Attached files

file filename
EX-31.1 - SUN HEALTHCARE GROUP INCex311.htm
EX-31.2 - SUN HEALTHCARE GROUP INCex312.htm
EX-32.2 - SUN HEALTHCARE GROUP INCex322.htm
EX-32.1 - SUN HEALTHCARE GROUP INCex321.htm
EX-10.1 - SUN HEALTHCARE GROUP INCex101.htm




UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2010

or

o     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.
(Exact name of Registrant as specified in its charter)

Delaware
85-0410612
(State of Incorporation)
(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400
Irvine, CA  92612
(949) 255-7100
(Address, zip code and telephone number of Registrant)


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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o No 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 filer  o
Accelerated filer  x
   
Non-accelerated filer  o
Smaller reporting company  o
   
(Do not check if a smaller reporting company)
 

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

As of July 28, 2010, there were 43,984,572 shares of the Registrant’s $.01 par value Common Stock outstanding.


 
1

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index
   
Page
Numbers
PART I.  FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements:
 
     
 
Consolidated Balance Sheets (unaudited)
3-4
 
As of June 30, 2010
 
 
As of December 31, 2009
 
     
 
Consolidated Income Statements (unaudited)
5-6
 
For the three months ended June 30, 2010 and 2009
 
 
For the six months ended June 30, 2010 and 2009
 
     
 
Consolidated Statements of Cash Flows (unaudited)
7
 
For the three months ended June 30, 2010 and 2009
 
 
For the six months ended June 30, 2010 and 2009
 
     
 
Notes to Consolidated Financial Statements (unaudited)
8-29
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
30-49
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
49
     
Item 4.
Controls and Procedures
49-50
     
PART II.  OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
50
     
Item 1A.
Risk Factors
50-51
     
Item 6.
Exhibits
51
     
Signature
 
51

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.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Quarterly Report on Form 10-Q (this “10-Q”) contains “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”) and the federal securities laws.  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 Separation and REIT Conversion Merger, 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, compliance with and changes in governmental regulations and environmental compliance costs and liabilities associated with our centers.  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, although not all forward-looking statements contain these identifying words.

We caution you that any forward-looking statements made in this 10-Q are not guarantees of future performance and that you should not place undue reliance on any of such forward-looking statements.  The forward-looking statements are based on the information currently available and are applicable only as of the date of this report or, in the case of forward-looking statements incorporated by reference, as of the date of the filing that includes the forward-looking statements. 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 as a result of, but not limited to, the factors described in this 10-Q (see Part II, Item 1(A)) and those described in our filings with the SEC, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 and our Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2010. You should also carefully consider the risks described in this 10-Q (see Part II, Item 1(A)) and in our 2009 Annual Report on Form 10-K (see Item 1A – “Risk Factors”).  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.  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.
_______________________

 
2

 

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS
(in thousands)


   
June 30, 2010
   
December 31, 2009
 
         
(Note 1)
 
Current assets:
           
Cash and cash equivalents
  $ 106,974     $ 104,483  
Restricted cash
    24,732       24,034  
Accounts receivable, net of allowance for doubtful accounts of $62,310
           
and $55,402 at June 30, 2010 and December 31, 2009, respectively
220,373       220,319  
Prepaid expenses and other assets
    18,021       21,757  
Deferred tax assets
    69,544       68,415  
                 
Total current assets
    439,644       439,008  
                 
Property and equipment, net
    620,999       622,682  
Intangible assets, net
    52,640       53,931  
Goodwill
    338,364       338,296  
Restricted cash, non-current
    348       3,317  
Deferred tax assets
    96,180       108,999  
Other assets
    5,000       4,961  
Total assets
  $ 1,553,175     $ 1,571,194  




See accompanying notes.


 
3

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

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

   
June 30, 2010
   
December 31, 2009
 
         
(Note 1)
 
Current liabilities:
           
Accounts payable
  $ 52,922     $ 57,109  
Accrued compensation and benefits
    63,015       58,953  
Accrued self-insurance obligations, current portion
    43,794       45,661  
Income taxes payable
    338       -  
Other accrued liabilities
    55,507       55,265  
Current portion of long-term debt and capital lease obligations
    74,827       46,416  
                 
Total current liabilities
    290,403       263,404  
                 
Accrued self-insurance obligations, net of current portion
    128,657       121,948  
Long-term debt and capital lease obligations, net of current portion
    588,736       654,132  
Unfavorable lease obligations, net
    11,233       12,663  
Other long-term liabilities
    60,692       69,983  
                 
Total liabilities
    1,079,721       1,122,130  
                 
Commitments and contingencies (Note 5)
               
                 
Stockholders' equity:
               
Preferred stock of $.01 par value, authorized 10,000,000
               
shares, zero shares issued and outstanding as of
               
June 30, 2010 and December 31, 2009
    -       -  
Common stock of $.01 par value, authorized 125,000,000
               
shares, 43,980,405 and 43,764,240 shares issued and outstanding
               
as of June 30, 2010 and December 31, 2009, respectively
    440       438  
Additional paid-in capital
    657,875       655,667  
Accumulated deficit
    (183,841 )     (204,012 )
Accumulated other comprehensive loss, net
    (1,020 )     (3,029 )
Total stockholders' equity
    473,454       449,064  
Total liabilities and stockholders' equity
  $ 1,553,175     $ 1,571,194  





See accompanying notes.

 
4

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Three Months Ended
 
   
June 30, 2010
   
June 30, 2009
 
             
Total net revenues
  $ 474,618     $ 468,713  
Costs and expenses:
               
Operating salaries and benefits
    267,880       261,967  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    14,558       16,809  
Operating administrative expenses
    13,301       13,192  
Other operating costs
    95,884       94,530  
Center rent expense
    18,810       18,215  
General and administrative expenses
    15,157       15,721  
Depreciation and amortization
    12,561       11,153  
Provision for losses on accounts receivable
    5,040       6,293  
Interest, net of interest income of $73 and $96, respectively
    11,776       12,465  
Transaction costs
    2,248       -  
Loss on sale of assets, net
    -       40  
Total costs and expenses
    457,215       450,385  
                 
Income before income taxes and discontinued operations
    17,403       18,328  
Income tax expense
    7,135       7,517  
Income from continuing operations
    10,268       10,811  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (295 )     (708 )
Loss on disposal of discontinued operations, net of
               
related taxes
    -       (7 )
Loss from discontinued operations, net
    (295 )     (715 )
                 
Net income
  $ 9,973     $ 10,096  
                 
Basic earnings per common and common equivalent share:
               
Income from continuing operations
  $ 0.23     $ 0.25  
Loss from discontinued operations, net
    -       (0.02 )
Net income
  $ 0.23     $ 0.23  
                 
Diluted earnings per common and common equivalent share:
               
Income from continuing operations
  $ 0.23     $ 0.25  
Loss from discontinued operations, net
    (0.01 )     (0.02 )
Net income
  $ 0.22     $ 0.23  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    44,233       43,851  
Diluted
    44,352       43,960  

See accompanying notes.

 
5

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Six Months Ended
 
   
June 30, 2010
   
June 30, 2009
 
             
Total net revenues
  $ 947,874     $ 936,843  
Costs and expenses:
               
Operating salaries and benefits
    534,918       524,878  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    29,096       31,462  
Operating administrative expenses
    25,589       25,769  
Other operating costs
    193,363       190,309  
Center rent expense
    37,362       36,578  
General and administrative expenses
    30,424       32,471  
Depreciation and amortization
    25,007       21,875  
Provision for losses on accounts receivable
    10,917       10,281  
Interest, net of interest income of $163 and $203, respectively
    23,752       25,191  
Transaction costs
    2,248       -  
Loss on sale of  assests, net
    -       40  
Total costs and expenses
    912,676       898,854  
                 
Income before income taxes and discontinued operations
    35,198       37,989  
Income tax expense
    14,431       15,575  
Income from continuing operations
    20,767       22,414  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (596 )     (1,760 )
Loss on disposal of discontinued operations, net of
               
related taxes
    -       (315 )
Loss from discontinued operations, net
    (596 )     (2,075 )
                 
Net income
  $ 20,171     $ 20,339  
                 
Basic earnings per common and common equivalent share:
               
Income from continuing operations
  $ 0.47     $ 0.51  
Loss from discontinued operations, net
    (0.01 )     (0.05 )
Net income
  $ 0.46     $ 0.46  
                 
Diluted earnings per common and common equivalent share:
               
Income from continuing operations
  $ 0.47     $ 0.51  
Loss from discontinued operations, net
    (0.01 )     (0.05 )
Net income
  $ 0.46     $ 0.46  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    44,119       43,748  
Diluted
    44,234       43,891  

See accompanying notes.

 
6

 

 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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

                         
   
For the
   
For the
 
   
Three Months Ended
   
Six Months Ended
 
   
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
Cash flows from operating activities:
                       
Net income
  $ 9,973     $ 10,096     $ 20,171     $ 20,339  
Adjustments to reconcile net income to net cash provided by
                               
operating activities, including discontinued operations:
                               
Depreciation and amortization
    12,561       11,153       25,007       21,875  
Amortization of favorable and unfavorable lease intangibles
(474 )     (474 )     (948 )     (876 )
Provision for losses on accounts receivable
    5,125       6,294       11,139       10,281  
Loss on sale of assets, including discontinued
                               
operations, net
    -       53       -       575  
Stock-based compensation expense
    1,694       1,641       3,087       2,909  
Deferred taxes
    6,755       6,345       11,691       12,520  
Changes in operating assets and liabilities, net of acquisitions:
                               
Accounts receivable
    (4,871 )     (11,599 )     (11,193 )     (21,667 )
Restricted cash
    3,427       1,415       2,271       9,521  
Prepaid expenses and other assets
    (1,670 )     (392 )     2,613       (238 )
Accounts payable
    7,140       (1,527 )     1,281       (5,063 )
Accrued compensation and benefits
    (4,362 )     (3,907 )     4,062       366  
Accrued self-insurance obligations
    2,805       344       4,842       1,251  
Income taxes payable
    (290 )     -       338       -  
Other accrued liabilities
    (2,457 )     (5,571 )     13       (825 )
Other long-term liabilities
    (4,144 )     885       (5,099 )     1,181  
Net cash provided by operating activities
    31,212       14,756       69,275       52,149  
                                 
Cash flows from investing activities:
                               
Capital expenditures
    (10,656 )     (13,137 )     (27,714 )     (25,002 )
Purchase of leased real estate
    -       (3,275 )     -       (3,275 )
Proceeds from sale of assets held for sale
    -       -       -       2,174  
Net cash used for investing activities
    (10,656 )     (16,412 )     (27,714 )     (26,103 )
                                 
Cash flows from financing activities:
                               
Principal repayments of long-term debt and capital lease
                               
obligations
    (16,036 )     (2,075 )     (36,976 )     (21,687 )
Payment to non-controlling interest
    -       -       (2,025 )     -  
Distribution to non-controlling interest
    -       (549 )     (69 )     (860 )
Proceeds from issuance of common stock
    -       7       -       20  
Net cash used for financing activities
    (16,036 )     (2,617 )     (39,070 )     (22,527 )
                                 
Net increase in cash and cash equivalents
    4,520       (4,273 )     2,491       3,519  
Cash and cash equivalents at beginning of period
    102,454       99,945       104,483       92,153  
Cash and cash equivalents at end of period
  $ 106,974     $ 95,672     $ 106,974     $ 95,672  
                                 


See accompanying notes.

 
7

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


(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 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, post-acute 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 202 healthcare centers in 25 states as of June 30, 2010.

