:
                   
                     
EBITDA (6)
$
166,886
 
$
161,533
 
$
118,744
 
$
44,013
 
$
16,721
 
EBITDA margin (6)
 
8.9
%
 
8.9
%
 
7.6
%
 
4.5
%
 
2.3
%
                               
Adjusted EBITDA (6)
$
168,232
 
$
160,557
 
$
121,941
 
$
45,161
 
$
17,588
 
Adjusted EBITDA margin (6)
 
8.9
%
 
8.8
%
 
7.8
%
 
4.6
%
 
2.5
%
                               
Adjusted EBITDAR (6)
$
241,381
 
$
234,158
 
$
192,353
 
$
96,575
 
$
51,353
 
Adjusted EBITDAR margin (6)
 
12.8
%
 
12.8
%
 
12.3
%
 
9.8
%
 
7.2
%

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
(1)
Results for the year ended December 31, 2009 include an increase of $8.2 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, $1.3 million of restructuring costs and $0.5 million of transaction costs related to a hospice acquisition.
   
(2)
Results for the year ended December 31, 2008 include a full year of revenues and expenses of Harborside Healthcare Corporation (“Harborside”), which was acquired on April 1, 2007 (see Note 6 – “Acquisitions” in our consolidated financial statements included in this Annual Report on Form 10-K), a release of $70.5 million of deferred tax valuation allowance, an increase of $0.9 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, and a gain of $0.9 million related to the sale of non-core business assets.
   
(3)
Results for the year ended December 31, 2007 include the revenues and expenses of the Harborside centers since April 1, 2007 (see Note 6 – “Acquisitions” in our consolidated financial statements included in this Annual Report on Form 10-K), a release of $28.8 million of deferred tax valuation allowance, a reduction of $8.6 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, and a charge of $3.2 million related to the early extinguishment of debt.
   
(4)
Results for the year ended December 31, 2006 include an $11.7 million release of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, a $2.5 million non-cash charge to account for certain lease rate escalation clauses (see Note 2 – “Summary of Significant Accounting Policies” in our consolidated financial statements included in this Annual Report on Form 10-K), a net loss on sale of assets of $0.2 million and a $1.0 million charge for the termination of a management contract associated with the acquisition of hospice operations.  Income from discontinued operations of $14.7 million was primarily comprised of: (i) a $6.8 million gain from the sale of our home health operations in the fourth quarter of 2006, (ii) a net $6.0 million reduction of reserves for self-insurance for general and professional liability and workers’ compensation for prior years on divested centers, (iii) a $4.2 million non-cash gain primarily related to the sale in July 2003 of our pharmaceutical services operations, and (iv) a $1.3 million gain on the sale of one of our healthcare centers in fourth quarter of 2006, offset in part by (v) a $3.6 million non-cash charge for closed centers with a continuing rent obligation, (vi) a net $2.0 million gain from divested operations from inpatient services and home health services, (vii) a $0.2 million loss related to the discontinued clinical laboratory and radiology operations, and (viii) a $1.8 million net tax provision for discontinued operations.
   
(5)
Results for the year ended December 31, 2005 include revenues and expenses of centers acquired in December 2005 for that month, a $6.8 million release of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, a $1.1 million non-cash charge for acquisition costs, a net loss on sale of assets of $0.4 million primarily due to a write-down of a property held for sale, a net loss on extinguishment of debt of $0.4 million related to mortgage restructurings.  Income from discontinued operations was $27.1 million due primarily to net reductions of $14.6 million in self-insurance reserves for general and professional liability and workers' compensation for prior years on divested centers and an $8.9 million gain from disposal of discontinued operations primarily due to receipt in September 2005 of $7.7 million in cash proceeds from the 2003 sale of our pharmaceutical services operations, pursuant to the terms of the sale agreement.
   

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
(6)
We define EBITDA as net income before loss (gain) on discontinued operations, interest expense (net of interest income), income tax expense (benefit), depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.  Adjusted EBITDA is EBITDA adjusted for the following:
 
·    gain (loss) on sale of asset, net
 
·    restructuring costs
 
·    loss on extinguishment of debt, net
 
·    loss on contract termination
 
·    loss on asset impairment
 
Adjusted EBITDA margin is Adjusted EBITDA as a percentage of revenue.  Adjusted EBITDAR is Adjusted EBITDA before center rent expense.  Adjusted EBITDAR margin is Adjusted EBITDAR as a percentage of revenue. We believe that the presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides useful information regarding our operational performance because they enhance the overall understanding of the financial performance and prospects for the future of our core business activities.
 
Specifically, we believe that a presentation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides consistency in our financial reporting and provides a basis for the comparison of results of core business operations between our current, past and future periods.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are three of the primary indicators we use for planning and forecasting in future periods, including trending and analyzing the core operating performance of our business from period-to-period without the effect of U.S. generally accepted accounting principles, or GAAP, expenses, revenues and gains that are unrelated to the day-to-day performance of our business. We also use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to benchmark the performance of our business against expected results, analyzing year-over-year trends as described below and to compare our operating performance to that of our competitors.
 
In addition to other financial measures, including net segment income, we use EBITDA, Adjusted EBITDA and Adjusted EBITDAR to assess the performance of our core business operations, to prepare operating budgets and to measure our performance against those budgets on a consolidated, segment and a center-by-center level.  EBITDA, Adjusted EBITDA and Adjusted EBITDAR are useful in this regard because they do not include such costs as interest expense (net of interest income), income taxes, depreciation and amortization expense and special charges, which may vary from business unit to business unit and period-to-period depending upon various factors, including the method used to finance the business, the amount of debt that we have determined to incur, whether a center is owned or leased, the date of acquisition of a facility or business, the original purchase price of a facility or business unit or the tax law of the state in which a business unit operates. These types of charges are dependent on factors unrelated to our underlying business. As a result, we believe that the use of EBITDA, Adjusted EBITDA and Adjusted EBITDAR provides a meaningful and consistent comparison of our underlying business between periods by eliminating certain items required by GAAP which have little or no significance in our day-to-day operations.
 
We also make capital allocations to each of our centers based on expected EBITDA returns and establish compensation programs and bonuses for our center-level employees that are based upon the achievement of pre-established EBITDA and Adjusted EBITDA targets.
 
Despite the importance of these measures in analyzing our underlying business, maintaining our financial requirements, designing incentive compensation and for our goal setting both on an aggregate and facility level basis, EBITDA, Adjusted EBITDA and Adjusted EBITDAR are non-GAAP financial measures that have no standardized meaning defined by GAAP.  As the items excluded from EBITDA, Adjusted EBITDA and Adjusted EBITDAR are
 

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
significant components in understanding and assessing our financial performance, EBITDA, Adjusted EBITDA and Adjusted EBITDAR should not be considered in isolation or as alternatives to net income, cash flows generated by or used in operating, investing or financing activities or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity.  Therefore, our EBITDA, Adjusted EBITDA and Adjusted EBITDAR measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP.  Some of these limitations are:
 
·  they do not reflect our cash expenditures, or future requirements for capital expenditures, or contractual commitments;
 
·  they do not reflect changes in, or cash requirements for, our working capital needs;
 
·  they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments,
    on our debt;
 
·  they do not reflect any income tax payments we may be required to make;
 
·  although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often
    have to be replaced in the future, and EBITDA, Adjusted EBITDA and Adjusted EBITDAR do not reflect any cash
    requirements for such replacements;
 
·  they are not adjusted for all non-cash income or expense items that are reflected in our consolidated statements of cash
    flows;
 
·  they do not reflect the impact on earnings of charges resulting from certain matters we consider not to be indicative of
    our ongoing operations; and
 
·  other companies in our industry may calculate these measures differently than we do, which may limit their usefulness
    as comparative measures.
 
We compensate for these limitations by using EBITDA, Adjusted EBITDA and Adjusted EBITDAR only to supplement net income on a basis prepared in conformance with GAAP in order to provide a more complete understanding of the factors and trends affecting our business. We strongly encourage investors to consider net income determined under GAAP as compared to EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and to perform their own analysis, as appropriate.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The following table provides a reconciliation of our net income (loss), which is the most directly comparable financial measure presented in accordance with GAAP for the periods indicated, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR (in thousands):
   
For the Years Ended December 31,
 
   
2009
   
2008
   
2007
   
2006
     
2005
 
                                 
Net income
  $ 38,671     $ 109,287     $ 57,510     $ 27,118       $ 24,761  
                                           
Plus:
                                         
Income (loss) from discontinued operations
    3,809       4,637       (3,417 )     (15,646       (27,266 )
Interest expense, net of interest income
    49,327       54,603       44,347       18,179         11,775  
Income tax expense (benefit)
    29,616       (47,348 )     (10,914 )     (214       (786 )
Depreciation and amortization
    45,463       40,354       31,218       14,576         8,237  
EBITDA
  $ 166,886     $ 161,533     $ 118,744     $ 44,013       $ 16,721  
                                           
Plus:
                                         
Gain (loss) on sale of assets, net
    42       (976 )     24       173         384  
Restructuring costs
    1,304       -       -       -         122  
Loss on extinguishment of debt
    -       -       3,173       -         -  
Loss on contract termination
    -       -       -       975         -  
Loss on asset impairment
    -       -       -       -         361  
Adjusted EBITDA
  $ 168,232     $ 160,557     $ 121,941     $ 45,161       $ 17,588  
                                           
Plus:
                                         
Center rent expense
    73,149       73,601       70,412       51,414         33,765  
Adjusted EBITDAR
  $ 241,381     $ 234,158     $ 192,353     $ 96,575       $ 51,353  
                                           

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

The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes, which appear elsewhere in this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report. See Item 1A – “Risk Factors.”

Overview

Our subsidiaries provide long-term, subacute and related specialty healthcare services primarily to the senior population in the United States. We were engaged in the following three principal business segments during 2009:

Ø
inpatient services, primarily skilled nursing centers;
Ø
rehabilitation therapy services; and
Ø
medical staffing services.

Commencing in 2005, we implemented a business strategy to leverage our existing platform, and in December 2005, we acquired an operator of 56 skilled nursing centers and independent and assisted living residences and a small hospice operation.  In 2006, we continued this strategy by purchasing a hospice company now known as SolAmor.  In April 2007, we acquired Harborside, an operator of 73 skilled nursing centers, one assisted living center and one independent living center with approximately 9,000 licensed beds in ten states.  Harborside’s results of operations have been included in our consolidated financial statements since April 1, 2007.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES



We periodically review our operations and portfolio of facilities to determine if any of these operations or assets no longer fit with our business strategies.  This review has resulted in dispositions of certain assets and operations.

In 2006, we sold a subsidiary that provided skilled home health care, non-skilled home care and pharmacy services.  During 2007, we sold our 75% interest in a home health services subsidiary and we sold our remaining laboratory and radiology business.

During 2008, we reclassified six skilled nursing centers into discontinued operations because they were divested, sold or qualified as assets held for sale. In 2008, we sold two hospitals that were classified as held for sale since 2007; exercised an option to purchase a skilled nursing center that was classified as held for sale since 2007 and simultaneously sold the asset; exercised options to purchase two skilled nursing centers that were classified as held for sale and sold those centers and a third center; transferred operations of two leased skilled nursing centers, and sold a regional provider of adolescent rehabilitation and special education services.

During 2009, we reclassified an assisted living facility into discontinued operations.  We elected not to renew the lease of the assisted living facility and allowed operations to transfer to another operator.  We also closed a leased skilled nursing center and transferred the remaining residents to other centers.

We have updated our historical financial statements to reflect the reclassification of one assisted living center to discontinued operations during the year ended December 31, 2009.  U.S. generally accepted accounting principles (“GAAP”) require that these operations be reclassified as discontinued operations on a retroactive basis. The financial information in this Annual Report reflects that reclassification for all periods since January 1, 2005.

Revenues from Medicare, Medicaid and Other Sources

We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and healthcare centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on state budgets resulting from the recent adverse economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes specialty services provided by us, such as skilled therapy services, to third parties. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

In addition, due to recent adverse economic conditions, we have experienced reduced demand for the specialty services that we provide to third parties.  If economic conditions do not improve or worsen, we may experience additional reductions in demand for the specialty services we provide.  We are unable at this time to predict the impact or extent of such reduced demand.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following table sets forth the total nonaffiliated revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (data includes revenues for acquired centers following the date of acquisition only):

   
For the Years Ended
 
Sources of Revenues
 
December 31, 2009
   
December 31, 2008
   
December 31, 2007
 
   
(dollars in thousands)
 
Consolidated:
                                   
  Medicaid
$
753,393
   
40.0
%
$
729,014
   
40.0
%
$
645,084
   
41.4
%
  Medicare
 
555,593
   
29.5
   
522,555
   
28.7
   
418,665
   
26.9
 
  Private pay and other
 
471,218
   
25.1
   
480,243
   
26.3
   
436,556
   
27.9
 
  Managed care and
                                   
   commercial insurance
 
101,595
   
5.4
   
91,691
   
5.0
   
57,451
   
3.8
 
Total
$
1,881,799
   
100.0
%
$
1,823,503
   
100.0
%
$
1,557,756
   
100.0
%
                                     
Inpatient Only:
                                   
  Medicaid
$
753,260
   
44.9
%
$
728,882
   
45.1
%
$
644,959
   
47.2
%
  Medicare
 
539,339
   
32.2
   
510,013
   
31.6
   
410,365
   
30.0
 
  Private pay and other
 
282,300
   
16.9
   
286,025
   
17.7
   
255,075
   
18.6
 
  Managed care and
                                   
   commercial insurance
 
100,876
   
6.0
   
91,139
   
5.6
   
57,000
   
4.2
 
Total
$
1,675,775
   
100.0
%
$
1,616,059
   
100.0
%
$
1,367,399
   
100.0
%

Medicare

Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation’s elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or those having end-stage renal disease. Medicare is comprised of four related health insurance programs.  Medicare Part A provides for inpatient services including hospital, skilled long-term care, hospice and home healthcare.  Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies.  Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B.  Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequently refined in 1999, 2000 and 2005.  PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group (“RUG”) categories that are based upon each patient’s acuity level.

CMS has announced that it expects to expand RUG categories to 66, effective October 1, 2010.  At the same time it is implementing a new patient assessment tool for the collection of clinical data to be used for classification into the RUG categories.  We are unable to estimate the effect that the new RUG categories and the new assessment tool will have on our Medicare revenues.

On July 31, 2008, the Centers for Medicare and Medicaid Services (“CMS”) issued a final rule to implement a 3.4% market basket increase for the 2009 federal fiscal year, which commenced on October 1,

 
25

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
2008. The rule also contained an update of the wage indices. The net impact of these changes was approximately a 3.3% increase in our reimbursement rates, which resulted in increased revenues of approximately $3.8 million per quarter. 

On July 31, 2009, CMS issued its final rule for skilled nursing facilities for the 2010 federal fiscal year, which commenced on October 1, 2009.  This rule provides for a market basket increase of 2.2% in our reimbursement rates and a 3.3% reduction for a forecast error/parity adjustment.  We estimate that the net result of the two adjustments, based on our current acuity mix, will be a decrease of 0.85% in our reimbursement rates, which we estimate will decrease our net revenues by approximately $1.0 million per quarter.

In addition to the changes that affect the upcoming 2010 federal fiscal year, the rule also contains provisions for the 2011 federal fiscal year, which commences on October 1, 2010.  We are not able to predict whether these changes will occur but are able to confirm that CMS has determined that the changes will be budget neutral.

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2009
 
2008
 
2007
$
455.00
$
424.19
$
391.50

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception was in place for patients residing in skilled nursing centers until December 31, 2009.   Legislation is pending in Congress to extend the exception.  If the exception is not extended, revenues from therapy services provided to our residents and residents of non-affiliated nursing centers in which we provide therapy services will be adversely affected.
 
We receive Medicare reimbursements for hospice care at daily or hourly rates based on the level of care furnished to the patient.  Our ability to receive Medicare reimbursement for our hospice services is subject to two limitations:
 
 
·
If inpatient days of care provided to all patients at a hospice exceed 20% of the total days of hospice care provided by that hospice for an annual period, then payment for days in excess of this limit are paid for at the routine home care rate.  None of our hospice programs exceeded the payment limits on inpatient services for 2009 or 2008.
 
 
·
Overall payments made by Medicare on a per hospice program basis are subject to a cap amount at the end of an annual period.  The cap amount is calculated by multiplying the number of first time Medicare hospice beneficiaries during the year by the Medicare per beneficiary cap amount, resulting in that hospice’s aggregate cap, which is the allowable amount of total Medicare payments that hospice can receive for that cap year.  If a hospice program exceeds its aggregate cap, then the hospice must repay the excess.  In 2009, only one of our hospice programs exceeded the Medicare cap limit.  The amount in excess of the aggregate cap was immaterial.

On July 31, 2009, CMS also issued its final rule for hospice services for the 2010 federal fiscal year.  The rule includes a market basket increase of 2.1% and a 0.7% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments will be an increase of 1.52% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.1 million per quarter.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing and rehabilitation centers has its own unique Medicaid reimbursement system.

Medicaid outlays are a significant component of state budgets, and there have been cost containment pressures on Medicaid outlays for nursing homes.  The recent economic downturn has caused many states to institute freezes on or reductions in Medicaid spending to address state budget concerns.

Twenty-one of the states in which we operate impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.  Those states that have imposed the provider tax have used some or all of the matching funds to fund Medicaid reimbursement to nursing homes.

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2009
 
2008
 
2007
$
171.55
$
166.62
$
159.36

For comparison purposes, the following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day, (including the impact from individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2009
 
2008
 
2007
$
159.51
$
157.08
$
149.95

Managed Care and Insurance

During the year ended December 31, 2009, we received 5.4% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the managed care option for Medicare beneficiaries.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2009
 
2008
 
2007
$
372.93
$
351.93
$
322.35



 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Private Payors, Veterans and Other

During the year ended December 31, 2009, we received 25.1% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the years ended December 31 (data includes revenues for acquired centers following the date of acquisition only):

 
2009
 
2008
 
2007
$
179.05
$
172.50
$
164.10

Other Reimbursement Matters

Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.


 
28

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following table sets forth our historical consolidated income statements and certain percentage relationships for the years ended December 31 (dollars in thousands):

                   
As a Percentage of Net Revenues
   
2009
   
2008
   
2007
 
2009
 
2008
 
2007
 
                               
Total net revenues
$
1,881,799
 
$
1,823,503
 
$
1,557,756
 
100.0
%
100.0
%
100.0
%
Costs and expenses:
                             
Operating salaries and benefits
 
1,057,645
   
1,028,987
   
888,102
 
56.2
 
56.4
 
56.9
 
Self-insurance for workers’ compensation
                             
and general and professional liabilities
 
63,752
   
59,694
   
44,524
 
3.4
 
3.3
 
2.9
 
General and administrative expenses
 
62,068
   
62,302
   
64,835
 
3.3
 
3.4
 
4.2
 
Other operating costs (1)
 
435,756
   
424,255
   
358,960
 
23.2
 
23.3
 
23.1
 
Center rent expense
 
73,149
   
73,601
   
70,412
 
3.9
 
4.0
 
4.5
 
Depreciation and amortization
 
45,463
   
40,354
   
31,218
 
2.4
 
2.2
 
2.0
 
Provision for losses on accounts receivable
 
21,197
   
14,107
   
8,982
 
1.1
 
0.8
 
0.6
 
Interest, net
 
49,327
   
54,603
   
44,347
 
2.6
 
3.0
 
2.8
 
Other expense (income)
 
1,346
   
(976
)
 
3,197
 
0.1
 
(0.1
)
0.2
 
Income before income taxes and
                             
discontinued operations
 
72,096
   
66,576
   
43,179
 
3.8
 
3.7
 
2.8
 
Income tax expense (benefit)
 
29,616
   
(47,348
)
 
(10,914
)
1.6
 
(2.6
)
(0.7
)
Income from continuing operations
 
42,480
   
113,924
   
54,093
 
2.2
 
6.3
 
3.5
 
(Loss) income from discontinued operations
 
(3,809
)
 
(4,637
)
 
3,417
 
(0.1
)
(0.3
)
0.2
 
Net income
$
38,671
 
$
109,287
 
$
57,510
 
2.1
%
6.0
%
3.7
%
                               
Supplemental Financial Information:
                             
EBITDA (2)
$
166,886
 
$
161,533
 
$
118,744
 
8.9
%
8.9
%
7.6
%
Adjusted EBITDA (2)
$
168,232
 
$
160,557
 
$
121,941
 
8.9
%
8.8
%
7.8
%
Adjusted EBITDAR (2)
$
241,381
 
$
234,158
 
$
192,353
 
12.8
%
12.8
%
12.3
%

(1) Operating administrative expenses are included in “other operating costs” above.
(2) We define EBITDA as net income before loss (gain) on discontinued operations, interest expense (net of interest income), income tax expense  (benefit), depreciation and amortization.  Adjusted EBITDA is EBITDA adjusted for gain (loss) on sale of assets, net, restructuring costs, loss on extinguishment of debt, net, loss on contract termination and loss on asset impairment. Adjusted EBITDAR is Adjusted EBITDA before center rent expense. See footnote 6 to Item 6 – “Selected Financial Data” of this report for an explanation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR, including a description of our uses of, and the limitations associated with, EBITDA, Adjusted EBITDA and Adjusted EBITDAR, and a reconciliation of EBITDA, Adjusted EBITDA and Adjusted EBITDAR to net income, the most directly comparable GAAP financial measure.


 
29

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following discussion of the “Year Ended December 31, 2009 Compared to Year Ended December 31, 2008” and “Year Ended December 31, 2008 Compared to Year Ended December 31, 2007” is based on the financial information presented in Note 14 – “Segment Information” of our consolidated financial statements included in this Annual Report on Form 10-K.

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Total net revenue increased $58.3 million, or 3.2%, to $1,881.8 million for the year ended December 31, 2009 from $1,823.5 million for the year ended December 31, 2008.  Of this increase in revenue $59.7 million was contributed by our Inpatient Services segment and $15.7 million by our Rehabilitation Therapy segment.  These increases were offset by a $17.1 million decrease in revenue from our Medical Staffing segment.

Operating salaries and benefits expense increased $28.6 million, or 2.8%, to $1,057.6 million (56.2% of net revenues) for the year ended December 31, 2009 from $1,029.0 million (56.4% of net revenues) for the year ended December 31, 2008.  The increase is primarily the result of wage rate increases.

Self insurance for workers’ compensation and general and professional liability insurance increased $4.1 million, or 6.9%, to $63.8 million (3.4% of net revenues) for the year ended December 31, 2009 from $59.7 million (3.3% of net revenues) for the year ended December 31, 2008.  The increase was attributable to a $6.1 million increase in general and professional liability insurance costs driven by an increased claims costs related to prior years, partially offset by a $1.7 million decrease in workers’ compensation costs resulting from costs recorded in 2008 related to earlier years.

General and administrative expenses decreased $0.2 million, or 0.3%, to $62.1 million (3.3% of net revenues) for the year ended December 31, 2009 from $62.3 million (3.4% of net revenues) for the year ended December 31, 2008.  The decrease was due to cost reductions in professional and consultant fees and benefits expenses.

Other operating costs increased $11.5 million, or 2.7%, to $435.8 million (23.2% of net revenues) for the year ended December 31, 2009 from $424.3 million (23.3% of net revenues) for the year ended December 31, 2008.  The increase in other operating costs was principally comprised of (1) cost increases relating to pharmaceutical, therapy and other ancillary services, which in turn were driven by increased patient needs, coupled with (2) increases in utilities and provider and real estate taxes.

Center rent expense decreased $0.5 million, or 1.0%, to $73.1 million (3.9% of net revenues) for the year ended December 31, 2009 from $73.6 million (4.0% of net revenues) for the year ended December 31, 2008.  The decrease was due to reduced rent for a previously leased center that was purchased in the first quarter of 2009.

Depreciation and amortization increased $5.1 million, or 12.6%, to $45.5 million (2.4% of net revenues) for the year ended December 31, 2009 from $40.4 million (2.2% of net revenues) for the year ended December 31, 2008.  The increase was primarily attributable to the purchase of previously leased centers and additional capital expenditures incurred for center and information systems improvements in 2009.

The provision for losses on accounts receivable increased $7.1 million, or 50.4%, to $21.2 million (1.1% of net revenues) for the year ended December 31, 2009 from $14.1 million (0.8% of net revenues) for the year ended December 31, 2008. The increase was principally driven by lower recoveries of inpatient services bad debt and continued deterioration in the aging of uncollected accounts, which are primarily private payor accounts.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        Net interest expense decreased $5.3 million, or 9.7%, to $49.3 million (2.6% of net revenues) for the year ended December 31, 2009 from $54.6 million (3.0% of net revenues) for the year ended December 31, 2008, principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances.

There is a provision for income taxes of $29.6 million for the year ended December 31, 2009, compared to an income tax benefit of $47.3 million for the year ended December 31, 2008.  The 2008 benefit amount included a $70.5 million benefit from the reversal of a portion of the valuation allowance on our net deferred tax assets offset by a provision from operations and other adjustments totaling $23.2 million.  Our valuation allowance on our net deferred tax assets decreased $6.7 million during the year ended December 31, 2009 due to the write-off of deferred tax assets for certain state net operating loss carryforwards that were fully reserved.  No portion of the $6.7 million reduction in our valuation allowance in 2009 affected our provision for income taxes.