Proposed Restructuring

On May 24, 2010, we announced a plan to restructure our business by separating our real estate assets and our operating assets into two separate publicly traded companies, subject to the approval of our stockholders and other conditions.  The plan consists of certain key transactions including the reorganization, through a series of internal corporate restructurings, such that (i) substantially all of the Company’s owned real property and related mortgage indebtedness owed to third parties will be held or assumed by Sabra Health Care REIT, Inc., a Maryland corporation and a wholly owned subsidiary of the Company (“Sabra”) and (ii) substantially all of the Company’s operations and other assets and liabilities will be held or assumed by SHG Services, Inc., a Delaware corporation and a wholly owned subsidiary of the Company (“New Sun”).  The Company will distribute to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”).  The Company will then merge with and into Sabra, with Sabra surviving the merger as a Maryland corporation and the Company’s stockholders receiving shares of Sabra common stock in exchange for their shares of the Company’s common stock (the “REIT Conversion Merger”).    Shares of New Sun common stock and Sabra common stock are both expected to trade on the NASDAQ Global Select Market.  Following the Separation and REIT Conversion Merger, New Sun will change its name to Sun Healthcare Group, Inc.    The Separation and REIT Conversion Merger are expected to be completed in the fourth calendar quarter of 2010.

Transaction Costs

Our results of operations for the three and six months ended June 30, 2010 include $2.2 million of transaction costs related to the proposed restructing, which consist primarily of professional services.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at June 30, 2010, and our consolidated results of operations and cash flows for the three-month and six-month periods ended June 30, 2010 and 2009, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2009, which are included in our Annual Report on Form 10-K for the year ended December 31, 2009 (the “2009 Form 10-K”).

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

 
8

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals, and income taxes. Actual results could differ from those estimates.
 
Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (the “FASB”) issued revised guidance for disclosures of fair value measurements.  The guidance requires additional disclosures regarding transfers between defined categories of  quality and reliability and prescribes a rollforward of activity in the lowest category (i.e. Level 3).  Disclosures regarding transfers are required beginning January 1, 2010 and the Level 3 rollforward is to be disclosed in reporting periods beginning after December 15, 2010.  Since we had no transfers between categories, the additional disclosures are not applicable to us for the periods presented.

Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2010 financial statement presentation.  Primarily, we have reclassified the results of operations of one divested center (see Note 4 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

(2)  Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):

   
June 30, 2010
   
December 31, 2009
 
             
Revolving credit facility
  $ -     $ -  
Mortgage notes payable due at various dates through 2047, interest at
               
rates from 3.5% to 9.4%, collateralized by the carrying values of
               
various centers totaling approximately $200,000 (1)
    154,307       170,608  
Term loans
    308,588       329,107  
Senior subordinated notes
    200,000       200,000  
Capital leases
    668       833  
Total long-term obligations
    663,563       700,548  
Less amounts due within one year
    (74,827 )     (46,416 )
Long-term obligations, net of current portion
  $ 588,736     $ 654,132  

(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 June 30, 2010, were as follows (in thousands):

For the twelve months ending June 30:
 
       
2011    
$
74,827
 
2012
 
6,121
 
2013
 
6,208
 
2014
 
306,842
 
2015
 
201,590
 
Thereafter
 
67,307
 
 
$
662,895
 

 
9

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


In June 2010, we amended our senior secured credit facility with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent (the “Credit Agreement”).  The amendment increased the permitted amount of expenditures for acquisitions, modified certain financial covenants, required a $25.0 million minimum principal repayment to be paid by December 31, 2010, decreased our letter of credit facility by $25.0 million and increased interest rates.  The loans under the amended 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 2.0% for alternative base rate loans and 3.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 2.0% for alternative base rate revolving loans and up to 3.0% for LIBOR rate revolving loans based on our total leverage ratio.  The applicable percentages for alternative base rate loans and LIBOR loans will increase by an additional 1.0% on January 1, 2011.  The $25.0 million decrease in our letter of credit facility has resulted in the use of our revolving credit facility for $24.7 million of undrawn letters of credit.  Accordingly, $25.3 million is available for drawing under our revolving credit facility at June 30, 2010.

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 into 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 three and six months ended June 30, 2010 and 2009 indicates that the swaps are highly effective hedges, and as such, there is no amount related to hedging ineffectiveness to expense.  We do not anticipate our 2010 other comprehensive loss to be reclassified into earnings within the next year as the agreements will expire in July 2010 without any cash settlement.

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

   
Liability Derivatives
   
June 30, 2010
 
December 31, 2009
   
Balance Sheet
       
Balance Sheet
       
   
Location
   
Fair Value
 
Location
   
Fair Value
 
Derivatives designated as
                     
hedging instruments:
                     
Interest rate swap
 
Other Accrued
       
Other Long-Term
       
agreements
 
Liabilities
 
$
1,701
 
Liabilities
 
$
5,048
 


 
10

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended June 30 is as follows (in thousands):

         
Gain Reclassified from
 
   
Amount of Income in
   
Accumulated Other Comprehensive
 
   
Other Comprehensive Income
   
Loss to Income (ineffective portion)
 
   
2010
   
2009
   
2010
   
2009
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate swap agreements
$
1,033
 
$
374
 
$
-
 
$
-
 

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the six months ended June 30 is as follows (in thousands):

         
Gain Reclassified from
 
   
Amount of Income in
   
Accumulated Other Comprehensive
 
   
Other Comprehensive Income
   
Loss to Income (ineffective portion)
 
   
2010
   
2009
   
2010
   
2009
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate swap agreements
$
2,009
 
$
305
 
$
-
 
$
-
 

The amounts stated above for income from changes in the fair value of our interest rate swap agreements are our only sources of other comprehensive income, resulting in comprehensive income of $11.0 million and $22.2 million for the three and six months ended June 30, 2010, respectively.  Comprehensive income for the three and six months ended June 30, 2009 was $10.5 million and $20.6 million, respectively.

(3)  Fair Value of Financial Instruments

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

   
June 30, 2010
   
December 31, 2009
 
   
Carrying
         
Carrying
       
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
                         
Cash and cash equivalents
$
106,974
 
$
106,974
 
$
104,483
 
$
104,483
 
Restricted cash
$
25,080
 
$
25,080
 
$
27,351
 
$
27,351
 
Long-term debt and capital lease obligations,
                       
including current portion
$
663,563
 
$
537,592
 
$
700,548
 
$
574,770
 
Interest rate swap agreements
$
1,701
 
$
1,701
 
$
5,048
 
$
5,048
 

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At June 30, 2010 and December 31, 2009, the fair value of our long-term debt, including current maturities, and our interest rate swap agreements 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.





 
11

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


GAAP establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  The applicable 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.

We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above pricing levels as of June 30, 2010 and December 31, 2009, respectively (in thousands):

   
June 30, 2010
 
       
Unadjusted Quoted
 
Significant Other
 
       
Market Prices
 
Observable Inputs
 
   
Total
 
(Level 1)
 
(Level 2)
 
Cash equivalents – money market
             
funds/certificate of deposit
$
25,601
$
20,546
$
5,055
 
Restricted cash – money market funds
$
1,463
$
1,463
$
-
 
Interest rate swap agreements – liability
$
1,701
$
-
$
1,701
 

   
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 agreements – liability
$
5,048
$
-
$
5,048
 

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

(4) Discontinued Operations

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.

In October 2009, we transferred operations of a leased assisted living center in Utah to an outside party, whose results have been reclassified to discontinued operations for all periods presented.


 
12

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


A summary of the discontinued operations for the periods presented is as follows (in thousands):

   
For the Three Months Ended
 
   
June 30, 2010
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
25
 
$
-
 
$
25
 
                   
Loss from discontinued operations, net (1)
$
(256
)
$
(39
)
$
(295
)
Loss on disposal of discontinued operations, net (2)
 
-
   
-
   
-
 
Loss from discontinued operations, net
$
(256
)
$
(39
)
$
(295
)

(1)  Net of related tax benefit of $205
(2)  No related tax benefit

   
For the Three Months Ended
 
   
June 30, 2009
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
181
 
$
-
 
$
181
 
                   
Loss from discontinued operations, net (1)
$
(699
)
$
(9
)
$
(708
)
Loss on disposal of discontinued operations, net (2)
 
(20
)
 
13
   
(7
)
Loss from discontinued operations, net
$
(719
)
$
4
 
$
(715
)

(1)  Net of related tax benefit of $496
(2)  Net of related tax benefit of $5

   
For the Six Months Ended
 
   
June 30, 2010
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
26
 
$
-
 
$
26
 
                   
Loss from discontinued operations, net (1)
$
(546
)
$
(51
)
$
(596
)
Loss on disposal of discontinued operations, net (2)
 
-
   
-
   
-
 
Loss from discontinued operations, net
$
(545
)
$
(51
)
$
(596
)

(1)  Net of related tax benefit of $414
(2)  No related tax benefit
 
 
 
13

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

   
For the Six Months Ended
 
   
June 30, 2009
 
   
Inpatient
             
   
Services
   
Other
   
Total
 
                   
Net operating revenues
$
391
 
$
-
 
$
391
 
                   
Loss from discontinued operations, net (1)
$
(1,743
)
$
(17
)
$
(1,760
)
Loss on disposal of discontinued operations, net (2)
 
(299
)
 
(16
)
 
(315
)
Loss from discontinued operations, net
$
(2,042
)
$
(33
)
$
(2,075
)

(1)  Net of related tax benefit of $1,223
(2)  Net of related tax benefit of $219

(5)  Commitments and Contingencies

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 from such reviews 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 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.  The purpose of these functions are to properly administer the claims 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 instances where our historical data are not statistically credible, stable, or mature, we supplement our experience with skilled nursing 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 limitation is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which include 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

 
14

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

accident year, and an estimated unpaid loss and allocated loss adjustment expense is determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

Activity in our insurance reserves as of and for the three and six months ended June 30, 2010 and 2009 is as follows (in thousands):

   
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
                   
Balance as of January 1, 2010
$
94,930
 
$
67,506
 
$
162,436
 
Current year provision, continuing operations
 
7,384
   
7,154
   
14,538
 
Claims paid, continuing operations
 
(4,219
)
 
(4,609
)
 
(8,828
)
Claims paid, discontinued operations
 
(563
)
 
(579
)
 
(1,142
)
Amounts paid for administrative services and other
 
(850
)
 
(1,696
)
 
(2,546
)
Balance as of March 31, 2010
$
96,682
 
$
67,776
 
$
164,458
 
                   
Current year provision, continuing operations
 
7,382
   
7,176
   
14,558
 
Claims paid, continuing operations
 
(3,605
)
 
(3,943
)
 
(7,548
)
Claims paid, discontinued operations
 
(1,553
)
 
(652
)
 
(2,205
)
Amounts paid for administrative services and other
 
(723
)
 
(1,620
)
 
(2,343
)
Balance as of June 30, 2010
$
98,183
 
$
68,737
 
$
166,920
 
 
 
   
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
                   
Balance as of January 1, 2009
$
87,282
 
$
66,588
 
$
153,870
 
Current year provision, continuing operations
 
7,240
   
7,419
   
14,659
 
Current year provision, discontinued operations
 
306
   
155
   
461
 
Claims paid, continuing operations
 
(4,234
)
 
(5,217
)
 
(9,451
)
Claims paid, discontinued operations
 
(936
)
 
(835
)
 
(1,771
)
Amounts paid for administrative services and other
 
(1,362
)
 
(1,900
)
 
(3,262
)
Balance as of March 31, 2009
$
88,296
 
$
66,210
 
$
154,506
 
                   
Current year provision, continuing operations
 
6,040
   
6,475
   
12,515
 
Current year provision, discontinued operations
 
331
   
155
   
486
 
Prior year reserve adjustments, continuing operations
 
4,300
   
-
   
4,300
 
Prior year reserve adjustments, discontinued operations
 
590
   
-
   
590
 
Claims paid, continuing operations
 
(6,858
)
 
(5,538
)
 
(12,396
)
Claims paid, discontinued operations
 
(1,487
)
 
(539
)
 
(2,026
)
Amounts paid for administrative services and other
 
(1,115
)
 
(1,757
)
 
(2,872
)
Balance as of June 30, 2009
$
90,097
 
$
65,006
 
$
155,103
 


 
15

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


A summary of the assets and liabilities related to insurance risks at June 30, 2010 and December 31, 2009 is as indicated (in thousands):

   
June 30, 2010
     
December 31, 2009
 
   
Professional
   
Workers’
       
|
 
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
|
 
Liability
   
Compensation
   
Total
 
Assets (1):
                 
|
                 
Restricted cash
                 
|
                 
Current
$
3,378
 
$
12,228
 
$
15,606
 
|
$
3,406
 
$
12,013
 
$
15,419
 
Non-current
 
-
   
-
   
-
 
|
 
-
   
-
   
-
 
Total
$
3,378
 
$
12,228
 
$
15,606
 
|
$
3,406
 
$
12,013
 
$
15,419
 
                   
|
                 
Liabilities (2)(3):
             
|
                 
Self-insurance
                 
|
                 
liabilities
                 
|
                 
Current
$
19,012
 
$
19,251
 
$
38,263
 
|
$
20,369
 
$
20,119
 
$
40,488
 
Non-current
 
79,171
   
49,486
   
128,657
 
|
 
74,561
   
47,387
   
121,948
 
Total
$
98,183
 
$
68,737
 
$
166,920
 
|
$
94,930
 
$
67,506
 
$
162,436
 
 
(1)
 
Total restricted cash includes cash collateral deposits posted and other cash deposits held by third parties.  Total restricted cash above excludes $9,474 and $11,932  at June 30, 2010 and December 31, 2009, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
     
(2)
 
Total self-insurance liabilities above exclude $5,531 and $5,173 at June 30, 2010 and December 31, 2009, respectively, related to our employee health insurance liabilities.
     
(3)
 
Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $60,291 for workers’ compensation, as of June 30, 2010, and $250 and $53,191 for general and professional liability insurance and workers’ compensation, respectively, as of December 31, 2009.

(6)  Income Taxes

The provision for income taxes of $7.1 million and $14.4 million for the three and six months, respectively, ended June 30, 2010 results in an effective rate of approximately 41%.  The provision for income taxes of $7.5 million and $15.6 million for the three and six months, respectively, ended June 30, 2009 also resulted in an effective tax rate of approximately 41%.  The rates for 2010 and 2009 differ from the statutory tax rate of 35% primarily due to state taxes.
 
 
During the second quarter of 2009, the Internal Revenue Service commenced an examination of the tax returns of Sun and Harborside for 2006, and the Harborside tax return for the short-period ended April 19, 2007.  These examinations were completed during this quarter, and the net adjustments were immaterial.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  The valuation allowance of $27.6 million at June 30, 2010 and December 31, 2009 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

The Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $24.9 million, which includes approximately $14.6 million due to a significant acquisition in 2007. Accordingly, our net operating loss, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, there is approximately $106.8 million of NOLs which can be used to

 
16

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
offset U.S. taxable income in 2010. Considering annual IRC Section 382 limitations and built-in gains, we have a total of $227.6 million of utilizable NOL carryforwards to offset taxable income in 2010 and future years.

(7)  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.

We operate in industries that are 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. For example, investigations of our California centers by the Bureau of Medi-Cal Fraud and Elder Abuse of the Office of the California Attorney General culminated in a Permanent Injunction and Final Judgment, originally entered in October 2001, as superseded by a Superseding Permanent Injunction and Final Judgment, entered in September 2005, which requires compliance with certain clinical practices in our California centers that are substantially consistent with existing law and our current practices. 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 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 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.

(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.

(8)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.  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.  More complete descriptions and accounting policies of the segments are described in Note 14 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2009 Form 10-K.

 
17

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

As of and for the
                                   
Three Months Ended
                                   
June 30, 2010
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
  $ 421,720     $ 30,017     $ 22,875     $ 6     $ -     $ 474,618  
                                                 
Intersegment revenues
    -       21,034       496       -       (21,530 )     -  
                                                 
Total revenues
    421,720       51,051       23,371       6       (21,530 )     474,618  
                                                 
Operating salaries and benefits
    208,755       42,109       17,016       -       -       267,880  
                                                 
Self-insurance for workers’
                                               
compensation and general and
                                               
professional liability insurance
    13,739       435       323       61       -       14,558  
                                                 
Other operating costs
    112,056       2,177       3,181       -       (21,530 )     95,884  
                                                 
General and administrative expenses
    10,652       1,966       682       17,406       -       30,706  
                                                 
Provision for losses on accounts
                                               
receivable
    4,892       166       (18 )     -       -       5,040  
                                                 
Segment operating income (loss)
  $ 71,626     $ 4,198     $ 2,187     $ (17,461 )   $ -     $ 60,550  
                                                 
Center rent expense
    18,489       118       203       -       -       18,810  
                                                 
Depreciation and amortization
    11,418       159       182       802       -       12,561  
                                                 
Interest, net
    2,706       -       -       9,070       -       11,776  
                                                 
Net segment income (loss)
  $ 39,013     $ 3,921     $ 1,802     $ (27,333 )   $ -     $ 17,403  
                                                 
Identifiable segment assets
  $ 1,189,410     $ 14,746     $ 20,546     $ 308,972     $ 20,895     $ 1,554,569  
                                                 
Goodwill
  $ 333,756     $ 75     $ 4,533     $ -     $ -     $ 338,364  
                                                 
Segment capital expenditures
  $ 10,326     $ 129     $ 35     $ 163     $ -     $ 10,653  

______________________________________

General and administrative expenses include operating administrative expenses and transaction costs.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

 
18

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



As of and for the
                                   
Three Months Ended
                                   
June 30, 2009
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
  $ 416,451     $ 26,155     $ 26,097     $ 10     $ -     $ 468,713  
                                                 
Intersegment revenues
    -       18,360       563       -       (18,923 )     -  
                                                 
Total revenues
    416,451       44,515       26,660       10       (18,923 )     468,713  
                                                 
Operating salaries and benefits
    206,531       36,801       18,635       -       -       261,967  
                                                 
Self-insurance for workers’
                                               
compensation and general and
                                               
professional liability insurance
    15,844       542       320       103       -       16,809  
                                                 
Other operating costs
    107,383       1,930       4,140       -       (18,923 )     94,530  
                                                 
General and administrative expenses
    10,691       1,777       723       15,722       -       28,913  
                                                 
Provision for losses on accounts
                                               
receivable
    6,095       109       89       -       -       6,293  
                                                 
Segment operating income (loss)
  $ 69,907     $ 3,356     $ 2,753     $ (15,815 )   $ -     $ 60,201  
                                                 
Center rent expense
    17,868       114       233       -       -       18,215  
                                                 
Depreciation and amortization
    10,118       131       232       672       -       11,153  
                                                 
Interest, net
    3,111       -       (1 )     9,355       -       12,465  
                                                 
Net segment income (loss)
  $ 38,810     $ 3,111     $ 2,289     $ (25,842 )   $ -     $ 18,368  
                                                 
                                                 
Identifiable segment assets
  $ 1,164,324     $ 14,612     $ 26,651     $ 861,749     $ (528,446 )   $ 1,538,890  
                                                 
Goodwill
  $ 322,412     $ 75     $ 4,533     $ -     $ -     $ 327,020  
                                                 
Segment capital expenditures
  $ 12,146     $ 123     $ 10     $ 858     $ -     $ 13,137  

______________________________________

General and administrative expenses include operating administrative expenses and transaction costs.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

 
19

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



As of and for the
                                   
Six Months Ended
                                   
June 30, 2010
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
  $ 842,248     $ 59,381     $ 46,231     $ 14     $ -     $ 947,874  
                                                 
Intersegment revenues
    -       42,187       640       -       (42,827 )     -  
                                                 
Total revenues
    842,248       101,568       46,871       14       (42,827 )     947,874  
                                                 
Operating salaries and benefits
    416,928       83,810       34,180       -       -       534,918  
                                                 
Self-insurance for workers’
                                               
compensation and general and
                                               
professional liability insurance
    27,480       864       630       122       -       29,096  
                                                 
Other operating costs
    225,546       3,995       6,649       -       (42,827 )     193,363  
                                                 
General and administrative expenses
    20,130       4,126       1,332       32,673       -       58,261  
                                                 
Provision for losses on accounts
                                               
receivable
    10,469       425       23       -       -       10,917  
                                                 
Segment operating income (loss)
  $ 141,695     $ 8,348     $ 4,057     $ (32,781 )   $ -     $ 121,318  
                                                 
Center rent expense
    36,709       240       413       -       -       37,362  
                                                 
Depreciation and amortization
    22,698       311       362       1,636       -       25,007  
                                                 
Interest, net
    5,517       -       (1 )     18,236       -       23,752  
                                                 
Net segment income (loss)
  $ 76,771     $ 7,797     $ 3,283     $ (52,653 )   $ -     $ 35,197  
                                                 
Identifiable segment assets
  $ 1,189,410     $ 14,746     $ 20,546     $ 308,972     $ 20,895     $ 1,554,569  
                                                 
Goodwill
  $ 333,756     $ 75     $ 4,533     $ -     $ -     $ 338,364  
                                                 
Segment capital expenditures
  $ 25,669     $ 330     $ 149     $ 1,564     $ -     $ 27,712  

______________________________________

General and administrative expenses include operating administrative expenses and transaction costs.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

 
20

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



As of and for the
                                   
Six Months Ended
                                   
June 30, 2009
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
  $ 831,687     $ 51,671     $ 53,471     $ 14     $ -     $ 936,843  
                                                 
Intersegment revenues
    -       36,576       1,123       -       (37,699 )     -  
                                                 
Total revenues
    831,687       88,247       54,594       14       (37,699 )     936,843  
                                                 
Operating salaries and benefits
    413,557       72,992       38,329       -       -       524,878  
                                                 
Self-insurance for workers’
                                               
compensation and general and
                                               
professional liability insurance
    29,488       1,077       692       205       -       31,462  
                                                 
Other operating costs
    215,691       3,720       8,596       1       (37,699 )     190,309  
                                                 
General and administrative expenses
    20,555       3,693       1,520       32,472       -       58,240  
                                                 
Provision for losses on accounts
                                               
receivable
    9,753       279       249       -       -       10,281  
                                                 
Segment operating income (loss)
  $ 142,643     $ 6,486     $ 5,208     $ (32,664 )   $ -     $ 121,673  
                                                 
Center rent expense
    35,872       229       477       -       -       36,578  
                                                 
Depreciation and amortization
    19,845       259       422       1,349       -       21,875  
                                                 
Interest, net
    6,322       (2 )     (1 )     18,872       -       25,191  
                                                 
Net segment income (loss)
  $ 80,604     $ 6,000     $ 4,310     $ (52,885 )   $ -     $ 38,029  
                                                 
                                                 
Identifiable segment assets
  $ 1,164,324     $ 14,612     $ 26,651     $ 861,749     $ (528,446 )   $ 1,538,890  
                                                 
Goodwill
  $ 322,412     $ 75     $ 4,533     $ -     $ -     $ 327,020  
                                                 
Segment capital expenditures
  $ 23,573     $ 259     $ 50     $ 1,120     $ -     $ 25,002  

______________________________________

General and administrative expenses include operating administrative expenses and transaction costs.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before income tax expense and discontinued operations.