Our Adjusted EBITDA increased $7.6 million, or 4.7%, to $168.2 million (8.9% of net revenues) for the year ended December 31, 2009 from $160.6 million (8.8% of net revenues) for the year ended December 31, 2008.  The increase was primarily attributable to additional revenues of $58.3 million, offset by additional expenses, primarily operating salaries and benefits ($28.6 million), other operating costs ($11.5 million), provision for losses on accounts receivable ($7.1 million) and self-insurance for workers’ compensation and general and professional liability insurance ($4.1 million), all discussed above.  For an explanation of Adjusted EBITDA, including a description of our uses of, and the limitations associated with, Adjusted EBITDA, and a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see footnote 6 to Item 6 – “Selected Financial Data” of this Annual Report on Form 10-K.

Segment information

Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.

The following table sets forth the amount and percentage of certain elements of total net revenues for the years ended December 31 (dollars in thousands):

   
2009
   
2008
   
2007
 
Inpatient Services
$
1,675,775
 
89.1
%
$
1,616,059
 
88.6
%
$
1,367,398
 
87.8
%
Rehabilitation Therapy Services
 
179,532
 
9.5
   
150,475
 
8.3
   
127,056
 
8.2
 
Medical Staffing Services
 
102,554
 
5.4
   
120,410
 
6.6
   
111,232
 
7.1
 
Corporate
 
34
 
0.0
   
37
 
0.0
   
77
 
0.0
 
Intersegment eliminations
 
(76,096)
 
(4.0
)
 
(63,478
)
(3.5
)
 
(48,007
)
(3.1
)
Total net revenues
$
1,881,799
 
100.0
%
$
1,823,503
 
100.0
%
$
1,557,756
 
100.0
%

Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients or third party payors for therapy and medical staffing services provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the years ended December 31 (in thousands):

   
2009
   
2008
   
2007
 
Rehabilitation Therapy Services
$
74,166
 
$
60,856
 
$
44,857
 
Medical Staffing Services
 
1,930
   
2,622
   
3,150
 
Total affiliated revenues
$
76,096
 
$
63,478
 
$
48,007
 


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations. Net segment income for the year ended December 31, 2009 for (1) our inpatient services segment increased $1.8 million, or 1.2%, to $156.1 million, (2) our rehabilitation therapy services segment increased $2.6 million, or 30.6%, to $11.1 million and (3) our medical staffing services segment decreased $1.1 million, or 11.3%, to $8.6 million due to the factors discussed below for each segment. We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment.  The following table sets forth the amount of net segment income for the years ended December 31 (in thousands):

   
2009
   
2008
   
2007
 
Inpatient Services
$
156,088
 
$
154,281
 
$
132,435
 
Rehabilitation Therapy Services
 
11,112
   
8,462
   
7,753
 
Medical Staffing Services
 
8,610
   
9,690
   
8,221
 
Net segment income before Corporate
 
175,810
   
172,433
   
148,409
 
Corporate
 
(102,368
)
$
(106,833
)
 
(102,033
)
Net segment income
$
73,442
   
65,600
 
$
46,376
 

Inpatient Services.  Net revenues increased $59.7 million, or 3.7%, to $1,675.8 million for the year ended December 31, 2009 from $1,616.1 million for the year ended December 31, 2008.  The increase in net revenues was primarily the result of:

-
an increase of $35.7 million in Medicare revenues driven by increases in Medicare Part A rates and Medicare Part B revenues, which drove $31.6 million and $4.1 million of the increase, respectively;
   
-
a $9.4 million increase in managed and commercial insurance revenues driven by a higher customer base and higher rates, which caused $4.1 million and $5.3 million of the increase, respectively;
   
-
an increase of $24.3 million in Medicaid revenues, driven by increases in rates and customer base, which drove $21.2 million and $3.1 million of the increase, respectively;
   
-
a $8.9 million increase in revenues from private sources due to higher rates;
   
-
an increase of $15.2 million in hospice revenues due to an acquisition, which contributed $4.4 million of the increase, and internal growth; and
   
-
an increase of $0.8 million in other revenue including veterans and other various inpatient services;
   
 
offset by
   
-
a $20.3 million decrease in Medicare revenues due to a lower customer base; and
   
-
a $14.3 million decrease in private revenues also due to a lower customer base.

Operating salaries and benefits expenses, excluding workers' compensation insurance costs, increased $17.2 million, or 2.1%, to $835.0 million for the year ended December 31, 2009 from $817.8 million for the year ended December 31, 2008.  The increase was primarily due to:

-
increases in compensation and related benefits and taxes of $25.1 million to remain competitive in local markets;
   

32

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
offset by
   
-
a decrease of $7.9 million in overtime expenses.
 
Self-insurance for workers’ compensation and general and professional liability insurance increased $4.3 million, or 7.7%, to $59.8 million for the year ended December 31, 2009 as compared to $55.5 million for the year ended December 31, 2008.  The increase was attributable to a $6.1 million increase in general and professional liability insurance costs offset by a $1.8 million decrease in workers’ compensation costs.  The increase in general and professional liability costs was a result of increased claims costs related to prior years.  The decrease in workers’ compensation costs resulted from costs recorded in 2008 from changes in estimates related to earlier years.

Other operating costs increased $25.7 million, or 6.2%, to $437.6 million for the year ended December 31, 2009, from $411.9 million for the year ended December 31, 2008.  The increase was primarily due to:

-
a $15.1 million increase in costs for therapy, pharmacy and medical supplies attributable to higher acuity, which was driven in part by the number of new Rehab Recovery Suites;
   
-
a $12.0 million increase in taxes (primarily provider taxes and real estate taxes);
   
-
a $4.4 million increase in purchased services, of which a majority of the increase was in operating service contracts and software maintenance;
   
-
a $1.0 million increase in legal fees; and
   
-
a $0.5 million increase in acquisition transaction costs related to a hospice acquisition;
   
 
offset by
   
-
a $2.5 million decrease in contract nursing labor due to lower volume and improved labor management;
   
-
a $1.2 million decrease in equipment rental;
   
-
a $1.2 million increase in vendor discounts and rebates;
   
-
a $1.2 million decrease in recruiting expenses;
   
-
a $1.1 million decrease in civil monetary penalties; and
   
-
a $0.1 million decrease in travel and vehicle expenses.

General and administrative expenses decreased $0.2 million, or 0.5%, to $41.2 million for the year ended December 31, 2009 from $41.4 million for the year ended December 31, 2008.

The provision for losses on accounts receivable increased $7.4 million, or 55.6%, to $20.7 million for the year ended December 31, 2009, from $13.3 million for the year ended December 31, 2008.  The increase is due to increased credit risk associated with slower cash collections.

 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        Center rent expense for the year ended December 31, 2009 decreased $0.5 million, or 0.7%, to $71.7 million, compared to $72.2 million for the year ended December 31, 2008. The decrease was attributable to the purchase of previously leased centers.

Depreciation and amortization increased $5.3 million, or 14.7%, to $41.3 million for the year ended December 31, 2009, from $36.0 million for the year ended December 31, 2008. The increase was attributable to additional depreciation expense due to the purchase of previously leased centers and for property and equipment acquired during the period.

Net interest expense for the year ended December 31, 2009 was $12.2 million as compared to $13.6 million for the year ended December 31, 2008.  The decrease of $1.5 million was a result of lower borrowing costs and lower aggregate borrowings.

Rehabilitation Therapy Services.  Total revenues increased $29.0 million, or 19.3%, to $179.5 million for the year ended December 31, 2009, from $150.5 million for the year ended December 31, 2008.  Of the $29.0 million increase in total revenues, affiliated revenues increased $13.3 million; nonaffiliated revenues increased $14.8 million and other revenue increased $0.9 million. The addition of nine affiliated contracts, coupled by a rate increase and service volume growth in our affiliated book of business, drove the affiliated revenue increase. The increase in nonaffiliated revenues was due primarily to new contracts (net positive change in contract count), rate increases in existing business and growth in dysphagia and management services business lines.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, increased $25.5 million, or 20.4%, to $150.3 million for the year ended December 31, 2009 from $124.8 million for the year ended December 31, 2008. The increase was primarily due to service volume growth and an average increase of 4.18% in therapy wage rates. These increases were compounded by an increase in health insurance costs of $1.5 million.

Other operating costs, including contract labor expenses, increased $0.5 million, or 7.0%, to $7.6 million for the year ended December 31, 2009 from $7.1 million for the year ended December 31, 2008. The increase was primarily due to increased administrative expenses and other direct contract expenses resulting from the increased business volume.

Provision for losses on accounts receivable increased $0.3 million to an expense of $0.5 million for the year ended December 31, 2009 from an expense of $0.2 million for the year ended December 31, 2008.  The increase was due to the aging of uncollected accounts and a higher reserve percentage for our oldest rehab agency accounts.

Medical Staffing Services.  Total revenues from Medical Staffing Services decreased $17.8 million, or 14.8%, to $102.6 million for the year ended December 31, 2009 from $120.4 million for the year ended December 31, 2008.  The decrease in revenues was primarily the result of:

-
a $11.2 million decrease in the nurse staffing business;
   
-
a $5.4 million decrease in staffing other medical professionals due to a decline in hours; and
   
-
a $2.4 million decrease due to nursing offices permanently closed in 2008;
   
 
offset by
   
-
an increase in locum tenens (physician placement) business of $1.2 million.


 
34

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, decreased $14.0 million, or 16.2%, to $72.3 million for the year ended December 31, 2009 from $86.3 million for the year ended December 31, 2008. The $14.0 million decrease was primarily driven by the decline in revenue.

Other operating costs decreased $1.9 million, or 10.8%, to $15.7 million for the year ended December 31, 2009 from $17.6 million for the year ended December 31, 2008. The decrease was primarily attributable to a decline in hours associated with the decline in revenue.

Provision for losses on accounts receivable decreased $0.5 million, or 83.3%, to $0.1 million for the year ended December 31, 2009 from $0.6 million for the year ended December 31, 2008 due primarily to the recovery of large accounts that were reserved in prior year and strong ongoing collections efforts.

Corporate.  General and administrative costs not directly attributed to operating segments decreased $0.2 million, or 0.3%, to $62.1 million for the year ended December 31, 2009 from $62.3 million for the year ended December 31, 2008.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the year ended December 31, 2009, we incurred $1.3 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Interest expense

Net interest expense not directly attributed to operating segments decreased $3.9 million, or 9.4%, to $37.1 million for the year ended December 31, 2009 from $41.0 million for the year ended December 31, 2008. The decrease was principally due to lower interest rates on variable rate indebtedness coupled with reduced debt balances.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Total net revenue increased $265.7 million, or 17.1%, to $1,823.5 million for the year ended December 31, 2008 from $1,557.8 million for the year ended December 31, 2007.  The increase in revenue was principally the result of the $248.6 million increase in revenue from our Inpatient Services segment, $183.9 million of which was incremental revenue related to the Harborside acquisition.  The remainder of the increase in revenue in 2008 resulted from (1) a $9.7 million increase in revenue from our Medical Staffing segment, and (2) a $7.4 million increase in revenue from our Rehabilitation Therapy segment.

Operating salaries and benefits expense increased $140.9 million, or 15.9%, to $1,029.0 million (56.4% of net revenues) for the year ended December 31, 2008 from $888.1 million (56.9% of net revenues) for the year ended December 31, 2007.  Approximately $102.5 million of the increase were incremental costs from the Harborside acquisition. The remaining $38.4 million of the increase principally resulted from wage rate increases.

Self insurance for workers’ compensation and general and professional liability insurance increased $15.2 million, or 34.2%, to $59.7 million (3.3% of net revenues) for the year ended December 31, 2008 from $44.5 million (2.9% of net revenues) for the year ended December 31, 2007.  Incremental self insurance costs related to acquisitions totaled $7.3 million.  Additionally, self-insurance expense increased by $0.9 million due to increased claims and administrative costs.


 
35

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

General and administrative expenses decreased $2.5 million, or 3.9%, to $62.3 million (3.4% of net revenues) for the year ended December 31, 2008 from $64.8 million (4.2% of net revenues) for the year ended December 31, 2007.  Incremental cost savings resulting from the integration of the Harborside acquisition contributed approximately $4.1 million of the decrease primarily related to salaries, contract labor, insurance and other administrative expenses. These cost savings were offset by an increase of $1.6 million in stock-based compensation expense.

Other operating costs increased $65.3 million, or 18.2%, to $424.3 million (23.3% of net revenues) for the year ended December 31, 2008 from $359.0 million (23.0% of net revenues) for the year ended December 31, 2007. Incremental other operating costs resulting from the Harborside acquisition totaled $41.2 million.  The remaining $24.1 million of the increase in other operating costs was principally comprised of (1) cost increases relating to pharmaceutical, therapy and other ancillary services, which in turn were driven by our increased revenue, coupled with (2) increases in utilities and provider and real estate taxes.

Center rent expense increased $3.2 million, or 4.5%, to $73.6 million (4.0% of net revenues) for the year ended December 31, 2008 from $70.4 million (4.5% of net revenues) for the year ended December 31, 2007.  Incremental rent expense, primarily resulting from the Harborside acquisition, contributed $1.4 million of the increase. The remaining increase of $1.9 million was due to normally scheduled contingency-based rent increases.

Depreciation and amortization increased $9.2 million, or 29.5%, to $40.4 million (2.2% of net revenues) for the year ended December 31, 2008 from $31.2 million (2.0% of net revenues) for the year ended December 31, 2007.  The increase was primarily attributable to $5.0 million of depreciation related to the Harborside acquisition. The remaining increase of $4.2 million was due primarily to additional capital expenditures incurred for center and information systems improvements in 2008.

The provision for losses on accounts receivable increased $5.1 million, or 56.7%, to $14.1 million (0.8% of net revenues) for the year ended December 31, 2008 from $9.0 million (0.6% of net revenues) for the year ended December 31, 2007. The addition of Harborside contributed $1.1 million of the increase, with the remaining increase principally driven by lower recoveries of inpatient services bad debt than in 2007 and a deterioration in the aging of uncollected accounts.

Interest expense increased $10.3 million, or 23.3%, to $54.6 million (3.0% of net revenues) for the year ended December 31, 2008 from $44.3 million (2.8% of net revenues) for the year ended December 31, 2007, principally due to the indebtedness we incurred and assumed in the Harborside acquisition.

The benefit for income taxes increased to $47.3 million for the year ended December 31, 2008 from a benefit of $10.9 million for the year ended December 31, 2007.  The $36.4 million increase includes an increased benefit of $41.6 million from the reversal of a portion of the valuation allowance on our net deferred tax assets, offset by an increased provision of $5.2 million related to pre-tax income.

The $98.6 million net decrease in the valuation allowance includes a $13.9 million increase related to additional deferred tax assets primarily from our pre-emergence period, offset by a $112.5 million decrease due to sufficient positive evidence regarding the generation of future taxable income to allow for the recognition of deferred tax assets under GAAP.

We believe that it is still necessary to have a valuation allowance on a portion of our net deferred tax assets. However, if we determine that sufficient positive evidence exists in future periods to enable us to reverse part or all of the valuation allowance of $34.3 million that remains as of December 31, 2008, such reversal would reduce the provision for income taxes.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    Our Adjusted EBITDA increased $38.7 million, or 31.7%, to $160.6 million (8.8% of net revenues) for the year ended December 31, 2008 from $121.9 million (7.8% of net revenues) for the year ended December 31, 2007.  The increase was primarily attributable to additional revenues of $265.7 million, offset by additional expenses primarily in operating salaries and benefits ($140.9 million), other operating costs ($65.3 million), provision for losses on accounts receivable ($5.1 million) and self-insurance for workers’ compensation and general and professional liability insurance ($15.2 million), all discussed above.  For an explanation of Adjusted EBITDA, including a description of our uses of, and the limitations associated with, Adjusted EBITDA, and a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see footnote 6 to Item 6 - “Selected Financial Data” of this Annual Report on Form 10-K.

Segment information

Net segment income for the year ended December 31, 2008 for (1) our inpatient services segment increased $21.9 million, or 16.5%, to $154.3 million, (2) our rehabilitation therapy services segment increased $0.7 million, or 9.0%, to $8.5 million and (3) our medical staffing services segment increased $1.5 million, or 18.3%, to $9.7 million due to the factors discussed below for each segment. We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment.

Inpatient Services.  Net revenues increased $248.7 million, or 18.2%, to $1,616.1 million for the year ended December 31, 2008 from $1,367.4 million for the year ended December 31, 2007. The addition of Harborside contributed $166.8 million of the increase in net revenues.  The remaining increase of $81.9 million in net revenues on a same store basis was primarily the result of:

-
an increase of $38.7 million in Medicare revenues driven by increases in Medicare Part A rates, our Medicare customer base and Medicare Part B revenues, which drove $31.5 million, $5.1 million and $2.1 million of the increase, respectively;
   
-
a $25.2 million increase in managed and commercial insurance revenues driven by a higher customer base and higher rates, which caused $18.2 million and $7.0 million of the increase, respectively;
   
-
an increase of $23.2 million in Medicaid revenues, primarily due to improved rates;
   
-
a $7.3 million increase in revenues from private sources due to higher rates;
   
-
an increase of $7.0 million in hospice revenues due to an acquisition and internal growth; and
   
-
an increase of $2.1 million in other revenue including veterans and other various inpatient services;
   
 
offset by
   
-
a $17.9 million decrease in Medicaid revenues due to a lower customer base; and
   
-
a $3.7 million decrease in private revenues also due to a lower customer base.

Operating salaries and benefits expenses, excluding workers' compensation insurance costs, increased $121.3 million, or 17.4%, to $817.8 million for the year ended December 31, 2008 from $696.5 million for the year ended December 31, 2007. Approximately $90.7 million of the increase was due to the addition of Harborside.  The remaining increase of $30.6 million on a same store basis was primarily due to:
37

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

-
increases in compensation and related benefits and taxes of $32.9 million to remain competitive in local markets;
   
 
offset by
   
-
a decrease of $2.1 million in overtime expenses.

Self-insurance for workers’ compensation and general and professional liability insurance increased $14.9 million, or 36.7%, to $55.5 million for the year ended December 31, 2008 as compared to $40.6 million for the year ended December 31, 2007.  The addition of Harborside contributed $4.7 million of the increase.  The remaining $10.2 million increase was attributable to a $3.4 million increase in general and professional liability insurance costs and a $6.8 million increase in workers’ compensation costs.  Both of these increases were related to a combination of higher claim costs in 2008 combined with the impact of prior year insurance reserve releases recorded in 2007 which did not repeat in 2008.

Other operating costs increased $62.4 million, or 17.9%, to $411.9 million for the year ended December 31, 2008, from $349.5 million for the year ended December 31, 2007.  Excluding the impact of Harborside, which contributed $39.3 million of the increase, the remaining $23.1 million increase on a same store basis was primarily due to:

-
a $19.0 million increase in therapy, pharmacy, medical supplies and equipment rental expense attributable to the increase in our skilled patient mix as well an increase in the number of new Rehab Recovery Suites coming on line;
   
-
a $3.4 million increase in utility expense primarily due to higher electricity, gas and oil and garbage collection costs;
   
-
a $2.7 million increase in education and training expense related to new clinical programs and processes;
   
-
a $2.5 million increase in purchased services of which a majority of the increase was in service contracts; and
   
-
a $1.4 million decrease in vendor discounts and rebates;
   
 
offset by
   
-
a $3.4 million decrease in contract nursing labor; and
   
-
a $2.5 million decrease in taxes (primarily provider taxes and real estate taxes).

General and administrative expenses increased $9.4 million, or 29.4%, to $41.4 million for the year ended December 31, 2008 from $32.0 million for the year ended December 31, 2007.  The addition of the Harborside operations contributed $3.2 million of the increase with the remaining $6.2 million increase due to higher salaries and benefits, travel costs, utilities and office leases.

The provision for losses on accounts receivable increased $3.8 million, or 40.0%, to $13.3 million for the year ended December 31, 2008, from $9.5 million for the year ended December 31, 2007.  The addition of Harborside contributed $1.1 million of the increase.  The remaining $2.7 million of the increase is due to lower recoveries of bad debt.  In 2007, we recovered $2.3 million of bad debt related to centers acquired in 2005.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    Center rent expense for the year ended December 31, 2008 increased $2.9 million, or 4.2%, to $72.2 million, compared to $69.3 million for the year ended December 31, 2007. The addition of Harborside accounted for $4.7 million of additional rent expense, which was offset by a $1.8 million decrease in same store rent due to conversions of leased centers to owned.

Depreciation and amortization increased $10.0 million, or 38.5%, to $36.0 million for the year ended December 31, 2008, from $26.0 million for the year ended December 31, 2007. The addition of the Harborside centers accounted for $4.5 million of the increase.  The remaining increase of $5.5 million was primarily due to the purchase of previously leased centers and capital expenditures incurred for center improvements in 2008.

Net interest expense for the year ended December 31, 2008 was $13.7 million as compared to $11.5 million for the year ended December 31, 2007.  The increase of $2.2 million was primarily due to debt incurred and assumed in the Harborside acquisition and debt incurred to purchase leased centers.

Rehabilitation Therapy Services.  Total revenues increased $23.4 million, or 18.4%, to $150.5 million for the year ended December 31, 2008, from $127.1 million for the year ended December 31, 2007.  Of the $23.4 million increase in total revenues, affiliated revenues increased $16.0 million; nonaffiliated revenues increased $7.0 million and other revenue increased $0.4 million. The addition of 18 affiliated contracts in Kentucky, gained by way of a 2007 acquisition, drove $8.9 million of the affiliated revenue increase. The addition of 13 affiliated contracts in Oklahoma, Idaho, and Montana, gained by way of a 2005 acquisition and transitioned to SunDance operations in 2008, drove $4.4 million of the affiliated revenue increase.  Service volume growth drove the remainder of the increase in affiliated revenues.  The increase in nonaffiliated revenues was due primarily to new contracts (net positive change in contract count), rate increases in existing business and growth of an emerging business segment.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, increased $18.6 million, or 17.5%, to $124.8 million for the year ended December 31, 2008 from $106.2 million for the year ended December 31, 2007. The increase was primarily due to service volume growth discussed above and an average increase of 4.4% in therapy wage rates. These increases were compounded by an increase in health insurance costs of $1.3 million.

Self-insurance for workers’ compensation and general and professional liability expenses increased $0.3 million, or 16.7%, to $2.1 million for the year ended December 31, 2008, from $1.8 million for the year ended December 31, 2007. The increase was due to an increase in workers’ compensation claims expense.

General and administrative expenses increased $1.8 million, or 36.0%, to $6.8 million for the year ended December 31, 2008 from $5.0 million for the year ended December 31, 2007.  The increase was the result of additional personnel and contracted services necessary to support the overall increased business volume.

Other operating costs, including contract labor expenses, increased $0.8 million, or 12.7%, to $7.1 million for the year ended December 31, 2008 from $6.3 million for the year ended December 31, 2007. The increase was primarily due to increased contract labor and other direct contract expenses in relation to the 2007 and 2005 acquisitions discussed above.

Provision for losses on accounts receivable increased $0.9 million to an expense of $0.2 million for the year ended December 31, 2008 from an adjustment of ($0.7) million for the year ended December 31, 2007.  The increase was due to the aging of uncollected accounts.

Depreciation expense remained flat at $0.5 million each for the years ended December 31, 2008 and 2007.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medical Staffing Services.  Total revenues from Medical Staffing Services increased $9.2 million, or 8.3%, to $120.4 million for the year ended December 31, 2008 from $111.2 million for the year ended December 31, 2007. The increase in revenues was primarily the result of:

-
an increase in Locum Tenens (physician placement) business of $4.3 million;
   
-
$3.8 million attributable to an increase of approximately 65,359 billable hours (a 3.9% increase in billable hours);
   
-
$2.5 million resulting from the acquisition of a medical staffing company in the Harborside acquisition in 2007; and
   
-
$0.9 million attributable to a bill rate increase of 1.0%;
   
 
offset by
   
-
a $2.3 million decrease due to nursing offices permanently closed in 2007.

Operating salaries and benefits expenses, excluding workers’ compensation insurance costs, increased $0.9 million, or 1.1%, to $86.3 million for the year ended December 31, 2008 from $85.4 million for the year ended December 31, 2007. The $0.9 million increase was primarily driven by acquisition mentioned above.

Other operating costs increased $6.4 million, or 57.1%, to $17.6 million for the year ended December 31, 2008 from $11.2 million for the year ended December 31, 2007. The increase was primarily attributable to a $3.1 million increase in physician placement fees related to Locum Tenens, a $2.9 million in various administrative expenses related to travel and meal stipends and a $0.4 million increase for professional fees related to third party vendors.

Self-insurance for workers’ compensation and general and professional liability expenses decreased $0.2 million, or 11.8%, to $1.5 million for the year ended December 31, 2008 from $1.7 million for the year ended December 31, 2007 due to a decrease in workers’ compensation claims expense.

Provision for loss increased $0.5 million to $0.6 million for the year ended December 31, 2008 from $0.1 million for the year ended December 31, 2007 due to an increase in non-payment and slow payments by customers.

Corporate.  General and administrative costs not directly attributed to operating segments decreased $2.5 million, or 3.9%, to $62.3 million for the year ended December 31, 2008 from $64.8 million for the year ended December 31, 2007. The decrease was primarily due to declining consulting fees, lobbying and political expenses and office lease expenses.

Interest expense

Net interest expense not directly attributed to operating segments increased $8.2 million, or 25.0%, to $41.0 million for the year ended December 31, 2008 from $32.8 million for the year ended December 31, 2007. The increase was primarily due to debt incurred and assumed in the Harborside acquisition.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Liquidity and Capital Resources
 
For the year ended and as of December 31, 2009, our net income was $38.7 million and our working capital was $175.6 million. As of December 31, 2009, we had cash and cash equivalents of $104.5 million, $50.0 million available on our revolving credit facility and $700.5 million in borrowings.  As of December 31, 2009, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility and our term loan indebtedness and the indenture governing our 9-1/8% Senior Subordinated Notes due 2015.