 
21

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


Measurement of Segment Income

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 (in thousands):

   
For the Three Months Ended
 
   
June 30,
 
   
2010
   
2009
 
             
Net segment income
  $ 19,651     $ 18,368  
Loss on sale of assets
    -       (40 )
Consolidated income before income taxes and
               
discontinued operations
  $ 19,651     $ 18,328  

   
For the Six Months Ended
 
   
June 30,
 
   
2010
   
2009
 
             
Net segment income
  $ 37,446     $ 38,029  
Loss on sale of assets
    -       (40 )
Consolidated income before income taxes and
               
discontinued operations
  $ 37,446     $ 37,989  


(9) Summarized Consolidating Information

In connection with the Company's offering of 9-1/8% Senior Subordinated Notes due 2015 (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:

 
22

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)



CONDENSED CONSOLIDATING BALANCE SHEETS

As of June 30, 2010
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Current assets:
                             
Cash and cash equivalents
  $ 90,614     $ 13,851     $ 2,509     $ -     $ 106,974  
Restricted cash
    15,647       5,597       3,488       -       24,732  
Accounts receivable, net
    -       217,872       2,521       (20 )     220,373  
Prepaid expenses and other assets
    4,866       14,602       464       (1,911 )     18,021  
Deferred tax assets
    -       72,822       1,291       (4,569 )     69,544  
Total current assets
    111,127       324,744       10,273       (6,500 )     439,644  
Property and equipment, net
    8,413       546,760       65,826       -       620,999  
Intangible assets, net
    32,201       16,159       5,278       (998     52,640  
Goodwill
    -       334,407       3,957       -       338,364  
Restricted cash, non-current
    -       348       -       -       348  
Other assets
    439       4,629       21       (89 )     5,000  
Deferred tax assets
    15,787       92,541       -       (12,148 )     96,180  
Intercompany balances
    257,658       -       2,862       (260,520 )     -  
Investment in subsidiaries
    692,371       -       -       (692,371 )     -  
Total assets
  $ 1,117,996     $ 1,319,588     $ 88,217     $ (972,626 )   $ 1,553,175  
                                         
Current liabilities:
                                       
Accounts payable
  $ 14,697     $ 37,527     $ 718     $ (20 )   $ 52,922  
Accrued compensation and benefits
    5,411       56,654       950       -       63,015  
Accrued self-insurance obligations, current
    3,869       39,925       -       -       43,794  
Income taxes payable
    338       -       -       -       338  
Other accrued liabilities
    12,950       38,509       4,048       -       55,507  
Deferred tax liability
    4,569       -       -       (4,569 )     -  
Current portion of long-term debt
    28,165       41,156       5,506       -       74,827  
Total current liabilities
    69,999       213,771       11,222       (4,589 )     290,403  
Accrued self-insurance obligations, net of current
    54,909       73,319       429       -       128,657  
Deferred tax liability
    -       -       12,148       (12,148 )     -  
Long-term debt, net of current
    480,948       49,527       58,261       -       588,736  
Unfavorable lease obligations, net
    -       12,231       -       (998 )     11,233  
Intercompany balances
    -       262,520       -       (262,520     -  
Other long-term liabilities
    38,686       22,006       -             60,692  
Total liabilities
    644,542       633,374       82,060       (280,255 )     1,079,721  
                                         
Stockholders’ equity:
                                       
Common stock
    440       -       -       -       440  
Additional paid-in capital
    657,875       -       -       -       657,875  
Accumulated deficit
    (183,841 )     686,214       6,157       (692,371 )     (183,841 )
Accumulated other comprehensive loss
    (1,020 )     -       -       -       (1,020 )
Total stockholders' equity
    473,454       686,214       6,157       (692,371 )     473,454  
Total liabilities and stockholders' equity
  $ 1,117,996     $ 1,319,588     $ 88,217     $ (972,626 )   $ 1,553,175  

 
23

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


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  


 
24

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended June 30, 2010
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
  $ 6     $ 488,596     $ 7,546     $ (21,530 )   $ 474,618  
Costs and expenses:
                                       
Operating salaries and benefits
    -       263,567       4,313       -       267,880  
Self-insurance for workers’ compensation and
                                       
general and professional liability insurance
    61       14,302       195       -       14,558  
General and administrative expenses (1)
    15,527       12,931       -       -       28,458  
Other operating costs
    -       115,617       1,797       (21,530 )     95,884  
Center rent expense
    -       18,605       205       -       18,810  
Depreciation and amortization
    802       11,152       607       -       12,561  
Provision for losses on accounts receivable
    -       4,929       111       -       5,040  
Interest, net
    8,985       1,728       1,063       -       11,776  
Transaction costs
    2,248       -       -       -       2,248  
Income from investment in subsidiaries
    (26,266 )     -       -       26,266       -  
Total costs and expenses
    1,357       442,831       8,291       4,736       457,215  
                                         
(Loss) income before income taxes and
                                       
discontinued operations
    (1,351 )     45,765       (745 )     (26,266 )     17,403  
Income tax (benefit) expense
    (11,324 )     18,764       (305 )     -       7,135  
Income (loss) from continuing operations
    9,973       27,001       (440 )     (26,266 )     10,268  
                                         
Discontinued operations:
                                       
Income (loss) from discontinued operations, net
    -       (346     (51 )     -       (295 )
Loss on disposal of discontinued
                                       
operations, net
    -       -       -       -       -  
Loss on discontinued operations, net
    -       (346     (51 )     -       (295 )
                                         
Net income (loss)
  $ 9,973     $ 26,655     $ (389 )   $ (26,266 )   $ 9,973  

         (1) Includes operating administrative expenses

 
25

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended June 30, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
  $ 10     $ 480,348     $ 7,278     $ (18,923 )   $ 468,713  
Costs and expenses:
                                       
Operating salaries and benefits
    -       257,870       4,097       -       261,967  
Self-insurance for workers’ compensation and
                                       
general and professional liability insurance
    103       16,547       159       -       16,809  
General and administrative expenses (1)
    16,093       12,820       -       -       28,913  
Other operating costs
    -       111,643       1,810       (18,923 )     94,530  
Center rent expense
    -       18,030       185       -       18,215  
Depreciation and amortization
    672       9,900       581       -       11,153  
Provision for losses on accounts receivable
    -       6,151       142       -       6,293  
Interest, net
    9,219       2,127       1,119       -       12,465  
Loss on sale of assets, net
    -       47       (7 )     -       40  
Income from investment in subsidiaries
    (25,481 )     -       -       25,481       -  
Total costs and expenses
    606       435,135       8,086       6,558       450,385  
                                         
(Loss) income before income taxes and
                                       
discontinued operations
    (596 )     45,213       (808 )     (25,481 )     18,328  
Income tax (benefit) expense
    (10,692 )     18,540       (331 )     -       7,517  
Income (loss) from continuing operations
    10,096       26,673       (477 )     (25,481 )     10,811  
                                         
Discontinued operations:
                                       
Loss from discontinued operations, net
    -       (129 )     (579 )     -       (708 )
(Loss) gain on disposal of discontinued
                                       
operations, net
    -       (12 )     5       -       (7 )
Loss on discontinued operations, net
    -       (141 )     (574 )     -       (715 )
                                         
Net income (loss)
  $ 10,096     $ 26,532     $ (1,051 )   $ (25,481 )   $ 10,096  

(1)   Includes operating administrative expenses

 
26

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Six Months Ended June 30, 2010
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
  $ 15     $ 975,334     $ 15,352     $ (42,827 )   $ 947,874  
Costs and expenses:
                                       
Operating salaries and benefits
    -       526,261       8,657       -       534,918  
Self-insurance for workers’ compensation and
                                       
general and professional liability insurance
    122       28,584       390       -       29,096  
General and administrative expenses (1)
    31,165       24,848       -       -       56,013  
Other operating costs
    -       232,706       3,484       (42,827 )     193,363  
Center rent expense
    -       36,951       411       -       37,362  
Depreciation and amortization
    1,636       22,161       1,210       -       25,007  
Provision for losses on accounts receivable
    -       10,720       197       -       10,917  
Interest, net
    18,029       3,570       2,153       -       23,752  
Transaction costs
    2,248       -       -       -       2,248  
Income from investment in subsidiaries
    (51,550 )     -       -       51,550       -  
Total costs and expenses
    1,650       885,801       16,502       8,723       912,676  
                                         
(Loss) income before income taxes and
                                       
discontinued operations
    (1,635 )     89,533       (1,150 )     (51,550 )     35,198  
Income tax (benefit) expense
    (21,806 )     36,709       (472 )     -       14,431  
Income (loss) from continuing operations
    20,171       52,824       (678 )     (51,550 )     20,767  
                                         
Discontinued operations:
                                       
(Loss) income from discontinued operations, net
    -       (621 )     25       -       (596 )
Loss on disposal of discontinued
                                       
operations, net
    -       -       -       -       -  
Loss on discontinued operations, net
    -       (621 )     25       -       (596 )
                                         
Net income (loss)
  $ 20,171     $ 52,203     $ (653 )   $ (51,550 )   $ 20,171  

          (1) Includes operating administrative expenses

 
27

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Six Months Ended June 30, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Total net revenues
  $ 14     $ 960,063     $ 14,465     $ (37,699 )   $ 936,843  
Costs and expenses:
                                       
Operating salaries and benefits
    -       516,774       8,104       -       524,878  
Self-insurance for workers’ compensation and
                                       
general and professional liability insurance
    205       30,938       319       -       31,462  
General and administrative expenses (1)
    33,214       25,026       -       -       58,240  
Other operating costs
    -       224,411       3,597       (37,699 )     190,309  
Center rent expense
    -       36,208       370       -       36,578  
Depreciation and amortization
    1,349       19,366       1,160       -       21,875  
Provision for losses on accounts receivable
    -       10,031       250       -       10,281  
Interest, net
    18,597       4,357       2,237       -       25,191  
Loss on sale of assets, net
    -       47       (7 )     -       40  
Income from investment in subsidiaries
    (51,816 )     -       -       51,816       -  
Total costs and expenses
    1,549       867,158       16,030       14,117       898,854  
                                         
(Loss) income before income taxes and
                                       
discontinued operations
    (1,535 )     92,905       (1,565 )     (51,816 )     37,989  
Income tax (benefit) expense
    (21,874 )     38,091       (642 )     -       15,575  
Income (loss) from continuing operations
    20,339       54,814       (923 )     (51,816 )     22,414  
                                         
Discontinued operations:
                                       
Loss from discontinued operations, net
    -       (957 )     (803 )     -       (1,760 )
(Loss) gain on disposal of discontinued
                                       
operations, net
    -       (534 )     219       -       (315 )
Loss on discontinued operations, net
    -       (1,491 )     (584 )     -       (2,075 )
                                         
Net income (loss)
  $ 20,339     $ 53,323     $ (1,507 )   $ (51,816 )   $ 20,339  

(1)   Includes operating administrative expenses



 
28

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)


CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30, 2010
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Net cash provided by operating activities
  $ 29,523     $ 36,659     $ 3,093     $ -     $ 69,275  
                                         
Cash flows from investing activities:
                                       
Capital expenditures
    (854 )     (26,645 )     (215 )     -       (27,714 )
Net cash used for investing activities
    (854 )     (26,645 )     (215 )     -       (27,714 )
                                         
Cash flows from financing activities:
                                       
Principal repayments of long-term debt and capital
                                       
lease obligations
    (20,518 )     (15,822 )     (636 )     -       (36,976 )
Payment to non-controlling interest
    -       -       (2,025 )     -       (2,025 )
Distribution to non-controlling interest
    -       -       (69 )     -       (69 )
Net cash used for financing activities
    (20,518 )     (15,822 )     (2,730 )     -       (39,070 )
Net increase (decrease) in cash and cash equivalents
    8,151       (5,808 )     148       -       2,491  
Cash and cash equivalents at beginning of period
    82,463       19,659       2,361       -       104,483  
Cash and cash equivalents at end of period
  $ 90,614     $ 13,851     $ 2,509     $ -     $ 106,974  