Based on current levels of operations, we believe that our operating cash flows (which were $108.9 million for the year ended December 31, 2009), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed under “Capital Expenditures”, scheduled debt service payments and our other commitments described in the table under “Obligations and Commitments” at least through the next twelve months. We believe our long term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness. Although our credit agreement, which is described under “Loan Agreements”, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed. However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

We have not drawn on our revolving credit facility since April 2007, and have since that time relied on our cash flows to provide for operational needs and capital expenditures. However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions. We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months. However, recent issues involving the stability of financial institutions generally have called into question credit availability, and under the terms of our revolving credit facility, if one lender defaults on a borrowing request, then the other lenders are not required to fund that lender’s share.  While we do not anticipate that any of our lenders will be unable to lend under our revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

In April 2009, we purchased a leased center in Oklahoma that we operate but did not own.  The purchase price of $3.3 million was funded through available cash.  In October 2009, we acquired all the capital stock of a hospice provider for approximately $16.1 million, which was funded with available cash.

Cash flows

During the year ended December 31, 2009, net cash provided by operating activities increased by $21.1 million as compared to last year.  This increase was the result of (i) our year-over-year decrease in net income of $70.6 million, (ii) our year-over-year increase in working capital changes of $5.5 million due to timing differences and (iii) a $86.2 million increase in non-cash adjustments to net income, principally related to depreciation and amortization expenses, the provision for losses on accounts receivable and recognition of deferred taxes.

Net cash used for investing activities of $70.3 million for the year ended December 31, 2009 is comprised of (i) $54.3 million used for capital expenditures, (ii) $3.3 million used to purchase previously leased real estate, (iii) $2.2 million in proceeds from the sale of assets held for sale, and (iv) $14.9 million used for acquisitions net of $0.6 million of cash acquired.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Net cash used for financing activities of $26.2 million for the year ended December 31, 2009 is comprised of (i) $20.8 million provided by long-term borrowings, (ii) $46.2 million used to repay long-term debt and capital lease obligations, (iii) $0.9 million used for distributions of to noncontrolling interest and (iv) $0.1 million in proceeds from the issuance of common stock.

During the year ended December 31, 2008, net cash provided by operating activities increased by $4.0 million as compared to the prior year.  This increase was the result of (i) our year-over-year increase in net income of $51.8 million, (ii) our year-over-year decrease in working capital changes of $32.4 million and (iii) a $15.4 million decrease in non-cash adjustments to net income, principally related to depreciation and amortization expenses, the provision for losses on accounts receivable, recognition of deferred taxes and a non-recurring loss on the extinguishment of debt.

During the year ended December 31, 2007, net cash provided by operating activities increased by $74.0 million as compared to the prior year.  This increase was the result of (i) our year-over-year increase in net income of $30.4 million, (ii) our year-over-year increase in working capital changes of $39.9 million and (iii) a $3.7 million increase in non-cash adjustments to net income, principally related to depreciation and amortization expenses, the provision for losses on accounts receivable, recognition of deferred taxes and a non-recurring loss on the extinguishment of debt.

Loan Agreements

In April 2007 we issued $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), which mature on April 15, 2015.  We are entitled to redeem some or all of the Notes at any time on or after April 15, 2011 at certain pre-specified redemption prices.  In addition, prior to April 15, 2011, we may redeem some or all of the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, if any, plus a “make whole” premium.  We are entitled to redeem up to 35% of the aggregate principal amount of the Notes until April 15, 2010 with the net proceeds from certain equity offerings at certain pre-specified redemption prices.  The Notes accrue interest at an annual rate of 9-1/8% and pay interest semi-annually on April 15th and October 15th of each year through the April 15, 2015 maturity date.  The Notes are unconditionally guaranteed on a senior subordinated basis by certain of our subsidiaries but are not secured by any of our assets or those of our subsidiaries.  (See Note 16 – “Summarized Consolidating Information” in the notes to consolidated financial statements included in this Annual Report on Form 10-K).

In April 2007, we entered into a $485.0 million senior secured credit facility with a syndicate of financial institutions led by Credit Suisse as the administrative agent and collateral agent (the “Credit Agreement”) in connection with our acquisition of Harborside (see Note 6 – “Acquisitions” in the notes to consolidated financial statements included in this Annual Report on Form 10-K).  The Credit Agreement provides for $365.0 million in term loans (of which $329.1 million was outstanding as of December 31, 2009), a $50.0 million revolving credit facility (undrawn at December 31, 2009) and a $70.0 million letter of credit facility ($62.8 million outstanding at December 31, 2009).  The final maturity date of the term loans is April 19, 2014, and the revolving credit facility and letter of credit facility terminate on April 19, 2013.  Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test, a total leverage covenant and a senior leverage covenant. We were in compliance with these covenants as of December 31, 2009.  The Credit Agreement contains customary events of default, such as our failure to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting, among other things, incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.  The Credit Agreement is collateralized by our assets and the assets of most of our subsidiaries.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Amounts borrowed under the term loan facility are due in quarterly installments of 0.25% of the aggregate principal amount of the term loans under the term loan facility outstanding as of January 15, 2008, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  The loans under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans is 1.0% for alternative base rate loans and 2.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 1.0% for alternative base rate revolving loans and up to 2.0% for LIBOR rate revolving loans based on our total leverage ratio.  Each year, commencing in 2009, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement.  Pursuant to this requirement, we paid $8.5 million during 2009 and we estimate that we will pay $18.9 million pursuant to this requirement in 2010.

Acquisitions

Hospice acquisitions

In October 2009, we completed the purchase of a hospice company, which operates four hospice programs in three states in the New England area, for $16.1 million.  The purchase price included allocations of $6.3 million for intangible assets, $11.3 million for goodwill, and $1.5 million for net working capital and other assets.

In September 2008, we completed the purchase of a hospice company, which operated a hospice program in New Jersey, for $7.7 million.  The purchase price included allocations of $3.4 million for intangible assets, $3.7 million for goodwill, and $0.6 million for net working capital

Harborside

In April 2007, we acquired Harborside, a privately-held healthcare company that operated 73 skilled nursing centers, one assisted living center and one independent living center with approximately 9,000 licensed beds in ten states, by purchasing all the outstanding Harborside stock for $349.4 million. In addition to the purchase price paid for Harborside, the former shareholders of Harborside are entitled to a distribution of cash in an amount equal to the future tax benefits realized by us, if any, from the deductibility of specified employee compensation and unamortized debt costs related to Harborside.  Harborside’s results of operations have been included in the consolidated financial statements since April 1, 2007.

Assets held for sale

We had no assets held for sale as of December 31, 2009.  During October 2009, we transferred operations of an assisted living center in Utah to an outside party.  This center has been classified as a discontinued operation.

As of December 31, 2008, assets held for sale consisted of (i) a skilled nursing center with a net carrying amount of $2.8 million, primarily consisting of property and equipment, and (ii) an undeveloped parcel of land valued at $0.9 million, which was classified in our Corporate segment.  See Note 14 - “Segment Information” to our consolidated financial statements included in this Annual Report on Form 10-K.

During November 2008, we transferred operations of a leased skilled nursing center in Utah to an outside party.  This center has been classified as a discontinued operation.

 
43

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

During September 2008, we reclassified the results of three skilled nursing centers (two of which were leased) to discontinued operations.  We exercised options to purchase the two centers and simultaneously sold them and the owned location for a net amount of $1.1 million (subject to resolution of certain contingencies).  We received $0.9 million of cash proceeds in October 2008 and we received the remaining $0.2 million of the sales price during the second quarter of 2009.  We recorded a $0.9 million loss on disposal of these centers.

In June and July 2008, we transferred operations of leased skilled nursing centers in Tennessee and Indiana to outside parties.  The operations of both centers have been classified as discontinued operations.

On June 30, 2008, we sold the operations of two hospitals for $10.1 million (subject to a final working capital reconciliation), which was recorded in other current assets as of June 30, 2008 and received $9.5 million in cash proceeds on July 1, 2008.  The remaining $0.6 million of sales price was received during 2009 in conjunction with the final working capital adjustment.  A $2.7 million loss on disposal of these operations was recognized in the three months ended June 30, 2008.  The lessor of the two hospitals did not fully release us from our rent obligation subsequent to the sale.  Therefore, in accordance applicable accounting guidance, the $2.7 million loss includes an accrued liability of $6.3 million for continuing costs incurred without economic benefit as of the date of disposal of the operations (i.e., the “cease-use” date).

As a result of June 2008 flooding in the Midwest, an Indiana center was severely damaged and the operation was permanently discontinued.  The operating results for the center have been reclassified to discontinued operations, and we have recorded a $1.8 million fixed assets impairment charge for the twelve months ended December 31, 2008, due to the damage to the building and contents.

As of December 31, 2007, assets held for sale consisted of (i) a skilled nursing center with a net carrying amount of $0.5 million, primarily consisting of property and equipment, (ii) two hospitals with a net carrying amount of $5.3 million, consisting of $8.5 million in assets, offset in part by $3.2 million in liabilities, and (iii) an undeveloped parcel of land valued at $0.9 million, which is classified in our Corporate segment in our consolidated financial statements.

During the year ended December 31, 2007, we sold our laboratory and radiology operations for $3.2 million. We also sold a skilled nursing center for $4.9 million during the first quarter of 2007. In October 2007, we sold our 75% interest in a home health services subsidiary for $1.6 million.

Capital expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, of $54.3 million, $42.5 million, and $33.5 million for the years ended December 31, 2009, 2008, and 2007, respectively, which included capital expenditures for discontinued operations of $0.1 million, and $0.6 million for the years ended December 31, 2008 and 2007, respectively.  We did not incur any capital expenditures related to discontinued operations in 2009.  During the year ended December 31, 2009, we incurred $30.5 million of capital expenditures for ongoing normal operational needs of our centers, plus we expended $17.8 million for major renovations of our centers, including $9.7 million spent on construction of our Rehab Recovery Suites.  Our development and rollout of a new billing platform and labor management system resulted in $3.1 million of expenditures during 2009.  We also incurred capital expenditures of $3.0 million in our Corporate segment for information systems and other needs.

We had construction commitments as of December 31, 2009 under various contracts of $1.9 million related to improvements at centers.  These commitments, and other expenditures in response to emergency situations at our centers, the amount of which we cannot predict, represent our non-discretionary capital expenditures.  The
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

remaining amount of our 2010 planned capital expenditures is discretionary.  We expect to incur approximately $50 million to $55 million in capital expenditures during 2010, related primarily to improvements at existing centers and information system upgrades.

 
Obligations and Commitments

The following table provides information about our contractual obligations and commitments in future years as of December 31, 2009 (in thousands):

   
Payments Due by Period
                           
After
   
Total
 
2010
 
2011
 
2012
 
2013
 
2014
 
2014
Contractual Obligations:
                           
Debt, including interest
                           
payments (1)
$
969,133
$
90,988
$
83,278
$
46,422
$
47,438
$
365,911
$
335,096
Capital leases (2)
 
995
 
409
 
334
 
193
 
52
 
7
 
-
Construction commitments
 
1,947
 
1,947
 
-
 
-
 
-
 
-
 
-
Purchase obligations (3)
 
178,200
 
82,200
 
24,000
 
24,000
 
24,000
 
24,000
 
-
Operating leases (4)
 
500,388
 
89,141
 
83,700
 
80,446
 
76,955
 
44,523
 
125,623
Other liabilities (5)
 
19,953
 
2,035
 
17,918
 
-
 
-
 
-
 
-
                             
Total
$
1,670,616
$
266,720
$
209,230
$
151,061
$
148,445
$
434,441
$
460,719

   
Amount of Commitment Expiration Per Period
   
Total
                       
   
Amounts
                     
After
   
Committed
 
2010
 
2011
 
2012
 
2013
 
2014
 
2014
Other Commercial Commitments:
                           
Letters of credit (6)
$
62,849
$
62,849
$
-
$
-
$
-
$
-
$
-
                             
Total
$
62,849
$
62,849
$
-
$
-
$
-
$
-
$
-

(1)
Debt includes principal payments and interest payments through the maturity dates. Total interest on debt, based on contractual rates, is $270.3 million, of which $2.1 million is attributable to variable interest rates determined using the weighted average method.
(2)
Includes interest of $0.3 million.
(3)
Represents our estimated level of purchasing from our main suppliers assuming that we continue to operate the same number of centers in future periods.
(4)
Some of our operating leases also have contingent rentals.
(5)
Represents the liability associated with partnership options yet to be exercised of $5.2 million, $14.1 million of liability due to the previous shareholders of Harborside when certain tax benefits associated with that acquisition are realized and $0.6 million for a liability assumed with a hospice acquisition.  Excludes liabilities for uncertain tax positions that are included in other liabilities at December 31, 2009 for which we are unable to make a reasonably reliable estimate as to when, if at all, cash settlements with taxing authorities will occur.
(6)
Letters of credit expire annually but may be reissued pursuant to a $70.0 million letter of credit facility that terminates in April 2013.


 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Critical Accounting Estimates

Our discussion and analysis of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from these estimates. We believe the following are the most significant judgments and estimates affecting the accounting policies we use in the preparation of the consolidated financial statements.

Net revenues.  Net revenues consist of long-term and subacute care revenues, rehabilitation therapy revenues, and medical staffing services revenues. Net revenues are recognized as services are provided. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. 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 current results of operations, when determined.

Accounts receivable and related allowance.  Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in healthcare centers that we operate are the Medicare program and the various state Medicaid programs. The rehabilitation therapy service operations provide services to patients in nonaffiliated healthcare centers. The billings for those services are submitted to the nonaffiliated centers. Many of the nonaffiliated healthcare centers receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

Estimated provisions for losses on accounts receivable are recorded each period as an expense in the income statement.  In evaluating the collectibility of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry conditions.  Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of change.  In addition, a retrospective collection analysis is performed within each operating company to test the adequacy of the reserve on a semi-annual basis.

The allowance for doubtful accounts related to centers that we have divested was based on a percentage of outstanding accounts receivable at the time of divestiture and was recorded in gain or loss on disposal of discontinued operations, net. As collections are recognized, the allowance is adjusted as appropriate. As of December 31, 2009, accounts receivable for divested operations were significantly reserved.

Insurance.  We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs.  Insurance reserves represent estimates of future claims payments. This liability includes an estimate of the development of reported losses and losses incurred but not reported. Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements. The methods of making such estimates and establishing the resulting reserves

 
46

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

 
are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure. Paid loss methods focus on development of claims actually paid to date. Expected loss methods are based upon an anticipated loss per unit of measure. The Bornhuetter-Ferguson method is a combination of loss development methods and expected loss methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls. We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses. The TPAs are under the oversight of our in-house risk management and legal functions. These functions ensure that the claims are properly administered so that the historical data is reliable for estimation purposes. Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims. In cases where our historical data are not statistically credible, stable, or mature, we supplement our experience with nursing home industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have. Management’s judgment based upon each method’s inherent limitations is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which includes the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported.   These results are compared by accident year and an estimated unpaid loss and allocated loss adjustment expense are determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

During 2009, we determined that the previous estimates for workers’ compensation reserves for accident years prior to 2009 were understated, based on currently available information, by $2.0 million or approximately 2.9%.  Of that amount, $1.7 million related to continuing operations and $0.3 million related to discontinued operations.  While certain of the claims settled for less than the case reserves, a number also settled for greater than the case reserves.  There were no large or unusual settlements during the period.  As of December 31, 2009, the discounting of the policy periods resulted in a reduction to our reserves of $13.0 million.

We also determined during 2009 that the previous estimates for general and professional liabilities reserves for accident years prior to 2009 were understated, based on currently available information, by $7.4 million or approximately 8.5%.  Of that amount, $6.5 million related to continuing operations and $0.9 million related to discontinued operations.  Although there were no large or unusual settlements or significant new claims during the period, we have experienced in 2009 higher level of claims than we anticipated. Professional liability claims have a reporting tail that exceeds one year.  A significant component of our reserves is estimates for incidents that have been incurred but not reported. The increase in prior period reserves is driven in part by an increase in our estimate of incurred but not reported claims.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Impairment of assets.

Goodwill and Accounting for Business Combinations

Goodwill represents the excess of the purchase price over the fair value of the net assets of acquired companies.  Our goodwill included in our consolidated balance sheets as of December 31, 2009 and 2008 was $338.3 and $326.8 million, respectively.  The increase in our goodwill during 2009 was primarily the result of a hospice acquisition in our Inpatient Services segment.

Under GAAP, goodwill and intangible assets with indefinite lives are not amortized; however, they are subject to annual impairment tests. Intangible assets with definite lives continue to be amortized over their estimated useful lives.

The purchase price of acquisitions is allocated to the assets acquired and liabilities assumed based upon their respective fair values.  We may engage independent third-party valuation firms to assist us in determining the fair values of assets acquired and liabilities assumed for significant acquisitions.  Such valuations require us to make significant estimates and assumptions, including projections of future events and operating performance.

We perform our annual goodwill impairment analysis during the fourth quarter of each year.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment and are reviewed at the division level.  For our Rehabilitation Therapy Services and Medical Staffing Services segments, the reporting unit for our annual goodwill impairment analysis was determined to be at the segment level.  For our Inpatient Services segment, the reporting unit for our annual goodwill impairment analysis was determined to be at one level below our segment level.  Our goodwill balances by reporting unit as of December 31, 2009 are (in thousands):

Inpatient Services – Healthcare facilities reporting unit
$
314,729
Inpatient Services – Hospice services reporting unit
 
18,959
Rehabilitation Therapy Services segment
 
75
Medical Staffing Services segment
 
4,533
     Total goodwill
$
338,296

We tested impairment by comparing the net assets of each reporting unit to their respective fair values. We determined the estimated fair value of each reporting unit using a discounted cash flow analysis and other appropriate valuation methodologies. The discounted cash flow model utilizes five years of projected cash flows for each reporting unit. The projected financial results are created from critical assumptions and estimates based upon management’s business plan and historical trends while giving consideration to the global economic environment. Determining fair value requires the exercise of significant judgments about appropriate discount rates, business growth rates, the amount and timing of expected future cash flows and market information relevant to our overall company value. In addition, to validate the reasonableness of our assumptions, we utilized our discounted cash flow model on a consolidated basis and compared the estimated fair value to our market capitalization as of December 31, 2009. Key assumptions in the discounted cash flow model are as follows:

Business Growth Assumptions – In determining our projected Inpatient Services revenue growth rates for our discounted cash flow model, we focus on the two primary drivers: average daily census (“ADC”) and reimbursement rates. Key revenue inputs include historical ADC adjusted for known trends and current Medicare and Medicaid rates adjusted for anticipated changes at next renewal cycle. ADC

 
48

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


trends have been reasonably constant within a narrow range and may be influenced over the long run by a number of factors, including demographic changes in the population we serve and our ability to deliver quality service in an attractive environment.  Generally long term care reimbursement rates are set annually by the payor. To estimate these rates, we evaluate the current reimbursement climate and adjust historical trends where appropriate. Significant adverse rate changes in any one year would cause us to reevaluate our projected rates.  In recent years we have generated historical revenue growth of 3.2% to 6.2% annually.  Expenses generally vary with ADC and have historically grown by approximately 2.9% to 5.6% annually.  Labor is the largest component of our expenses.  We consider labor market trends and staffing needs for the projected ADC levels in determining labor growth rates to be used in our projections. The projected growth rates used in our discounted cash flow model took into account the potential adverse effects of the current economic downturn on our projected revenue and expenses.

Terminal Value EBITDA Multiple – Consistent with commonly accepted valuation techniques, a terminal multiple for the final year’s projected results is applied to estimate our value in the final year of the analysis. That multiple is applied to the final year’s projected EBITDA from continuing operations.

Discount Rate – Market conditions indicated that a discount rate of 17.5% was appropriate at December 31, 2009.  This discount rate is consistent with our overall market capitalization comparison. We consistently apply the same discount rate to the evaluation of each reporting unit.

In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.  Based on the analysis performed, we determined there was no goodwill impairment for the years ended December 31, 2009, 2008 or 2007.

In order to analyze the sensitivity our assumptions have on our overall impairment assessment, we evaluated the impact that a hypothetical reduction in the fair value of a reporting unit would have on our conclusions.  Without giving consideration to a control premium, we can incur up to a cumulative 5.0% decrease in our net cash from revenues and expenses over the next five years, which equates to approximately $110 million in less net cash than our projections, and still avoid having a goodwill impairment charge in any reporting unit.

Indefinite Lived Intangibles

Our indefinite lived intangibles primarily consist of values assigned to CONs obtained through various acquisitions.

We evaluate the recoverability of our indefinite lived intangibles, which are principally CONs, by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place. We determined there was no impairment charge to our indefinite lived intangibles for the years ended December 31, 2009, 2008 or 2007.

Finite Lived Intangibles

Our finite lived intangibles include tradenames (principally recognized with the Harborside and hospice acquisitions), favorable lease intangibles, deferred financing costs, customer contracts and various licenses.

 
49

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    We evaluate the recoverability of our finite lived intangibles if an impairment indicator is present.  As there were no such indicators, we determined there was no impairment of our finite lived intangibles for the years ended December 31, 2009, 2008 or 2007.

Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts at each center. The impairment loss is measured by comparing the estimated fair value of the asset, usually based on discounted cash flows, to its carrying amount.  We assess the need for an impairment write-down when such indicators of impairment are present.  We determined there was no impairment to our long-lived assets used in continuing operations for the years ended December 31, 2009, 2008, and 2007.

Income Taxes.  Pursuant to GAAP, an asset or liability is recognized for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.  Deferred tax assets are also recognized for the future tax benefits from net operating loss, capital loss and tax credit carryforwards.  A valuation allowance is to be provided for the net deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

In evaluating the need to record or continue to reflect a valuation allowance, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) are considered.  In determining future sources of taxable income, we use management-approved budgets and projections of future operating results for an appropriate number of future periods, taking into consideration our history of operating results, taxable income and losses, etc.  This future taxable income is then used, along with all other items of positive and negative evidence, to determine the amount of valuation allowance that is needed, and whether any amount of such allowance should be reversed.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  Effective January 1, 2007, we adopted the GAAP guidance for accounting for uncertainty in income tax positions, which contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.  We reserve for our uncertain tax positions, and we adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the expiration of the statute of limitations.


Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 2 – “Summary of Significant Accounting Policies” to our consolidated financial statements included in this Annual Report on Form 10-K, which is incorporated by reference in response to this item.

 
 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Impact of Inflation

CMS implemented market basket increases of 2.2%, 3.4%, and 3.3% to the Medicare reimbursement rates for Federal fiscal years 2009, 2008, and 2007, respectively, which increases were primarily intended to keep track with inflation. The final rule for Federal fiscal year 2009 also had a 3.3% reduction for a forecast error/parity adjustment.  We estimate that the net result of the two 2009 adjustments, based on our current acuity mix, will be a decrease of 0.85% in our reimbursement rates, which we estimate will decrease our net revenues by approximately $1.0 million per quarter.

Off-Balance Sheet Arrangements

None.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk because we hold debt that is sensitive to changes in interest rates.  We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates for debt.  We also manage our interest expense by entering into interest rate swap agreements.  We entered into interest rate swap agreements in July 2008 and July 2007.  The interest rate swap agreements effectively modify our exposure to interest rate risk by converting a portion of our floating rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The July 2008 agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.  The July 2007 agreement is based on a notional amount of $100.0 million and has a term of three years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 5.388%.

   
Expected Maturity Dates
         
Fair Value
   
Fair Value
 
                                             
December 31,
   
December 31,
 
   
2010
   
2011
   
2012
   
2013
   
2014
   
Thereafter
   
Total
   
2009 (1)
   
2008 (1)
 
   
(Dollars in thousands)
 
Long-term Debt:
                                                     
Fixed rate debt(2)
$
34,652
 
$
15,537
 
$
4,727
 
$
6,045
 
$
166,688
 
$
268,117
 
$
495,766
 
$
375,801
 
$
442,992
 
Rate
 
9.8
%
 
7.8
%
 
7.3
%
 
6.8
%
 
6.8
%
 
8.4
%
                 
Variable rate debt
$
11,764
 
$
26,465
 
$
1,902
 
$
1,902
 
$
162,072
 
$
-
 
$
204,105
 
$
198,969
 
$
202,442
 
Rate
 
2.6
%
 
3.2
%
 
2.5
%
 
2.5
%
 
2.5
%
 
-
%
                 
                                                       
Interest rate swap:
                                                     
Variable to fixed
$
150,000
   
-
   
-
   
-
   
-
   
-
 
$
150,000
 
$
(5,048
)
$
(7,644
)
Average pay rate
 
4.8
%
 
-
   
-
   
-
   
-
   
-
                   
Average receive rate
0.3
%
 
-
   
-
   
-
   
-
   
-
                   
 
(1)
The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.
(2)
Excludes fair value premiums of $0.7 million related to acquisitions.

Item 8.  Financial Statements and Supplementary Data

Information with respect to Item 8 is contained in our consolidated financial statements and financial statement schedules and is set forth herein beginning on Page F-1 which information is incorporated by reference into this Item 8.

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

 
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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


Item 9A.  Controls and Procedures

Management's Report on Disclosure Controls and Procedures

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Exchange Act, as controls and other procedures that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”), Rick Matros, and Chief Financial Officer (“CFO”), Bryan Shaul, as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of management, including the CEO and CFO, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our CEO and CFO concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2009.