For the Six Months Ended June 30, 2009
(in thousands)

         
Combined
   
Combined
             
   
Parent
   
Guarantor
Non-Guarantor          
   
Company
   
Subsidiaries
   
Subsidiaries
   
Elimination
   
Consolidated
 
                               
Net cash provided by operating activities
  $ 21,916     $ 25,134     $ 5,099     $ -     $ 52,149  
                                         
Cash flows from investing activities:
                                       
Capital expenditures
    (1,118 )     (23,802 )     (82 )     -       (25,002 )
Purchase of lease real estate
    -       (3,275 )     -       -       (3,275 )
Proceeds from sale of assets held for sale
    -       2,174       -       -       2,174  
Net cash used for investing activities
    (1,118 )     (24,903 )     (82 )     -       (26,103 )
                                         
Cash flows from financing activities:
                                       
Principal repayments of long-term debt and capital
                                       
lease obligations
    (15,654 )     (1,888 )     (4,145 )     -       (21,687 )
Distribution to non-controlling interest
    -       -       (860 )     -       (860 )
Proceeds from issuance of common stock
    20       -       -       -       20  
Net cash used for financing activities
    (15,634 )     (1,888 )     (5,005 )     -       (22,527 )
Net increase (decrease) in cash and cash equivalents
    5,164       (1,657 )     12       -       3,519  
Cash and cash equivalents at beginning of period
    72,529       17,952       1,672       -       92,153  
Cash and cash equivalents at end of period
  $ 77,693     $ 16,295     $ 1,684     $ -     $ 95,672  

 
29

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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

Overview

Sun Healthcare Group, Inc.’s subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 166 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, ten assisted living centers, two independent living centers and eight mental health centers with 23,209 licensed beds located in 25 states as of June 30, 2010. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 were signed into law. Together, these two measures make the most sweeping and fundamental changes to the U.S. health care system since the creation of Medicare and Medicaid. These new laws include a large number of health-related provisions that are scheduled to take effect over the next four years, including expanding Medicaid eligibility, requiring most individuals to have health insurance, establishing new regulations on health plans, establishing health insurance exchanges, and modifying certain payment systems to encourage more cost-effective care and a reduction of inefficiencies and waste, including through new tools to address fraud and abuse. We cannot predict the effect these newly enacted laws or any future legislation or regulation will have on our future operations, including future reimbursement rates and occupancy in our inpatient facilities.

Proposed Restructuring

On May 24, 2010, we announced a plan to restructure our business by separating our real estate assets and our operating assets into two separate publicly traded companies, subject to the approval of our stockholders and other conditions.  The plan consists of certain key transactions including the reorganization, through a series of internal corporate restructurings, such that (i) substantially all of the Company’s owned real property and related mortgage indebtedness owed to third parties will be held or assumed by Sabra Health Care REIT, Inc., a Maryland corporation and a wholly owned subsidiary of the Company (“Sabra”) and (ii) substsantially all of the Company’s operations and other assets and liabilities will be held or assumed by SHG Services, Inc., a Delaware corporation and a wholly owned subsidiary of the Company (“New Sun”).  The Company will distribute to its stockholders on a pro rata basis all of the outstanding shares of New Sun common stock (the “Separation”).  The Company will then merge with and into Sabra, with Sabra surviving the merger as a Maryland corporation and the Company’s stockholders receiving shares of Sabra common stock in exchange for their shares of the Company’s common stock (the “REIT Conversion Merger”).    Shares of New Sun common stock and Sabra common stock are both expected to trade on the NASDAQ Global Select Market.  Following the Separation and REIT Conversion Merger, New Sun will change its name to Sun Healthcare Group, Inc.  The Separation and REIT Conversion Merger are expected to be completed in the fourth calendar quarter of 2010.

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 current 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, we have experienced, and may continue to experience, due to current economic conditions, reduced demand for the specialty services that we provide to third parties.  We are unable to predict the future impact or extent of such reduced demand.

 
30

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following table sets forth the 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 is in thousands and includes revenues for acquired centers following the date of acquisition only):

   
For the
   
For the
 
   
Three Months Ended
   
Six Months Ended
 
Sources of Revenues
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
                                                 
Consolidated:
                                               
Medicaid
  $ 190,596       40.2 %   $ 188,030       40.1 %   $ 379,920       40.1 %   $ 369,480       39.4 %
Medicare
    141,520       29.8       137,863       29.4       283,701       29.9       279,739       29.9  
Private pay and other
    118,457       25.0       117,031       25.0       235,795       24.9       235,426       25.1  
Managed care and
                                                               
 commercial insurance
    24,045       5.0       25,789       5.5       48,458       5.1       52,198       5.6  
Total
  $ 474,618       100.0 %   $ 468,713       100.0 %   $ 947,874       100.0 %   $ 936,843       100.0 %
                                                                 
Inpatient Only:
                                                               
Medicaid
  $ 190,568       45.2 %   $ 187,990       45.1 %   $ 379,855       45.1 %   $ 369,400       44.4 %
Medicare
    136,803       32.4       133,766       32.1       274,526       32.6       271,630       32.7  
Private pay and other
    70,600       16.7       69,073       16.6       139,984       16.6       138,768       16.7  
Managed care and
                                                               
 commercial insurance
    23,749       5.7       25,622       6.2       47,883       5.7       51,889       6.2  
Total
  $ 421,720       100.0 %   $ 416,451       100.0 %   $ 842,248       100.0 %   $ 831,687       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, 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, 2005, 2006 and 2010.  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.

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.  Notwithstanding this reduction in reimbursement rates for the 2010 federal fiscal year, as shown in the table below, we did experience a slight increase in our average amount of Medicare Part A revenues on a per patient, per day basis in the six months ended June 30, 2010, compared to the six months ended June 30, 2009, due to a higher acuity mix of our patient population.

In addition to the changes that affect the 2010 federal fiscal year, the rule also contained provisions for the 2011 federal fiscal year, which commences on October 1, 2010.  The changes create a RUG-IV system that contains 66 levels of care.  The basis for calculating the RUG-IV category is the Minimum Data Set (“MDS”) 3.0, a patient assessment tool, which will

 
31

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
also be implemented on October 1, 2010.  The MDS 3.0 replaces the MDS 2.0 which is the basis of the RUG-III levels of care. The RUG-IV system changes the way certain services that occur prior to the residency at a skilled nursing center impact reimbursement (known as the look back provision) and the extent to which therapy services that are delivered on a concurrent basis impact reimbursement.

A portion of the provisions of the 2010 final rule applicable to the 2011 federal fiscal year was subsequently changed by the Patient Protection and Affordable Care Act (“ACA”). ACA postponed the implementation of the RUG-IV reimbursement system but maintained the changes in the look back and concurrent therapy provisions. The House of Representatives has passed legislation that rescinds the postponement of the RUG IV implementation, but has not been passed by the Senate.

On July 16, 2010, CMS issued its final rule for skilled nursing facilities for the 2011 federal fiscal year, which commences on October 1, 2010.  This rule provides for a market basket increase of 2.3% which is reduced by a prior period market basket adjustment of  0.6%, generating a net market basket increase of 1.7%.

The rule also addressed the postponement of the implementation of RUG-IV.  If this postponement is not rescinded, CMS will implement a Hybrid RUG III system (“HR-III”).  The HR-III system will not be available for implementation on the effective date of October 1, 2010.  CMS would make payments from October 1, 2010 until the HR-III system is implemented using the RUG-IV system.  Payments would then be adjusted retroactively from the date of the HR-III implementation to October 1, 2010.

CMS has stated that it will implement either the RUG-IV or the HR-III system on a budget neutral basis. Based on this assertation, we believe that the impact of the system change will be budget neutral plus 1.7%.

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 periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
$
464.00
 
$
454.44
 
$
464.99
 
$
452.37
 

Under current law, there are limits on reimbursement provided under Medicare Part B for therapy services. An automatic exception to this limit is in place for patients residing in skilled nursing centers until December 31, 2010. In addition, therapy rates are calculated using the Physicians Fee Schedule, for which rates are subject to a reduction of 21.3% based on a statutory formula. Congress has repeatedly eliminated this reduction in prior years and has eliminated it through November 30th of the current year.

On June 25, 2010, CMS issued the Physicians Fee Schedule proposed rule for calendar year 2011.  The proposed rule expands the Multiple Procedure Payment Reduction previously applied to diagnostic procedures to physical, occupational and speech therapy services reimbursed by Medicare Part B.  The proposal reduces the reimbursement for these services by an average of 12%.  This rule is proposed and we are not able to predict the changes that will occur prior to its finalization and cannot estimate its impact on Sun’s revenue.

On July 16, 2010, CMS also issued its final rule for hospice services for the 2011 federal fiscal year. The rule includes a market basket increase of 2.6% and a 0.8% reduction reflecting the combined effects of the updated wage data and the continuation of the phase out of the wage index budget neutrality factor.

The rule also implements the ACA requirement that hospice providers adopt program eligibility recertification standards, including a requirement for a physician or nurse practitioner to have a face-to-face visit with patients prior to the 180 day recertification, and to attest that such a visit took place.  We estimate the impact of these changes will be an increase in hospice revenues of 2.2% or $1 million annually.


 
32

 
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 current 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 periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
$
173.30
 
$
171.77
 
$
173.19
 
$
170.25
 

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 periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
$
159.94
 
$
160.12
 
$
159.78
 
$
159.36
 

Managed Care and Insurance

During the three months ended June 30, 2010, we received 5.0% 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 periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
$
367.89
 
$
376.44
 
$
365.84
 
$
375.17
 

Private Payors, Veterans and Other

During the three months ended June 30, 2010, we received 25.0% 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.

 
33

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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 periods indicated:

 
For the
   
For the
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
$
188.85
 
$
178.12
 
$
189.25
 
$
178.52
 

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.

Recent Accounting Pronouncements

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 1 – “Nature of Business” to our consolidated financial statements.