Management's Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act).  Because of its inherent limitations, internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation and presentation. Therefore, even those systems determined to be effective may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of internal control over financial reporting as of December 31, 2009, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control – Integrated Framework.  Based on this assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2009.

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 has been audited by PricewaterhouseCoopers LLP (“PwC”), an independent registered public accounting firm, as stated in their report which appears herein.

Changes to Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2009 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Item 9B.  Other Information

Not applicable.



 
52

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART III

Item 10.  Directors, Executive Officers and Corporate Governance

The information required under Item 10 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to April 30, 2010.

Item 11.  Executive Compensation

The information required under Item 11 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to April 30, 2010.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required under Item 12 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to April 30, 2010.

Item 13.  Certain Relationships and Related Transactions and Director Independence

The information required under Item 13 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to April 30, 2010.

Item 14.  Principal Accountant Fees and Services

The information required under Item 14 is incorporated herein by reference to our definitive proxy statement, which we will file pursuant to Exchange Act Regulation 14A prior to April 30, 2010.


 
53

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART IV

Item 15.  Exhibits, Financial Statements and Schedules

(a)
(1)
The following consolidated financial statements of Sun Healthcare Group, Inc. and subsidiaries are filed as part of this report under Item 8 – “Financial Statements and Supplementary Data”:
     
   
Report of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
   
   
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
     
   
Consolidated Balance Sheets as of December 31, 2009 and 2008
     
   
Consolidated Income Statements for the years ended December 31, 2009, 2008 and 2007
     
   
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended December 31, 2009, 2008 and 2007
     
   
Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007
     
   
Notes to Consolidated Financial Statements
     
 
(2)
Financial schedules required to be filed by Item 8 of this form, and by Item 15(a)(2) below:
     
   
Schedule II Valuation and Qualifying Accounts for the years ended December 31, 2009, 2008 and 2007
     
   
All other financial schedules are not required under the related instructions or are inapplicable and therefore have been omitted.
     
 
(3)
Exhibits

Exhibit
 
Number
Description of Exhibits
   
2.1(1)
Agreement and Plan of Merger dated October 19, 2006 by and among Sun Healthcare Group, Inc., Horizon Merger, Inc. and Harborside Healthcare Corporation
   
3.1(10)
Amended and Restated Certificate of Incorporation of Sun Healthcare Group, Inc., as amended
   
3.2(3)
Amended and Restated Bylaws of Sun Healthcare Group, Inc.
   
4.1*
Sample Common Stock Certificate of Sun Healthcare Group, Inc.
   
4.2(4)
Indenture, dated as of April 12, 2007, between Sun Healthcare Group, Inc., the subsidiaries of Sun Healthcare Group, Inc., named therein and Wells Fargo Bank, National Association, as Trustee
 


54

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
4.2.1(5)
First Supplemental Indenture, dated as of April 19, 2007, among Sun Healthcare Group, Inc., Harborside Healthcare Corporation, certain subsidiaries of Harborside Healthcare Corporation named therein and Wells Fargo Bank, National Association, as Trustee
   
4.2.2(6)
Second Supplemental Indenture, dated as of October 31, 2008, among Sun Healthcare Group, Inc., Holisticare Hospice, LLC and Wells Fargo Bank, National Association, as Trustee
   
4.2.3*
Third Supplemental Indenture, dated as of October 26, 2009, among Sun Healthcare Group, Inc., Allegiance Hospice Group, Inc., certain subsidiaries of Allegiance Hospice Group, Inc. named therein and Wells Fargo Bank, National Association, as Trustee
   
4.3(4)
Registration Rights Agreement, dated April 12, 2007, among Sun Healthcare Group, Inc., the subsidiaries of Sun Healthcare Group, Inc. named therein and the Initial Purchasers of the Notes issued pursuant to the above described Indenture.
   
4.3.1(5)
Joinder to the Registration Rights Agreement, dated April 19, 2007, among Harborside Healthcare Corporation, the subsidiaries of Harborside Healthcare Corporation named therein and the Initial Purchasers of the Notes issued pursuant to the above described Indenture.
   
4.5(4)
Escrow Agreement, dated as of April 12, 2007, between Sun Healthcare Group, Inc. and Wells Fargo Bank, National Association, as Escrow Agent
   
4.6
The Registrant has instruments that define the rights of holders of long-term debt that are not being filed herewith, in reliance upon Item 601(b)(4)(iii) of Regulation S-K. The Registrant agrees to furnish to the SEC, upon request, copies of these instruments
   
10.1(5)
Credit Agreement, dated as of April 19, 2007, among Sun Healthcare Group, Inc., the Lenders named therein and Credit Suisse, as Administrative Agent and Collateral Agent for the Lenders
   
10.2(7)+
Amended and Restated 2002 Non-Employee Director Equity Incentive Plan of Sun Healthcare Group, Inc.
   
10.3(6)+
Amended and Restated 2004 Equity Incentive Plan of Sun Healthcare Group, Inc.
   
10.3.1(6)+
Form of Stock Option Agreement
   
10.3.2(6)+
Form of Stock Unit Agreement for employees
   
10.3.3(6)+
Form of Stock Unit Agreement for non-employee directors
   
10.4(6)+
Non-employee Directors Stock-for-Fees Program and Payment Election Form
   
10.6(12)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and Richard K. Matros dated as of October 26, 2009
   
10.7(6)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and L. Bryan Shaul dated as of December 17, 2008
   
 
55

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

10.8(6)+
Amended and Restated Employment Agreement by and between Sun Health Specialty Services, Inc. and William A.  Mathies dated as of December 17, 2008
   
10.9(6)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and Michael Newman dated as of December 17, 2008
   
10.10(6)+
Amended and Restated Employment Agreement by and between Sun Healthcare Group, Inc. and Chauncey J. Hunker dated as of December 17, 2008
   
10.11(8)+
Non-Employee Director Compensation Policy of Sun Healthcare Group, Inc. adopted as of March 18, 2008
   
10.12*+
Sun Healthcare Group, Inc. Executive Bonus Plan
   
10.13(10)
Second Amended and Restated Master Lease Agreement among Sun Healthcare Group, Inc. and certain of its subsidiaries (as Lessees) and Omega Healthcare Investors, Inc. and certain of its subsidiaries (as Lessors) dated February 1, 2008
   
10.13.1(6)
First Amendment to Second Amended and Restated Master Lease Agreement among Sun Healthcare Group, Inc. and certain of its subsidiaries (as Lessees) and Omega Healthcare Investors, Inc. and certain of its subsidiaries (as Lessors) dated August 26, 2008
   
10.13.2(6)
Second Amendment to Second Amended and Restated Master Lease Agreement among Sun Healthcare Group, Inc. and certain of its subsidiaries (as Lessees) and Omega Healthcare Investors, Inc. and certain of its subsidiaries (as Lessors) dated February 26, 2009
   
10.14(9)+
Sun Healthcare Group, Inc. Deferred Compensation Plan
   
10.15(11)+
Amended and Restated Severance Benefits Agreement dated as of December 17, 2008 by and between Richard L. Peranton and CareerStaff Unlimited, Inc.
   
10.16*+
2010 Incentive Bonus Plan for President of SunDance Rehabilitation Corporation
   
10.17(13)+
Sun Healthcare Group, Inc. 2009 Performance Incentive Plan
   
10.18*+
Amended and Restated Severance Benefits Agreement dated as of December 17, 2008 by and between Sue Gwyn and SunDance Rehabilitation Corporation
   
14.1(2)
Code of Ethics for Chief Executive Officer, Financial Officers and Financial Personnel
   
21.1*
Subsidiaries of Sun Healthcare Group, Inc.
   
23.1*
Consent of PricewaterhouseCoopers LLP
   
23.2*
Consent of Ernst & Young LLP
   
31.1*
Section 302 Sarbanes-Oxley Certifications by Principal Executive Officer
 
 
 
56

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

31.2*
Section 302 Sarbanes-Oxley Certifications by Principal Financial and Accounting Officer
   
32.1*
Section 906 Sarbanes-Oxley Certifications by Principal Executive Officer
   
32.2*
Section 906 Sarbanes-Oxley Certifications by Principal Financial and Accounting Officer
_______________

*      Filed herewith.
+      Designates a management compensation plan, contract or arrangement

(1)
Incorporated by reference from exhibits to our Form 8-K filed on October 25, 2006
(2)
Incorporated by reference from exhibits to our Form 10-Q filed on May 7, 2004
(3)
Incorporated by reference from exhibits to our Form 8-K filed on December 27, 2007
(4)
Incorporated by reference from exhibits to our Form 8-K filed on April 18, 2007
(5)
Incorporated by reference from exhibits to our Form 8-K filed on April 25, 2007
(6)
Incorporated by reference from exhibits to our Form 10-K filed on March 4, 2009
(7)
Incorporated by reference from exhibits to our Form 10-Q filed on August 16, 2002
(8)
Incorporated by reference from exhibits to our Form 8-K filed on April 3, 2008
(9)
Incorporated by reference from exhibits to our Form 10-Q filed on April 29, 2009
(10)
Incorporated by reference from exhibits to our Form 10-K filed on March 7, 2008
(11)
Incorporated by reference from exhibits to our Form 10-Q filed on August 7, 2009
(12)
Incorporated by reference from exhibits to our Form 10-Q filed on October 28, 2009
(13)
Incorporated by reference from exhibits to our Form 8-K filed on June 11, 2009


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

 
SUN HEALTHCARE GROUP, INC.
   
   
   
 
By:    /s/ L. Bryan Shaul                            
 
       L. Bryan Shaul
 
       Chief Financial Officer

March 4, 2010
 
 
57

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant as of March 4, 2010 in the capacities indicated.

Signatures
Title
   
 
Chairman of the Board and Chief Executive Officer
  /s/ Richard K. Matros                           
(Principal Executive Officer)
   Richard K. Matros
 
   
 
Executive Vice President and Chief Financial
  /s/ L. Bryan Shaul                                 
Officer (Principal Financial and Accounting Officer)
   L. Bryan Shaul
 
   
   
  /s/ Gregory S. Anderson
Director
   Gregory S. Anderson
 
   
   
  /s/ Tony M. Astorga
Director
   Tony M. Astorga
 
   
   
  /s/ Christian K. Bement
Director
   Christian K. Bement
 
   
   
  /s/ Michael J. Foster
Director
   Michael J. Foster
 
   
   
  /s/ Barbara B. Kennelly
Director
   Barbara B. Kennelly
 
   
   
  /s/ Steven M. Looney
Director
   Steven M. Looney
 
   
   
  /s/ Milton J. Walters
Director
   Milton J. Walters
 
   
   
   
   
 
 
58

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index to Consolidated Financial Statements

December 31, 2009


 
Page
   
Report of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
F-2
   
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
F-3
   
Consolidated Balance Sheets
F-4 – F-5
As of December 31, 2009 and 2008
 
   
Consolidated Income Statements
F-6
For the years ended December 31, 2009, 2008 and 2007
 
   
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
F-7
For the years ended December 31, 2009, 2008 and 2007
 
   
Consolidated Statements of Cash Flows
F-8 – F-9
For the years ended December 31, 2009, 2008 and 2007
 
   
Notes to Consolidated Financial Statements
F-10 – F-55
   
Supplementary Data (Unaudited) - Quarterly Financial Data
1 – 3
   
Schedule II – Valuation and Qualifying Accounts
4

F-1


Report of Independent Registered Public Accounting Firm


To the Board of Directors and Stockholders
Sun Healthcare Group, Inc.

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Sun Healthcare Group, Inc and its subsidiaries at December 31, 2009 and 2008, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.  In addition, in our opinion the financial statement schedule listed in the accompanying index on page F-1 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.


/s/ PricewaterhouseCoopers LLP
Irvine, California
March 4, 2010

 
F-2

 

Report of Ernst & Young LLP, Independent Registered Public Accounting Firm


The Board of Directors and Stockholders
Sun Healthcare Group, Inc.
 
We have audited the accompanying consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows of Sun Healthcare Group, Inc. (the Company) for the year ended December 31, 2007.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Sun Healthcare Group, Inc. for the year ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

As discussed in Notes 2 and 10 to the consolidated financial statements, effective January 1, 2007, the Company has changed its method of accounting for uncertain tax positions.

 
/s/ Ernst & Young LLP

Dallas, Texas
March 5, 2008,
except for Notes 2(n) and 8(b), as to which the date is
March 4, 2010


 
F-3

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS
(in thousands)

   
December 31, 2009
   
December 31, 2008
 
             
Current assets:
           
Cash and cash equivalents
$
104,483
 
$
92,153
 
Restricted cash
 
24,034
   
34,676
 
Accounts receivable, net of allowance for doubtful accounts of $55,402
           
and $44,830 at December 31, 2009 and 2008, respectively
 
220,319
   
205,620
 
Prepaid expenses and other assets
 
21,757
   
21,456
 
Assets held for sale
 
-
   
3,654
 
Deferred tax assets
 
68,415
   
57,261
 
             
Total current assets
 
439,008
   
414,820
 
             
Property and equipment, net of accumulated depreciation and amortization
           
of $153,854 and $114,415 at December 31, 2009 and 2008, respectively
 
622,682
   
603,645
 
Intangible assets, net of accumulated amortization of $19,005 and $13,292 at
       
December 31, 2009 and 2008, respectively
 
53,931
   
54,388
 
Goodwill
 
338,296
   
326,808
 
Restricted cash, non-current
 
3,317
   
3,303
 
Deferred tax assets
 
108,999
   
134,807
 
Other assets
 
4,961
   
5,563
 
Total assets
$
1,571,194
 
$
1,543,334
 

 
F-4

 


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (Continued)

LIABILITIES AND STOCKHOLDERS' EQUITY
(in thousands, except share data)

   
December 31, 2009
   
December 31, 2008
 
Current liabilities:
           
Accounts payable
$
57,109
 
$
62,000
 
Accrued compensation and benefits
 
58,953
   
60,660
 
Accrued self-insurance obligations, current portion
 
45,661
   
45,293
 
Other accrued liabilities
 
55,265
   
56,857
 
Current portion of long-term debt and capital lease obligations
 
46,416
   
17,865
 
             
Total current liabilities
 
263,404
   
242,675
 
             
Accrued self-insurance obligations, net of current portion
 
121,948
   
114,557
 
Long-term debt and capital lease obligations, net of current portion
 
654,132
   
707,976
 
Unfavorable lease obligations, net of accumulated amortization of
           
$16,450 and $13,599 at December 31, 2009 and 2008, respectively
 
12,663
   
15,514
 
Other long-term liabilities
 
69,983
   
58,903
 
             
Total liabilities
 
1,122,130
   
1,139,625
 
             
Commitments and contingencies (Note 9)
           
             
Stockholders' equity:
           
Preferred stock of $.01 par value, authorized 10,000,000
           
shares, zero shares issued and outstanding as of
           
December 31, 2009 and 2008
 
-
   
-
 
Common stock of $.01 par value, authorized 125,000,000
           
shares, 43,764,240 shares issued and outstanding
           
as of December 31, 2009 and 43,544,765 shares issued
           
and outstanding as of December 31, 2008
 
438
   
435
 
Additional paid-in capital
 
655,667
   
650,543
 
Accumulated deficit
 
(204,012
)
 
(242,683
)
Accumulated other comprehensive loss, net
 
(3,029
)
 
(4,586
)
Total stockholders' equity
 
449,064
   
403,709
 
Total liabilities and stockholders' equity
$
1,571,194
 
$
1,543,334
 

See accompanying notes.

 
F-5

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS
(in thousands, except per share data)

   
For the Years Ended December 31,
 
   
2009
   
2008
   
2007
 
                   
Total net revenues
$
1,881,799
 
$
1,823,503
 
$
1,557,756
 
Costs and expenses:
                 
Operating salaries and benefits
 
1,057,645
   
1,028,987
   
888,102
 
Self-insurance for workers' compensation and general
                 
and professional liability insurance
 
63,752
   
59,694
   
44,524
 
Operating administrative expenses
 
50,924
   
51,171
   
39,950
 
Other operating costs
 
384,832
   
373,084
   
319,010
 
Center rent expense
 
73,149
   
73,601
   
70,412
 
General and administrative expenses
 
62,068
   
62,302
   
64,835
 
Depreciation and amortization
 
45,463
   
40,354
   
31,218
 
Provision for losses on accounts receivable
 
21,197
   
14,107
   
8,982
 
Interest, net of interest income of $383, $1,781, and $3,255, respectively
 
49,327
   
54,603
   
44,347
 
Loss (gain) on sale of assets, net
 
42
   
(976
)
 
24
 
Loss on extinguishment of debt
 
-
   
-
   
3,173
 
Restructuring costs
 
1,304
   
-
   
-
 
Total costs and expenses
 
1,809,703
   
1,756,927
   
1,514,577
 
                   
Income before income taxes and discontinued operations
 
72,096
   
66,576
   
43,179
 
Income tax expense (benefit)
 
29,616
   
(47,348
)
 
(10,914
)
Income from continuing operations
 
42,480
   
113,924
   
54,093
 
                   
Discontinued operations:
                 
(Loss) income from discontinued operations
 
(3,476
)
 
(1,636
)
 
3,617
 
Loss on disposal of discontinued operations, net of related
                 
tax benefit of $231, $1,949, and $0, respectively
 
(333
)
 
(3,001
)
 
(200
)
(Loss) income from discontinued operations
 
(3,809
)
 
(4,637
)
 
3,417
 
                   
Net income
$
38,671
 
$
109,287
 
$
57,510
 
                   
Basic earnings per common and common equivalent share:
                 
Income from continuing operations
$
0.97
 
$
2.63
 
$
1.28
 
(Loss) income from discontinued operations, net
 
(0.09
)
 
(0.11
)
 
0.08
 
Net income
$
0.88
 
$
2.52
 
$
1.36
 
                   
Diluted earnings per common and common equivalent share:
                 
Income from continuing operations
$
0.97
 
$
2.59
 
$
1.25
 
(Loss) income from discontinued operations, net
 
(0.09
)
 
(0.10
)
 
0.08
 
Net income
$
0.88
 
$
2.49
 
$
1.33
 
                   
Weighted average number of common and common equivalent
                 
shares outstanding:
                 
Basic
 
43,841
   
43,331
   
42,350
 
Diluted
 
43,963
   
43,963
   
43,390
 
 
See accompanying notes.

 
F-6

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
COMPREHENSIVE INCOME
(in thousands)

 
For the Years Ended December 31,
 
 
2009
 
2008
 
2007
 
 
Shares
   
Amount
 
Shares
   
Amount
 
Shares
   
Amount
 
Common stock
                             
Issued and outstanding at beginning of period
43,545
 
$
435
 
43,016
 
$
430
 
42,890
 
$
429
 
Retirement of common stock
-
   
-
 
-
   
-
 
(160
)
 
(2
)
Issuance of common stock
219
   
3
 
529
   
5
 
286
   
3
 
Common stock issued and outstanding at
                             
end of period
43,764
   
438
 
43,545
   
435
 
43,016
   
430
 
                               
Additional paid-in capital
                             
Balance at beginning of period
     
650,543
       
600,199
       
553,275
 
Issuance of common stock in excess of par value
     
101
       
2,488
       
1,619
 
Stock based compensation expense
     
5,810
       
5,270
       
-
 
Retirement of common stock
     
-
       
-
       
(2,647
)
Realization of pre-emergence tax benefits
     
-
       
43,093
       
45,587
 
Other
     
(787
)
     
(507
)
     
2,365
 
Additional paid-in capital at end of period
     
655,667
       
650,543
       
600,199
 
                               
Accumulated deficit
                             
Balance at beginning of period
     
(242,683
)
     
(351,970
)
     
(409,480
)
Net income
     
38,671
       
109,287
       
57,510
 
Accumulated deficit at end of period
     
(204,012
)
     
(242,683
)
     
(351,970
)
                               
Accumulated other comprehensive loss
                             
Balance at beginning of period
     
(4,586
)
     
(2,403
)
     
-
 
Other comprehensive income (loss) from cash
flow hedge, net of related tax expense (benefit)
of $1,038, ($3,058) and ($1,602)
     
1,557
       
(2,183
)
     
(2,403
)
Accumulated other comprehensive loss at
                             
end of period
     
(3,029
)
     
(4,586
)
     
(2,403
)
                               
Common stock in treasury
                             
Common stock in treasury at beginning of period
-
   
-
 
-
   
-
 
10
   
(91
)
Shares reacquired
-
   
-
 
-
   
-
 
150
   
(2,558
)
Retirement of common stock in treasury
-
   
-
 
-
   
-
 
(160
)
 
2,649
 
Common stock in treasury at end of period
-
   
-
 
-
   
-
 
-
   
-
 
                               
Total stockholders' equity
   
$
449,064
     
$
403,709
     
$
246,256
 
                               
Comprehensive income:
                             
                               
Net income
   
$
38,671
     
$
109,287
     
$
57,510
 
Other comprehensive income (loss) from cash
   flow hedge, net of related tax expense (benefit) of
  $1,038 ($3,058) and ($1,602)
   
1,557
       
(2,183
)
     
(2,403
)
Comprehensive income
   
$
40,228
     
$
107,104
     
$
55,107
 
                               
 
 
See accompanying notes.
F-7


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

   
For the Years Ended December 31,
 
   
2009
   
2008
   
2007
 
Cash flows from operating activities:
                 
Net income
$
38,671
 
$
109,287
 
$
57,510
 
Adjustments to reconcile net income to net cash provided by
                 
operating activities, including discontinued operations:
                 
Depreciation and amortization
 
45,465
   
40,614
   
31,801
 
Amortization of favorable and unfavorable lease intangibles
 
(1,824
)
 
(1,879
)
 
(1,315
)
Provision for losses on accounts receivable
 
21,196
   
15,283
   
10,345
 
Loss on sale of assets, including discontinued operations, net
 
605
   
2,151
   
224
 
Impairment charge for discontinued operation
 
-
   
1,800
   
-
 
Stock-based compensation expense
 
5,810
   
5,270
   
3,678
 
Deferred taxes
 
27,003
   
(51,128
)
 
(33,581
)
Loss on extinguishment of debt
 
-
   
-
   
3,173
 
Other
 
-
   
(10
)
 
(866
)
Changes in operating assets and liabilities, net of acquisitions:
                 
Accounts receivable
 
(33,547
)
 
(35,136
)
 
(9,899
)
Restricted cash
 
10,628
   
3,215
   
2,497
 
Prepaid expenses and other assets
 
2,940
   
(4,213
)
 
16,127
 
Accounts payable
 
(8,390
)
 
4,032
   
(17,266
)
Accrued compensation and benefits
 
(2,989
)
 
(2,367
)
 
14,486
 
Accrued self-insurance obligations
 
7,759
   
4,773
   
(12,108
)
Income taxes payable
 
-
   
(1,806
)
 
4,779
 
Other accrued liabilities
 
(3,196
)
 
(8,719
)
 
3,615
 
Other long-term liabilities
 
(1,223
)
 
7,020
   
10,637
 
Net cash provided by operating activities
 
108,908
   
88,187
   
83,837
 
                   
Cash flows from investing activities:
                 
Capital expenditures
 
(54,312
)
 
(42,543
)
 
(33,450
)
Purchase of leased real estate
 
(3,275
)
 
(8,956
)
 
(56,462
)
Proceeds from sale of assets held for sale
 
2,174
   
18,354
   
7,589
 
Acquisitions, net of cash acquired
 
(14,936
)
 
(11,734
)
 
(368,454
)
Insurance proceeds received
 
-
   
628
   
-
 
Net cash used for investing activities
 
(70,349
)
 
(44,251
)
 
(450,777
)
                   
Cash flows from financing activities:
                 
Net repayments under revolving credit facility
 
-
   
-
   
(9,994
)
Borrowings of long-term debt
 
20,822
   
20,290
   
347,000
 
Principal repayments of long-term debt and capital lease obligations
 
(46,292
)
 
(29,627
)
 
(54,509
)
Payment to non-controlling interest
 
(311
)
 
(418
)
 
(57
)
Distribution to non-controlling interest
 
(549
)
 
(353
)
 
(657
)
Proceeds from issuance of common stock
 
101
   
2,493
   
1,459
 
Release of cash collateral
 
-
   
-
   
25,640
 
Deferred financing costs
 
-
   
-
   
(18,045
)
Net cash (used for) provided by financing activities
 
(26,229
)
 
(7,615
)
 
290,837
 
                   
Net increase (decrease) in cash and cash equivalents
 
12,330
   
36,321
   
(76,103
)
Cash and cash equivalents at beginning of period
 
92,153
   
55,832
   
131,935
 
Cash and cash equivalents at end of period
$
104,483
 
$
92,153
 
$
55,832
 
Supplemental disclosure of cash flow information:
                 
Interest payments
$
48,781
 
$
52,208
 
$
35,346
 
Capitalized interest
$
523
 
$
447
 
$
442
 
Income taxes paid, net
$
3,484
 
$
2,231
 
$
1,780
 



 
F-8

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(in thousands)

Supplemental Disclosures of Non-Cash Investing and Financing Activities

For the year ended December 31, 2009, capital lease obligations of $79 were incurred in 2009 when we entered into new equipment and vehicle leases.

For the year ended December 31, 2008, stockholders’ equity increased by $43,093 due to a change in the valuation allowance for deferred tax assets and income tax payable attributable to fresh-start accounting and business combinations (see Note 10 – “Income Taxes”).  Capital lease obligations of $575 were incurred in 2008 when we entered into new equipment and vehicle leases.