 
34

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following tables set forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):

   
For the Three
   
For the Three
   
As a Percentage of Net Revenues
 
  Months Ended Months Ended            
   
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
                         
Total net revenues
  $ 474,618     $ 468,713       100.0 %     100.0 %
Costs and expenses:
                               
Operating salaries and benefits
    267,880       261,967       56.4       55.9  
Self-insurance for workers’ compensation and
                               
general and professional liabilities
    14,558       16,809       3.1       3.6  
Other operating costs (1)
    109,185       107,722       23.0       23.0  
Center rent expense
    18,810       18,215       4.0       3.9  
General and administrative expenses (2)
    17,405       15,721       3.7       3.3  
Depreciation and amortization
    12,561       11,153       2.6       2.4  
Provision for losses on accounts receivable
    5,040       6,293       1.1       1.3  
Interest, net
    11,776       12,465       2.5       2.7  
Loss on sale of assets, net
    -       40       -       -  
Income before income taxes and discontinued
                               
operations
    17,403       18,328       3.7       3.9  
Income tax expense
    7,135       7,517       1.5       1.6  
Income from continuing operations
    10,268       10,811       2.2       2.3  
Loss from discontinued operations, net
    (295 )     (715 )     (0.1 )     (0.1 )
Net income
  $ 9,973     $ 10,096       2.1 %     2.2 %
                                 
Supplemental Financial Information (3):
                               
EBITDA
  $ 41,740     $ 41,946       8.8 %     8.9 %
Adjusted EBITDA
  $ 41,740     $ 41,986       8.8 %     9.0 %
Adjusted EBITDAR
  $ 60,550     $ 60,201       12.8 %     12.8 %


 
35

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


   
For the Six
   
For the Six
   
As a Percentage of Net Revenues
 
  Months Ended Months Ended            
   
June 30, 2010
   
June 30, 2009
   
June 30, 2010
   
June 30, 2009
 
                         
Total net revenues
  $ 947,874     $ 936,843       100.0 %     100.0 %
Costs and expenses:
                               
Operating salaries and benefits
    534,918       524,878       56.4       56.0  
Self-insurance for workers’ compensation and
                               
general and professional liabilities
    29,086       31,462       3.1       3.4  
Other operating costs (1)
    218,952       216,078       23.1       23.1  
Center rent expense
    37,362       36,578       3.9       3.9  
General and administrative expenses (2)
    32,672       32,471       3.4       3.5  
Depreciation and amortization
    25,007       21,875       2.6       2.3  
Provision for losses on accounts receivable
    10,917       10,281       1.2       1.1  
Interest, net
    23,752       25,191       2.5       2.7  
Loss on sale of assets, net
    -       40       -       -  
Income before income taxes and discontinued
                               
operations
    35,198       37,989       3.7       4.1  
Income tax expense
    14,431       15,575       1.5       1.7  
Income from continuing operations
    20,767       22,414       2.2       2.4  
Loss from discontinued operations, net
    (596 )     (2,075 )     -       (0.2 )
Net income
  $ 20,171     $ 20,339       2.1 %     2.2 %
                                 
Supplemental Financial Information (3):
                               
EBITDA
  $ 83,957     $ 85,055       8.9 %     9.1 %
Adjusted EBITDA
  $ 83,957     $ 85,095       8.9 %     9.1 %
Adjusted EBITDAR
  $ 121,319     $ 121,673       12.8 %     13.0 %

(1) Operating administrative expenses are included in “other operating costs” above.

(2) General and administrative expenses include transaction costs.

(3) We define EBITDA as net income before loss from discontinued operations, interest expense (net of interest income), income tax expense, depreciation and amortization.  EBITDA margin is EBITDA as a percentage of revenue.  Adjusted EBITDA is EBITDA adjusted for the loss on sale of assets, net. 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.

 
36

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    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 and depreciation and amortization expense, 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 the centers’ lease terms and their expected Adjusted EBITDA returns.  We establish compensation and bonus programs for our center-level employees that are based upon the achievement of pre-established 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 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 in order to remain competitive in the market, 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; 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.

 
37

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES


The following table provides a reconciliation of our net income, which is the most directly comparable financial measure presented in accordance with GAAP, to EBITDA, Adjusted EBITDA and Adjusted EBITDAR for the periods indicated (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net income
  $ 9,973     $ 10,096     $ 20,171     $ 20,339  
                                 
Plus:
                               
Loss from discontinued operations
    295       715       596       2,075  
Interest expense, net
    11,776       12,465       23,752       25,191  
Income tax expense
    7,135       7,517       14,431       15,575  
Depreciation and amortization
    12,561       11,153       25,007       21,875  
EBITDA
  $ 41,740     $ 41,946     $ 83,957     $ 85,055  
                                 
Plus:
                               
Loss on sale of assets, net
    -       40       -       40  
Adjusted EBITDA
  $ 41,740     $ 41,986     $ 83,957     $ 85,095  
                                 
Plus:
                               
Center rent expense
    18,810       18,215       37,362       36,578  
Adjusted EBITDAR
  $ 60,550     $ 60,201     $ 121,319     $ 121,673  
                                 

The following discussion of the “Three Months Ended June 30, 2010 Compared to Three Months Ended June 30, 2009” is based, in part, on the financial information presented in Note 8 – “Segment Information” in our interim consolidated financial statements.

Three Months Ended June 30, 2010 Compared to Three Months Ended June 30, 2009

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $5.9 million, or 1.3%, to $474.6 million for the three months ended June 30, 2010 from $468.7 million for the three months ended June 30, 2009.  We reported net income for the three month periods ended June 30, 2010 and 2009 of $10.0 million  and $10.1 million, respectively.

The increase in net revenues for the 2010 period included $5.2 million of additional revenue in our Inpatient Services segment primarily due to higher Medicare hospice, Medicaid and veterans customer bases plus the October 2009 acquisition of a hospice company.  A $6.6 million increase in revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes and billing rates, also contributed to the increase in net revenues.  These increases were partially offset by lower customer bases in our Medicare Part A and Part B, managed care and commercial insurance programs coupled with a $3.3 million decrease in revenue from our Medical Staffing segment, mainly due to a decrease in billable therapy and pharmacy hours plus reduced fees from temporary placement of physicians.

Operating salaries and benefits increased $5.9 million, or 2.3%, to $267.9 million (56.4% of net revenues) for the three months ended June 30, 2010 from $262.0 million (55.9% of net revenues) for the three months ended June 30, 2009.  The increase resulted primarily from a $5.3 million increase in our Rehabilitation Therapy segment driven by increased service volume and wage rate increases and a $2.2 million increase in our Inpatient Services segment driven by health insurance

 
38

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
costs and wage increases. These increases were offset by a $1.6 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the therapy staffing and pharmacy business.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $2.3 million, or 13.4%, to $14.6 million (3.1% of net revenues) for the three months ended June 30, 2010 from $16.8 million (3.6% of net revenues) for the three months ended June 30, 2009, primarily due to decreased claims related activity in our general and professional liability programs.

Other operating costs increased $1.5 million, or 1.4%, to $109.2 million (23.0% of net revenues) for the three months ended June 30, 2010 from $107.7 million (23.0% of net revenues) for the three months ended June 30, 2009.  The increase was primarily due to provider taxes and increased therapy costs in our Inpatient Services segment resulting from an increase in higher acuity patients requiring more rehabilitation therapy.

Center rent expense increased $0.6 million, or 3.3%, to $18.8 million (4.0% of net revenues) for the three months ended June 30, 2010 from $18.2 million (3.9% of net revenues) for the three months ended June 30, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

General and administrative expenses increased $1.7 million, or 10.8%, to $17.4 million (3.7% of net revenues) for the three months ended June 30, 2010 from $15.7 million (3.3% of net revenues) for the three months ended June 30, 2009.  The increase was primarily due to transaction costs incurred for the proposed restructuring.

Depreciation and amortization increased $1.4 million, or 12.6%, to $12.6 million (2.6% of net revenues) for the three months ended June 30, 2010 from $11.2 million (2.4% of net revenues) for the three months ended June 30, 2009.  The increase was attributable to additional depreciation expense for property and equipment placed into service since the year ago period.

The provision for losses on accounts receivable decreased $1.3 million, or 19.9%, to $5.0 million (1.1% of net revenues) for the three months ended June 30, 2010 from $6.3 million (1.3% of net revenues) for the three months ended June 30, 2009.  The decrease resulted from improving cash collections trends experienced in the three months ended June 30, 2010 when compared to the three months ended June 30, 2009.  These cash collection trends improved our accounts receivable aging, leading to a reduction in our provision for losses on accounts receivable for the three months ended June 30, 2010 when compared to the three months ended June 30, 2009.

Net interest expense decreased $0.7 million, or 5.5%, to $11.8 million (2.5% of net revenues) for the three months ended June 30, 2010 from $12.5 million (2.7% of net revenues) for the three months ended June 30, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended June 30 (dollars in thousands):

   
2010
   
2009
 
                         
Inpatient Services
  $ 421,720       88.8 %   $ 416,451       88.8 %
Rehabilitation Therapy Services
    51,051       10.8       44,515       9.5  
Medical Staffing Services
    23,371       4.9       26,660       5.7  
Corporate
    6       -       10       -  
Intersegment Eliminations
    (21,530 )     (4.5 )     (18,923 )     (4.0 )
                                 
Total net revenues
  $ 474,618       100.0 %   $ 468,713       100.0 %


 
39

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

    Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended June 30 (in thousands):

   
2010
   
2009
 
             
Rehabilitation Therapy Services
  $ 21,034     $ 18,360  
Medical Staffing Services
    496       563  
Total intersegment revenue
  $ 21,530     $ 18,923  

The following table sets forth the amount of net segment income for the three months ended June 30 (in thousands):

   
2010
   
2009
 
             
Inpatient Services
  $ 39,013     $ 38,810  
Rehabilitation Therapy Services
    3,921       3,111  
Medical Staffing Services
    1,802       2,289  
Net segment income before Corporate
    44,736       44,210  
Corporate
    (27,333 )     (25,842 )
Net segment income
  $ 17,403     $ 18,368  

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 income tax expense and discontinued operations. Net segment income for the three months ended June 30, 2010 for (1) our Inpatient Services segment increased $0.2 million, or 0.5%, to $39.0 million, (2) our Rehabilitation Therapy Services segment increased $0.8 million, or 26.0%, to $3.9 million and (3) our Medical Staffing Services segment decreased $0.5 million, or 21.3%, to $1.8 million in comparison to the three months ended June 30, 2009, 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 $5.2 million, or 1.2%, to $421.7 million for the three months ended June 30, 2010 from $416.5 million for the three months ended June 30, 2009.  The increase was primarily the result  of:

-
a $5.1 million increase in hospice revenues resulting from an October 2009 acquisition of a hospice company and a higher customer base;
   
-
an increase of $2.9 million in Medicaid revenues consisting of $1.5 million related to improved rates, which were significantly offset by increased provider tax expense (as discussed below), and $1.4 million from an increase in customer base; and
   
-
a $1.0 million increase in private pay and other revenues, primarily resulting from higher veterans customer base;
   
 
Offset in part by:
   
-
a decrease of $1.7 million in Medicare revenues as a result of a $3.8 million decrease in revenues due to a lower customer base and a $0.3 million decrease in Medicare Part B revenues, partially offset by a $2.4 million increase in revenues from higher Medicare Part A rates; and
   
-
a $2.1 million decrease in managed care and commercial insurance revenues driven by lower customer base, which contributed $1.3 million of the decrease, and lower rates, which drove the remaining $0.8 million of the decrease.


 
40

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Operating salaries and benefits expenses increased $2.3 million, or 1.1%, to $208.8 million for the three months ended June 30, 2010 from $206.5 million for the three months ended June 30, 2009.  The increase was attributable to the following:

-
an increase of $1.8 million in health insurance expense; and
   
-
wage increases and related benefits and taxes of $1.0 million;
   
 
Offset in part by:
   
-
a decrease of $0.5 million in overtime pay.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $2.1 million, or 13.3%, to $13.7 million for the three months ended June 30, 2010 as compared to $15.8 million for the three months ended June 30, 2009, which was driven by decreased claims related activity in our general and professional liability programs.

Other operating costs increased $4.7 million, or 4.4%, to $112.1 million for the three months ended June 30, 2010 from $107.4 million for the three months ended June 30, 2009.  The increase was attributable to the following:

-
a $1.9 million increase in provider taxes;
   
-
a $1.1 million increase in contract labor driven by therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;
   
-
a $1.1 million increase in purchased services primarily related to housekeeping contracts;
   
-
a $0.4 million decrease in rebates and vendor cash discounts; and
   
-
a $0.2 million increase in brochures and forms.

Operating administrative expenses remained at $10.7 million for the three months ended June 30, 2010 compared to the three months ended June 30, 2009, primarily due to lower aggregate salaries offset by the higher cost of benefits.

The provision for losses on accounts receivable decreased $1.2 million, or 19.7%, to $4.9 million for the three months ended June 30, 2010 from $6.1 million for the three months ended June 30, 2009.  The decreased expense is due to improving cash collections trends experienced in the three months ended June 30, 2010 when compared to the three months ended June 30, 2009.  These cash collection trends improved our accounts receivable aging, leading to a reduction in our provision for losses on accounts receivable for the three months ended June 30, 2010 when compared to the three months ended June 30, 2009.

Center rent expense increased $0.6 million, or 3.4%, to $18.5 million for the three months ended June 30, 2010 from $17.9 million for the three months ended June 30, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

Depreciation and amortization increased $1.3 million, or 12.9%, to $11.4 million for the three months ended June 30, 2010 from $10.1 million for the three months ended June 30, 2009.  The increase was attributable to depreciation of additional property and equipment placed into service during the period.

Net interest expense decreased $0.4 million, or 12.9%, to $2.7 million for the three months ended June 30, 2010 from $3.1 million for the three months ended June 30, 2009.  The decrease is a result of lower interest rates and lower aggregate borrowings.

 
41

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $6.6 million, or 14.8%, to $51.1 million for the three months ended June 30, 2010 from $44.5 million for the three months ended June 30, 2009. The revenue increase was the result of:

-
an increase of $5.4 million attributable to increased billable minutes, due in part to the addition of 19 new contracts, net of lost contracts;
   
-
an increase of $1.0 million attributable to a higher revenue per minute rate due to our renegotiation of certain customer contract rates and a shift in payor mix; and
   
-
an increase of $0.2 million in other revenue, primarily related to contract management fees.

Operating salaries and benefits expenses increased $5.3 million, or 14.4%, to $42.1 million for the three months ended June 30, 2010 from $36.8 million for the three months ended June 30, 2009.  The increase was primarily driven by the increase in service volume mentioned above coupled with wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $3.3 million, or 12.4%, to $23.4 million for the three months ended June 30, 2010 from $26.7 million for the three months ended June 30, 2009.  The decrease was primarily the result of:

-
a decrease of $2.0 million due to a decline for therapy and pharmacy staffing hours; and
 
-
a decrease of $1.3 million due to lower fees earned from the temporary placement of physicians.

Operating salaries and benefits expenses decreased $1.6 million, or 8.6%, to $17.0 million for the three months ended June 30, 2010 as compared to $18.6 million for the three months ended June 30, 2009.  The decrease in operating salaries and benefits is a direct result of the decline in staffing levels for our therapy staffing and temporary physicians.

Corporate

General and administrative expenses not directly attributed to segments increased $1.7 million, or 10.8%, to $17.4 million for the three months ended June 30, 2010 from $15.7 million for the three months ended June 30, 2009.  The increase was primarily due to transaction costs incurred for the proposed restructuring.

Interest expense

Interest expense not directly attributed to operating segments decreased $0.3 million, or 3.2%, to $9.1 million for the three months ended June 30, 2010 from $9.4 million for the three months ended June 30, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since June 30, 2009.


 
42

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $11.0 million, or 1.2%, to $947.9 million for the six months ended June 30, 2010 from $936.8 million for the six months ended June 30, 2009. We reported net income for the six month periods ended June 30, 2010 and 2009 of $20.2 million and $20.3 million, respectively.

The increase in net revenues for the 2010 period included $10.6 million of additional revenue in our Inpatient Services segment primarily due to increases in rates from Medicare Part A and Medicaid, although the Medicaid rate increases were significantly offset by increased provider taxes.  Higher Medicaid,  managed care, commercial insurance and Medicare hospice customer bases, the October 2009 acquisition of a hospice company and a $13.3 million increase in revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes and billing rates, also contributed to the increase in net revenues.  This increase was partially offset by lower Medicare Part A and Part B, managed care and commercial insurance customer bases, coupled with a $7.7 million decrease in revenue from our Medical Staffing segment, mainly due to a decrease in billable nursing hours.

Operating salaries and benefits increased $10.0 million, or 1.9%, to $534.9 million (56.4% of net revenues) for the six months ended June 30, 2010 from $524.9 million (56.0% of net revenues) for the six months ended June 30, 2009.  The increase resulted primarily from a $10.8 million increase in our Rehabilitation Therapy segment driven by increased service volume and wage rate increases and a $3.4 million increase in our Inpatient Services segment driven by health insurance costs and wage increases. These increases were offset by a $4.1 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the therapy staffing and pharmacy business.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $2.4 million, or 7.6%, to $29.1 million (3.1% of net revenues) for the six months ended June 30, 2010 from $31.5 million (3.4% of net revenues) for the six months ended June 30, 2009, primarily due to decreased claims related activity in our general and profession liability programs.

Other operating costs increased $2.9 million, or 1.3%, to $219.0 million (23.1% of net revenues) for the six months ended June 30, 2010 from $216.1 million (23.1% of net revenues) for the six months ended June 30, 2009.  The increase was primarily due to provider taxes and increased therapy costs in our Inpatient Services segment resulting from an increase in higher acuity patients requiring more rehabilitation therapy.

Center rent expense increased $0.8 million, or 2.1%, to $37.4 million (3.9% of net revenues) for the six months ended June 30, 2010 from $36.6 million (3.9% of net revenues) for the six months ended June 30, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

General and administrative expenses increased $0.2 million, or 0.6%, to $32.7 million (3.4% of net revenues) for the six months ended June 30, 2010 from $32.5 million (3.5% of net revenues) for the six months ended June 30, 2009.  The increase was primarily due to transaction costs incurred for the proposed restructuring, offset by decreases in salaries and benefits resulting from restructuring efforts undertaken in 2009.

Depreciation and amortization increased $3.1 million, or 14.3%, to $25.0 million (2.6% of net revenues) for the six months ended June 30, 2010 from $21.9 million (2.3% of net revenues) for the six months ended June 30, 2009.  The increase was attributable to additional depreciation expense for property and equipment acquired during the period.

The provision for losses on accounts receivable increased $0.6 million, or 6.2%, to $10.9 million (1.2% of net revenues) for the six months ended June 30, 2010 from $10.3 million (1.1% of net revenues) for the six months ended June 30, 2009.  The increase resulted from increased credit risk associated with slower cash collections experienced in the six months ended June 30, 2010 when compared with the six months ended June 30, 2009.

 
43

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Net interest expense decreased $1.4 million, or 5.7%, to $23.8 million (2.5% of net revenues) for the six months ended June 30, 2010 from $25.2 million (2.7% of net revenues) for the six months ended June 30, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the six months ended June 30 (dollars in thousands):

   
2010
   
2009
 
                         
Inpatient Services
  $ 842,248       88.9 %   $ 831,687       88.8 %
Rehabilitation Therapy Services
    101,568       10.7       88,247       9.4  
Medical Staffing Services
    46,871       4.9       54,594       5.8  
Corporate
    14       -       14       -  
Intersegment Eliminations
    (42,827 )     (4.5 )     (37,699 )     (4.0 )
                                 
Total net revenues
  $ 947,874       100.0 %   $ 936,843       100.00 %

Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the six months ended June 30 (in thousands):

   
2010
   
2009
 
             
Rehabilitation Therapy Services
  $ 42,187     $ 36,576  
Medical Staffing Services
    640       1,123  
Total intersegment revenue
  $ 42,827     $ 37,699  

The following table sets forth the amount of net segment income for the six months ended June 30 (in thousands):

   
2010
   
2009
 
             
Inpatient Services
  $ 76,771     $ 80,604  
Rehabilitation Therapy Services
    7,797       6,000  
Medical Staffing Services
    3,283       4,310  
Net segment income before Corporate
87,851       90,914  
Corporate
    (52,653 )     (52,885 )
Net segment income
  $ 35,197     $ 38,029  

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 income tax expense and discontinued operations. Net segment income for the six months ended June 30, 2010 for (1) our Inpatient Services segment decreased $3.8 million, or 4.8%, to $76.8 million, (2) our Rehabilitation Therapy Services segment increased $1.8 million, or 30.0%, to $7.8 million and (3) our Medical Staffing Services segment decreased $1.0 million, or 23.8%, to $3.3 million in comparison to the six months ended June 30, 2009, 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. 

 
44

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

Net revenues increased $10.5 million, or 1.3%, to $842.2 million for the six months ended June 30, 2010 from $831.7 million for the six months ended June 30, 2009.  The increase was primarily the result of:

-
an increase of $11.2 million in Medicaid revenues consisting of $6.2 million related to improved rates, which were significantly offset by increased provider tax expense (as discussed below), and $5.0 million from an increase in customer base; and
   
-
a $10.4 million increase in hospice revenues resulting from an October 2009 acquisition of a hospice company and a higher customer base;
   
 
Offset in part by:
   
-
a decrease of $6.6 million in Medicare revenues as a result of a $12.3 million decrease in revenues due to a lower customer base and a $0.7 million decrease in Medicare Part B revenues, partially offset by a $6.4 million increase in revenues from higher Medicare Part A rates;
   
-
a $4.3 million decrease in managed care and commercial insurance revenues driven by lower customer base, which contributed $2.8 million of the decrease, and lower rates, which drove the remaining $1.5 million of the decrease; and
   
-
a $0.2 million decrease in private pay and other revenues, primarily resulting from lower customer base.

Operating salaries and benefits expenses increased $3.3 million, or 0.8%, to $416.9 million for the six months ended June 30, 2010 from $413.6 million for the six months ended June 30, 2009.  The increase was attributable to the following:

-
an increase of $3.6 million in health insurance expense; and
   
-
wage increases and related benefits and taxes of $1.7 million;
   
 
Offset in part by:
   
-
a decrease of $2.0 million in overtime pay.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $2.0 million, or 6.8%, to $27.5 million for the six months ended June 30, 2010 as compared to $29.5 million for the six months ended June 30, 2009, which was driven by decreased claims related activity in our general and professional liability programs.

Other operating costs increased $9.8 million, or 4.5%, to $225.5 million for the six months ended June 30, 2010 from $215.7 million for the six months ended June 30, 2009.  The increase was attributable to the following:

-
a $5.8 million increase in provider taxes;
   
-
a $2.3 million increase in contract labor driven by therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy; and
   
-
a $1.7 million increase in purchased services primarily related to housekeeping contracts.

Operating administrative expenses decreased $0.5 million, or 2.4%, to $20.1 million for the six months ended June 30, 2010 from $20.6 million for the six months ended June 30, 2009, primarily due to lower aggregate salaries and benefits.

The provision for losses on accounts receivable increased $0.7 million, or 7.1%, to $10.5 million for the six months ended June 30, 2010 from $9.8 million for the six months ended June 30, 2009.  The increase resulted from increased credit

 
45

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
risk associated with slower cash collections experienced in the six months ended June 30, 2010 when compared with the six months ended June 30, 2009.

Center rent expense increased $0.8 million, or 2.2%, to $36.7 million for the six months ended June 30, 2010 from $35.9 million for the six months ended June 30, 2009.  The increase is attributable to additional offices for a hospice operation we acquired in 2009.

Depreciation and amortization increased $2.9 million, or 14.6%, to $22.7 million for the six months ended June 30, 2010 from $19.8 million for the six months ended June 30, 2009.  The increase was attributable to depreciation of additional property and equipment placed into service since the year ago period.

Net interest expense decreased $0.8 million, or 12.7%, to $5.5 million for the six months ended June 30, 2010 from $6.3 million for the six months ended June 30, 2009.  The decrease is a result of lower interest rates and lower aggregate borrowings.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $13.4 million, or 15.2%, to $101.6 million for the six months ended June 30, 2010 from $88.2 million for the six months ended June 30, 2009. The revenue increase was the result of:

-
an increase of $10.6 million attributable to increased billable minutes, due in part to the addition of 19 new contracts, net of lost contracts;
   
-
an increase of $2.2 million attributable to a higher revenue per minute rate due to our renegotiation of certain customer contract rates and a shift in payor mix; and
   
-
an increase of $0.6 million in other revenue, primarily related to contract management fees.