For the year ended December 31, 2007, in connection with the purchase of leased real estate, we assumed mortgages payable of $29,825 and reduced notes receivable by $7,487.  See Note 6 – “Acquisitions” for non-cash activity related to the Harborside acquisition.  Capital lease obligations of $1,693 were incurred in 2007 when we entered into new equipment and vehicle leases.  Stockholders’ equity increased by $45,587 due to a change in the valuation allowance for deferred tax assets attributable to fresh-start accounting and business combinations (see Note 10 – “Income Taxes”).





























See accompanying notes
F-9


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009


(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission's “Plain English” guidelines, this Annual Report has been written in the first person. In this document, the words “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, subacute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 205 healthcare facilities in 25 states as of December 31, 2009.

Restructuring Costs

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the year ended December 31, 2009, we incurred $1.3 million of restructuring costs, of which $1.0 million was paid during 2009 and the remainder paid in 2010.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff and costs related to closure of a center in Massachusetts.

Comparability of Financial Information

GAAP requires reclassification of the results of operations of subsequent divestitures that qualify as discontinued operations for all periods presented.

(2)  Summary of Significant Accounting Policies

(a)  Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of net revenues, allowances for doubtful accounts, self-insurance obligations, goodwill and other intangible assets (including impairments), and allowances for deferred tax assets.  Actual results could differ from those estimates.

(b)  Principles of Consolidation

Our consolidated financial statements include the accounts of our subsidiaries in which we own more than 50% of the voting interest. Investments of companies in which we own between 20% - 50% of the voting interests and have significant influence were accounted for using the equity method, which records as income an ownership percentage of the reported income of the subsidiary.  Investments in companies in which we own less than 20% of the voting interests and do not have significant influence are carried at lower of cost or fair value. All significant intersegment accounts and transactions have been eliminated in consolidation.

 
F-10

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

(c)  Cash and Cash Equivalents

We consider all highly liquid, unrestricted investments with original maturities of three months or less when purchased to be cash equivalents. Cash equivalents are stated at fair value.

(d)  Restricted Cash

Certain of our cash balances are restricted for specific purposes such as funding of self-insurance reserves, mortgage escrow requirements and capital expenditures on HUD-insured buildings (see Note 9 – “Commitments and Contingencies”).  These balances are presented separately from cash and cash equivalents on our consolidated balance sheets and are classified as a current asset when expected to be utilized within the next year.  Restricted cash balances are stated at fair value.

(e)  Net Revenues

Net revenues consist of long-term and subacute care revenues, rehabilitation therapy services revenues, temporary medical staffing services revenues and other ancillary services revenues. Net revenues are recognized as services are provided. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. 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. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation.

Revenues from Medicaid accounted for 40.0%, 40.0%, and 41.4% of our net revenue for the years ended December 31, 2009, 2008 and 2007, respectively.  Revenues from Medicare comprised 29.5%, 28.6%, and 26.9% of our net revenues for the years ended December 31, 2009, 2008 and 2007, respectively.

(f)  Accounts Receivable

Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in healthcare centers that we operate are the Medicare program and the various state Medicaid programs. Our rehabilitation therapy service operations provide services to patients in unaffiliated healthcare centers. The billings for those services are submitted to the unaffiliated centers. Many of the unaffiliated healthcare centers receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

Estimated provisions for losses on accounts receivable are recorded each period as an expense in the income statement.  In evaluating the collectibility of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry and economic conditions.  Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of change.  In addition, a retrospective collection analysis is performed within each operating company to test the adequacy of the reserve.

 
F-11

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

    The allowance for doubtful accounts related to centers that we have divested was based on a percentage of outstanding accounts receivable at the time of divestiture and is recorded with the gain or loss on disposal of discontinued operations.  As collections are realized, the allowance is adjusted as appropriate. As of December 31, 2009 and 2008, accounts receivable for divested operations were significantly reserved.

(g)  Property and Equipment

Property and equipment are stated at historical cost. Property and equipment held under capital lease are stated at the net present value of future minimum lease payments and their amortization is included in depreciation expense.  Major renewals or improvements are capitalized whereas ordinary maintenance and repairs are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows: buildings and improvements – five to forty years; leasehold improvements - the shorter of the estimated useful lives of the assets or the life of the lease; and equipment - three to twenty years.  We subject our long-lived assets to an impairment test if an indicator of potential impairment is present. (See Note 7 – “Goodwill, Intangible Assets and Long-Lived Assets.”)

(h)  Intangible Assets

Consistent with GAAP, we do not amortize goodwill and intangible assets with indefinite lives. Consequently, we subject them at a minimum to annual impairment tests. Intangible assets with definite lives are amortized over their estimated useful lives. (See Note 7 – “Goodwill, Intangible Assets and Long-Lived Assets.”)

(i) Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. These provisions are based on actuarial analyses, internal evaluations of the merits of individual claims, and industry loss development factors or lag analyses. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any resulting adjustments are reflected in current earnings. Claims are paid over varying periods, and future payments may differ materially than the estimated reserves.  (See Note 9 – “Commitments and Contingencies.”)

(j)  Stock-Based Compensation

We follow the fair value recognition provisions of GAAP, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values.  (See Note 12 – “Capital Stock.”)

(k)  Income Taxes

Pursuant to GAAP, an asset or liability is recognized for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported

 
F-12

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
amounts of the assets are recovered or liabilities are settled.  Deferred tax assets are also recognized for the future tax benefits from net operating loss, capital loss and tax credit carryforwards.  A valuation allowance is to be provided for the net deferred tax assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

In evaluating the need to record or continue to reflect a valuation allowance, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) are considered.  In determining future sources of taxable income, we use management-approved budgets and projections of future operating results for an appropriate number of future periods, taking into consideration our history of operating results, taxable income and losses, etc.  This future taxable income is then used, along with all other items of positive and negative evidence, to determine the amount of valuation allowance that is needed, and whether any amount of such allowance should be reversed.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  Effective January 1, 2007, we adopted the GAAP guidance for accounting for uncertainty in income tax positions, which contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.  We reserve for our uncertain tax positions, and we adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate.  (See Note 10 – “Income Taxes.”)

(l)  Net Income Per Share

Basic net income per share is based upon the weighted average number of common shares outstanding during the period.  The weighted average number of common shares for the years ended December 31, 2009, 2008 and 2007 includes all the common shares that are presently outstanding and the common shares issued as common stock awards and exclude non-vested restricted stock.  (See Note 12 – “Capital Stock.”)

The diluted calculation of income per common share includes the dilutive effect of warrants, stock options and non-vested restricted stock, using the treasury stock method (see Note 12 – “Capital Stock). However, in periods of losses from continuing operations, diluted net income per common share is based upon the weighted average number of common shares outstanding.

(m)  Discontinued Operations and Assets Held for Sale

GAAP requires that long-lived assets to be disposed of be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations.  GAAP also requires the reporting of discontinued operations which include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Depreciation is discontinued once an asset is classified as held for sale.  (See Note 8 – “Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale.”)



 
F-13

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

(n)  Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2009 financial statement presentation.  Specifically, we have reclassified the results of operations of material divestitures subsequent to December 31, 2008 (see Note 8 – Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.  As discussed in “Recent Accounting Pronouncements” below, the adoption of the new guidance for accounting for noncontrolling interests did not have a material impact on our financial position, cash flows or results of operations.  We have, however, reclassified $1.5 million previously reported as minority interest payable on our December 31, 2008 consolidated balance sheet in our 2008 Form 10-K to other long-term liabilities on our consolidated balance sheet in this Form 10-K to conform to the 2009 financial statement presentation.

(o)  Interest Rate Swap Agreements

We manage interest expense using a mix of fixed and variable rate debt, and to help manage borrowing costs, we have entered into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. We use interest rate swaps to manage interest rate risk related to borrowings.  Our intent is to only enter such arrangements that qualify for hedge accounting treatment.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive (loss).  Ineffectiveness, if any, would be recognized in earnings.  (See Note 3 – “Loan Agreements.”)

(p)  Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (the “FASB”) issued revised guidance for accounting for noncontrolling interests.  The guidance requires that a noncontrolling interest in a subsidiary be reported as equity in the consolidated financial statements; that net income attributable to the parent and the noncontrolling interest be clearly identifiable; that changes in a parent’s ownership interest, while the parent retains its controlling financial interest in its subsidiary, be accounted for as equity transactions and that disclosures be expanded to clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners.  The guidance was effective beginning January 1, 2009, and did not have a material impact on our financial position, cash flows or results of operations.

In March 2008, the FASB issued rules that expanded quarterly disclosure requirements about an entity’s derivative instruments and hedging activities. The expanded disclosure requirements were required effective for fiscal years beginning January 1, 2009, and we have included the required disclosures in Note 4 – “Long-Term Debt and Capital Lease Obligations” to our consolidated financial statements included in this Annual Report on Form 10-K.

In May 2009, the FASB issued guidance on accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  Companies are required to evaluate events or transactions taking place after the balance sheet date for recognition in the financial statements prior to issuance.  These requirements became effective for our interim and annual reporting periods on April 1, 2009 and their adoption did not have a material impact on our financial position, cash flows or results of operations.

 
F-14

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

In June 2009, the FASB established the FASB Accounting Standards CodificationTM (“Codification”) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP.  Recognition of the Codification in financial statements is effective for interim and annual periods ending after September 15, 2009.  The impact in our financial statements was only to references for accounting guidance.

(3)  Loan Agreements

In April 2007, we issued $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), which mature on April 15, 2015.  We are entitled to redeem some or all of the Notes at any time on or after April 15, 2011 at certain pre-specified redemption prices.  In addition, prior to April 15, 2011, we may redeem some or all of the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, if any, plus a “make whole” premium.  We are entitled to redeem up to 35% of the aggregate principal amount of the Notes until April 15, 2010 with the net proceeds from certain equity offerings at certain pre-specified redemption prices.  The Notes accrue interest at an annual rate of 9-1/8% and pay interest semi-annually on April 15th and October 15th of each year through the April 15, 2015 maturity date.  The Notes are unconditionally guaranteed on a senior subordinated basis by certain of our subsidiaries but are not secured by any of our assets or those of our subsidiaries. (See Note 16 – “Summarized Consolidating Information.”)

In April 2007, we entered into a $485.0 million senior secured credit facility with a syndicate of financial institutions led by Credit Suisse as the administrative agent and collateral agent (the “Credit Agreement”) in connection with our acquisition of Harborside (see Note 6 – “Acquisitions”).  The Credit Agreement provides for $365.0 million in term loans (of which $329.1 million was outstanding as of December 31, 2009), a $50.0 million revolving credit facility (undrawn at December 31, 2009) and a $70.0 million letter of credit facility ($62.8 million outstanding at December 31, 2009).  The final maturity date of the term loans is April 19, 2014, and the revolving credit facility and letter of credit facility terminate on April 19, 2013.  Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test, a total leverage covenant and a senior leverage covenant. We were in compliance with these covenants as of December 31, 2009.  The Credit Agreement contains customary events of default, such as our failure to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting, among other things, incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.  The Credit Agreement is collateralized by our assets and the assets of most of our subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of 0.25% of the aggregate principal amount of the term loans under the term loan facility outstanding as of January 15, 2008, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  The loans under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans is 1.0% for alternative base rate loans and 2.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 1.0% for alternative base rate revolving loans and up to 2.0% for LIBOR rate revolving loans based on our total leverage ratio.  Each year, commencing in 2009, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement.  Pursuant to this requirement, we paid $8.5 million during 2009 and we estimate that we will pay $18.9 million in 2010.

 
F-15

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

    We manage interest expense using a mix of fixed and variable rate debt, and to help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. We use interest rate swaps to manage interest rate risk related to borrowings.  Our intent is to only enter such arrangements that qualify for hedge accounting treatment in accordance with GAAP.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive loss.  Ineffectiveness, if any, would be recognized in earnings.

We entered into interest rate swap agreements in July 2008 and July 2007 for interest rate risk management purposes.  The interest rate swap agreements effectively modify our exposure to interest rate risk by converting a portion of our floating rate debt to a fixed rate.  These agreements involve the receipt of floating rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The July 2008 agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.  The July 2007 agreement is based on a notional amount of $100.0 million and has a term of three years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 5.388%.

The interest rate swap agreements qualify for hedge accounting treatment and have been designated as cash flow hedges.  Hedge effectiveness testing for the years ended December 31, 2009, 2008 and 2007 indicates that the swaps are highly effective hedges and as such, the derivative mark-to-market adjustment increased our other comprehensive loss by $3.0 million, $4.6 million and $2.4 million, respectively, net of related tax benefit. We do not anticipate our 2009 other comprehensive loss to be reclassified into earnings within the next year.  Also, since the swaps are highly effective hedging arrangements, there is no amount related to hedging ineffectiveness to expense.

The fair values of our interest rate swap agreements as presented in the consolidated balance sheets at December 31 are as follows (in thousands):

   
Liability Derivatives
   
2009
 
2008
   
Balance Sheet
       
Balance Sheet
       
   
Location
   
Fair Value
 
Location
   
Fair Value
 
Derivatives designated as
                     
hedging instruments:
                     
Interest rate swap
 
Other Long-Term
       
Other Long-Term
       
agreements
 
Liabilities
 
$
5,048
 
Liabilities
 
$
7,644
 


 
F-16

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the year ended December 31 is as follows (in thousands):

         
Gain Reclassified from
 
   
Amount of Income/(Loss)
   
Accumulated Other Comprehensive
 
   
In Other Comprehensive
Income/(Loss)
   
Loss to Net Income (ineffective
portion)
 
   
2009
   
2008
   
2009
   
2008
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate swap agreements
$
1,557
 
$
(2,183
)
$
-
 
$
-
 

(4)  Long-Term Debt and Capital Lease Obligations

Our long-term debt and capital lease obligations consisted of the following as of December 31 (in thousands):

   
2009
   
2008
 
Revolving loans
$
-
 
$
-
 
Mortgage notes payable due at various dates through 2037, interest at
           
rates from 3.3% to 11.6%, collateralized by the carrying values of
           
various centers totaling approximately $200,000 (1)
 
170,608
   
178,142
 
Term loans
 
329,107
   
346,359
 
Senior subordinated notes
 
200,000
   
200,000
 
Capital leases
 
833
   
1,340
 
Total long-term obligations
 
700,548
   
725,841
 
Less amounts due within one year
 
(46,416
)
 
(17,865
)
Long-term obligations, net of current portion
$
654,132
 
$
707,976
 

(1)
The mortgage notes payable balance includes fair value premiums of $0.7 million related to acquisitions.


The scheduled or expected maturities of long-term obligations, excluding premiums, as of December 31, 2009 were as follows (in thousands):

2010
$
46,416
2011
 
42,002
2012
 
6,629
2013
 
7,947
2014
 
328,760
Thereafter
 
268,117
 
$
699,871


 
F-17

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

(5)  Property and Equipment

Property and equipment consisted of the following as of December 31 (in thousands):

   
2009
   
2008
 
Land
$
78,848
 
$
75,383
 
Buildings and improvements
 
464,136
   
451,001
 
Equipment
 
128,939
   
106,410
 
Leasehold improvements
 
83,751
   
69,302
 
Construction in process(1)
 
20,862
   
15,964
 
Total
 
776,536
   
718,060
 
Less accumulated depreciation and amortization
 
(153,854
)
 
(114,415
)
Property and equipment, net
$
622,682
 
$
603,645
 

(1)
Capitalized interest associated with construction in process at December 31, 2009 is $0.4 million.

(6)  Acquisitions

Hospice Companies

On October 1, 2009 we acquired a hospice company that provides services to patients in Maine, Massachusetts and New Hampshire, for $16.1 million in cash, excluding transaction costs.  The purchase price excludes $0.5 million of transaction costs, primarily investment banker success fees, that were expensed in the accompanying income statement in accordance with GAAP.  Pro forma information related to this acquisition is not provided because the impact on our consolidated financial position and results of operations is not significant.  The purchase price was funded through cash on-hand at the time of the acquisition and allocated to the following fair values of assets acquired and liabilities assumed at the date of acquisition (in thousands):

Net working capital
632
 
Property and equipment
 
264
 
Licensing intangible asset
 
6,271
 
Goodwill(1)
 
11,276
 
Other long-term assets
 
24
 
Total assets acquired
 
18,467
 
       
Liabilities assumed
 
(2,322
)
       
Net assets acquired
16,145
 

                       
                                  (1)    Tax-deductible goodwill is $3.6 million.

 
F-18

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


    On September 5, 2008, we acquired a company that conducts hospice operations in the State of New Jersey.  Its results of operations have been included in the consolidated financial statements since September 1, 2008.  Pro forma information related to this acquisition is not provided because the impact on our consolidated financial position and results of operations is not significant.  The $7.7 million purchase price was funded through cash on-hand at the time of acquisition and allocated to the following fair values of assets acquired and liabilities assumed at the date of acquisition (in thousands):

Net working capital
695
 
Property and equipment
 
7
 
Identifiable intangible assets
 
3,317
 
Goodwill
 
3,657
 
Other long-term assets
 
96
 
Total assets acquired
 
7,772
 
       
Debt assumed
 
(92
)
       
Net assets acquired
7,680
 

The identifiable intangible asset was a regulatory license from the state in which the hospice company operates. Its value was based upon incremental cash flows of the hospice company with licensing versus cash flows without the licensing in place. Actual cost data to acquire licensing was also a factor of the fair value determination and based on estimates from our experience in other states’ licensing approval processes.

We paid a premium (i.e., goodwill) over the fair value of the net tangible and identified intangible assets acquired because we believed the acquisition of the hospice company would create the following benefits:  (1) increase the scale of our operations, thus leveraging our corporate and regional infrastructure and (2) expand our hospice operations into a state in which we did not previously have a presence due to limitations with regulatory licensing.

Harborside

On April 19, 2007, we acquired Harborside, a privately-held healthcare company that operated 73 skilled nursing centers, one assisted living center and one independent living center with approximately 9,000 licensed beds in ten states, by purchasing all of the outstanding Harborside stock for $349.4 million.  In addition to the purchase price paid for Harborside, the former shareholders of Harborside are entitled to a distribution of cash in an amount equal to the future tax benefits realized by us from the deductibility of specified employee compensation and unamortized debt costs related to Harborside and which is included in other long-term liabilities. In connection with the acquisition of Harborside, we entered into the Credit Agreement. The proceeds from the Credit Agreement, plus cash on hand and the net proceeds from our issuance of the Notes, were used to purchase all of the outstanding stock of Harborside, refinance certain of the Harborside debt and replace our prior revolving credit facility. Harborside’s results of operations have been included in the consolidated financial statements since April 1, 2007.




 
F-19

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


The total purchase price of the Harborside acquisition is as follows (in thousands):

Cash consideration paid
$
349,401
Refinanced debt obligations, net of associated transaction costs
 
219,270
Estimated direct transaction costs
 
17,238
 
$
585,909
 
The purchase price was funded with the following (in thousands):

Term loan facility, net of fees and expenses
$
298,223
Senior subordinated notes, net of fees and expenses
 
194,257
Revolving credit facility
 
15,000
Cash on hand
 
78,429
 
$
585,909

In addition to the above, we exercised real estate purchase options acquired with Harborside for $54.1 million plus assumption of $29.8 million of mortgages payable and a $7.5 million reduction of notes receivable.

Under the purchase method of accounting, the total purchase price, as shown in the table above plus the exercise of real estate purchase options, was allocated to Harborside’s net tangible and intangible assets based upon their estimated fair values as of April 1, 2007. The excess of the purchase price over the estimated fair value of the net tangible and intangible assets is recorded as goodwill.

We paid a premium (i.e., goodwill) over the fair value of the net tangible and identified intangible assets acquired because we believed the acquisition of Harborside would create the following benefits:  (1) increase the scale of our operations, thus leveraging our corporate and regional infrastructure; (2) improve our payor mix with increased revenue derived from Medicare; (3) increase our services to high-acuity patients for whom we are reimbursed at higher rates; (4) increase our percentage of owned skilled nursing centers; and (5) increase our presence in four states and expand into six contiguous states.

The application of the accounting for business combinations requires that the total purchase price be allocated to the fair value of assets acquired and liabilities assumed based on their fair values at the effective acquisition date, with amounts exceeding fair values being recorded as goodwill.  The allocation process requires an analysis of acquired fixed assets, contracts, contractual commitments, legal contingencies and brand value to identify and record the fair value of assets acquired and liabilities assumed.  In valuing acquired assets and liabilities assumed, fair values were based on, but not limited to:  future expected discounted cash flows for trade names and customer relationships; current replacement cost for similar capacity and obsolescence for certain fixed assets; comparable market rates for contractual obligations and certain investments, real estate, and liabilities; expected settlement amounts for litigation and contingencies, including self-insurance reserves; and appropriate discount rates and growth rates.  Other than for a contingent liability related to a litigation matter (see Note 13 – “Other Events”) and any payments related to third-party reimbursements as a result of the acquisition, the valuation of Harborside’s assets and liabilities, including intangibles and insurance reserves for general and professional and workers’ compensation liabilities, was completed during the fourth quarter of 2007.

Property and equipment values were based primarily on the cost and market approaches.  The land value was based upon comparisons to sales of similar properties.  The building and improvements were valued at replacement
 
F-20

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
costs estimated utilizing the Marshall Valuation Service cost guide.  Equipment values were determined based on historical costs adjusted to reflect costs as of the acquisition date.

Values for favorable or unfavorable lease intangibles were based on stabilized net income for each leased location based upon historical and budgeted income and expense trends for each property.  Market rent was estimated for each location using a coverage ratio technique and then deducted from the stabilized net income to derive a market net income after lease payments. Then a direct capitalization approach was utilized for each location based on its risk profile and market data. The capitalization rates generally ranged from 7% to 11%.  These rates are greater than the rates utilized for owned locations above due to differing risk profiles and lessors’ expectation of a premium over owned location returns.  The net present value of the above or below market lease in place was added to adjust for the favorable or unfavorable value effect of the lease.

The intangible value for Certificates of Need (“CONs”) in certain states was based upon incremental cash flows of Harborside with CONs versus cash flows without the CONs in place. Actual cost data to acquire CONs was also a factor and based on estimates from market sources for each of those states.

The intangible value for tradenames was based on the relief-from-royalty method.  This method is a discounted cash flow model based on an estimated royalty rate, which is then applied to revenues expected to be generated from the services sold using the tradename.  The royalty rate was determined based on many quantitative and qualitative factors including industry analysis, market share and barriers to entry.  Market evidence of royalty rates was also considered.

The fair values of assets acquired and liabilities assumed at the date of acquisition were as follows (in thousands):

Net working capital
$
33,109
Property and equipment
 
271,258
Identifiable intangible assets
 
24,258
Deferred tax assets
 
27,792
Goodwill
 
273,316
Other long-term assets
 
14,440
Total assets acquired
 
644,173
     
Debt
 
22,858
Other long-term liabilities
 
35,406
Total liabilities assumed
 
58,264
     
Net assets acquired
$
585,909


We identified $24.3 million in intangible assets in connection with the Harborside acquisition: $11.0 million related to CONs, $13.0 million related to tradenames and the remaining $0.3 million related to deferred financing costs. The $273.3 million in goodwill has been assigned to the Inpatient Services segment and none of the goodwill is expected to be deductible for tax purposes.

 
F-21

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

        The CONs are an indefinite life intangible asset.  The tradenames are a finite life intangible with a useful life of eight years.  The deferred financing costs will be amortized into interest expense over the remaining life of the debt to which the costs relate.

As a result of the exercise of Harborside’s real estate purchase options, property and equipment increased by $76.3 million, resulting in a $15.1 million increase to goodwill, which adjustment is reflected in the fair value table above.

The following unaudited summarized pro forma results of operations for the year ended December 31, 2007 assume that the Harborside acquisition occurred at the beginning of the period.  These unaudited pro forma results are not necessarily indicative of the actual results of operations that would have been achieved, nor are they necessarily indicative of future results of operations (in thousands, except per share data):


     For the Year Ended  
   
December 31, 2007
 
   
(pro forma)
 
       
Revenues
$
1,718,656
 
Costs and expenses:
     
Operating costs
 
1,511,685
 
Center rent expense
 
77,366
 
Depreciation and amortization
 
35,918
 
Interest, net
 
48,940
 
Non-operating costs
 
3,196
 
Total costs and expenses
 
1,677,105
 
       
Income before income taxes and
     
discontinued operations
 
41,551
 
Income tax benefit
 
(11,734
)
Income from continuing operations
 
53,285
 
Income from discontinued
     
operations, net
 
2,359
 
Net income
$
55,644
 
       
Earnings per share:
     
Basic:
     
Income from continuing operations
$
1.26
 
Net income
$
1.31
 
       
Diluted:
     
Income from continuing operations
$
1.23
 
Net income
$
1.28
 

 
F-22

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


(7)  Goodwill, Intangible Assets and Long-Lived Assets

(a)  Goodwill

The following table provides information regarding our goodwill, which is included in the accompanying consolidated balance sheets at December 31 (in thousands):

       
Rehabilitation
 
Medical
     
   
Inpatient
 
Therapy
 
Staffing
     
   
Services
 
Services
 
Services
 
Consolidated
 
                   
Balance as of January 1, 2008
$
319,744
$
-
$
4,533
$
324,277
 
                   
Goodwill acquired
 
3,657
 
75
 
-
 
3,732
 
Purchase price adjustments for prior
                 
year acquisition
 
(1,201
)
-
 
-
 
(1,201
)
                   
Balance as of December 31, 2008
$
322,200
$
75
$
4,533
$
326,808
 
                   
Goodwill acquired
 
11,276
 
-
 
-
 
11,276
 
Purchase price adjustments for prior
                 
year acquisition
 
212
 
-
 
-
 
212
 
                   
Balance as of December 31, 2009
$
333,688
$
75
$
4,533
$
338,296
 


 
F-23

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

(b)  Intangible Assets

The following table provides information regarding our intangible assets, which are included in the accompanying consolidated balance sheets at December 31 (in thousands):

   
Gross
           
   
Carrying
   
Accumulated
   
Net
   
Amount
   
Amortization
   
Total
Finite-lived Intangibles:
               
Favorable lease intangibles:
               
2009
$
10,311
 
$
3,140
 
$
7,171
2008
 
11,653
   
2,995
   
8,658
Deferred financing costs:
               
2009
$
24,548
 
$
9,306
 
$
15,242
2008
 
24,263
   
5,902
   
18,361
Management and customer contracts:
               
2009
$
3,334
 
$
2,024
 
$
1,310
2008
 
3,334
   
1,501
   
1,833
Tradenames:
               
2009
$
13,121
 
$
4,535
 
$
8,586
2008
 
13,119
   
2,894
   
10,225
                 
Indefinite-lived Intangibles:
               
Certificates of need/licenses:
               
2009
$
21,433
 
$
-
 
$
21,433
2008
 
15,195
   
-
   
15,195
Other intangible assets:
               
2009
$
189
 
$
-
 
$
189
2008
 
116
   
-
   
116
                 
Total Intangible Assets:
               
2009
$
72,936
 
$
19,005
 
$
53,931
2008
 
67,680
   
13,292
   
54,388
                 
Unfavorable Lease Obligations:
               
2009
$
29,113
 
$
16,450
 
$
12,663
2008
 
29,113
   
13,599
   
15,514

A net credit to rent expense was a result of the amortization of favorable and unfavorable lease intangibles, recognized as adjustments in rent expense in connection with fair market valuations performed on our center lease agreements associated with fresh-start accounting and our acquisitions.  Amortization of deferred financing costs is included in interest expense.