Operating salaries and benefits expenses increased $10.8 million, or 14.8%, to $83.8 million for the six months ended June 30, 2010 from $73.0 million for the six months ended June 30, 2009.  The increase was primarily driven by the increase in service volume mentioned above coupled with wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $7.7 million, or 14.1%, to $46.9 million for the six months ended June 30, 2010 from $54.6 million for the six months ended June 30, 2009.  The decrease was primarily the result of:

-
a decrease of $4.4 million due to a decline for therapy and pharmacy staffing hours;
   
-
a decrease of $1.9 million due to lower fees earned from the temporary placement of physicians;
   
-
a decrease of $1.2 million attributable to a decline in nurse staffing hours; and
   
-
a decrease of $0.1 million related to closed offices.

Operating salaries and benefits expenses decreased $4.1 million, or 10.7%, to $34.2 million for the six months ended June 30, 2010 as compared to $38.3 million for the six months ended June 30, 2009.  The decrease in operating salaries and benefits is a direct result of the decline in staffing levels for our nurse staffing, therapy staffing, pharmacy businesses and temporary physicians.

 
46

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Corporate

General and administrative expenses not directly attributed to segments increased $0.2 million, or 0.6%, to $32.7 million for the six months ended June 30, 2010 from $32.5 million for the six months ended June 30, 2009.  The increase was primarily due to transaction costs incurred for the proposed restructuring, offset by decreases in salaries and benefits resulting from restructuring efforts taken in 2009.

Interest expense

Interest expense not directly attributed to operating segments decreased $0.7 million, or 3.7%, to $18.2 million for the six months ended June 30, 2010 from $18.9 million for the six months ended June 30, 2009 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since March 31, 2009.

Liquidity and Capital Resources

For the three and six months ended June 30, 2010, our net income was $10.0 million and $20.2 million, respectively.  As of June 30, 2010, our working capital was $142.4 million and we had cash and cash equivalents of $107.0 million and $663.6 million in borrowings.  On June 30, 2010, we amended our credit agreement, described below under “Loan Agreements.”  One of the changes effected by the amendment was a $25.0 million decrease in our letter of credit facility, and the consequent use of our revolving credit facility for $24.7 million of undrawn letters of credit.  Accordingly, $25.3 million is available for drawing under our revolving credit facility at June 30, 2010.  As of June 30, 2010, 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 $31.2 million for the three months ended June 30, 2010 and $69.3 million for the six months ended June 30, 2010), 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 our 2009 Form 10-K 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 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.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

Prior to completion of the Separation, New Sun will enter into debt agreements that potentially will be secured by substantially all of its assets (other than assets securing mortgage indebtedness). The amount of indebtedness that New Sun will incur will depend on the net cash generated by Sun between July 1, 2010 and the Separation. The actual amount of indebtedness to be incurred by New Sun could decrease if Sun’s cash position at the time the debt agreements are entered into is greater than Sun’s cash position as of June 30, 2010 together with the anticipated net proceeds of an equity offering that Sun anticipates it will complete before the debt agreements are entered into or, conversely, could increase if Sun’s cash position at the time the debt agreements are entered into is less than Sun’s cash position as of June 30, 2010 together with the anticipated net proceeds of the equity offering. It is anticipated that the debt agreements will contain customary covenants that will include restrictions on New Sun’s ability to make acquisitions and other investments, pay dividends, incur additional indebtedness and make capital expenditures as well as customary events of default. The Senior Subordinated Notes and the outstanding term loans under Sun’s Credit Agreement will be repaid at the same time that the debt agreements

 
47

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
are entered into by New Sun from the net proceeds to be borrowed by New Sun under these debt agreements, the net proceeds of the indebtedness to be incurred by Sabra prior to completion of the Separation, and Sun’s cash on hand.

Cash Flows

During the three months ended June 30, 2010, net cash provided by operating activities increased by $16.4 million as compared to the same period last year.  In spite of decreased net income of $0.1 million, the increase in cash flows from operating activities was the result of (i) our quarter-over-quarter increase in working capital changes of $15.9 million, driven by changes in accounts receivable, including a $3.8 million impact of additional efforts made to collect Medicare bad debt claims, prepaid expenses and other assets, income taxes payable, accrued compensation and benefits and other liabilities and (ii) a $0.6 million increase in non-cash adjustments to net income, principally related to depreciation and amortization.

Net cash used for investing activities of $10.7 million for the three months and $27.7 million for the six months ended June 30, 2010 were for capital expenditures.

Net cash used for financing activities was $16.0 million of repayments of long-term debt for the three months ended June 30, 2010.  We anticipate refinancing a significant portion of the repaid indebtedness during the third quarter of 2010.  Net cash used for financing activities during the six months ended June 30, 2010 of $39.1 million is comprised of (i) $37.0 million used to repay long-term debt and capital lease obligations and (ii) $2.1 million paid to a non-controlling interest.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $10.7 million and $13.1 million for the three months ended June 30, 2010 and 2009, respectively, and $27.7 million and $25.0 million for the six months ended June 30, 2010 and 2009, respectively.

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.  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 9 – “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 administrative agent and collateral agent (as amended in June 2010, the “Credit Agreement”) in connection with an acquisition.  The June 2010 amendment increased the permitted amount of expenditures for acquisitions, modified certain financial covenants, required a $25.0 million minimum principal repayment by December 31, 2010, decreased our letter of credit facility by $25.0 million and increased interest rates (as stated below).  The Credit Agreement provides for $365.0 million in term loans (of which $308.6 million was outstanding at June 30, 2010), a $50.0 million revolving credit facility ($24.7 million utilized for letters of credit, but otherwise undrawn at June 30, 2010) and a $45.0 million letter of credit facility ($45.0 million outstanding at June 30, 2010).  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 June 30, 2010.  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 certain actions, including 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.

 
48

 
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 2.0% for alternative base rate loans and 3.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 2.0% for alternative base rate revolving loans and up to 3.0% for LIBOR rate revolving loans based on our total leverage ratio.  The applicable percentages for alternative base rate loans and LIBOR loans will increase by an additional 1.0% on January 1, 2011.  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 $18.9 million and $8.5 million in the six months ended June 30, 2010 and 2009, respectively.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk because we have issued 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 of interest on our debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

                                             
Fair Value
   
Fair Value
 
   
Expected Maturity Dates
 
   June 30,
 
December 31,
 
   
2011
   
2012
   
2013
   
2014
   
2015
   
Thereafter
   
Total
   
2010 (1)
   
2009 (1)
 
     
(Dollars in thousands)
     
Long-term debt:
                                                     
Fixed rate debt (2)
$
38,533
 
$
4,587
 
$
4,675
 
$
162,824
 
$
201,590
 
$
67,308
 
$
479,519
 
$
359,033
 
$
442,992
 
Rate
 
7.6
%
 
7.2
%
 
7.1
%
 
6.8
%
 
9.1
%
 
6.1
%
                 
                                                       
Variable rate debt
$
36,292
 
$
1,533
 
$
1,533
 
$
144,019
 
$
-
 
$
-
 
$
183,377
 
$
178,559
 
$
202,442
 
Rate
 
3.2
%
 
2.6
%
 
2.6
%
 
2.6
%
 
-
%
 
-
%
                 
                                                       
Interest rate swaps:
                                                     
Variable to fixed
$
150,000
 
$
-
 
$
-
 
$
-
 
$
-
 
$
-
       
$
1,701
 
$
(5,048
)
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 4.  CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”), as amended, as controls and procedures that are designed to ensure that information required to be disclosed by an 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 principal executive and principal financial officers, or persons performing similar functions, 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 our Chief Executive Officer, Richard Matros, and our Chief Financial Officer, L. Bryan Shaul, of the effectiveness of the Company’s disclosure controls and procedures.  Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2010.

 
49

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

There were no changes in our internal control over financial reporting occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

For a description of our legal proceedings, see Note 7(a) – “Other Events – Litigation” of our consolidated financial statements included in this 10-Q, which is incorporated by reference to this item.

ITEM 1A.  RISK FACTORS

Except for the addition of the risk factors below, there have been no material changes in our assessment of our risk factors from those set forth in our 2009 Form 10-K as updated by our Form 10-Q for the quarter ended March 31, 2010.

The Separation and REIT Conversion Merger may not be completed, which may harm our business, financial position or results of operations.

On May 24, 2010, we announced that we intend to restructure our business by separating our real estate assets and our operating assets into two separate publicly traded companies. The proposed transactions are highly complex and the completion of the transactions may require significant time, effort and expense. This could lead to a distraction from the day to day operations of our business, which could adversely affect our operations.

Although our board of directors has unanimously approved the Separation and REIT Conversion Merger, the completion of the Separation and REIT Conversion Merger is subject to a number of conditions, and there is no assurance that all of the conditions to these transactions will be met or waived and that the Separation and REIT Conversion Merger will be completed. In addition, we reserve the right to abandon, defer or modify the Separation and REIT Conversion Merger at any time, even if our stockholders approve the Separation and REIT Conversion Merger, if our board of directors determines for any reason that these transactions are no longer in the best interests of Sun and our stockholders.

If the Separation and REIT Conversion Merger are not completed for any reason, our business may be harmed in a number of ways, including the following:

 
·
the market price of our common stock may decline to the extent that the current market price reflects a market assumption that the Separation and REIT Conversion Merger will be completed;
 
 
·
an adverse reaction from investors and potential investors may reduce our future financing opportunities;
 
 
·
the pending Separation and REIT Conversion Merger may cause us to defer or potentially lose business opportunities; and
 
 
·
costs related to the transactions, including legal and accounting fees and certain fees payable to our financial advisors, must be paid even if the Separation and REIT Conversion Merger are not completed.
 

Environmental compliance costs and liabilities associated with our centers may have a material adverse effect on our business, financial position or results of operations.

We are subject to various federal, state and local environmental and health and safety laws and regulations with respect to our centers. These laws and regulations address various matters, including asbestos, polychlorinated biphenyls, fuel oil management, wastewater discharges, air emissions, radioactive materials, medical wastes and hazardous wastes. The costs of complying with these laws and regulations and the penalties for non-compliance can be substantial. For example, with
 
50

 
 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES
 
respect to our owned and leased property, we may be held liable for costs relating to the investigation and clean up of any property from which there has been a release or threatened release of a regulated material and any other affected properties. In addition to these costs, which are typically not limited by law or regulation and could exceed the property’s value, we could be liable for certain other costs, including governmental fines and injuries to persons, property or natural resources. Further, some environmental laws create a lien on the contaminated site in favor of the government for damages and the costs it incurs in connection with the contamination.  Such environmental compliance costs and liabilities may have a material adverse effect on our business, financial position or results of operations.

ITEM 6. EXHIBITS

3.1
Certificate of Designations, Rights and Preferences of the Series A Junior Participating Preferred Stock, as filed with the Secretary of State of the State of Delaware on May 24, 2010 (incorporated herein by reference to Exhibit 3.3 of the Company’s registration statement on Form 8-A, filed with the Securities and Exchange Commission on May 24, 2010).
   
4.1
Rights Agreement, dated May 24, 2010, between Sun Healthcare Group, Inc. and American Stock Transfer & Trust Company, LLC (incorporated herein by reference to Exhibit 4.1 of the Company’s registration statement on Form 8-A, filed with the Securities and Exchange Commission on May 24, 2010).
   
10.1
Amendment No. 1 to Credit Agreement, dated June 30, 2010 among Sun Healthcare Group, Inc., the Lenders named therein and Credit Suisse, as Administrative Agent and Collateral Agent for the Lenders
   
31.1
Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
   
31.2
Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
   
32.1
Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
   
32.2
Section 906 Sarbanes-Oxley Certification by Chief Financial Officer


SIGNATURE

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

SUN HEALTHCARE GROUP, INC.
 
 
 
By:  /s/ L. Bryan Shaul                                        
L. Bryan Shaul
Executive Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

July 29, 2010

 
51