 
F-24

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

The net amount recorded to amortization was as follows for the years ended December 31 (in thousands):

   
2009
   
2008
   
2007
 
                   
Amortization expense
$
7,367
 
$
7,246
 
$
6,241
 
Amortization of unfavorable
                 
and favorable lease intangibles, net
                 
included in rent expense
 
(1,831
)
 
(1,714
)
 
(1,318
)
Amortization of deferred financing
                 
costs, included in interest expense
 
(3,333
)
 
(3,363
)
 
(3,215
)
 
$
2,203
 
$
2,169
 
$
1,708
 

Total estimated amortization expense (credit) for our intangible assets for the next five years is as follows (in thousands):
 
   
Expense
   
Credit
   
Net
 
                   
2010
$
6,191
 
$
(2,848
)
$
3,343
 
2011
 
6,014
   
(2,972
)
 
3,042
 
2012
 
5,816
   
(2,703
)
 
3,113
 
2013
 
5,299
   
(2,172
)
 
3,127
 
2014
 
3,959
   
(1,171
)
 
2,788
 

The weighted-average amortization period for lease intangibles is approximately six years at December 31, 2009.

(c)  Impairment of Intangible Assets

Goodwill

We perform our annual goodwill impairment analysis for our reporting units during the fourth quarter of each year.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment and are reviewed at the division level.  For our Rehabilitation Therapy Services and Medical Staffing Services segments, the reporting unit for our annual goodwill impairment analysis was determined to be at the segment level.  For our Inpatient Services segment, the reporting unit for our annual goodwill impairment analysis was determined to be at one level below our segment level.  We determined potential impairment by comparing the net assets of each reporting unit to their respective fair values. We determined the estimated fair value of each reporting unit using a discounted cash flow analysis and other appropriate valuation methodologies. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value. Based on the analysis performed, we determined there was no goodwill impairment for the years ended December 31, 2009, 2008, or 2007.

During 2008, we determined that the valuation allowance for net deferred tax assets related to our recent acquisitions should be reduced by $1.2 million, which decreased goodwill.

 
F-25

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

Indefinite Lived Intangibles

Our indefinite lived intangibles consist primarily of values assigned to CONs obtained through our acquisition of Harborside.

We evaluate the recoverability of our indefinite lived intangibles, which are principally CONs, by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place. We determined there was no impairment of our indefinite lived intangibles for the years ended December 31, 2009, 2008 or 2007.

During 2007, we determined that a portion of the income tax payable balance established in fresh-start could be offset by net operating loss (“NOL”) carrybacks.  We also determined that a portion of the pre-emergence net deferred tax assets will more likely than not be realized, and a reduction in the valuation allowance established in fresh-start accounting has been recorded.  Accordingly, we have reduced remaining intangible assets recorded in fresh-start accounting by $0.7 million, which consisted primarily of favorable lease intangibles.  (See Note 10 – “Income Taxes.”)

Finite Lived Intangibles

Our finite lived intangibles include tradenames (principally recognized with the Harborside acquisition), favorable lease intangibles, deferred financing costs, customer contracts and various licenses.

We evaluate the recoverability of our finite lived intangibles if an impairment indicator is present.  As there were no such indicators, we determined there was no impairment of our finite lived intangibles for the years ended December 31, 2009, 2008 or 2007.

(d)  Impairment of Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts. In estimating the undiscounted cash flows for our impairment assessment, we primarily use our internally prepared budgets and forecast information including adjustments for the following items: Medicare and Medicaid funding; overhead costs; capital expenditures; and patient care liability costs.  We assess the need for an impairment write-down when such indicators of impairment are present.  We determined there was no impairment of long-lived assets used in continuing operations for the years ended December 31, 2009, 2008 or 2007.

(e)  Long Lived Assets to be Disposed Of

GAAP requires that long-lived assets to be disposed of be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations.  GAAP defines the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Depreciation is discontinued once an asset is classified as held for sale.



 
F-26

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


(8)  Sale of Assets, Discontinued Operations and Assets and Liabilities Held for Sale

(a)  Gain (Loss) on Sale of Assets, net of related taxes

We reported a $0.3 million net loss, $3.0 million net loss, and $0.2 million net loss for the years ended December 31, 2009, 2008, and 2007, respectively, primarily related to the disposals of assets associated with discontinued operations.

(b)  Discontinued Operations

In accordance with GAAP, the results of operations of assets to be disposed of, disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

Inpatient Services: During 2009, we reclassified one assisted living center into discontinued operations as we elected to not renew that center’s lease and allowed operations to transfer to another operator.

During 2008, we reclassified six skilled nursing centers into discontinued operations because they were divested, sold or qualified as assets held for sale. In the second quarter of 2008, we sold two hospitals that were classified as held for sale since 2007 for $10.1 million and recorded a net loss of $2.7 million. In the third quarter of 2008, we exercised an option to purchase a skilled nursing center in Indiana that was classified as held for sale since 2007 and simultaneously sold the asset for a net $0.4 million and recorded a net loss of $0.2 million.  In the third quarter of 2008, we also exercised options to purchase two skilled nursing centers in Oklahoma that were classified as held for sale and sold three skilled nursing centers in Oklahoma for $7.6 million and recorded a net loss of $0.9 million, and transferred operations of a leased skilled nursing center in Tennessee to an outside party. In the fourth quarter of 2008, we transferred operations of a leased skilled nursing center in Utah to an outside party.

During 2007, we reclassified two hospitals and one skilled nursing center into discontinued operations because they were divested, sold or qualified as assets held for sale. In the first quarter of 2007, we sold a skilled nursing center that was classified as held for sale since 2006 for $4.9 million and recorded a net loss of $0.5 million.

The two hospitals moved to discontinued operations in 2007 are part of a larger master lease agreement.  In 2008, the lessor sold the two hospitals to a third party and reduced the master lease’s rent charged to us.  However, the rent reduction was only a portion of the rent charged to us and we will continue to be responsible for the remainder.  Therefore, in accordance with the accounting guidance for costs associated with exit activities, we accrued a liability for continuing costs incurred without economic benefit upon disposal of the operation (i.e. the “cease-use” date).  The liability at December 31, 2008 was $6.0 million, $1.0 million of which is in current liabilities in the accompanying consolidated balance sheet.

Home Health Services: In October 2007, we sold our 75% interest in a home health services subsidiary, which we acquired as part of the Harborside acquisition, for $1.6 million, and we recorded a net loss of $0.1 million.

Laboratory and Radiology Services: In the second quarter of 2007, we sold our remaining laboratory and radiology business for $3.2 million, and we recorded a net gain of $1.6 million.

 
F-27

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


Other: We also sold a subsidiary that provided adolescent rehabilitation and special education services during the fourth quarter of 2008.

(c)  Assets and Liabilities Held for Sale

We had no assets held for sale as of December 31, 2009.  As of December 31, 2008, assets held for sale consisted of (i) a skilled nursing center with a net carrying amount of $2.8 million, primarily consisting of property and equipment and, (ii) an undeveloped parcel of land valued at $0.9 million, which was classified in our Corporate segment in our consolidated financial statements.

Other discontinued operations are principally comprised of the operations of a regional provider of adolescent rehabilitation and special education services.

A summary of the discontinued operations for the years ended December 31 is as follows (in thousands):

   
2009
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
521
 
$
-
 
$
521
 
                   
Loss from discontinued operations, net (1)
$
(3,442
)
$
(34
)
$
(3,476
)
Loss on disposal of discontinued operations, net (2)
 
(317
)
 
(16
)
 
(333
)
Loss from discontinued operations, net
$
(3,759
)
$
(50
)
$
(3,809
)

(1)  Net of related tax benefit of $2,416
(2)  Net of related tax benefit of $231

   
2008
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
42,288
 
$
17,888
 
$
60,176
 
                   
Loss from discontinued operations, net (1)
$
(1,423
)
$
(213
)
$
(1,636
)
Loss on disposal of discontinued operations, net (2)
 
(2,246
)
 
(755
)
 
(3,001
)
Loss from discontinued operations, net
$
(3,669
)
$
(968
)
$
(4,637
)

(1)  Net of related tax benefit of $1,125
(2)  Net of related tax benefit of $1,949

 
F-28

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

   
2007
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
76,634
 
$
24,474
 
$
101,108
 
                   
Income (loss) from discontinued operations, net (1)
$
5,796
 
$
(2,179
)
$
3,617
 
Income (loss) on disposal of discontinued operations, net (2)
 
(1,588
)
 
1,388
   
(200
)
Loss from discontinued operations, net
$
4,208
 
$
(791
)
$
3,417
 

(1)  Net of related tax benefit of $653
(2)  Net of related tax expense of $0

(9)  Commitments and Contingencies

(a)  Lease Commitments

We lease real estate and equipment under cancelable and noncancelable agreements. Most of our operating leases have original terms from seven to twelve years and contain at least one renewal option (which could extend the terms of the leases by five to ten years), escalation clauses (primarily related to inflation) and provisions for payments by us of real estate taxes, insurance and maintenance costs. Leases with a fixed escalation are accounted for on a straight-line basis. Future minimum operating lease payments as of December 31, 2009 under real estate leases and non-cancelable equipment leases are as follows (in thousands):
 
2010
$
89,141
 
2011
 
83,700
 
2012
 
80,446
 
2013
 
76,955
 
2014
 
44,523
 
Thereafter
 
125,623
 
Total minimum lease payments
$
500,388
 

Center rent expense for continuing operations totaled $73.1 million, $73.6 million, and $70.4 million for the years ended December 31, 2009, 2008, and 2007, respectively. Center rent expense for discontinued operations for the years ended December 31, 2009, 2008 and 2007 was $0.2 million, $3.6 million, and $6.7 million, respectively.

(b)  Purchase Commitments

We have an agreement establishing Medline Industries, Inc. (“Medline”) as the primary medical supply vendor through December 31, 2014 for all of the healthcare centers that we operate.  The agreement provides that the long-term care division of the Inpatient Services segment shall purchase at least 90% of its medical supply products from Medline.

We have an agreement establishing SYSCO Corporation (“SYSCO”) as our primary foodservice supply vendor through March 31, 2010 for all of our healthcare centers.  The agreement provides that the long-term care division of the Inpatient Services segment shall purchase at least 80% of its foodservice supply products from SYSCO.

 
F-29

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


    We have an agreement establishing Omnicare Pharmacy Services as the primary pharmacy services vendor through December 31, 2010 for all of the healthcare centers that we currently operate and acquire during the term of the agreement.

(c)  Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs.  Insurance reserves represent estimates of future claims payments. This liability includes an estimate of the development of reported losses and losses incurred but not reported. Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure. Paid loss methods focus on development of claims actually paid to date. Expected loss methods are based upon an anticipated loss per unit of measure. The Bornhuetter-Ferguson method is a combination of loss development methods and expected loss methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls. We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses. The TPAs are under the oversight of our in-house risk management and legal functions. These functions ensure that the claims are properly administered so that the historical data is reliable for estimation purposes. Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims. In cases where our historical data are not statistically credible, stable, or mature, we supplement our experience with nursing home industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have. Management’s judgment based upon each method’s inherent limitations is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which includes the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported.   These results are compared by accident year and an estimated unpaid loss and allocated loss adjustment expense are determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

During 2009, we determined that the previous estimates for workers’ compensation reserves for accident years

 
F-30

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
prior to 2009 were understated based on currently available information, by $2.0 million or approximately 2.9%.   Of that amount, $1.7 million related to continuing operations and $0.3 million related to discontinued operations.  While certain of the claims settled for less than the case reserves, a number also settled for greater than the case reserves.  There were no large or unusual settlements during the period.  As of December 31, 2009, the discounting of the policy periods resulted in a reduction to our reserves of $13.0 million.

We also determined during 2009 that the previous estimates for general and professional liabilities reserves for accident years prior to 2009 were understated, based on currently available information, by $7.4 million or approximately 8.5%.  Of that amount, $6.5 million related to continuing operations and $0.9 million related to discontinued operations.  Although there were no large or unusual settlements or significant new claims during the period, we experienced in 2009 a higher amount of claims than anticipated. Professional liability claims have a reporting tail that exceeds one year.  A significant component of our reserves is estimates for incidents that have been incurred but not reported. The reduction in prior period’s reserves is driven in part by a decrease in our estimate of incurred but not reported claims.

Activity in our insurance reserves as of and for the years ended December 31, 2009, 2008 and 2007 is as follows (in thousands):
 
   
Professional
Liability
   
Workers’
Compensation
   
Total
 
                   
Balance as of January 1, 2007
$
75,078
 
$
51,521
 
$
126,599
 
                   
Current year provision, continuing operations
 
28,413
   
24,709
   
53,122
 
Current year provision, discontinued operations
 
1,611
   
1,365
   
2,976
 
Prior year reserve adjustments, continuing operations
 
(6,605
)
 
(1,994
)
 
(8,599
)
Prior year reserve adjustments, discontinued operations
 
(2,395
)
 
(1,506
)
 
(3,901
)
Claims paid, continuing operations
 
(12,936
)
 
(15,600
)
 
(28,536
)
Claims paid, discontinued operations
 
(8,547
)
 
(4,850
)
 
(13,397
)
Amounts paid for administrative services and other
 
(6,124
)
 
(6,558
)
 
(12,682
)
Reserve established through purchase accounting
 
17,796
   
14,352
   
32,148
 
                   
Balance as of December 31, 2007
$
86,291
 
$
61,439
 
$
147,730
 
                   
Current year provision, continuing operations
 
29,454
   
29,339
   
58,793
 
Current year provision, discontinued operations
 
790
   
848
   
1,638
 
Prior year reserve adjustments, continuing operations
 
(1,700
)
 
2,600
   
900
 
Prior year reserve adjustments, discontinued operations
 
(20
)
 
400
   
380
 
Claims paid, continuing operations
 
(20,343
)
 
(18,499
)
 
(38,842
)
Claims paid, discontinued operations
 
(3,755
)
 
(3,674
)
 
(7,429
)
Amounts paid for administrative services and other
 
(3,435
)
 
(5,865
)
 
(9,300
)
                   
Balance as of December 31, 2008
$
87,282
 
$
66,588
 
$
153,870
 
                   
Current year provision, continuing operations
 
27,152
   
28,380
   
55,532
 
Current year provision, discontinued operations
 
1,512
   
632
   
2,144
 
Prior year reserve adjustments, continuing operations
 
6,500
   
1,720
   
8,220
 
Prior year reserve adjustments, discontinued operations
 
890
   
230
   
1,120
 
Claims paid, continuing operations
 
(20,394
)
 
(20,165
)
 
(40,559
)
Claims paid, discontinued operations
 
(3,699
)
 
(2,530
)
 
(6,229
)
Amounts paid for administrative services and other
 
(4,313
)
 
(7,349
)
 
(11,662
)
                   
Balance as of December 31, 2009
$
94,930
 
$
67,506
 
$
162,436
 


 
F-31

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

A summary of the assets and liabilities related to insurance risks at December 31 is as indicated below (in thousands):

   
2009
|
 
2008
   
Professional
   
Workers'
     
|
 
Professional
   
Workers'
     
   
Liability
   
Compensation
   
Total
|
 
Liability
   
Compensation
   
Total
Assets (1):
               
|
               
Restricted cash
               
|
               
Current
$
3,406
 
$
12,013
 
$
15,419
|
$
3,439
 
$
22,131
 
$
25,570
Non-current
 
-
   
-
   
-
|
 
-
   
-
   
-
Total
$
3,406
 
$
12,013
 
$
15,419
|
$
3,439
 
$
22,131
 
$
25,570
                 
|
               
Liabilities (2)(3):
               
|
               
Self-insurance
               
|
               
liabilities
               
|
               
Current
$
20,369
 
$
20,119
 
$
40,488
|
$
20,739
 
$
18,574
 
$
39,313
Non-current
 
74,561
   
47,387
   
121,948
|
 
66,543
   
48,014
   
114,557
Total
$
94,930
 
$
67,506
 
$
162,436
|
$
87,282
 
$
66,588
 
$
153,870

(1)
Total restricted cash excluded $11,932 and $12,409 at December 31, 2009 and 2008, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD-insured buildings.
   
(2)
Total self-insurance liabilities excluded $5,173 and $5,980 at December 31, 2009 and 2008, respectively, related to our health insurance liabilities.
   
(3)
Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $250 and $53,191 for general and professional liability insurance and workers' compensation, respectively, as of December 31, 2009 and $750 and $48,172 for general and professional liability insurance and workers' compensation, respectively, as of December 31, 2008.

(d)  Construction Commitments

As of December 31, 2009, we had construction commitments under various contracts of approximately $1.9 million. These items consisted primarily of contractual commitments to improve existing centers.

(e)  Labor Relations

As of December 31, 2009, SunBridge operated 35 centers with union employees. Approximately 2,856 of our employees (9.5% of all of our employees) who worked in healthcare centers in Alabama, California, Connecticut, Georgia, Massachusetts, Maryland, Montana, New Jersey, Ohio, Rhode Island, Washington and West Virginia were covered by collective bargaining contracts. Collective bargaining agreements covering approximately 1,429 of these employees (4.8% of all our employees) either are currently in renegotiations or will shortly be in renegotiations due to the expiration of the collective bargaining agreements.


 
F-32

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

(10)  Income Taxes

The provision for income taxes was based upon management's estimate of taxable income or loss for each respective accounting period.  We recognized an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.  We also recognized as deferred tax assets the future tax benefits from net operating loss, capital loss, and tax credit carryforwards.  A valuation allowance was provided for certain deferred tax assets, since it is more likely than not that a portion of the net deferred tax assets will not be realized.

Income tax expense/(benefit) on income attributable to continuing operations consisted of the following for the years ended December 31 (in thousands):

   
2009
   
2008
   
2007
 
Current:
                 
Federal
$
-
 
$
941
 
$
177
 
State
 
2,300
   
1,417
   
1,026
 
   
2,300
   
2,358
   
1,203
 
Deferred:
                 
Federal
 
24,829
   
(40,150
)
 
(9,788
)
State
 
2,487
   
(9,556
)
 
(2,329
)
   
27,316
   
(49,706
)
 
(12,117
)
  Total
$
29,616
 
$
(47,348
)
$
(10,914
)

Actual tax expense/(benefit) differed from the expected tax expense , which was computed by applying the U.S. Federal corporate income tax rate of 35% to our profit before income taxes for the years ended December 31 as follows (in thousands):

   
2009
   
2008
   
2007
 
                   
                   
Computed expected tax expense
$
25,234
 
$
23,302
 
$
15,113
 
Adjustments in income taxes resulting from:
                 
Change in valuation allowance
 
                         -
   
(70,465
)
 
(28,834
)
State income tax expense, net of Federal
                 
income tax effect
 
3,814
   
3,568
   
2,357
 
Reduction in unrecognized tax benefits
 
(56)
   
(2,202
)
 
-
 
Refunds from net operating loss carrybacks
 
-
   
-
   
(322
)
Tax credits
 
(1,339)
   
(1,114
)
 
(320
)
Nondeductible compensation
 
53
   
137
   
197
 
Other nondeductible expenses
 
728
   
964
   
1,018
 
Other
 
1,182
   
(1,538
)
 
(123
)
Total
$
29,616
 
$
(47,348
)
$
(10,914
)


 
F-33

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


Deferred tax assets (liabilities) at December 31 consisted of the following (in thousands):

   
2009
   
2008
 
             
Deferred tax assets:
           
Accounts and notes receivable
$
22,722
 
$
18,977
 
Accrued liabilities
 
82,018
   
79,136
 
Intangible assets
 
19,555
   
26,873
 
Write-down of assets held for sale
 
1,016
   
1,016
 
Partnership investments
 
4,274
   
3,657
 
Minimum tax and other credit carryforwards
 
8,794
   
7,720
 
State net operating loss carryforwards
 
25,035
   
33,918
 
Federal net operating loss carryforwards
 
79,122
   
85,060
 
Other
 
37
   
182
 
   
242,573
   
256,539
 
             
Less valuation allowance
 
(27,572)
   
(34,321
)
Total deferred tax assets
 
215,001
   
222,218
 
             
Deferred tax liabilities:
           
Property and equipment
 
(37,587)
   
(30,150
)
Deferred tax assets, net
$
177,414
 
$
192,068
 

The $6.7 million decrease in the valuation allowance resulted from the expiration of certain state net operating loss (“NOL”) carryforwards, which were fully reserved.  As such, the deferred tax asset for these expired state net operating losses and the corresponding valuation allowance were reduced accordingly.  In evaluating the need to maintain a valuation allowance on our net deferred tax assets, all items of positive evidence (e.g., future sources of taxable income and tax planning strategies) and negative evidence (e.g., history of taxable losses) were considered.  This assessment required significant judgment.  Based upon our estimates of future taxable income, we believe that we will more likely than not realize a significant portion of our net deferred tax assets.  If any future reversals of the remaining valuation allowance of $27.6 million as of December 31, 2009, should occur, then such reversal would reduce the provision for income taxes.

Internal Revenue Code Section 382 imposes a limitation on the use of a company’s NOL carryforwards and other losses when the company has an ownership change.  In general, an ownership change occurs when shareholders owning 5% or more of a “loss corporation” (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any 3-year testing period beginning on the first day following the change date for an earlier ownership change.  The annual base Section 382 limitation is calculated by multiplying the loss corporation's value at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the IRS in the month of the ownership change or the two preceding months.

The issuance of our common stock in connection with an acquisition in 2005 resulted in an ownership change under Section 382.  The annual base Section 382 limitation to be applied to our tax attribute carryforwards as a result of this ownership change is approximately $10.3 million.  Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these

 
F-34

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
tax attributes.  In addition, a separate annual base Section 382 limitation of approximately $14.6 million is to be applied to the tax attribute carryforwards of Harborside as a result of the Harborside acquisition.

After considering the reduction in tax attributes resulting from the Section 382 limitation discussed above, we have Federal NOL carryforwards of approximately $226.1 million with expiration dates from 2019 through 2027.  Various subsidiaries have state NOL carryforwards totaling approximately $518.1 million with expiration dates beginning in 2010 through the year 2029.  Our application of the rules under Section 382 is subject to challenge upon IRS review.  A successful challenge could significantly impact our ability to utilize tax attribute carryforwards from periods prior to the ownership change dates.

We are subject to income taxes in the U.S. and numerous state and local jurisdictions.  Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.  Effective January 1, 2007, we adopted the guidance for accounting for uncertain tax positions, which contains a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.

Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different.  We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the expiration of the statute of limitations.  To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.  The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):

   
2009
   
2008
   
2007
 
                   
Balance at the beginning of the period
$
25,654
 
$
5,417
 
$
     17,989
 
                   
Additions for tax positions of prior years
 
730
   
-
   
-
 
Reductions for tax positions of prior years
 
-
   
(1,501
)
 
-
 
Additions based on tax positions related to the current year
 
-
   
23,497
   
       1,417
 
Lapsing of statutes of limitations
 
(68)
   
(1,759
)
 
-
 
Other adjustments
 
-
   
-
   
    (13,989
)
                   
Balance at the end of the period
$
26,316
 
$
25,654
 
$
    5,417
 
                   
All of the gross unrecognized tax benefits would affect the effective tax rate if recognized.  Unrecognized tax benefits are adjusted in the period in which new information about a tax position becomes available or the final outcome differs from the amount recorded.  Unrecognized tax benefits are not expected to change significantly over the next twelve months.

We recognize potential accrued interest related to unrecognized tax benefits in income tax expense.  Penalties,

 
F-35

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
if incurred, would also be recognized as a component of income tax expense.  The amount of accrued interest related to unrecognized tax benefits as of December 31, 2009, and 2008 was $0.2 million and $0.1 million, respectively.

We file numerous consolidated and separate state and local income tax returns in addition to our consolidated U.S. federal income tax return.  With few exceptions, we are no longer subject to U.S. federal, state or local income tax examinations for years before 2005.  These jurisdictions can, however, adjust NOL carryforwards from earlier years.


(11)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments as of December 31 were as follows (in thousands):

   
2009
 
2008
   
Carrying
     
Carrying
   
   
Amount
 
Fair Value
 
Amount
 
Fair Value
                 
Cash and cash equivalents
$
104,483
$
104,483
$
92,153
$
92,153
Restricted cash
$
27,351
$
27,351
$
37,979
$
37,979
Long-term debt and capital lease obligations,
               
including current portion
$
700,548
$
574,770
$
725,841
$
645,434
Interest rate swap agreements
$
5,048
$
5,048
$
7,644
$
7,644

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At December 31, 2009 and 2008, the fair value of our long-term debt, including current maturities, and our interest rate swap agreement was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

The FASB accounting guidance establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  This guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:
Unadjusted quoted market prices in active markets for identical assets or liabilities.
   
Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
   
Level 3:
Unobservable inputs for the asset or liability.


 
F-36

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


We endeavor to utilize the best available information in measuring fair value.  The following table summarizes the valuation of our financial instruments by the above pricing levels as of December 31 (in thousands):

   
December 31, 2009
       
Unadjusted Quoted
 
Significant Other
       
Market Prices
 
Observable Inputs
   
Total
 
(Level 1)
 
(Level 2)
Cash equivalents – money market
           
funds/certificate of deposit
$
36,480
$
31,429
$
5,051
Restricted cash – money market funds
$
1,275
$
1,275
$
-
Interest rate swap agreement – liability
$
5,048
$
-
$
5,048

   
December 31, 2008
       
Unadjusted Quoted
 
Significant Other
       
Market Prices
 
Observable Inputs
   
Total
 
(Level 1)
 
(Level 2)
Cash equivalents – money market
           
funds/certificate of deposit
$
10,098
$
5,053
$
5,045
Restricted cash – money market funds
$
1,272
$
1,272
$
-
Interest rate swap agreement – liability
$
7,644
$
-
$
7,644

We currently have no other financial instruments subject to fair value measurement on a recurring basis.


(12)  Capital Stock

(a)  Basic and Diluted Shares

Basic net income per common share is calculated by dividing net income applicable to common stock by the weighted average number of common shares outstanding during the period. The calculation of diluted net income per common share is similar to that of basic net income per common share, except the denominator is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares, principally those issuable upon the exercise of stock options and warrants and the vesting of stock units, were issued during the period.

 
F-37

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

The following table summarizes the calculation of basic and diluted net income per common share for each period (in thousands except per share data):

   
2009
   
2008
   
2007
 
Numerator:
                 
Net income
$
38,671
 
$
109,287
 
$
57,510
 
Denominator:
                 
Weighted average shares for basic net
                 
income per common share
 
43,841
   
43,331
   
42,350
 
Add dilutive effect of assumed exercise of
                 
stock options and warrants and vesting
                 
of restricted stock units using the
                 
treasury stock method
 
122
   
632
   
1,040
 
Weighted average shares for diluted net
                 
income per common share
 
43,963
   
43,963
   
43,390
 
                   
Basic net income per common share
$
0.88
 
$
2.52
 
$
1.36
 
Diluted net income per common share
$
0.88
 
$
2.49
 
$
1.33
 

(b)  Equity Incentive Plans

Pursuant to our 2004 Equity Incentive Plan (the “2004 Plan”), as of December 31, 2009 our employees and directors held options to purchase 1,809,432 shares of common stock and 512,904 unvested restricted stock units. No additional awards can be made under the 2004 Plan.

As of December 31, 2009, our directors held options to purchase 20,000 shares under our 2002 Non-employee Director Equity Incentive Plan (the “Director Plan”). No additional awards can be made under the Director Plan.

Our 2009 Performance Incentive Plan (the “2009 Plan”) allows for the issuance of shares of common stock equal to the sum of:  (i) 5.2 million shares, plus (ii) the number of any shares subject to stock options granted under the 2004 Plan or the Director Plan  which expire, or for any reason are canceled or terminated, without being exercised, plus (3) 1.25 times the number of any shares subject to restricted stock units under the 2004 Plan which are forfeited, terminated or cancelled without having become vested.  As of December 31, 2009 our employees and directors held options to purchase 480,236 shares of common stock and 486,503 unvested restricted stock units.

Option awards are granted with an exercise price equal to the market price of our stock at the date of grant; those option awards generally vest based on four years of continuous service and have seven-year contractual terms.  Share awards generally vest over four years and no dividends are paid on unexercised options or unvested share awards.  Certain option and share awards provide for accelerated vesting if there is a change in control (as defined in the applicable plan).

During the year ended December 31, 2009, we issued 219,475 shares of common stock upon the vesting of restricted stock shares and restricted stock units and the exercise of stock options.

In connection with an acquisition in 2005, we assumed the Peak Medical Corporation 1998 Stock Incentive Plan (the “Peak Plan”). As of December 31, 2009, there were no options outstanding to purchase shares of common

 
F-38

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
stock under the Peak Plan and 100,837 shares had been issued upon the exercise of stock options. No additional awards can be made under the Peak Plan.

A summary of option activity under the 2004 Plan, the 2009 Plan, the Director Plan and the Peak Plan during the year ended December 31, 2009 is presented below:

               
Weighted-
       
               
Average
   
Aggregate
 
         
Weighted-
   
Remaining
   
Intrinsic
 
   
Shares
   
Average
   
Contractual
   
Value
 
Options
 
(in thousands)
   
Exercise Price
   
Term (in years)
   
(in thousands)
 
                         
Outstanding at January 1, 2009
 
1,898
 
$
10.12
             
Granted
 
493
   
9.86
             
Exercised
 
(20
)
 
6.84
             
Forfeited
 
(61
)
 
11.66
             
Outstanding at December 31, 2009
 
2,310
 
$
10.05
   
4
 
$
561
 
                         
Exercisable at December 31, 2009
 
1,130
 
$
8.94
   
4
 
$
255
 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table.  Expected volatility is based on the historical volatility of our stock.  The expected term of options granted is derived using a temporary “shortcut approach” of our “plain vanilla” employee stock options as we do not have sufficient data to develop a more precise estimate. Under this approach, the expected term would be presumed to be the mid-point between the vesting date and the end of the contractual term.  The risk-free rate for the period within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The weighted-average grant-date fair value of stock options granted during the year ended December 31, 2009, 2008 and 2007 was $9.86, $5.78 and $6.38, respectively.

The significant assumptions in the valuation model for the years ended December 31 are as follows:

 
2009
 
2008
 
2007
Expected volatility
51.2% - 51.9%
 
50.7% - 80.6%
 
52.4% - 80.6%
Weighted-average volatility
51.6%
 
61.3%
 
63.2%
Expected term (in years)
4.75
 
4.75
 
4.75
Risk-free rate
1.8% - 2.6%
 
1.6% - 5.0%
 
3.0% - 5.0%


 



 
F-39

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

    In connection with the restricted stock units granted to employees we recognized the full fair value of the shares of nonvested restricted stock awards.  A summary of restricted stock activity with our share-based compensation plans during the year ended December 31, 2009 is as follows:

         
Weighted-
         
Average
   
Shares
   
Grant-Date
Nonvested Shares
 
(in thousands)
   
Fair Value
           
Nonvested at January 1, 2009
 
902
 
$
11.60
Granted
 
521
   
9.86
Vested
 
(381
)
 
10.92
Forfeited
 
(43
)
 
11.65
Nonvested at December 31, 2009
 
999
   
10.93
           

The total fair value of restricted shares vested was $4.0 million for the year ended December 31, 2009 and $3.3 million for the year ended December 31, 2008.

We recognized stock compensation expense of $5.8 million, $5.3 million and $3.7 million for the years ended December 31, 2009, 2008 and 2007, respectively.

(13)  Other Events

(a)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition and cash flows.  In certain states in which we have operations, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions.  There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

We operate in an industry that is extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of

 
F-40

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

 
Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

In December 2006, Harborside was notified by the United States Department of Justice (“DOJ”) that one of its subsidiaries is one of a significant number of unrelated defendants in a qui tam lawsuit filed under the Federal False Claims Act.  We have cooperated with the DOJ since we became aware of the lawsuit and have consistently denied the allegations in the lawsuit, which relate to Medicare billings for durable medical equipment.  In October 2009, we agreed to settle this lawsuit to avoid the protracted costs of litigation.  The settlement agreement provides that the settlement is not an admission of liability by us or the defendants, releases Harborside and its subsidiary from all liability arising from allegations in the lawsuit, and required the defendants to pay $1.4 million, which was paid prior to December 31, 2009.

(b)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time we are unable to predict the outcome of any existing or future examinations.

(c)  Legislation, Regulations and Market Conditions

We are subject to extensive federal, state and local government regulation relating to licensure, conduct of operations, ownership of centers, expansion of centers and services and reimbursement for services. As such, in the ordinary course of business, our operations are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which may be non-routine. We believe that we are in substantial compliance with the applicable laws and regulations. However, if we are ever found to have engaged in improper practices, we could be subjected to civil, administrative or criminal fines, penalties or restitutionary relief, which may have a material adverse impact on our financial position, results of operations and cash flows.


(14)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of nursing, rehabilitative, and related ancillary care services to nursing home patients.

The following summarizes the services provided by our reportable and other segments:

Inpatient Services:  This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these centers by registered nurses, licensed practical nurses and certified nursing aids.  At December 31, 2009, we operated 205 healthcare centers (consisting of 183 skilled nursing centers, 14 assisted living and independent living centers and eight mental health centers) with 23,205 licensed beds as compared with 207 healthcare centers (consisting of 184 skilled nursing centers, 15 assisted living and independent living centers and eight mental health centers) with 23,345 licensed beds at December 31, 2008.

 
F-41

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

Rehabilitation Therapy Services:  This segment provides, among other services, physical, occupational, speech and respiratory therapy supplies and services to affiliated and nonaffiliated skilled nursing centers. At December 31, 2009, this segment provided services in 36 states via 464 contracts, 337 nonaffiliated and 127 affiliated, as compared to 445 contracts at December 31, 2008, of which 327 were nonaffiliated and 118 were affiliated.

Medical Staffing Services:  For the year ended December 31, 2009, this segment provided services in 44 states and derived 56.1% of its revenues from hospitals and other providers, 24.7% from skilled nursing centers, 15.3% from schools and 3.9% from prisons. We provide (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians, and (v) related medical personnel.  As of December 31, 2009, this segment had 30 branch offices, which provided temporary therapy, nursing, pharmacy and physician staffing services in major metropolitan areas and one office servicing locum tenens.  As of December 31, 2008, this segment had 29 branch offices, which provided temporary therapy, nursing, pharmacy and physician staffing services in major metropolitan areas and one division office, which specializes in the placement of temporary traveling therapists, and one office servicing locum tenens.

Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable, property and equipment and unallocated intangible assets. Although corporate assets include unallocated intangible assets, the amortization, if applicable, is reflected in the results of operations of the associated segment.

The accounting policies of the segments are the same as those described in Note 2 – “Summary of Significant Accounting Policies.” We primarily evaluate segment performance based on profit or loss from operations before reorganization and restructuring items, income taxes and extraordinary items. Gains or losses on sales of assets and certain items including impairment of assets recorded in connection with annual impairment testing and restructuring costs are not considered in the evaluation of segment performance. Interest expense is recorded in the segment carrying the obligation to which the interest relates.

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations. Net segment income for the year ended December 31, 2009 for (1) our inpatient services segment increased $1.8 million, or 1.2%, to $156.1 million, (2) our rehabilitation therapy services segment increased $2.6 million, or 30.6%, to $11.1 million and (3) our medical staffing services segment decreased $1.1 million, or 11.3%, to $8.6 million due to the factors discussed below for each segment.  We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment. 

 
F-42

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009



As of and for the
                                   
Year Ended
                                   
December 31, 2009
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,675,775
 
$
105,366
 
$
100,624
 
$
34
 
$
-
 
$
1,881,799
 
                                     
Intersegment revenues
 
-
   
74,166
   
1,930
   
-
   
(76,096
)
 
-
 
                                     
Total revenues
 
1,675,775
   
179,532
   
102,554
   
34
   
(76,096
)
 
1,881,799
 
                                     
Operating salaries and benefits
 
835,038
   
150,271
   
72,336
   
-
   
-
   
1,057,645
 
                                     
Self insurance for workers'
                                   
compensation and general and
                                   
professional liability insurance
 
59,842
   
2,161
   
1,331
   
418
   
-
   
63,752
 
                                     
Other operating costs
 
437,594
   
7,620
   
15,713
   
1
   
(76,096
)
 
384,832
 
                                     
General and administrative expenses
 
41,243
   
6,868
   
2,811
   
62,070
   
-
   
112,992
 
                                     
Provision for losses on
                                   
accounts receivable
 
20,660
   
482
   
55
   
-
   
-
   
21,197
 
                                     
Segment operating income (loss)
$
281,398
 
$
12,130
 
$
10,308
 
$
(62,455
)
$
-
 
$
241,381
 
                                     
Center rent expense
 
71,749
   
480
   
920
   
-
   
-
   
73,149
 
                                     
Depreciation and amortization
 
41,335
   
540
   
780
   
2,808
   
-
   
45,463
 
                                     
Interest, net
 
12,226
   
(2
)
 
(2
)
 
37,105
   
-
   
49,327
 
                                     
Net segment income (loss)
$
156,088
 
$
11,112
 
$
8,610
 
$
(102,368
)
$
-
 
$
73,442
 
                                     
Identifiable segment assets
$
1,194,306
 
$
16,011
 
$
25,143
 
$
856,259
 
$
(528,456
)
$
1,563,263
 
                                     
Goodwill
$
333,688
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
338,296
 
                                     
Segment capital expenditures
$
50,418
 
$
650
 
$
74
 
$
3,170
 
$
-
 
$
54,312
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, loss on extinguishment of debt, income tax benefit and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations.

 
F-43

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


 
As of and for the
                                   
Year Ended
                                   
December 31, 2008
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,616,059
 
$
89,619
 
$
117,788
 
$
37
 
$
-
 
$
1,823,503
 
                                     
Intersegment revenues
 
-
   
60,856
   
2,622
   
-
   
(63,478
)
 
-
 
                                     
Total revenues
 
1,616,059
   
150,475
   
120,410
   
37
   
(63,478
)
 
1,823,503
 
                                     
Operating salaries and benefits
 
817,825
   
124,817
   
86,345
   
-
   
-
   
1,028,987
 
                                     
Self insurance for workers'
                                   
compensation and general and
                                   
professional liability insurance
 
55,485
   
2,138
   
1,514
   
557
   
-
   
59,694
 
                                     
Other operating costs
 
411,899
   
7,113
   
17,553
   
(2
)
 
(63,478
)
 
373,085
 
                                     
General and administrative expenses
 
41,380
   
6,806
   
2,983
   
62,303
   
-
   
113,472
 
                                     
Provision for losses on
                                   
accounts receivable
 
13,331
   
213
   
563
   
-
   
-
   
14,107
 
                                     
Segment operating income (loss)
$
276,139
 
$
9,388
 
$
11,452
 
$
(62,821
)
$
-
 
$
234,158
 
                                     
Center rent expense
 
72,231
   
394
   
976
   
-
   
-
   
73,601
 
                                     
Depreciation and amortization
 
35,957
   
533
   
806
   
3,058
   
-
   
40,354
 
                                     
Interest, net
 
13,670
   
(1
)
 
(20
)
 
40,954
   
-
   
54,603
 
                                     
Net segment income (loss)
$
154,281
 
$
8,462
 
$
9,690
 
$
(106,833
)
$
-
 
$
65,600
 
                                     
Identifiable segment assets
$
1,148,320
 
$
12,489
 
$
28,262
 
$
880,428
 
$
(528,449
)
$
1,541,050
 
                                     
Goodwill
$
322,200
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
326,808
 
                                     
Segment capital expenditures
$
39,976
 
$
286
 
$
188
 
$
1,962
 
$
-
 
$
42,412
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, loss on extinguishment of debt, income tax benefit and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations.

 
F-44

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


As of and for the
                                   
Year Ended
                                   
December 31, 2007
       
Segment Information (in thousands):
 
                                     
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
1,367,399
 
$
82,198
 
$
108,082
 
$
77
 
$
-
 
$
1,557,756
 
                                     
Intersegment revenues
 
-
   
44,857
   
3,150
   
-
   
(48,007
)
 
-
 
                                     
Total revenues
 
1,367,399
   
127,055
   
111,232
   
77
   
(48,007
)
 
1,557,756
 
                                     
Operating salaries and benefits
 
696,487
   
106,173
   
85,441
   
-
   
-
   
888,101
 
                                     
Self insurance for workers'
                                   
compensation and general and
                                   
professional liability insurance
 
40,615
   
1,782
   
1,656
   
471
   
-
   
44,524
 
                                     
Other operating costs
 
349,536
   
6,292
   
11,165
   
24
   
(48,007
)
 
319,010
 
                                     
General and administrative expenses
 
31,998
   
4,978
   
2,974
   
64,835
   
-
   
104,785
 
                                     
Provision (adjustment) for losses on
                                   
accounts receivable
 
9,549
   
(670
)
 
103
   
-
   
-
   
8,982
 
                                     
Segment operating income (loss)
$
239,214
 
$
8,500
 
$
9,893
 
$
(65,253
)
$
-
 
$
192,354
 
                                     
Center rent expense
 
69,298
   
208
   
907
   
-
   
-
   
70,413
 
                                     
Depreciation and amortization
 
25,994
   
528
   
749
   
3,947
   
-
   
31,218
 
                                     
Interest, net
 
11,487
   
11
   
16
   
32,833
   
-
   
44,347
 
                                     
Net segment income (loss)
$
132,435
 
$
7,753
 
$
8,221
 
$
(102,033
)
$
-
 
$
46,376
 
                                     
Identifiable segment assets
$
1,095,763
 
$
15,430
 
$
37,217
 
$
724,553
 
$
(521,049
)
$
1,351,914
 
                                     
Goodwill
$
319,744
 
$
-
 
$
4,533
 
$
-
 
$
-
 
$
324,277
 
                                     
Segment capital expenditures
$
27,472
 
$
1,324
 
$
426
 
$
3,589
 
$
-
 
$
32,811
 
 
_____________________________________
General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net, loss (gain) on sale of assets, net, restructuring costs, loss on extinguishment of debt, income tax benefit and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before loss (gain) on sale of assets, net, restructuring costs, income tax benefit and discontinued operations.
F-45


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

Measurement of Segment Income or Loss

The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies (See Note 2 – “Summary of Significant Accounting Policies”).  We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items.

The following table reconciles net segment income to consolidated income before income taxes and discontinued operations for the years ended December 31 (in thousands):

   
2009
   
2008
   
2007
 
                   
Net segment income
$
73,442
 
$
65,600
 
$
46,376
 
Restructuring costs, net
 
(1,304
)
 
-
   
-
 
Loss on extinguishment of debt
 
-
   
-
   
(3,173
)
(Loss) gain on sale of assets, net
 
(42
)
 
976
   
(24
)
Income before income taxes and
                 
discontinued operations
$
72,096
 
$
66,576
 
$
43,179
 

(15)  401(k) Plan

We have a defined contribution plan (the “401(k) plan”). Employees who have completed three months of service are eligible to participate. The 401(k) plan allows for a discretionary employer match of contributions made by participants for any participants employed on the last day of the year. We may make matching contributions under this plan of 25% of a participant’s contribution, up to 6% of the participant's compensation. Expenses for discretionary matching contributions are recognized in the year they are determined. In January 2008, matching contributions for the 2007 participant contributions of $1.4 million were authorized.  In January 2009, matching contributions for the 2008 participant contributions of $1.9 million were authorized.  There were no matching contributions in January 2010 for 2009 participant contributions as the discretionary matching program was suspended.


 
F-46

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


(16) Summarized Consolidating Information

In connection with the Company's offering of the Notes in April 2007, certain 100% owned subsidiaries of the Company (the “Guarantors”) have, jointly and severally, unconditionally guaranteed the Notes. These guarantees are subordinated to all existing and future senior debt and senior guarantees of the Guarantors and are unsecured.

The Company conducts all of its business through and derives virtually all of its income from its subsidiaries. Therefore, the Company's ability to make required payments with respect to its indebtedness (including the Notes) and other obligations depends on the financial results and condition of its subsidiaries and its ability to receive funds from its subsidiaries.

Pursuant to Rule 3-10 of Regulation S-X, the following summarized consolidating information is provided for the Company (the “Parent”), the Guarantors, and the Company's non-Guarantor subsidiaries with respect to the Notes. This summarized financial information has been prepared from the books and records maintained by the Company, the Guarantors and the non-Guarantor subsidiaries. The summarized financial information may not necessarily be indicative of the results of operations or financial position had the Guarantors or non-Guarantor subsidiaries operated as independent entities. The separate financial statements of the Guarantors are not presented because management has determined they would not be material to investors. In addition, intercompany activities between subsidiaries and the Parent are presented within operating activities on the condensed consolidating statement of cash flows.

Condensed consolidating financial statements for the Company and its subsidiaries, including the Parent only, the combined Guarantor Subsidiaries and the combined Non-Guarantor Subsidiaries are as follows:


 
F-47

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
   
Non-Guarantor
             
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Current assets:
                             
Cash and cash equivalents
$
82,463
 
$
19,659
 
$
2,361
 
$
-
 
$
104,483
 
Restricted cash
 
15,419
   
5,288
   
3,327
   
-
   
24,034
 
Accounts receivable, net
 
-
   
217,805
   
2,542
   
(28
)
 
220,319
 
Prepaid expenses and other assets
 
9,493
   
13,383
   
608
   
(1,727
)
 
21,757
 
Deferred tax assets
 
-
   
85,766
   
1,266
   
(18,617
)
 
68,415
 
Total current assets
 
107,375
   
341,901
   
10,104
   
(20,372
)
 
439,008
 
Property and equipment, net
 
9,195
   
546,772
   
66,715
   
-
   
622,682
 
Intangible assets, net
 
32,702
   
16,897
   
2,336
   
1,996
   
53,931
 
Goodwill
 
-
   
334,338
   
3,958
   
-
   
338,296
 
Restricted cash, non-current
 
2,972
   
345
   
-
   
-
   
3,317
 
Other assets
 
280
   
4,741
   
9
   
(69
)
 
4,961
 
Deferred tax assets
 
15,393
   
123,963
   
-
   
(30,357
)
 
108,999
 
Intercompany balances
 
307,307
   
-
   
7,925
   
(315,232
)
 
-
 
Investment in subsidiaries
 
640,821
   
-
   
-
   
(640,821
)
 
-
 
Total assets
$
1,116,045
 
$
1,368,957
 
$
91,047
 
$
(1,004,855
)
$
1,571,194
 
                               
Current liabilities:
                             
Accounts payable
$
10,883
 
$
45,130
 
$
1,124
 
$
(28
)
$
57,109
 
Accrued compensation and benefits
 
9,546
   
48,617
   
790
   
-
   
58,953
 
Accrued self-insurance obligations, current
 
4,034
   
41,627
   
-
   
-
   
45,661
 
Other accrued liabilities
 
11,275
   
41,272
   
2,718
   
-
   
55,265
 
Deferred tax liability
 
9,843
   
-
   
-
   
(9,843
)
 
-
 
Current portion of long-term debt
 
22,244
   
18,592
   
5,580
   
-
   
46,416
 
Total current liabilities
 
67,825
   
195,238
   
10,212
   
(9,871
)
 
263,404
 
Accrued self-insurance obligations, net of current
 
48,200
   
73,319
   
429
   
-
   
121,948
 
Deferred tax liability
 
-
   
-
   
11,559
   
(11,559
)
 
-
 
Long-term debt, net of current
 
507,394
   
87,916
   
58,822
   
-
   
654,132
 
Unfavorable lease obligations, net
 
-
   
14,659
   
-
   
(1,996
)
 
12,663
 
Intercompany balances
 
-
   
340,608
   
-
   
(340,608
)
 
-
 
Other long-term liabilities
 
43,562
   
23,206
   
3,215
   
-
   
69,983
 
Total liabilities
 
666,981
   
734,946
   
84,237
   
(364,034
)
 
1,122,130
 
                               
Stockholders’ equity:
                             
Common stock
 
438
   
-
   
-
   
-
   
438
 
Additional paid-in capital
 
655,667
   
-
   
-
   
-
   
655,667
 
Accumulated deficit
 
(204,012
)
 
634,011
   
6,810
   
(640,821
)
 
(204,012
)
Accumulated other comprehensive loss
 
(3,029
)
 
-
   
-
   
-
   
(3,029
)
Total stockholders' equity
 
449,064
   
634,011
   
6,810
   
(640,821
)
 
449,064
 
Total liabilities and stockholders' equity
$
1,116,045
 
$
1,368,957
 
$
91,047
 
$
(1,004,855
)
$
1,571,194
 


 
F-48

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2008
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
   
Non-Guarantor
             
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Current assets:
                             
Cash and cash equivalents
$
72,529
 
$
17,952
 
$
1,672
 
$
-
 
$
92,153
 
Restricted cash
 
25,570
   
5,135
   
3,971
   
-
   
34,676
 
Accounts receivable, net
 
-
   
201,390
   
4,251
   
(21
)
 
205,620
 
Prepaid expenses and other assets
 
8,909
   
13,229
   
496
   
(1,178
)
 
21,456
 
Assets held for sale
 
951
   
2,693
   
10
   
-
   
3,654
 
Deferred tax assets
 
-
   
64,445
   
1,261
   
(8,445
)
 
57,261
 
Total current assets
 
107,959
   
304,844
   
11,661
   
(9,644
)
 
414,820
 
Property and equipment, net
 
7,877
   
527,413
   
68,355
   
-
   
603,645
 
Intangible assets, net
 
37,202
   
12,681
   
4,505
   
-
   
54,388
 
Goodwill
 
-
   
323,062
   
3,746
   
-
   
326,808
 
Restricted cash, non-current
 
2,963
   
340
   
-
   
-
   
3,303
 
Other assets
 
912
   
4,643
   
16
   
(8
)
 
5,563
 
Deferred tax assets
 
15,140
   
132,718
   
-
   
(13,051
)
 
134,807
 
Intercompany balances
 
372,179
   
-
   
3,730
   
(375,909
)
 
-
 
Investment in subsidiaries
 
539,385
   
-
   
-
   
(539,385
)
 
-
 
Total assets
$
1,083,617
 
$
1,305,701
 
$
92,013
 
$
(937,997
)
$
1,543,334
 
                               
Current liabilities:
                             
Accounts payable
$
14,630
 
$
46,107
 
$
1,284
 
$
(21
)
$
62,000
 
Accrued compensation and benefits
 
9,271
   
50,433
   
956
   
-
   
60,660
 
Accrued self-insurance obligations, current
 
4,001
   
40,735
   
557
   
-
   
45,293
 
Other accrued liabilities
 
14,741
   
42,585
   
709
   
(1,178
)
 
56,857
 
Deferred tax liability
 
8,445
   
-
   
-
   
(8,445
)
 
-
 
Current portion of long-term debt
 
10,255
   
6,394
   
1,216
   
-
   
17,865
 
Total current liabilities
 
61,343
   
186,254
   
4,722
   
(9,644
)
 
242,675
 
Accrued self-insurance obligations, net of current
 
43,159
   
70,969
   
429
   
-
   
114,557
 
Deferred tax liability
 
-
   
-
   
13,051
   
(13,051
)
 
-
 
Long-term debt, net of current
 
543,214
   
100,360
   
64,402
   
-
   
707,976
 
Unfavorable lease obligations, net
 
-
   
15,514
   
-
   
-
   
15,514
 
Intercompany balances
 
-
   
375,917
   
-
   
(375,917
)
 
-
 
Other long-term liabilities
 
32,192
   
26,711
   
-
   
-
   
58,903
 
Total liabilities
 
679,908
   
775,725
   
82,604
   
(398,612
)
 
1,139,625
 
                               
Stockholders’ equity:
                             
Common stock
 
435
   
-
   
-
   
-
   
435
 
Additional paid-in capital
 
650,543
   
-
   
-
   
-
   
650,543
 
Accumulated deficit
 
(242,683
)
 
529,976
   
9,409
   
(539,385
)
 
(242,683
)
Accumulated other comprehensive loss
 
(4,586
)
 
-
   
-
   
-
   
(4,586
)
Total stockholders' equity
 
403,709
   
529,976
   
9,409
   
(539,385
)
 
403,709
 
Total liabilities and stockholders' equity
$
1,083,617
 
$
1,305,701
 
$
92,013
 
$
(937,997
)
$
1,543,334
 



 
F-49

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Year Ended December 31, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
   
Non-Guarantor
             
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
$
34
 
$
1,927,595
 
$
30,266
 
$
(76,096
)
$
1,881,799
 
Costs and expenses:
                             
Operating salaries and benefits
 
-
   
1,041,057
   
16,588
   
-
   
1,057,645
 
Self insurance for workers’ compensation
                             
and general and professional liability
                         
insurance
 
418
   
62,721
   
613
   
-
   
63,752
 
Other operating costs
 
-
   
453,705
   
7,223
   
(76,096
)
 
384,832
 
Center rent expense
 
-
   
72,392
   
757
   
-
   
73,149
 
General and administrative expenses(1)
 
63,555
   
49,437
   
-
   
-
   
112,992
 
Depreciation and amortization
 
2,808
   
40,304
   
2,351
   
-
   
45,463
 
Provision for losses on accounts receivable
 
-
   
20,681
   
516
   
-
   
21,197
 
Interest, net
 
36,571
   
8,286
   
4,470
   
-
   
49,327
 
Loss (gain) on sale of assets, net
 
-
   
49
   
(7
)
 
-
   
42
 
Restructuring costs, net
 
1,161
   
143
   
-
   
-
   
1,304
 
Income from investment in subsidiaries
 
(101,436
)
 
-
   
-
   
101,436
   
-
 
Total costs and expenses
 
3,077
   
1,748,775
   
32,511
   
25,340
   
1,809,703
 
                               
(Loss) income before income taxes and
                             
discontinued operations
 
(3,043
)
 
178,820
   
(2,245
)
 
(101,436
)
 
72,096
 
Income tax (benefit) expense
 
(42,780
)
 
73,316
   
(920
)
 
-
 
 
29,616
 
Income from continuing operations
 
39,737
   
105,504
   
(1,325
)
 
(101,436
)
 
42,480
 
                               
Discontinued operations:
                             
Loss from discontinued
                             
operations, net
 
(1,066
)
 
(905
)
 
(1,505
)
 
-
   
(3,476
)
(Loss) gain on disposal of discontinued
                             
operations, net
 
-
   
(564
)
 
231
   
-
   
(333
)
Loss on discontinued operations, net
 
(1,066
)
 
(1,469
)
 
(1,274
)
 
-
   
(3,809
)
                               
Net income
$
38,671
 
$
104,035
 
$
(2,599
)
$
(101,436
)
$
38,671
 
 
(1) Includes operating administrative expenses

 
F-50

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Year Ended December 31, 2008
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
   
Non-Guarantor
             
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
$
37
 
$
1,856,726
 
$
30,218
 
$
(63,478
)
$
1,823,503
 
Costs and expenses:
                             
Operating salaries and benefits         
 
-
   
1,015,839
   
13,148
   
-
   
1,028,987
 
Self insurance for workers’ compensation
                             
and general and professional liability
                             
insurance
 
557
   
58,504
   
633
   
-
   
59,694
 
Other operating costs
 
2
   
430,171
   
6,389
   
(63,478
)
 
373,084
 
Center rent expense
 
-
   
72,914
   
687
   
-
   
73,601
 
General and administrative expenses(1)
 
61,780
   
51,693
   
-
   
-
   
113,473
 
Depreciation and amortization
 
3,058
   
35,035
   
2,261
   
-
   
40,354
 
Provision for losses on accounts receivable
 
-
   
13,719
   
388
   
-
   
14,107
 
Interest, net
 
40,954
   
8,770
   
4,879
   
-
   
54,603
 
(Gain) loss on sale of assets, net
 
(976
)
 
-
   
-
   
-
   
(976
)
Income from investment in subsidiaries
 
(289,483
)
 
-
   
-
   
289,483
   
-
 
Total costs and expenses             
 
(184,107
)
 
1,686,645
   
28,385
   
226,005
   
1,756,927
 
                               
Income before income taxes and
                             
discontinued operations
 
184,145
   
170,081
   
1,833
   
(289,483
)
 
66,576
 
Income tax expense (benefit)
 
74,858
   
(120,903
)
 
(1,303
)
 
-
   
(47,348
)
Income from continuing operations
 
109,287
   
290,984
   
3,136
   
(289,483
)
 
113,924
 
                               
Discontinued operations:
                             
(Loss) income from discontinued
                             
operations, net
 
-
   
(2,575
)
 
939
   
-
   
(1,636
)
(Loss) gain on disposal of discontinued
                             
operations, net
 
-
   
(4,896
)
 
1,895
   
-
   
(3,001
)
(Loss) income on discontinued operations, net
 
-
   
(7,471
)
 
2,834
   
-
   
(4,637
)
                               
Net income
$
109,287
 
$
283,513
 
$
5,970
 
$
(289,483
)
$
109,287
 
 
(1) Includes operating administrative expenses

 
F-51

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Year Ended December 31, 2007
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
  Non-Guarantor            
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
$
78
 
$
1,587,609
 
$
18,076
 
$
(48,007
)
$
1,557,756
 
Costs and expenses:
                             
Operating salaries and benefits
 
-
   
879,017
   
9,085
   
-
   
888,102
 
Self insurance for workers’ compensation
                             
and general and professional liability
                             
insurance
 
470
   
43,567
   
487
   
-
   
44,524
 
Other operating costs
 
-
   
363,142
   
3,893
   
(48,025
)
 
319,010
 
Center rent expense
 
-
   
72,539
   
(2,127
)
 
-
   
70,412
 
General and administrative expenses(1)
 
65,991
   
38,777
   
17
   
-
   
104,785
 
Depreciation and amortization
 
3,947
   
25,214
   
2,057
   
-
   
31,218
 
Provision for losses on accounts receivable
 
-
   
8,676
   
306
   
-
   
8,982
 
Interest, net
 
32,170
   
7,761
   
4,416
   
-
   
44,347
 
Loss on extinguishment of debt
 
3,173
   
-
   
-
   
-
   
3,173
 
Loss on sale of assets, net
 
-
   
24
   
-
   
-
   
24
 
Income from investment in subsidiaries
 
(150,890
)
 
-
   
-
   
150,890
   
-
 
Total costs and expenses
 
(45,139
)
 
1,438,717
   
18,134
   
102,865
   
1,514,577
 
                               
Income (loss) before income taxes and
                             
discontinued operations
 
45,217
   
148,892
   
(58
)
 
(150,872
)
 
43,179
 
Income tax benefit
 
(11,458
)
 
-
   
-
   
544
   
(10,914
)
Income (loss) from continuing operations
 
56,675
   
148,892
   
(58
)
 
(151,416
)
 
54,093
 
                               
Discontinued operations:
                             
Income from discontinued
                             
operations, net
 
1,035
   
2,012
   
1,079
   
(509
)
 
3,617
 
(Loss) gain on disposal of discontinued
                             
operations, net
 
(200
)
 
(1,669
)
 
1,467
   
202
   
(200
)
Income (loss) on discontinued operations, net
 
835
   
343
   
2,546
   
(307
)
 
3,417
 
                               
Net income
$
57,510
 
$
149,235
 
$
2,488
 
$
(151,723
)
$
57,510
 
 
(1) Includes operating administrative expenses


 
F-52

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
  Non-Guarantor            
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Net cash provided by operating activities
$
30,334
 
$
71,832
 
$
6,742
 
$
-
 
$
108,908
 
                               
Cash flows from investing activities:
                             
   Capital expenditures
 
(3,167
)
 
(50,708
)
 
(437
)
 
-
   
(54,312
)
   Purchase of lease real estate
 
-
   
(3,275
)
 
-
   
-
   
(3,275
)
   Proceeds from sale of assets held for sale
 
-
   
2,174
   
-
   
-
   
2,174
 
   Acquisitions
 
-
   
(14,936
)
 
-
   
-
   
(14,936
)
       Net cash used for investing activities
 
(3,167
)
 
(66,745
)
 
(437
)
 
-
   
(70,349
)
                               
Cash flows from financing activities:
                             
   Borrowings of long-term debt
 
-
   
20,822
   
-
   
-
   
20,822
 
   Principal repayments of long-term debt and capital
 lease obligations
 
 
(17,334
)
 
 
(24,202
)
 
 
(4,756
)
 
 
-
   
 
(46,292
)
   Payment to non-controlling interest
 
-
   
-
   
(311
)
 
-
   
(311
)
   Distribution to non-controlling interest
 
-
   
-
   
(549
)
 
-
   
(549
)
   Proceeds from issuance of common stock
 
101
   
-
   
-
   
-
   
101
 
       Net cash used for financing activities
 
(17,233
)
 
(3,380
)
 
(5,616
)
 
-
   
(26,229
)
Net (decrease) increase in cash and cash equivalents
 
9,934
   
1,707
   
689
   
-
   
12,330
 
Cash and cash equivalents at beginning of period
 
72,529
   
17,952
   
1,672
   
-
   
92,153
 
Cash and cash equivalents at end of period
$
82,463
 
$
19,659
 
$
2,361
 
$
-
 
$
104,483
 


 
F-53

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2008
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
  Non-Guarantor            
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Net cash provided by operating activities
$
44,955
 
$
37,135
 
$
6,097
 
$
-
 
$
88,187
 
                               
Cash flows from investing activities:
                             
   Capital expenditures
 
(1,960
)
 
(40,304
)
 
(279
)
 
-
   
(42,543
)
   Purchase of leased real estate
 
-
   
(8,956
)
 
-
   
-
   
(8,956
)
   Proceeds from sale of assets held for sale
 
-
   
18,354
   
-
   
-
   
18,354
 
   Acquisitions
 
-
   
(7,633
)
 
(4,101
)
 
-
   
(11,734
)
   Insurance proceeds received
 
628
   
-
   
-
   
-
   
628
 
       Net cash used for investing activities
 
(1,332
)
 
(38,539
)
 
(4,380
)
 
-
   
(44,251
)
                               
Cash flows from financing activities:
                             
   Borrowings of long-term debt
 
-
   
20,290
   
-
   
-
   
20,290
 
   Principal repayments of long-term debt and capital
     lease obligations
 
                  
      (3,808
)
 
                   
    (24,481
)
 
                        
   (1,338
)
 
                             
   -
   
                    
 (29,627
)
   Payment to non-controlling interest
 
-
   
-
   
(418
)
 
-
   
(418
)
   Distribution to non-controlling interest
 
-
   
-
   
(353
)
 
-
   
(353
)
   Proceeds from issuance of common stock
 
2,493
   
-
   
-
   
-
   
2,493
 
       Net cash used for financing activities
 
(1,315
)
 
(4,191
)
 
(2,109
)
 
-
   
(7,615
)
Net (decrease) increase in cash and cash equivalents
 
42,308
   
(5,595
)
 
(392
)
 
-
   
36,321
 
Cash and cash equivalents at beginning of period
 
30,221
   
23,547
   
2,064
   
-
   
55,832
 
Cash and cash equivalents at end of period
$
72,529
 
$
17,952
 
$
1,672
 
$
-
 
$
92,153
 


 
F-54

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 2009


CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2007
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
    Non-Guarantor            
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Net cash (used for) provided by operating activities
$
(34,392
)
$
122,199
 
$
(3,970
)
$
-
 
$
83,837
 
                               
Cash flows from investing activities:
                             
   Capital expenditures
 
(3,642
)
 
(29,368
)
 
(440
)
 
-
   
(33,450
)
   Purchase of lease real estate
 
7,487
   
(63,949
)
 
-
   
-
   
(56,462
)
   Proceeds from sale of assets held for sale
 
3,851
   
3,238
   
500
   
-
   
7,589
 
   Acquisitions
 
(367,757
)
 
(697
)
 
-
   
-
   
(368,454
)
       Net cash (used for) provided by investing activities
(360,061
)
 
(90,776
)
 
60
   
-
   
(450,777
)
                               
Cash flows from financing activities:
                             
   Net repayments under Credit Agreement
 
(9,994
)
 
-
   
-
   
-
   
(9,994
)
   Borrowings of long-term debt
 
324,142
   
10,404
   
12,454
   
-
   
347,000
 
   Principal repayments of long-term debt and capital
      lease obligations
 
                  
    (18,338
)
 
       
               (29,560
)
 
                
        (6,611
)
 
                       
     -
   
            
    (54,509
)
   Payment to non-controlling interest
 
-
   
-
   
(657
)
 
-
   
(657
)
   Distribution to non-controlling interest
 
-
   
(57
)
 
-
   
-
   
(57
)
   Proceeds from issuance of common stock
 
1,459
   
-
   
-
   
-
   
1,459
 
   Deferred financing costs
 
(18,045
)
 
-
   
-
   
-
   
(18,045
)
   Release of third party collateral
 
25,640
   
-
   
-
   
-
   
25,640
 
       Net cash provided by (used for) financing activities
 
304,864
   
(19,213
)
 
5,186
   
-
   
290,837
 
Net (decrease) increase in cash and cash equivalents
 
(89,589
)
 
12,210
   
1,276
   
-
   
(76,103
)
Cash and cash equivalents at beginning of period
 
119,810
   
11,337
   
788
   
-
   
131,935
 
Cash and cash equivalents at end of period
$
30,221
 
$
23,547
 
$
2,064
 
$
-
 
$
55,832
 


 
F-55


SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
SUPPLEMENTARY DATA (UNAUDITED)
QUARTERLY FINANCIAL DATA

The following tables reflect unaudited quarterly financial data for fiscal years 2009 and 2008 (in thousands, except per share data):
 
   
For the Year Ended
 
   
December 31, 2009 (1)
 
   
Fourth
   
Third
   
Second
   
First
       
   
Quarter
   
Quarter
   
Quarter
   
Quarter
   
Total
 
                               
Total net revenues
$
474,064
 
$
470,893
 
$
468,713
 
$
468,129
 
$
1,881,799
 
                               
Income from continuing operations
$
9,678
 
$
10,389
 
$
10,811
 
$
11,602
 
$
42,480
 
Loss from discontinued operations
$
(1,003
)
$
(731
)
$
(715
)
$
(1,359
)
$
(3,809
)
                               
Net income
$
8,675
 
$
9,658
 
$
10,096
 
$
10,243
 
$
38,671
 
                               
Basic earnings per common and
                             
common equivalent share:
                             
Income from continuing operations
$
0.22
 
$
0.24
 
$
0.25
 
$
0.27
 
$
0.97
 
Loss from discontinued operations
 
(0.02
)
 
(0.02
)
 
(0.02
)
 
(0.04
)
 
(0.09
)
Net income
$
0.20
 
$
0.22
 
$
0.23
 
$
0.23
 
$
0.88
 
                               
Diluted earnings per common and
                             
common equivalent share:
                             
Income from continuing operations
$
0.22
 
$
0.24
 
$
0.25
 
$
0.26
 
$
0.97
 
Loss from discontinued operations
 
(0.02
)
 
(0.02
)
 
(0.02
)
 
(0.03
)
 
(0.09
)
Net income
$
0.20
 
$
0.22
 
$
0.23
 
$
0.23
 
$
0.88
 
                               
Weighted average number of
                             
common and common equivalent
                             
shares outstanding:
                             
Basic
 
43,944
   
43,923
   
43,851
   
43,643
   
43,841
 
Diluted
 
44,602
   
44,015
   
43,960
   
43,872
   
43,963
 

 
1

 
 
 
   
For the Year Ended
 
   
December 31, 2008 (1)(2)
 
   
Fourth
   
Third
   
Second
   
First
       
   
Quarter
   
Quarter
   
Quarter
   
Quarter
   
Total
 
                               
Total net revenues
$
466,796
 
$
455,757
 
$
450,756
 
$
450,194
 
$
1,823,503
 
                               
Income from continuing  operations  (3)
$
83,826
 
$
9,421
 
$
12,602
 
$
8,075
 
$
113,924
 
(Loss) income from discontinued operations
$
(1,405
)
$
(817
)
$
(2,917
)
$
502
 
$
(4,637
)
                               
Net income
$
82,421
 
$
8,604
 
$
9,685
 
$
8,577
 
$
109,287
 
                               
Basic earnings per common and
                             
common equivalent share:
                             
Income from continuing operations
$
1.92
 
$
0.22
 
$
0.29
 
$
0.19
 
$
2.63
 
(Loss) income from discontinued operations
 
(0.03
)
 
(0.02
)
 
(0.07
)
 
0.01
   
(0.11
)
Net income
$
1.89
 
$
0.20
 
$
0.22
 
$
0.20
 
$
2.52
 
                               
Diluted earnings per common and
                             
common equivalent share:
                             
Income from continuing operations
$
1.91
 
$
0.21
 
$
0.29
 
$
0.18
 
$
2.59
 
(Loss) income from discontinued operations
 
(0.03
)
 
(0.02
)
 
(0.07
)
 
0.01
   
(0.10
)
Net income
$
1.88
 
$
0.19
 
$
0.22
 
$
0.19
 
$
2.49
 
                               
Weighted average number of
                             
common and common equivalent
                             
shares outstanding:
                             
Basic
 
43,602
   
43,468
   
43,188
   
43,067
   
43,331
 
Diluted
 
43,873
   
44,478
   
43,928
   
44,474
   
43,963
 
 
(1)
We have reclassified all activity related to entities whose operations were divested or identified for disposal for the years ended December 31, 2009 and 2008 to discontinued operations.  Therefore, the quarterly financial data presented above including revenues, income (loss) before income taxes and discontinued operations and income (loss) on discontinued operations will not reflect the amounts reported previously in our Quarterly Reports on Form 10-Q filed with the SEC.  However, net income remains the same.
   
(2)
Results for the year ended December 31, 2008 include a full year of revenues and expenses of Harborside, which was acquired on April 1, 2007 (see Note 6 – “Acquisitions”), a release of $70.5 million of deferred tax valuation allowance, an increase of $0.9 million of self-insurance reserves for general and professional liability and workers’ compensation related to prior years’ continuing operations, and a gain of $0.9 million related to the sale of non-core business assets.
   
(3)
In 2008, we recorded a benefit of $70.5 million in the fourth quarter from the release of a portion of the valuation allowance on our net deferred tax assets (see Note 10 – “Income Taxes”).  Additionally, we recorded a net gain on the sale of assets in the 2008 fourth quarter of $0.9 million.
   


 
2

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

SUPPLEMENTARY DATA (UNAUDITED)


INSURANCE RESERVES

Activity in our insurance reserves as of and for the three months ending December 31, 2009 and 2008 is as follows (in thousands):
 
   
Professional
Liability
   
Workers’
Compensation
   
Total
 
                   
Balance as of September 30, 2008
$
81,980
 
$
63,763
 
$
145,743
 
Current year provision, continuing operations
 
7,607
   
7,554
   
15,161
 
Current year provision, discontinued operations
 
45
   
13
   
58
 
Prior year reserve adjustments, continuing operations
 
3,550
   
-
   
3,550
 
Prior year reserve adjustments, discontinued operations
 
750
   
-
   
750
 
Claims paid, continuing operations
 
(5,816
)
 
(3,213
)
 
(9,029
)
Claims paid, discontinued operations
 
(659
)
 
(932
)
 
(1,591
)
Amounts paid for administrative services and other
 
(175
)
 
(597
)
 
(772
)
Balance as of December 31, 2008
$
87,282
 
$
66,588
 
$
153,870
 
                   
                   
Balance as of September 30, 2009
$
90,007
 
$
65,554
 
$
155,561
 
Current year provision, continuing operations
 
6,942
   
7,263
   
14,205
 
Current year provision, discontinued operations
 
434
   
158
   
592
 
Prior year reserve adjustments, continuing operations
 
2,200
   
1,720
   
3,920
 
Prior year reserve adjustments, discontinued operations
 
300
   
230
   
530
 
Claims paid, continuing operations
 
(4,045
)
 
(4,901
)
 
(8,946
)
Claims paid, discontinued operations
 
(635
)
 
(680
)
 
(1,315
)
Amounts paid for administrative services and other
 
(273
)
 
(1,838
)
 
(2,111
)
Balance as of December 31, 2009
$
94,930
 
$
67,506
 
$
162,436
 

 
3

 

SCHEDULE II

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS
(in thousands)


   
Column A
   
Column B
   
Column C
   
Column D
   
Column E
 
   
Balance at
   
Charged to
   
Additions
         
Balance at
 
   
Beginning
   
Costs and
   
Charged to
   
Deductions
   
End of
 
Description
 
of Period
   
Expenses(1)
   
Other Accounts(2)
   
Other(3)
   
Period
 
Year ended December 31, 2009
                             
  Allowance for doubtful accounts
$
44,830
 
$
21,196
 
$
214
 
$
(10,838
)
$
55,402
 
  Other receivables reserve (4)
$
1,077
 
$
105
 
$
-
 
$
-
 
$
1,182
 
  Allowance for deferred tax assets
$
34,321
 
$
-
 
$
-
 
$
(6,749
)
$
27,572
 
                               
Year ended December 31, 2008
                             
  Allowance for doubtful accounts
$
42,144
 
$
15,283
 
$
180
 
$
(12,777
)
$
44,830
 
  Other receivables reserve (4)
$
1,587
 
$
-
 
$
-
 
$
(510
)
$
1,077
 
  Allowance for deferred tax assets
$
132,905
 
$
-
 
$
13,945
 
$
(112,529
)
$
34,321
 
                               
Year ended December 31, 2007
                             
  Allowance for doubtful accounts
$
24,866
 
$
10,345
 
$
19,011
 
$
(12,078
)
$
42,144
 
  Other receivables reserve (4)
$
3,064
 
$
273
 
$
-
 
$
(1,750
)
$
1,587
 
  Allowance for deferred tax assets
$
185,473
 
$
-
 
$
22,750
 
$
(75,318
)
$
132,905
 
 
(1)
Charges included in (adjustment) provision for losses on accounts receivable of $(1), $1,176, and $1,363 for the years ended December 31, 2009, 2008, and 2007, respectively, related to discontinued operations.  The year ended December 31, 2007 also included a recovery of $2.3 million as a result of an indemnification claim relating to a 2005 acquisition.
   
(2)
Column C primarily represents increases that resulted from acquisition activity (see Note 6 – “Acquisitions”).
   
(3)
Column D primarily represents write offs and recoveries of receivables that have been fully reserved or releases of valuation allowance on deferred tax assets (see Note 10 – “Income Taxes”).
   
(4)
The other receivables reserve is classified in prepaid and other assets on our consolidated balance sheets.  Other receivables, net of reserves, were $4,943, $5,599, and $1,635 as of December 31, 2009, 2008 and 2007, respectively.



 
 
4